Reorganizing the ERISA analysis: understanding ERISA and the Bankruptcy Code.

INTRODUCTION

An employer's financial condition and use of various statutory protections can have a significant impact on qualified pension plans and other obligations. (1) Understanding the interplay between The Bankruptcy Reform Act of 1978, as amended (the "Bankruptcy Code"), Employee Retirement Income Security Act of 1974, as amended ("ERISA"), and the Internal Revenue Code of 1986, as amended (the "Internal Revenue Code" or "IRC"), is important, since all must be used to analyze employee benefit claims in the context of bankruptcy. (2)

BACKGROUND

ERISA

Plan Assets Generally, the assets of a qualified plan may not inure to the benefit

of an employer and must be held for the exclusive purposes of providing benefits to participants and administering the plan. (3) Once assets are placed in a qualified plan, they are generally no longer assets of the employer, (4) and, therefore, the assets of the plan will not be included in the bankruptcy estate of the employer upon the commencement of a bankruptcy case.

The Pension Benefit Guaranty Corporation

Title IV of ERISA establishes the termination rules for defined benefit plans and establishes the Pension Benefit Guaranty Corporation (the "PBGC"). The PBGC administers plan termination rules and the pension insurance program. (5) The PBGC guarantees a certain minimum level of benefits under most tax-qualified defined benefit plans to participants in plans that are not properly funded by their employers. Defined contribution plans (e.g., profit sharing, stock bonus, and ESOPs) and certain nonqualified plans are excluded from Title IV of ERISA and are not guaranteed by the PBGC. (6)

Joint and Several Liability

Pension plan liability (other than multiemployer pension plan liability, as discussed below) is joint and several across all members of a "controlled group" of entities. (7) As a result of joint and several pension liability rules under the Internal Revenue Code and ERISA, a corporation that would not usually expect pension liability (such as a corporate entity that does not maintain or contribute to any employee benefit plans, or a foreign entity organized outside of the United States) could potentially face substantial exposure to employee benefit liabilities generated by its affiliates. As a result, many liabilities that arise in connection with pension plans are somewhat unique corporate obligations.

A number of potentially significant ERISA liabilities are joint and several among all members of the group of trades or businesses which are aggregated for purposes of ERISA (generally 80 percent-or-more commonly controlled entities). Examples of such liabilities include defined benefit plan termination liabilities and multiemployer plan withdrawal liabilities. These liabilities may be obligated, for example, to the PBGC, which insures certain pension benefits, or to the pension plan itself. If any member of the ERISA controlled group incurs one of these liabilities, it is the direct joint and several liability of all members of the group.

In general, where (i) an entity owns 80 percent or more of another entity, or (ii)(A) two entities are 80 percent or more owned by the same five or fewer common owners (who are individuals, estates, or trusts) and (B) over 50 percent of each such entity is owned by the same five or fewer common owners (who are individuals, estates, or trusts) taking into account each owner's interests only to the extent such interests are identical with respect to each entity, the two entities will be in the same "controlled group" (along with any other entities that are, in turn, in the same controlled group as either aggregated entity). (8) It should be noted that foreign entities are not excluded for these purposes merely because they are located or organized outside of the United States. (9) Under applicable "attribution" rules, (i) ownership interests may sometimes be attributed from one owner to another, and (ii) certain options to purchase equity of another organization may be treated as having been exercised. (10) A plan's contributing sponsor that is subject to advance reporting must generally notify the PBGC within 30 days of a reportable event. (11) Under ERISA, this requirement may be waived by the PBGC. (12)

Structural Subordination

Controlled group issues under ERISA could result in a type of structural subordination of the interests of creditors of a parent company. If a creditor of a parent company does not have an enforceable upstream guarantee from the parent's subsidiaries, then, with respect to the assets of the subsidiaries, the creditor may, in effect, be structurally subordinated to all ERISA creditors of any member of the controlled group (including ERISA creditors of the parent itself). This result arises because the parent, as a mere holder of equity of its subsidiaries, takes after all of the creditors of the subsidiaries and, as noted above, an ERISA creditor anywhere in the group (including an ERISA creditor of the parent) will be a direct creditor of each subsidiary. While it may be possible for a creditor of the parent under certain circumstances to request that the controlled group be consolidated and treated as a single entity, it is particularly difficult to succeed in such an attempt where a creditor (e.g., the PBGC or another creditor with ERISA claims) may be materially adversely affected. (13) Thus, the risk of this type of structural subordination in respect of a subsidiary's assets can be significant, where there is a loan to a parent (without a claim against the assets of the subsidiary), if there is material ERISA liability anywhere in the controlled group.

Successor Liability

Generally, the common-law rule is that the purchaser of a corporation's assets does not automatically become responsible for the corporation's liabilities. (14) However, the question may arise whether the successor is liable under ERISA for a delinquency in the predecessor's payments to a plan or for its own failure to continue contributing to a plan. (15)

Defined Contribution Plans

A defined contribution plan is a retirement plan that "provides for an individual account for each participant and for benefits based solely upon the amount contributed to the participant's account, and any income, expenses, gains, and losses, and any forfeitures of accounts of other participants which may be allocated to such participant's account." (16) Defined contribution plans include 401(k) plans, stock bonus plans, employer stock ownership plans (so-called "ESOPs"), and profit sharing plans. Because the participant is entitled only to the assets in the plan held on his or her behalf, there is little potential for a significant unfunded corporate liability to develop. (17) The PBGC insurance programs do not cover defined contribution plans. (18)

Defined Benefit Plans

A defined benefit plan is "a pension plan other than an individual account plan." (19) Therefore, a pension plan that is not a defined contribution plan is a defined benefit plan. The benefit earned under a defined benefit plan is generally determined by a formula described in the plan, which is often based on compensation and years of service. Generally, these plans are employer-funded. The PBGC insurance programs cover certain defined benefit plans.

