Tag: ERISA

Recent Case Suggests How Private Equity Funds Can Protect Against Unfunded Pension Liabilities of Portfolio Companies

The National Law Review recently published an article, Recent Case Suggests How Private Equity Funds Can Protect Against Unfunded Pension Liabilities of Portfolio Companies, written by Joseph S. Adams, Laurence R. Bronska, Nancy S. Gerrie, Andrew C. Liazos, and Maureen O’Brien of McDermott Will & Emery:

McDermott Will & Emery

A significant objective for a private equity (PE) fund when making an investment is to avoid exposing itself to portfolio company liabilities.  Generally, corporate law would protect the purchaser of a controlling interest in an acquired corporation against portfolio company liabilities as long as the acquired company is operated independently of the purchaser.  However, special considerations apply under theEmployee Retirement Income Security Act (ERISA), the federal law that governs employee benefit plans.  ERISA makes all members of a controlled group liable on a joint and several basis for any pension-related liabilities of single employer and multi-employer pension plans.  The Pension Benefit Guaranty Corporation (PBGC), the federal agency responsible for overseeing these pension plans, has been aggressive in broadly interpreting what is a “controlled group” for this purpose and in pursuing PE funds for pension liabilities incurred by portfolio companies.  But a recent case out of the U.S. District Court for the District of Massachusetts signals that courts may not agree with the PBGC’s broad assessment of pension liability for PE funds.

In a recently decided case, Sun Capital Partners III L.P. v. New England Teamsters and Trucking Industry Pension Fund, D. Mass., No. 1:10-cv-10921-DPW, 10/18/12, the U.S. District Court for the District of Massachusetts became the first court to reject a multi-employer pension plan’s attempt to rely on PBGC precedent to assess a PE fund with a portfolio company’s unfunded pension liabilities.  While this likely is not the last word on this subject, the Sun Capital Partners case offers a roadmap for how a PE fund may take a position to avoid controlled group liability for single employer and multi-employer pension liability.

Background

Title IV of ERISA imposes joint and several liability with respect to a broad array of pension liabilities, including an employer’s minimum funding contributions to a single employer pension plan, unfunded pension liabilities upon plan termination, PBGC premium payments and withdrawal liability under a multi-employer pension plan.  Under ERISA, joint and several liability applies to any entity under common control with the employer sponsoring the pension plan.

  • The definition of “common control” is interpreted under federal tax rules that are applicable to tax-qualified plans under Section 414 of the Internal Revenue Code (the Code).
  • These Internal Revenue Service (IRS) regulations have long provided that entities are under common control if they are “trades or businesses” that share common ownership of 80 percent or more (by vote or value).
  • In the 1987 case of Commissioner v. Groetzinger, the Supreme Court of the United States established a test for when an activity constitutes a “trade or business” for these purposes.  Under Groetzinger, for a person to be engaged in a trade or business, the primary purpose of the activity must be income or profit, and the activity must be performed with continuity and regularity.

In 2007, the PBGC issued an opinion (PBGC Appeals Board opinion dated September 26, 2007) finding that a PE fund was engaged in a trade or business.  According to the PBGC, the PE fund subject to the opinion was engaged in a “trade or business” because it had a stated purpose of creating a profit; provided investment services; and had a general partner that received management fees, a carried interest and consulting fees (i.e., the PE funds did not receive just investment income as a passive investor similar to an individual investor).  The PBGC stated that this activity was regular and continuous because of the size of the PE fund and its profits.

The Sun Capital Decision

In the Sun Capital Partners case, the court determined that the one-time investment of capital by a PE fund into a portfolio company was a passive investment and did not result in the PE funds engaging in a trade or business.  The investment was structured such that the portfolio company was owned by two PE funds in a 70/30 split.  Each PE fund had a general partner, and each general partner had a management company that performed consulting and advisory services.  The PE funds, as shareholders, could appoint members of the board of directors of the portfolio company.

In its decision, the court determined that receipt of non-investment compensation in the form of consulting, management or advisory fees and carried interest by the management companies and the general partners could not be attributable to the PE funds.  The non-investment income was a result of a contractual relationship between the management companies, the general partners and the portfolio company.  The court found that the receipt of this non-investment income did not mean that the PE funds themselves were engaged in the full range of the general partners’ activities.  The PE funds themselves did not perform any consulting, advising or management services, and did not have employees, own any office space, or make or sell any goods.  In fact, on tax returns, the PE funds reported only capital gains and dividends, both sources of investment income.  Further, the court held that the ability of the PE funds to appoint the board of directors of the portfolio company did not mean that the funds were engaged in a trade or business, because such appointments were made in the PE funds’ capacity as shareholders of the portfolio company.  The court also noted that the fact that the same persons signed the management agreements representing both sides of the contract was not persuasive evidence of engaging in a trade or business, since officers of different entities can sign in different capacities.

