401(k) Plan Administrators: Be Very Afraid!

A recent decision of the Federal Ninth Circuit Court of Appeals should give pause to anyone who administers a 401(k) plan or other employee benefit plan subject to the Employee Retirement Income Security Act (“ERISA”).  In Tibble v. Edison Int’l, 10-cv-56406, 2013 WL 1174167 (9th Cir. Mar. 21, 2013), the court ruled that 401(k) plan fiduciaries breached their duty of prudence in the selection of investment options because their reliance on a consultant’s advice was unreasonable. The court said that plan fiduciaries must make certain that their reliance on a consultant’s advice is reasonably justified and they cannot “reflexively and uncritically adopt [a consultant’s] recommendations.”   The court did not say how to determine whether such reliance is “reasonably justified”.   Problem is, the issue will only arise when plan participants have suffered losses and, with the benefit of hindsight, a plaintiff’s lawyer will call into question the soundness of the consultant’s advice and the reliance placed on such advice by the plan administrators.

As background, ERISA, a federal law enacted into law in 1974, contains requirements for the administration of employee benefit plans.   Employee benefit plans include pension plans and welfare plans.  A pension plan means any plan, fund or program that provides retirement income to employees or the deferral of income for a period extending to the termination of employment.  The most common employer-administered pension plan is a 401(k) plan.  The term “welfare plan” means a plan that provides benefits such as healthcare benefits or long-term disability plans.

ERISA creates fiduciary duties for administrators of ERISA plans and imposes personal liability for breach of those duties.  In most corporations with 401(k) plans, the plan is administered by a committee consisting of officers of the corporation.  Each member of the committee is an “administrator” of the plan under ERISA and therefore has fiduciary duties.

Among the fiduciary duties of plan administrators, the most subjective is the “prudent man rule”, i.e., a fiduciary must act “with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity” would act.  While this sounds like an objective standard, it is really quite ambiguous.  There are “prudent men” who male speculative investments every day.  Offering many of those investments to 401(k) participants would probably be a breach of a plan administrator’s fiduciary duty.  Moreover, most plan administrators lack the experience and knowledge to choose among the wide range of investment options available today.  Hence, most plan administrators hire a financial consultant to advise them.  ERISA not only allows this, it expressly requires it:  if a fiduciary lacks the expertise for a certain area then the fiduciary must obtain expert help.  29 U.S.C. §1104 (a)(1)(B).  Typically, a 401(k) plan will offer a range of investment choices to plan participants and the plan administrators will hire a financial consultant to recommend this range of diversified investment options.   A very important issue raised by the Tibble case is the extent to which plan administrators can rely on advice on financial consultants.

To summarize the facts, Edison International, a California utility, offered its employees investment options in the company’s 401(k) plan, including three retail-class mutual funds. Edison’s 401(k) investment options did not include lower-fee institutional-class funds available from the same investment firm.  The trial court found that the Edison plan fiduciaries did not properly investigate the alternative of offering these institutional-class funds. The Ninth Circuit affirmed.

The court did not accept the plaintiffs’ argument that retail-class mutual funds are an imprudent investment option for an ERISA plan, despite the fact that institutional-class funds charge lower fees.  The court emphasized that retail-class mutual funds have certain advantages, such as participant familiarity and the ready availability of public information on the fund’s performance.  However, the court found that it was imprudent to not consider the option of institutional-class funds.  There was no evidence that Edison or its adviser had investigated the option of institutional-class funds.  Edison argued that it had acted prudently because it based its decision on advice received from Hewitt, which had been retained to provide advisory services to the plan. The Ninth Circuit rejected this argument, stating that expert advice does not absolve a fiduciary of responsibility: “Just as fiduciaries cannot blindly rely on counsel . . . or on credit rating agencies . . .  a firm in Edison’s position cannot reflexively and uncritically adopt investment recommendations.”

Edison also argued that it was not liable because the plan participants who suffered losses had made their own investment decisions.  This defense was based on Section 404(c) of ERISA, which precludes breach of fiduciary duty claims in situations involving decisions made by plan participants.  The Ninth Circuit rejected this argument, saying that section 404(c) only protects fiduciaries from losses that are a “direct and necessary result” of a participant’s action. In other words, if the plan fiduciaries act imprudently when they create the investment options, they cannot later argue that they not liable for the participants’ losses because the participants made the wrong choices.

