BNA Pension and Benefits Blog

Automakers' Insolvency Opens All the Benefit Cutback Targets and Problems

    The insolvency (whether or not in Chapter 11 reorganization) of the three automakers brings “legacy costs” back to the center stage of ERISA cutback negotiation and litigation. 

    The automakers have already put themselves on the cutting edge of many of these issues outside of bankruptcy.   

    They have litigated retirees’ medical benefit cutbacks, arguing that retirees were not vested (Sprague v. General Motors Corp., 133 F.3d 388, 21 Employee Benefits Cases 2267 (6th Cir. 1998)). 

    They have negotiated VEBAs with the UAW and then sought to bind the retirees by class action settlements and court approval after a fairness hearing. International Union, United Auto., Aerospace, and Agr. Implement Workers of America [McKnight] v. General Motors Corp., 497 F.3d 615, 41 Employee Benefits Cases 1692 (6th Cir. 2007)   Still, further developments are inevitable, particularly in light of the recent VEBA history. 

    Some of the key “legacy cost” questions are these:

        1.  The first question, logically, is this: Are the retirees’ medical benefits “vested”?   The “vesting” of retiree medical benefits is certainly possible, and it depends on the words of the plan, the magic of language such as “for your lifetime,” the admissibility of parole evidence to clarify “ambiguities” in the plan and SPD, and so on. UAW v. Yard-Man, Inc., 716 F.2d 1476, 4 Employee Benefits Cases 2108 (6th Cir. 1983), cert. denied, 465 U.S. 1007 (1984); Sprague v. General Motors Corp., 133 F.3d 388, 21 Employee Benefits Cases 2267 (6th Cir. 1998); Yolton v. El Paso Tennessee Pipeline Co., 435 F.3d 571, 36 Employee Benefits Cases 2217 (6th Cir. 2006); Bland v. Fiatallis, 401 F.3d 779, 34 Employee Benefits Cases 1875 (7th Cir. 2005); Doubtless the rules need clarification, and the various circuits’ positions need reconciliation.

        2. If the case reaches the bankruptcy court, does “vesting” really matter?  The answer ought to be obvious, but if you read the actual language of the Bankruptcy Code (11 U.S.C. section 1114), the statute on its face never mentions vesting, instead requiring continuation of a “program” of  “retiree benefits” that was “maintained” before the bankruptcy filing (Sec. 1114(a)).

        3. If a union makes a cutback bargain, how does the union get to "represent" its retirees, when unions legally only represent actives? Allied Chem. & Alkali Workers v. Pittsburgh Plate Glass Co., 404 U.S. 157, 1 Employee Benefits Cases 1019 (1971).  A retirees’ medical benefit program would not be a mandatory bargaining subject under the NLRA if the bargaining issue did not affect any currently active employee. But that may be a non-problem because the bargaining topic frequently includes benefits for current employees, payable when they retire (which is certainly a mandatory bargaining subject). And in any event, there is an overriding reality in distress situations – the union has at least a little “muscle,” and the retirees ordinarily do not.

        4. In any event, how do you bind the retirees?  Typically, the court certifies a group of retirees as a Rule 23 class action representative.  International Union, United Auto., Aerospace, and Agr. Implement Workers of America [McKnight] v. General Motors Corp., 497 F.3d 615, 41 Employee Benefits Cases 1692 (6th Cir. 2007)

        5. What standard is used by the court to decide whether to force retirees to give up their claim against the employer in exchange for reliance on the VEBA? See the GM and Ford rulings. And while the Ford/GM standards are not (yet) actually under the Chapter 11 cutback devices (sections 1113 and 1114), the VEBA settlements previously approved by the district court were based on findings that the VEBA deals were less severe than the cutbacks the retirees might have lost in bankruptcy (497 F.2d at 628).  And yet only recently GM has backed out of its VEBA funding commitment.

        6.  How can you VEBA-ize a solution to legacy costs, when a VEBA can only accumulate one year’s worth of benefit costs?  A “garden variety” VEBA is allowed only a very limited pre-funding accumulation, but a collectively bargained VEBA is not so restricted. IRC §§ 419(c), 419A(f)(5)(A), 501(c)(9).

        7. What if the employer buys this deal in exchange for payments into the VEBA, and then the employer defaults or goes bankrupt before full payment?

        8. Is there some hidden logic in this -- an assumption that the VEBA only has to remain solvent for a few years, and then National Health will arrive in all its glory and bail out everyone?   How many years?  And in the meantime, what sort of “booking” treatment is allowed, in such situations, for financial statements of public corporations?

        9. Do the rules really change after a filing in Chapter 11?  Chapter 11 bankruptcy reorganization has its own collective bargaining provisions, which apply to changes in labor agreements (11 USC 1113) and even to retirees medical benefits (11 USC 1114). This special “last offer” bargaining lowers but does not ordinarily wipe out retirees medical benefits, because the court’s approval of the “bargain” depends upon a finding that the cut-back is the least severe change necessary to save the debtor.

        10.  And then there is the whole array of issues arising under the defined benefit pension plans.  Termination of these plans (“distress” or involuntary termination under ERISA 4041(c) or 4042), inevitably generates losses by surprise.  Employees and retirees are often surprised that they are not eligible for funded benefit levels as high as they expected, because of the calculation of “PC3" priority benefits under ERISA 4044(a)(3)), particularly after the funding level of the terminated plan is recalculated by the PBGC.  And even the guaranteed benefit level may not be as high as anticipated, given the obscure rules for ERISA Title IV guaranteed benefit calculations.  And the liability of the plan debtor/employer/sponsor may be higher than expected, given PBGC’s determination to argue and re-argue questions concerning their priorities in bankruptcy, even though PBGC seemingly has lost these arguments repeatedly.