The court in the Sun Capital Partners case expressly considered and declined to rely on the 2007 PBGC opinion.  Importantly, the court held that the 2007 PBGC opinion had misapplied the theory of agency and incorrectly imputed the management companies’ or general partners’ actions to the PE funds.  In addition, the court held that, as a matter of law, the PBGC had misapplied the Groetzinger test and other relevant tax law precedent.

Finally, the court determined that the structuring of the PE funds’ investment in the portfolio company (using multiple funds each owning less than 80 percent of the portfolio company) did not violate ERISA provisions allowing certain transactions to be undone if they were undertaken to evade or avoid ERISA liabilities.  Although the PE funds admitted that one of the reasons that the investment was structured to be two funds with a 70/30 split was in order to minimize pension liability risk, the court found that ERISA’s evade-or-avoid provisions did not apply in this context, because such provisions were meant to apply to sellers rather than first-time investors.  Indeed, as the court noted, if the investment was undone and the controlled group determined without regard to the investment as contemplated under ERISA, the PE funds would still not be liable.  Thus, application of the evade-or-avoid provisions did not make sense in this context.

Implications

Most importantly, this decision provides support for the widely held position that a PE fund is not engaged in trade or business and cannot be determined to be under common control with its portfolio companies under Code Section 414.  Under this interpretation, no PE fund could be held liable for withdrawal liability under a multi-employer pension plan, or unfunded benefits liabilities upon termination of a single employer plan (or minimum funding or contractually required ongoing contributions to such plans), because PE funds are not engaged in a trade or business.  Further, if the PE fund cannot be held liable, then the chain of ownership between portfolio companies held by the same private equity fund is also broken.  This decision also provides significant leverage to negotiate with the PBGC or a multi-employer pension fund should a PE fund be defending itself against the PBGC or multi-employer pension fund for pension liability claims.

In order to avail themselves of the benefits of this decision, PE funds should evaluate their operations and contractual relationships to determine if such operations and relationships are comparable to those outlined by the court in the Sun Capital Partners case.  In addition, PE funds may wish, when possible, to structure future investments across multiple funds with each fund owning less than 80 percent of the portfolio company in order to minimize risk of pension liability.

On November 2, 2012, the multi-employer pension fund appealed the decision in the Sun Capital Partners case to the U.S. Court of Appeals for the First Circuit.

© 2012 McDermott Will & Emery

Seventh Circuit Joins Ranks of Courts Holding that Internal Grievances about Employer Fiduciary Duty Breaches is Actionable Under ERISA Section 510

Seventh Circuit Joins Ranks of Courts Holding that Internal Grievances about Employer Fiduciary Duty Breaches is Actionable Under ERISA Section 510, an article by Mark E. Furlane of Drinker Biddle & Reath LLP recently appeared in The National Law Review:

 

In Victor George v. Junior Achievement of Central Indiana Inc.,decided September 24, 2012, the Seventh Circuit joined the Fifth and Ninth Circuits in holding that Section 510 of ERISA applies to unsolicited, informal grievances to employers.  The courts of appeals have disagreed about the scope of §510, and the Second, Third and Fourth Circuits have permitted Section 510 retaliation claims only where the person’s activities were made a part of formal proceedings or in response to an inquiry from employers (i.e., §510’s language does not protect employees who make “unsolicited complaints that are not made in the context of an inquiry or a formal proceeding.”).  Concluding that the language of Section 510 of ERISA was “ambiguous” and “a mess of unpunctuated conjunctions and prepositions,” the Seventh Circuit concluded that, “an employee’s grievance is within §510’s scope whether or not the employer solicited information.”  The court did, however, reiterate the high threshold to prevail on a Section 510 claim:  “It does ‘not mean that §510 covers trivial bellyaches—the statute requires the retaliation to be ‘because’ of a protected activity…. What’s more, the grievance must be a plausible one, though not necessarily one on which the employee is correct.”

Section 510 of ERISA prohibits retaliation “against any person because he has given information or has testified or is about to testify in any inquiry or proceeding relating to this [Act].”  Remedies for violation of that section are limited to “injunctive and other ―appropriate equitable relief,” which would not include back pay typically, but could include an injunction and reinstatement.  Attorney’s fees are also possible.  In the case, Victor George was a former vice president of Junior Achievement who sued his former employer alleging he was terminated after complaining that money withheld from his pay was not being deposited into his retirement and health savings accounts.  He complained to management, outside accountants, the board, the Department of Labor (although he did not file a complaint).  The District Court dismissed the case on summary judgment, holding George’s informal complaints to his employer did not constitute an “inquiry” under ERISA.  The appellate court reversed holding that George’s informal proceedings do trigger the statute’s protections.