The Ninth Circuit opinion in the Tibble case, although 50 pages long, is not very helpful on the issue of how plan administrators should ‘investigate’ the investment options recommended by a financial consultant.  What does it mean to say that a fiduciary cannot ‘reflexively and uncritically’ rely on a consultant?  Presumably, it means asking questions.  But does a non-expert know what questions to ask of an expert, apart from “Have you presented all the available options?” and “What else do we need to know to make an informed decision?”  Of course, it will now be common to ask about institutional-class funds and other investment choices with more favorable fee structures, but that is only one issue out of many that a fiduciary could ‘investigate’.  At a minimum, plan administrators should require the financial consultant to thoroughly document its advice, including reference to all the criteria that might be important to plan participants.   Perhaps the company’s legal counsel should prepare a list of the challenges that have been raised by plaintiffs’ lawyers in the many published cases that have been brought against plan adminsitrators, and to question the consultant on how these challenges are address in company’s plan.  Of course, all of this should be part of a written record that can later be used, if necessary, to show that a proper ‘investigation’ was conducted by the plan administrators.

To repeat a point made earlier, ERISA plan administrators have personal liability if they breach their fiduciary duty and plan participants suffer a loss as a result.  If you are on the committee that administers your employer’s 401(k) plan, it would be a good idea to check the company’s indemnification provisions for officers and directors. A “prudent man” would do no less.

Law Offices of Roger D. Wiegley




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Ten Things to Consider When Forming a Joint Venture

1.         Know your partner.    This is obvious.  Go beyond the obvious.  Do as much research as you can so that you understand the corporate culture of the party you will be partnering with.  Do not assume that the individuals you have been talking to at your prospective partner have the same values and vision as the organization they represent.  Has the organization done joint ventures before?  What were the results?  Can you talk to someone at their former partners?  There is more at risk than the hoped for financial results.  Your reputation can be adversely affected by the acts of your partner, even acts that are not directly related to the joint venture itself.

2.         Know your partner’s national culture.  If your partner is located in a country other than your own, invest the time to learn how your partner’s national culture could affect your joint venture.  Learn business etiquette in your partner’s country.  Learn how contracts are perceived, how problems are solved and how partners are expected to behave in your partner’s culture, even if the location of the joint venture operations is elsewhere.  Cultural values and perspectives shape the way people think and act, and the only certainty is that every culture is different.  The more diverse the cultures of the two partners, the more likely it is that unexpected disagreements will develop. This is not a simple undertaking but it is worth the effort.

3.         Decide on the respective roles in detail at the start.   Do not assume that a general description of a partner’s role implies that all related tasks are included in the role.  Create a list of tasks—both expected and those arising in the event of possible contingencies—and assign them to the respective partners.  If there are tasks that neither partner can or will perform, choose the third-party contractors for those tasks before the venture is formed or at least have a clearly defined selection procedure.  This list of assigned roles should include less-than-obvious responsibilities such as risk management and emergency planning.  If the management team of the joint venture is responsible for these areas, this should be clearly delineated and written policies should be required.  Shared management responsibility sometimes results in circular finger pointing when things go wrong.

4.         Discuss contingencies before the agreement is signed.  The only constant in this world is change.  Discuss the “what if’s” with your prospective partner and try to determine how the joint venture will respond to the various changes that might be encountered:  changes in market conditions, competition, personnel or equipment shortages, new regulations, loss of key customers, etc.  This type of discussion serves two purposes.  First, it may lead to adaptive processes and procedures in the joint venture’s structure that allow for greater flexibility when needed.  Equally important, it can give you a better understanding of how easy it will be to get your prospective partner’s cooperation when you believe that changes will be needed.

5.         Create a detailed joint venture agreement.   There are certain areas that should always be covered:

  • Structure of the joint venture (ownership, voting rights, governing body)
  • Objectives (or a reference to a business plan)
  • Financial contributions each will make (up-front and callable or contingent)
  • Composition of the management team and any key individuals to be assigned
  • Contributions of intellectual property to the joint venture and ownership of      intellectual property created by the joint venture
  • Allocation of profits and losses.
  • Liabilities of partners to each other and indemnities.
  • Rights to business opportunities found by but not suitable for the joint venture
  • Distributions
  • Dispute resolution procedure

This list is just a beginning.  Leave as little as possible “to be worked out later.”  More likely than not, later will be harder.

6.             Clear performance indicators.  Establish clear performance indicators for each party to the joint venture.  What if the projections in the business plan are not met? It is not uncommon for the two parties to have different expectations about what the joint venture can achieve at different times in the future and if those expectations are not met, how it will affect the respective contributions of the parties.  For example, if one party is providing the financing and the other party is providing expertise, will the former feel that its financial commitments should be reduced if there are delays in achieving the profit targets?  Performance indicators will provide both parties with a better understanding of what each can expect from the other and it will also probably raise important questions about the changes that should occur if the performance indicators fall short.