Bankruptcy

Creditors

Companies entering bankruptcy often have many creditors. Prepetition creditors generally fall into one of three categories: (i) secured creditors with perfected liens, (ii) secured creditors with unperfected liens, and (iii) unsecured creditors. In general terms, creditors with liens that have been perfected and which are not avoided by the trustee or debtor-in-possession pursuant to Chapter 5 of the Bankruptcy Code, will have their liens satisfied first. Secured creditors holding unperfected liens generally have their liens avoided and are therefore treated as unsecured creditors. Unsecured creditors, whether they enter the case as unsecured or arrive at that status by having their security interests avoided, in effect compete for the remaining assets of the debtor (after secured claims have been satisfied) and share in such assets in accordance with priorities established by the Bankruptcy Code. (20) It is noted that, in the case of certain ERISA liabilities (e.g., termination liability as discussed below), the liabilities may be unexpectedly large.

Chapter 7 and Chapter 11 Distinctions

The manner in which the Bankruptcy Code applies may depend upon whether the debtor has a case pending under Chapter 7 or Chapter 11 of the Bankruptcy Code. A Chapter 7 case results in the complete liquidation of the debtor. On the other hand, in a Chapter 11 case, the debtor generally will try to propose a plan of reorganization that is acceptable to its creditors and that satisfies the requirements of the Bankruptcy Code. (21) Following confirmation of a plan of reorganization, the debtor hopes to emerge from bankruptcy as a viable entity, free of its pre-petition obligations (i.e., obligations incurred prior to bankruptcy) that are treated in accordance with the terms of the plan of reorganization, resulting in a discharge of such debts.

Whereas the priorities noted below are similar regardless of whether the bankruptcy case is pending under Chapter 7 or Chapter 11, if a Chapter 11 reorganization is converted to a Chapter 7 liquidation, the administrative expenses that are incurred in the Chapter 7 portion of the case have priority over the administrative expenses incurred prior to a conversion to Chapter 7. (22) The foregoing distinction is important economically because an employer with a plan that will be terminated in bankruptcy may have numerous claims against the plan discharged in the bankruptcy proceeding (reducing funding obligations); however, in the event that the plan will continue, all funding obligations must be met (which may occur after the bankruptcy). Other distinctions are discussed in relevant part below.

DISCUSSION

Priority of Unsecured Claims

Unsecured claims are paid according to a list of priorities established in the Bankruptcy Code. (23) The various levels of priority of unsecured claims and how priority is assigned in bankruptcy are important to understand because, in practice, many claims that arise under ERISA and the Internal Revenue Code will be unsecured. Four of the nine categories of unsecured claims that have priority status under the Bankruptcy Code are directly relevant to the discussion of employee-related claims and bankruptcy. The following four unsecured expenses and claims have priority under the Bankruptcy Code: second-, fourth-, fifth-, and eighth-level categories.

Administrative Expenses

Second-level priority under the Bankruptcy Code is given to administrative expense claims, which are the actual, necessary costs and expenses incurred by a debtor for services rendered or goods purchased after the filing of a bankruptcy petition. (24) Post-filing employee wages, taxes incurred after the filing, and payments to suppliers for goods purchased post-petition, would generally be included in the normal operating costs of a debtor in Chapter 11. In Chapter 7, these expenses would include the costs of liquidation and would sometimes include those items described above, if a Chapter 7 trustee operated the debtor's business after the bankruptcy filing. In some cases, courts differ in the treatment of various necessary costs as administrative costs. (25)

Courts have held that the "normal cost" component of minimum funding requirements that arise directly out of post-petition services satisfy these requirements and, therefore, are entitled to administrative priority under Bankruptcy Code Section 507(a)(2). (26) Whereas the PBGC has argued that the non-normal cost component that accrues post-petition should also receive administrative priority status--even though such costs appear to be based on pre-petition services or events--this argument has met with mixed results in the courts. In one successful example, the District Court of Massachusetts agreed with the PBGC. In Columbia Packing, the district court found that past service liability was simply an actuarial unit of measure, not consideration for pre-petition work and, therefore, both the normal costs and non-normal costs (i.e., past service liability) should be given priority status under Bankruptcy Code Section 507(a)(2), to the extent they accrued after the bankruptcy filing. (27) Conversely, the Court of Appeals for the Sixth Circuit has held that only the normal cost component of a minimum funding obligation, the portion that relates directly to the post-petition period, should receive priority status under Bankruptcy Code Section 507(a)(2). (28) Accordingly, the issue of whether any portion of a PBGC claim based on a pre-petition funding deficiency will receive priority pursuant to Bankruptcy Code Section 507(a)(2) remains unsettled. This disagreement is noteworthy, as non-normal costs are frequently much larger than normal costs. (29)

Professional fees connected with the bankruptcy, if approved by the court, will be included in the administrative expense category. (30) However, with respect to cases filed after October 20, 2005, amendments to Section 503(c) of the Bankruptcy Code under the Bankruptcy Abuse Prevention Act prohibit (i) certain retention payments to insiders, (ii) certain severance payments to insiders, and (iii) certain other transfers. Retention payments to an insider are prohibited, without a finding by the court that (i) the payment is essential to the retention of such person because the individual has a bona fide job offer from another business at the same or greater rate of compensation; (ii) the services provided by the person are essential to the survival of the business; and (iii) either (A) the retention payment is not greater than an amount equal to 10 times the amount of the mean transfer or obligation of a similar kind given to nonmanagement employees for any purpose during the calendar year in which the transfer is made or the obligation is incurred; or (B) if no such similar transfers were made to, or obligations were incurred for the benefit of, such nonmanagement employees during such calendar year, the amount of the …