©2012 Drinker Biddle & Reath LLP

Second Circuit's Citigroup Decision Endorses Presumption of Prudence, Upholds Dismissal of Disclosure Claims

Posted this week at the National Law Review by Morgan, Lewis & Bockius LLP regarding the decision that employer stock in a 401(k) plan is subject to a “presumption of prudence” that a plaintiff alleging fiduciary breach:

 

 

 

In a much-anticipated decision, the U.S. Court of Appeals for the Second Circuit joined five other circuits in ruling that employer stock in a 401(k) plan is subject to a “presumption of prudence” that a plaintiff alleging fiduciary breach can overcome only upon a showing that the employer was facing a “dire situation” that was objectively unforeseeable by the plan sponsor. In re Citigroup ERISA Litigation, No. 09-3804, 2011 WL 4950368 (2d Cir. Oct. 19, 2011). The appellate court found the plaintiffs had not rebutted the presumption of prudence and so upheld the dismissal of their “stock drop” claims.

BACKGROUND

The Citigroup plaintiffs were participants in two 401(k) plans that specifically required the offering of Citigroup stock as an investment option. The plaintiffs alleged that Citigroup’s large subprime mortgage exposure caused the share price of Citigroup stock to decline sharply between January 2007 and January 2008, and that plan fiduciaries breached their duties of prudence and loyalty by not divesting the plans of the stock in the face of the declines. The plaintiffs further alleged that the defendants breached their duty of disclosure by not providing complete and accurate information to plan participants regarding the risks associated with investing in Citigroup stock in light of the company’s exposure to the subprime market. On a motion to dismiss, the district court found no fiduciary breach because the defendants had “no discretion whatsoever” to eliminate Citigroup stock as an investment option (sometimes referred to as “hardwiring”). Alternatively, the lower court ruled that Citigroup stock was a presumptively prudent investment and the plaintiffs had not alleged sufficient facts to overcome the presumption.

SECOND CIRCUIT DECISION

Oral argument in the Citigroup case occurred nearly a year ago, and legal observers have been anxiously awaiting the court’s ruling. In a 2-1 decision, with Judge Chester J. Straub issuing a lengthy dissent, the Second Circuit rejected the “hardwiring” rationale but confirmed the application of the presumption of prudence, which was first articulated by the Third Circuit in Moench v. Robertson, 62 F.3d 553 (3d Cir. 1995). The court also rejected claims that the defendants violated ERISA’s disclosure obligations by failing to provide plan participants with information about the expected future performance of Citigroup stock.

Prudence

Joining the Third, Fifth, Sixth, Seventh, and Ninth Circuits,[1] the court adopted the presumption of prudence as the “best accommodation between the competing ERISA values of protecting retirement assets and encouraging investment in employer stock.” Under the presumption of prudence, a fiduciary’s decision to continue to offer participants the opportunity to invest in employer stock is reviewed under an abuse of discretion standard of review, which provides that a fiduciary’s conduct will not be second-guessed so long as it is reasonable. The court also ruled that the presumption of prudence applies at the earliest stages of the litigation and is relevant to all defined contribution plans that offer employer stock (not just ESOPs, which are designed to invest primarily in employer securities).

Having announced the relevant legal standard, the court of appeals dispatched the plaintiffs’ prudence claim in relatively short order. The plaintiffs alleged that Citigroup made ill-advised investments in the subprime market and hid the extent of its exposure from plan participants and the public; consequently, Citigroup’s stock price was artificially inflated. These facts alone, the court held, were not enough to plead a breach of fiduciary duty: “[T]hat Citigroup made a bad business decision is insufficient to show that the company was in a ‘dire situation,’ much less that the Investment Committee or the Administrative Committee knew or should have known that the situation was dire.” Nor could the plaintiffs carry their burden by alleging in conclusory fashion that individual fiduciaries “knew or should have known” about Citigroup’s subprime exposure but failed to act. Relying on the Supreme Court’s decision in Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007), the court of appeals held these bald assertions were insufficient at the pleadings stage to suggest knowledge of imprudence or to support the inference that the fiduciaries could have foreseen Citigroup’s subprime losses.