7.         Establish an open dialogue.  Generally speaking, unless there is a problem joint ventures do not generate as many meetings or senior-level discussions as would be the case if the joint venture project were simply a project of one of the partners.  Perhaps this is because there is usually travel involved or because the collegial environment inside a single organization is missing.  Or perhaps it is because discussions may disclose differences of opinion and such differences, while easy to resolve within a typical corporate organization, are not so easily resolved in a joint venture.  Whatever the reason, it is important for the joint venture partners to meet regularly face-to-face to discuss progress and to discuss openly all of the issues either party may wish to discuss.  This type of regular dialogue not only mitigates the risk of misunderstandings but also brings attention to matters that, if not discussed, can grow into serious disputes.  It can also foster personal relationships between individuals that prevent the parties from becoming suspicious of each other.

8.         Keep good records.   Who keeps the financial, operational and other records?  Which records are kept and where are they kept?  Who has access?   What records are required by regulations in the location of the joint venture’s operations and in the country of each partner?  How are the records protected?   It is easy to underestimate the importance of the answers to these and similar questions.  The advantages of good record-keeping are of course well known but there is an additional advantage in the case of joint ventures: If a key person who was assigned to the joint venture by one of the parties leaves his or her employer, it will be harder for the person’s replacement to reconstruct the “corporate history” of the joint venture by “asking around”.  The records will have to speak for themselves.  One approach might be to store all the records in a cloud that is accessed through the Internet independently of either party’s IT network.  The access could be controlled through assigned user names and passwords, and permissions could be assigned for adding, deleting and editing documents.  In addition, interested parties could be notified when documents are added and the storage system could have an access log showing who logged-in and when.

9.         Select advisers carefully.   Again, this seems obvious but it should not be considered routine.  Select legal, accounting, tax and strategic advisers who are practical, creative and knowledgeable about the reasons joint ventures can go awry.  Advisers that a company has used in the past with good results may not be the right choice if they lack experience in joint venture planning.  In addition, it is useful to think about who will act as legal counsel to the joint venture after it is formed.   Often, neither partner wants the other partner’s regular counsel to be giving advice to the joint venture because of the potential for a conflict of interest.

10.       Have an exit plan.   When a couple is planning their marriage, the last thing they want to talk about is how they would handle a divorce.  People planning a joint venture are not much different.  Unlike divorce, however, the process of unwinding a joint venture is not spelled out in the law.  It is a creature of contract and if the contract is silent, the parties must negotiate the terms of separation at the time they want to end their relationship. This is often a time when the partners have widely divergent views on what is “fair” and there may even be ill will between the parties.  One common way of addressing the prospect of “irreconcilable differences” in the future is to have a buy-sell agreement (or incorporate buy-sell provisions in the joint venture agreement).  It is important to create such an agreement at the outset of the joint venture because it can be very difficult to negotiate anything at the time of separation, even the process by which the terms of separation will be decided.  There are two types of buy-sell agreements:  traditional and so-called “guts ball” agreements.  In a traditional buy-sell agreement, the parties agree on an appraisal process to determine the value of the joint venture.  Either partner can initiate this process and the initiating partner agrees to buy the other partner’s interest at the appraised value.  The problem with this approach is that the appraised value, even if it is the average of three valuations by three independent appraisers, might be significantly above the initiating partner’s estimate of the true value of the other partner’s interest or significantly below the selling partner’s estimate.  In contrast, the guts-ball agreement does not require an appraisal.  Either partner can offer to buy the other partner’s interest at any time at a specified price.  The partner receiving the offer has two choices and only two choices:  accept the offer or purchase the offering partner’s interest at the same price.   In other words, the partner receiving the offer must either sell or buy, in either case at the price specified by the offering partner.  If the partner receiving the offer makes no decision, that is deemed an election to sell and the deemed election can be enforced in court.  This process is inherently fair because the offering partner could find itself in the position of either a buyer or a seller.  Therefore, it must offer a price at which it would be willing to buy or sell, as the other partner elects.  What could be fairer?  Speaking practically, such buy-sell arrangements are seldom exercised, but the fact that they could be is an inducement to the parties to resolve their differences through negotiation.

The ten points above are just a starting point.  Every joint venture is different and requires a plan that addresses all its unique aspects.  Still, it is well to remember that joint ventures often either fail or they disappoint one or both partners.  Be skeptical, be cautious and be clear.  Don’t let the excitement of the planning stage foster the assumption that the results will be so beneficial to both partners that the future will take care of itself.



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Obamacare: Proposed IRS Regs Define “Large Employer”

Under the Patient Protection and Affordable Care Act (ACA, often called Obamacare), companies with 50 or more full-time workers are required to provide health benefits to at least 95 percent of their full-time employees or pay a $2,000 per-employee penalty (the penalty excludes payment for the first 30 full-time employees).  This requirement will become effective January 1, 2014.  Some employers have been reducing the hours of some employees in order to avoid the threshold of 50 full-time employees.  The IRS has now proposed regulations that will make many such avoidance measures ineffective. Proposed IRS Regulations.

Under the proposed IRS regulations, a full-time employee for purposes of the 50-employee threshold means any worker who is compensated for 30 hours in an average week. These 30 hours thus include all paid hours whether or not the employee actually works during those hours.  For example, paid hours include paid vacation time, jury duty, sick days and voting.

Even more surprising, the IRS views a “full-time employee” as a full-time equivalent.   That is, the hours of part-time employees working under 30 average hours per week will be combined to determine how many 30-hour-per-week equivalents are created in the aggregate.  Thus, two 15-hour per week workers will count as one full-time employee, and six 20-hour per week employees will count as four full-time employees for purposes of the 50 full-time employee threshold.

The proposed regulations also describe the health care insurance requirements that must be met by companies within the definition of “large employer” to avoid the penalty.  This is an area where careful planning is needed.  To avoid the penalty, an employer must offer “affordable” coverage to 95% of its full time employees.  “Affordable” means that the cost to the employee (or the cost of the cheapest option if more than one option is offered to employees) cannot exceed 9.5% of any full-time employee’s household income.  If this requirement is not met and any one of the employees receives a government subsidy or tax credit intended to allow purchase of coverage on an insurance exchange, the employer must make a $2,000 per-employee “shared responsibility payment.”  The problem with a reference to household income is that an employer cannot know the household income of each full-time employee.  Even if it did know, circumstances change and the employer could suddenly find itself outside the ACA requirement.  Thus, employers choosing to provide health insurance will feel that they must offer at least one coverage option that does not require a premium contribution greater than 9.5% of the lowest-paid full-time employee’s annual compensation.   Note that “low cost” option is a relative term; it may not actually come at a low cost to the employer.  The IRS, in cooperation with the Department of Health and Human Services, proposes that employer coverage must meet a minimum value threshold based on a combination of co-payments, deductibles, and other cost factors, determined through an as-yet undeveloped automated tool employers can use to see if their coverage options qualify.

It is quite possible that some small employers, although “large” under the proposed IRS regulations, that currently provide health care coverage for their employees will drop the coverage and elect to pay the penalty of $2,000 per full-time employee.  This penalty could be significantly less than the employer’s share of the premium under the lowest cost option meeting federal requirements.  Some employers may even drop their current coverage and “share” the savings by increasing employees’ compensation, thereby shifting what was previously the employer’s cost to the government through the subsidies and tax credits that will supplement the cost of insurance purchased through an exchange by lower paid individuals.

The deadline for public comment on the proposed IRS regulations is March 18, 2013.


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Obamacare: Businesses Need to Start Planning

Many of the tax-related provisions of Obamacare–the Patient Protection and Affordable Care Act or the “Act”—will require businesses to take action this year and next. Here is a short summary:

W-2 reporting

 Employers that filed 250 or more 2011 W-2 forms must begin reporting the cost of employer-provided health care coverage on the W-2 beginning with the 2012 tax year — that means the W-2s distributed in January 2013.  IRS Notice 2011-28 explains that the new requirement calls for informational reporting only.  It does not cause excludable benefits to become taxable or change the tax treatment in any way. The purpose of the requirement is “to provide useful and comparable consumer information to employees on the cost of their health care coverage.”

Medicare subsidy payments

 As of Jan. 1, 2013, employers can no longer claim an income tax deduction for the Medicare Part D retiree drug subsidy payments they receive from the federal government.

Medicare tax withholding

 Starting in 2013, employers must withhold an additional 0.9% in Medicare taxes on employee earnings over $200,000 (even for married employees).  However, employers are not required to match that extra payment.  Employers need only pay 1.45% on all earnings.

The IRS has indicated that employers are not required to break out the additional withholding amounts on employees’ W-2 forms. In fact, to avoid penalties, employers are required to do little more than arrange to withhold the additional amounts.

FSA compliance

Employers that offer health care flexible spending accounts (FSAs) are currently allowed to set the employee contribution limits for them, but starting in 2013 a $2,500 limit applies. According to the IRS, this is on a plan year basis.  Thus, non-calendar-year plans must comply for the plan year that starts in 2013. Employers will need to amend their plans and summary plan descriptions to reflect the $2,500 limit (or a lower one, if they choose) by Dec. 31, 2014, and institute measures to ensure employees don’t elect contributions that exceed the limit. Note that there will continue to be no limit on employer contributions to FSAs.