Disclosure

The court’s treatment of the disclosure claims was equally instructive. Plaintiffs’ allegations rested on two theories of liability under ERISA: (1) failing to provide complete and accurate information to participants (the “nondisclosure” theory), and (2) conveying materially inaccurate information about Citigroup stock to participants (the “misrepresentation” theory).

As to the nondisclosure theory, the court found that Citigroup adequately disclosed in plan documents made available to participants the risks of investing in Citigroup stock, including the undiversified nature of the investment, its volatility, and the importance of diversification. The court also emphasized that ERISA does not impose an obligation on employers to disclose nonpublic information to participants regarding a specific plan investment option.

Turning to the misrepresentation theory, the court found plaintiffs’ allegations that the fiduciaries “knew or should have known” about Citigroup’s subprime losses, or that they failed to investigate the prudence of the stock, were too threadbare to support a claim for relief. Though plaintiffs claimed that false statements in SEC filings were incorporated by reference into summary plan descriptions (SPDs), the court found no basis to infer that the individual defendants knew the statements were false. It also concluded there were no facts which, if proved, would show (without the benefit of hindsight) that an investigation of Citigroup’s financial condition would have revealed the stock was no longer a prudent investment.

IMPLICATIONS

Coming from the influential Second Circuit, the Citigroup decision represents something of a tipping point in stock-drop jurisprudence, especially with respect to the dozens of companies (including many financial services companies) that have been sued in stock-drop cases based on events surrounding the 2007-08 global financial crisis. The Second Circuit opinion gives the presumption of prudence critical mass among appellate courts and signals a potential shift in how stock-drop claims will be evaluated, including at the motion to dismiss stage.[2]

Under the Citigroup analysis, fiduciaries should not override the plan terms regarding employer stock unless maintaining the stock investment would frustrate the purpose of the plan, such as when the company is facing imminent collapse or some other “dire situation” that threatens its viability. Like other circuits that have adopted the prudence presumption, the Citigroup court emphasized the long-term nature of retirement investing and the need to refrain from acting in response to “mere stock fluctuations, even those that trend downhill significantly.” It also sided with other courts in holding that the presumption of prudence should be applied at the motion to dismiss stage (i.e., not allowing plaintiffs to gather evidence through discovery to show the imprudence of the stock). Taken together, these rulings may make it harder for plaintiffs to survive a motion to dismiss, especially where their allegations of imprudence are based on relatively short-lived declines in stock price.

Some had predicted the Second Circuit would endorse the “hardwiring” argument and allow employers to remove fiduciary discretion by designating stock as a mandatory investment in the plan document. The Citigroup court was unwilling to go that far, but it did adopt a “sliding scale” under which judicial scrutiny will increase with the degree of discretion a plan gives its fiduciaries to offer company stock as an investment. This is similar to the approach taken by the Ninth Circuit inQuan and consistent with the heightened deference that courts generally give to fiduciaries when employer stock is hardwired into the plan. Thus, through careful plan drafting, employers should be able to secure the desired standard of review. Language in the plan document and trust agreement (as well as other documents) confirming that employer stock is a required investment option should result in the most deferential standard and provide fiduciaries the greatest protection.

Also noteworthy was the court’s treatment of the disclosure claims. Many stock-drop complaints piggyback on allegations of securities fraud, creating an inevitable tension between disclosure obligations under the federal securities laws and disclosure obligations under ERISA. The Second Circuit did not resolve this tension, but it construed ERISA fiduciary disclosure requirements narrowly and rejected the notion that fiduciaries have a general duty to tell participants about adverse corporate developments. The court made this ruling in the context of SPD disclosures under the 401(k) plan that identified specific risks of investing in Citigroup stock. Plan sponsors should review their SPDs and other participant communications to make sure company stock descriptions are sufficiently explicit about issues such as the volatility of a single-stock investment and the importance of diversification. These disclosures may go beyond what is already required under Department of Labor regulations.

[1]. See Howell v. Motorola, Inc., 633 F.3d 552, 568 (7th Cir.), cert.denied, ­­­2011 WL 4530151 (2011); Quan v. Computer Sciences Corp., 623 F.3d 870, 881 (9th Cir. 2010); Kirschbaum v. Reliant Energy, Inc., 526 F.3d 243, 254 (5th Cir. 2008); Kuper v. Iovenko, 66 F.3d 1447, 1459-60 (6th Cir. 1995).

[2]. That said, plan sponsors and fiduciaries should continue to monitor future developments in Citigroup in light of Judge Straub’s dissenting opinion and the likelihood of a petition for rehearing (or rehearing en banc), which the Citigroup plaintiffs have indicated they intend to seek. In his dissent, Judge Straub rejected the Moench presumption in favor of plenary review of fiduciary decisions regarding employer stock. He also disagreed with the majority’s interpretation of ERISA disclosure duties.