Play or pay provision

The employer mandate provision is scheduled to take effect Jan. 1, 2014. It does not require employers to provide health care coverage but it in some cases imposes penalties on employers that do not offer coverage or that provide coverage that isn’t “affordable.” Penalties will increase annually based on premium growth.

Employers with 50 or more full-time employees (those working 30 hours or more per week) that don’t provide their employees with health coverage will be assessed a penalty if just one of their workers receives a premium tax credit—a government subsidy for persons with incomes below certain thresholds–when buying insurance in a health insurance exchange. The annual penalty is $2,000 per full-time employee in excess of 30 workers.  For example, if the employer has 53 full-time employees, the penalty would be $46,000 (23 × $2,000).

Employers that do provide coverage could also face penalties unless the coverage is deemed affordable. Penalties may be triggered if (1) the coverage doesn’t cover at least 60% of covered health care expenses for a “typical population,” or (2) the premium for the coverage exceeds 9.5% of a worker’s income. In such cases, the worker can opt to obtain coverage in an exchange and qualify for the premium tax credit. If any workers receive the credit, the employer must annually pay the lesser of $3,000 per employee for each employee receiving the credit or $2,000 for each full-time employee beyond the first 30 employees.

Some employers may opt to simply pay the penalties because the increased costs due to the broader scope of coverage now required (for example, coverage of dependents up to age 26) may be greater than the penalties, even after consideration of the lost tax benefits (unlike health care benefits, penalties aren’t deductible).

Other employers may try to avoid the penalty by holding employees’ hours below thirty per week so that they are not deemed full-time.  The CEO of Papa John’s Pizza recently announced that his franchisees are likely to take that approach.  Darden Restaurants,  which operates 2,000 restaurants (Olive Garden, Red Lobster, and Longhorn Steakhouse), is currently experimenting with a 29.5 hour work week aimed at avoiding the Act’s employer mandate.  Applebee’s and Jimmy John’s are making similar plans, as are, according to the Wall Street Journal, Pillar Hotels and Resorts (owner of 210 franchise hotels), CKE Restaurants (parent of Carl’s Jr. and Hardee’s restaurants), and Anna’s Linens.

Small business tax credits

The Act’s provision providing tax credits to qualifying small businesses took effect in 2010. Businesses with fewer than 25 full-time equivalent employees (FTEs) and average annual wages of less than $50,000 that pay at least half of the cost of health insurance for their employees may qualify.

For 2012 and 2013, the credit is for up to 35% of the cost of group health coverage. The maximum credit is available to employers with 10 or fewer FTEs and average annual wages of less than $25,000. Businesses that exceed either threshold are entitled to partial credits on a sliding scale, and the credit is phased out altogether when a company reaches 25 FTEs or average annual wages of $50,000.

The number of FTEs is determined by calculating the total hours of service for which the business pays wages to employees during the year (but not more than 2,080 for any one employee), and then dividing that figure by 2,080.

Only the employer’s portion of health insurance premiums counts in calculating the credit. And that amount is further limited to the amount the employer would have paid based on the average premium for the small group market in the employer’s state or area, if it’s less than the actual premium. (See the example below.)

For 2014 and later, small businesses must purchase coverage through their state exchanges to qualify, but the amount of the credit may be higher — as much as 50% of their contributions toward the health insurance premiums.

After 2013, businesses can take the credit for only two years, although there is no requirement stating which two years must be chosen. Thus, some planning could be involved in determining when to claim the credit. That is, if the credit will be reduced in a particular year due to one or more of the various limits that apply, the business may be better off waiting until the following year to see if the credit will then be more valuable.

Example:  For the 2012 tax year, Company XYZ offers its employees a group health plan with single and family coverage and pays 50% of the premiums. Company XYZ has 10 FTEs with average annual wages of $23,000. Six employees are enrolled in single coverage and four are enrolled in family coverage. Total premiums are $4,000 a year for single coverage and $10,000 a year for family coverage.  Average premiums for the small group market in XZY’s state are $5,000 and $12,000, respectively. XYZ’s premium payments ($2,000 for single coverage and $5,000 for family coverage) don’t exceed 50% of these averages, so it computes the credit based on its actual premium payments of $32,000 (6 × $2,000 + 4 × $5,000).  XYZ’s tax credit is $11,200 ($32,000 × 35%).

It is not likely the negotiations between the White House and the Congress over the “Fiscal Cliff” will affect any of these provisions of the Act so it is time for businesses to start preparing, starting with a call to their tax adviser.


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New California Law Protects Religious Dress and Grooming in the Workplace

On September 8, 2012, the Governor of California signed into law Assembly Bill 1964, amending the existing state law that protects individuals from employment discrimination based on race, religious creed, color, national origin, ancestry, physical disability, mental disability, medical condition, genetic information, marital status, sex, gender, gender identity, gender expression, age, or sexual orientation.

The new law, which is effective January 1, 2013, expands the definition of “religious creed” to include religious dress and grooming practices that are part of an individual’s religious observance or belief. 

“Religious dress practice” will be construed broadly to include “wearing or carrying of religious clothing, head or face covering, jewelry, artifacts, and any other item that is part of the observance by an individual of his or her religious creed.” Religious grooming practice includes all forms of head, facial, and body hair that are likewise part of observing an individual’s religious creed.

California employers are required to reasonably accommodate the religious belief or observance of an employee, now including religious dress practice or religious grooming practice, unless the accommodation would be an undue hardship on the conduct of the business of the employer.  If a claim of discrimination is brought, which can arise based on adverse employment action, refusal to provide reasonable accommodation, or failure to hire, the employer will need to be able to demonstrate an “undue hardship” as defined in California law. For an employer to show it is unable to reasonably accommodate the religious belief or observance of an employee without undue hardship on the conduct of its business, it must demonstrate that it has explored all available reasonable means of accommodating the religious belief or observance (such as excusing the individual from the duties that conflict with his or her religious belief or permitting those duties to be performed at another time or by another employee), but is unable to accommodate the religious belief or observance without undue hardship.

 Under the new law, an accommodation will not be considered reasonable if it requires an employee to be segregated from customers or the general public.


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Three Mistakes Common to Privately Held Businesses

  1. Underestimating Regulatory Risk

Regulatory compliance may seem like a nuisance or a “necessary evil” to most business owners but, if neglected, it can actually be much worse than that.  Three trends appear to be emerging in this area.  First, the number of regulations—both federal and state—is growing at an extraordinary rate, and not all of the new rules are made widely known (and may not even be logical).  Indeed, we seem to moving from an era of regulations that have the import of “do this (or don’t do this) and you could be sued by private parties that are harmed” to and era where the effect is “do this (or don’t do this) and you will be guilty of a violation for which there are civil and possibly criminal penalties”.  Second, regulators are becoming more aggressive about enforcement and less forgiving of first-time violations.  The days of the “warning” for first-time violations seem to be disappearing.  And third, regulators typically put emphasis on, and ask for, a company’s policies and procedures when investigating possible violations.  Each of these trends becomes more relevant as a business grows and its operations become more diverse and complex.

Of course, the risks are higher for some companies than others.  Heavily regulated industries, government contractors, companies with overseas sales, and manufacturers of consumer products have special concerns.  That is not to say, however, that other businesses can simply deal with regulatory risk when problems arise.  Every business is regulated to some extent, and if the full scope of the regulatory environment is not known and addressed, the result can be unexpected (and intrusive) governmental inquiries, fines, legal fees, bad publicity and, for some officers, embarrassment or even reputational damage.

One valuable tool that companies can use to address regulatory risk is a compliance audit.   This audit should cover all regulatory compliance issues applicable to the business (including anticipated new regulations) and the policies and procedures of the company to comply with those regulations.  The policies and procedures can take many forms, such as a compliance manual or part of a risk register that includes all risks facing the business or separate, regulation–specific policy statements aimed at certain personnel.   It should be clear who is responsible for managing each of the risks and what steps need to be taken to improve risk mitigation.  In addition, the Board of Directors should be informed about the risks of non-compliance and the adequacy of the company’s compliance program.   A compliance audit report developed by an attorney is not discoverable in an investigation or lawsuit because of the attorney-client privilege. Hence, hiring an attorney to perform the audit and make recommendations gives management more discretion when deciding whether the company will adopt the attorney’s recommendations.   In some cases, the decision to implement changes or not will be determined by a cost/benefit analysis.   The point is not to make every change that might possibly mitigate risk; rather, it is to understand the risks and make informed decisions about them.