Copyright © 2011 by Morgan, Lewis & Bockius LLP. All Rights Reserved.

The Wrongful Distribution of Retirement Benefits to a Plan Fiduciary is Prohibited by ERISA Section 406(b)

This week’s featured bloggers at the National Law Review are from Cosgrove Law L.L.C.   In the ‘who knew’ category from Kurt J. Schafers:  the wrongful distribution of plan benefits to a Plan Fiduciary.  

Although the distribution of benefits to a plan participant is not a “transaction” as that term is used in Section 406(a), the wrongful distribution of benefits to a plan fiduciary is clearly prohibited conduct under Section 406(b). For example, inLockheed Corp. v. Spink, 517 U.S. 882 (1996), the plaintiff brought suit against his employer (administrator of his 401(k) plan) under Section 406(a)(1)(D) because the employer wrongfully allowed some of its employees to receive early retirement benefits that the plaintiff was unable to receive. Id. at 892-93. The respondent argued that the payment of benefits is not a “transaction” under Section 406(a). Id.at 892. In its holding, the Court agreed with the respondent, but made clear that its holding was strictly limited to the language of Section 406(a). Indeed, the Court clarified that “the payment of benefits is in fact not a ‘transaction’ in the sense that Congress used that term in § 406(a).” Id. at 892 (emphasis added).

The narrow scope of Lockheed becomes clear upon a review of subsequent federal caselaw. See Armstrong, 2004 WL 1745774, at *10 (holding “payments to participants in accordance with plan terms not to be transactions within the meaning of [Section 406(a)]”); Owen v. SoundView Financial Group, Inc., 54 F.Supp.2d 305, 323 (S.D. N.Y. 1999) (holding that “ERISA’s “Prohibited Transaction” rules, see 29 U.S.C. §§ 1106(a) [ERISA Section 406(a)]…are not applicable to the payment of Plan benefits to a Plan beneficiary, because the beneficiary is not a “party in interest”). The limited scope of Lockheed is confirmed by the equally limited scope of Section 406(a). For instance, Section 406(a), entitled, “Transactions between plan and party in interest,” is plainly intended to govern only those transactions in which fiduciaries cause a plan to engage. Indeed, Section 406(a)(1) begins with the following language: “A fiduciary with respect to a plan shall not cause the plan to engage in a transaction, if he knows or should know that such transaction constitutes a direct or indirect. . . .” (emphasis added). Section 406(a)(1) then lists five narrow types of transactions in which a fiduciary should not cause a plan to engage. Courts have determined that the purpose of Section 406(a) is limited to “prevent[ing] plan fiduciaries from engaging in certain transactions that benefit third parties at the expense of plan participants and beneficiaries.” Armstrong v. Amsted Industries, Inc., 2004 WL 1745774, at *10 (N.D. Ill. 2004); Marks v. Independence Blue Cross, 71 F.Supp.2d 432, 437 (E.D. Pa. 1999).

The limited holding of Lockheed (and the subsequent federal court decisions) does not, however, apply in many cases. Indeed, a plaintiff’s prohibited transactions claim against a defendant may be brought under a completely separate ERISA provision: Section 406(b). This Section, entitled “Transactions between plan and fiduciary,” may more clearly apply to a defendant’s conduct. Importantly, unlike Section 406(a), Section 406(b) does not specifically limit which types of transactions apply to the Section. As such, the “transactions” contemplated under Section 406(b) are much broader in scope than those specifically set forth in Section 406(a). Moreover, rather than aiming to prevent plan fiduciaries from engaging in transactions that benefit third parties at the expense of plan participants and beneficiaries, Section 406(b) aims to prevent—among other things—plan fiduciaries from engaging in prohibited transactions for their own account. A plan fiduciary wrongfully using his or her power to obtain a higher distribution than is warranted, for example, obviously falls under the broad conduct contemplated under Section 406(b).

Finally, Section 408(c)(1) reads as follows:

Nothing in [ERISA Section 406] shall be construed to prohibit any fiduciary from—

(1) receiving any benefit to which he may be entitled as a participant or beneficiary in the plan, so long as the benefit is computed and paid on a basis which is consistent with the terms of the plan as applied to all other participants and beneficiaries.

A plain reading of this Section establishes that Section 406 should be construed to prohibit a fiduciary from receiving a benefit that is computed and paid on a basis which is inconsistent with the terms of the plan as applied to all other participants and beneficiaries.

Copyright © 2011 Cosgrove Law, LLC.