A compliance audit should be done periodically.  How often depends on the rate of growth of the company and the number of changes to its business plan.   An interesting example of this concept can be found in the rules of the Financial Industry Regulatory Authority (FINRA), a self-regulatory organization that regulates broker-dealers.  While there is no simple correlation between a heavily regulated business like that of broker-dealers and companies in a more typical business environment, there are sometimes lessons to be learned by considering the requirements developed by regulators.  For example, FINRA Rule 3130 requires the CEO (or equivalent) of each broker-dealer member to certify in writing annually that the firm “has in place processes to establish, maintain, review, test and modify written compliance policies and written supervisory procedures reasonably designed to achieve compliance with applicable FINRA rules, MSRB rules and federal securities laws and regulations, and that the chief executive officer(s) has conducted one or more meetings with the chief compliance officer(s) in the preceding 12 months to discuss such processes.”    Adapting this concept to “unregulated companies” (a misnomer), the CEO or the Board might want an annual certification from one of the other officers in the company that describes the results of a compliance review. Not only might such a policy lead to a discovery of under-appreciated regulatory risks, but it can also provide evidence to government investigators that the company takes compliance seriously.

2.     Not Using a Board of Directors Effectively

Too often, the Board of Directors acts as a “rubber stamp” for the CEO and Board meetings are viewed as a formality.   This is not hard to explain.  Directors who are employees of the company will invariably defer to the CEO.  Directors who are not employees want to be collegial and supportive.  Contentious Board meetings are unpleasant; directors do not want to diminish the CEO’s authority because, after all, the CEO was appointed to make the hard decisions; and the CEO undoubtedly has a more detailed understanding than the directors of any proposal or recommendation put before the Board.  That said, a passive Board is a wasted resource.

Directors should have a meaningful opportunity to add items to the agenda of a meeting. This might be anything of interest to a director, e.g., an analysis of competitors or competitive trends, a comparison of certain expenses on a period-to-period basis, financial projections using various assumptions, or a valuation of certain assets with a view to purchase or sale.   The agenda should be a collaborative process.  There are items that the CEO should cover and wants to cover, but the meeting is also an opportunity for the directors to learn about aspects of the business that feel they should know more about.   The agenda controls the discussion.  To expand the discussion, expand the agenda.

Independent directors are a good idea.  Few are the employee-directors who will question, let alone challenge, the views of the CEO in a Board meeting.   Moreover, independent directors can add a different perspective because they have not been so deep in the trees that they can no longer see the forest.  For an employee-director, a Board meeting can be a “nuisance”, another internal meeting that must be endured while more pressing work awaits.  This should not be the view of an independent director, who in most cases would not take on the responsibility of a directorship unless he or she was willing to give Board meetings the attention they deserve.  Moreover, an independent director can fill a gap in the Board’s collective expertise.   The company might want an accountant, an engineer, a lawyer or a person with a depth of experience in certain operations to be an independent director.  The possibilities are numerous.  It is a relatively inexpensive way to enhance the quality of Board discussions and Board decisions.  And if an independent director is not noticeably adding value to meetings or is being overly critical without being constructive, they can and should be replaced.

Presentations made to the Board should be thorough and objective.  If they are backward-looking (reviews) they should identify where expectations were met and where they were not met and, in the latter case, the reasons for the failure to meet expectations.  If the presentations are forward-looking (planning or proposals) they should identify all the risks, all the assumptions and all alternatives to the plan or proposal being recommended.  Any presentation can be “spun”, any statistics can be manipulated, and any idea can be made to look better than it is, especially with charts, artwork, photos and the other impressive techniques now readily available.  Typically, such biased presentations are not deliberate attempts to mislead or deceive.  They are simply “result oriented”, i.e., designed to show why someone’s good idea is really a good idea.  This can be a disservice to the directors and the shareholders they represent.  Shareholders are investors.  Just as investors are entitled to accurate, fairly presented information when they make their initial investment decision (and the securities laws require this, whether in the context of a public offering or a private placement), investors’ representatives are entitled to accurate, fairly presented information so that they can discharge their responsibilities properly.

Another good idea is special committees.  The Board can appoint a special committee for any purpose.  The committee can have any number of directors, even just one.  Typically, the special committee has no authority to make decisions.  Its role is to study an issue or a plan and make recommendations to the full Board.  This use of special committees offers two benefits.  First, the committee will usually devote more time to their assigned task than the Board would devote on its own.  The committee deliberations might even include seeking advice from outsider advisers.  And second, this is a way to mitigate the dominating influence of one Board member, such as the CEO.  Assuming the dominant director is not put on the special committee, the committee members will feel less like they are reacting to one point of view and more like they are exploring a range of ideas.  Special committees consisting of independent directors are often used by publicly held companies in situations such as takeover proposals where insider-directors have a vested interest in the outcome of the decision.   The same concept can be used by privately held companies for less significant matters.

Finally, the board of directors should have an appropriate number of members to conduct effective oversight.  A board with too few members may not bring enough perspectives to ensure that plans are properly vetted and risks are fully understood.  With an overly large board, individual directors may have less sense of individual responsibility for overseeing the financial affairs of the corporation

3.   Not Anticipating Changes in Regulations

Change happens.  In fact, change happens at an ever-accelerating pace.  And there are many types of change:  technology, the competitive landscape, laws and regulations, taxes, costs, consumer preferences, accounting standards, etc.  The list is endless.  There are now many consultants who specialize in “change management” because change is often disruptive, unsettling for employees, and threatening to organizational efficiency.  This all speaks to coping with change.  An even bigger challenge lies in anticipating change.

For example, businesses should understand the regulatory implications of any possible change to the business model before the change is adopted. It should also identify and prepare for changes in law and regulation, and look for ways to reduce the costs and effects of anticipated changes even if it means modifying the structure, traditional business practices or other aspects of business model, such as markets, products, or distribution channels.  The common approach is to wait for such external events to occur (and be discovered) and then adapt as necessary.  The problem with that “reactive” approach is that it takes time to learn and adapt and in that span of time, even if relatively short, unexpected problems can arise.  To give just one example, consider the recent Treasury Department requirement that officers of a company report annually the foreign bank accounts of the company over which they have signature authority, even if they have no personal or beneficial interest in the accounts. A company that was not monitoring regulatory developments might not have learned about and responded to this reporting requirement until the deadline for reporting had already passed.

This third “common mistake” relates to the first two.  Understanding regulatory risk means learning about proposed regulatory changes before they occur.  How does your company monitor regulatory developments?  Who in the organization is responsible for this monitoring and do they know how to do this?  Should you be using an outside firm for this monitoring?   Law firms will do this, of course, but there are other, less expensive alternatives.

And the Board of Directors should be apprised of possible changes in laws and regulations and how it might affect the business.  This is part of the Board’s oversight responsibility.  It is far better to tell the Board what might be happening, even if it never occurs, than to explain to the Board why the company is paying a fine or responding to a regulator because it did not learn about a new regulatory requirement until it was too late to prevent a violation.

Publicly held companies make these mistakes, too, but to a lesser extent because they have more financial resources and personnel to devote to compliance and regulatory monitoring.  They have also regular contact with outside law firms and accounting firms and many of them have dedicated compliance officers and/or in-house counsel (or a legal department) and their Board structure must meet SEC and other requirements, such as Sarbanes-Oxley.  In contrast, privately held businesses must manage their risks with fewer resources.  The risks may seem smaller, but not if they turn into problems.

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Possible Tax Law Changes — January 1, 2013

If Congress allows the so-called “Bush tax cuts” to expire at the end of this year—a not unreasonable assumption–the personal tax rates on ordinary income will increase as follows:

      Unmarried Filers     Married Joint Filers   Marginal Rate
    Over But Not Over       Over But Not Over 2012 2013
       0   $8,700       0  $17,400 10%  15%
   $8,700  $35,350  $17,400  $70,700 15%  15%
 $35,350  $85,650  $70,700 $142,700 25%  28%
 $85,650 $178,650 $142,700 $217,450 28%  31%
$178,650 $388,350 $217,450 $388,450 33%  36%
$388,350   ___ $388,350    ___ 35% 39.6%

The end of the Bush tax cuts will also impact itemized deductions and personal exemptions.  Individual taxpayers will lose some current personal exemptions and deductions, including mortgage interest, charitable contributions and more.

In terms of payroll deductions, the 2% Social Security reduction that has been in effect for a few years will be reinstated.  Also, the new 3.8% health care tax that is part of Obamacare will apply to all wages. This will increase the current Medicare withholding on individuals from 2.9% to 3.8%. The “employee portion” of the Medicare tax will increase from 1.45% to 2.35% while the employer’s portion will remain the same at 1.45%.

Taxes on passive, ordinary income, such as interest and dividends, will increase from 35% to 43.4%, including the health care tax. The long-term capital gain rate will increase from 15% to 23.8%. This includes a basic capital gain increase from 15% to 20%, as well as a new 3.8% “health care tax” on interest, dividends and other passive income realized by “high earners” — individuals earning more than $200,000 per year, or $250,000 for married taxpayers.

In addition, the estate and gift tax will also increase in 2013. Currently, the estate and gift tax exclusion amount is $5 million per person. For a surviving spouse, the exclusion amount in 2012 is as high as $10 million. Above that level, any excess is subject to a federal estate tax of 35%. Unless the tax laws change, the maximum estate and gift tax rate will increase from 35% to 55% on Jan. 1, 2013. The lifetime exclusion (i.e., including gifts during lifetime) amount will revert to $1 million.

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