    The core problems, however, concern conflicts of interest – conflicts by the union, by the employer, and by the PBGC – and these conflicts abound. 

    The union’s conflict:  It does seem clear that the UAW – now as in the past, all the way back to the seminal Studebaker case – will inevitably be faced with a terrible Hobson’s choice:  Save jobs by lowering costs (“selling out” the retirees)? Or fighting tenaciously for protection of retirees, and risk destruction of the enterprise?  Section 1114(c) of the Bankruptcy Code recognizes the conflict of interest of the incumbent union, but presumes that the conflict may be avoided or ignored.  And yet, inevitably, it is still there.

    The employer’s conflict: ERISA by its express terms makes the employer a presumptive fiduciary – even a named fiduciary – and plan administrator.  ERISA §§ 3(16)(A)(ii), 402(a)(2)(A).  The existence of the conflict is assumed by the statute, but the employer, even with a conflict, is prohibited from acting on the conflict (wearing “two hats” but not at the same time).  And in chapter 11, the employer has three hats – employer, fiduciary for the plan, and fiduciary for the creditors.  Again, the conflict is inherent in the situation.  In the ordinary course, the situation is manageable.  But the puzzles described above are not ordinary.

    And the PBGC’s conflict: The PBGC was invented to protect employees and retirees.  In recent years (decades?), however, the PBGC has often seemed more interested in protecting its balance sheet than its natural constituents.

    We shall see.

Frank Cummings

Election and Retirement Security

The election is now only days away and will occur within the context of a financial markets meltdown. The effect on retirement security has been significant. Public policy considerations must be addressed asap.

DB plan asset values have tanked and funding requirements for 2009 and thereafter will undoubtedly increase substantially. (Partial offsetting relief is experienced because of higher corporate bond rates.) Without some form of pension funding relief, more plan freezes can be expected. We could see some as early as 11/15/08 204(h) notices for 1/1/09 freezes. Several organizations have proposed various relief measures. An alternative simple proposal would be a measure that limited mandatory 2009 contributions to the amount of 2008 contributions with an accompanying rule that 2008 could be ignored for at risk plan status, etc. Hopefully, Congress could address this quickly during the upcoming lameduck session.

More long term, we need to evaluate how we can make 401(k) plans better vehicles for providing retirement security. Several suggestions (some of which have been conceptually addressed by others, e.g. Teresa Ghilarducci, in other conceptual frameworks) include:

1. Improve the market and regulatory rules regarding annuities- deferred annuities purchased throughout one's career, terminal annuities acquired at retirement, and longevity annuities that would commence in at some advanced age (e.g. 80). The first would allow for cost averaging of annuity purchases, the second (a market for which is slowly developing now) may need to be mandated for a portion of terminal account balance (if participant didn't acquire deferred annuities during active participation), and the third would guarantee a level of income for those that survive and allow the rest of one's account to be payable over a fixed period from date of retirement to longevity annuity starting date. Lump sum distributions would be limited to a specified percentage of account balance.
2. Require mandatory participation in some retirement vehicle. If an employee doesn't have a db plan, then they must participate in a 401(k) or similar vehicle. For those employers that don't want to sponsor, individuals should be able to participate in free-standing plans similar to 401(k) sponsored by current (and other) 401(k) vendors.
3. The investment responsibility should be moved from the participants to the sponsor or toher fiduciaries. Plans would only provide balanced, target date funds that employees participated in during their working lives and until distribution or annuitization. Protections for sponsors or vendors similar to 404(c) should apply as long as the manager of the target date funds was prudently selected and monitored.
4. A portion of 401(k) or other retirement plan distributions should be able to be used for retiree health costs on a pre-tax or other tax effective basis (e.g. very low tax rate).
5. For immediate assistance with current financial crisis and longer term thereafter, 10% excise tax on distributions for true financial hardships should be eliminated. It makes no sense to apply this tax to those suffering a financial emergency/hardship.

Investment Advice—ERISA’s Culture War

The DOL’s recent proposed class exemption for the provision of investment advice has re-ignited the debate over the need for and the role of investment advice in participant directed plans. The proposal would strike a good balance between the need to offer investment advice to plan participants and the importance of participant safeguards.

The genesis of the issue comes from DOL’s broad interpretation of the prohibition on self-dealing in section 406(b). DOL takes the position that a fiduciary engages in self-dealing if it uses its authority to affect the amount or timing of its compensation. This, according to DOL, is an automatic, per se violation regardless of the terms of the transaction and whether it is in the interests of plan participants.

This issue is important to financial institutions who sell investment products to plans and are fiduciaries because they provide investment advice. If the advice results in investments in mutual funds that pay varying fees to the advisor, then under the DOL view, the giving of the advice would be a 406(b) violation since the advisor would be using its fiduciary authority to affect the amount of its compensation.

For a number of years, the financial services industry tried unsuccessfully to convince DOL to grant a class exemption for the provision of investment advice. The industry then went to Congress. The House several times passed an advice exemption based on disclosure, but the Senate refused to take any action. Such an exemption finally was passed as part of the Pension Protection Act. The exemption contains relief for advice that is provided through computer models, or where the fees or other compensation paid to the advisor are not affected by the investments selected by the participant as a result of the advice – i.e. fee leveling. These two approaches are intended to minimize the possibility of self-dealing, but have limited utility. Using computer models is not an effective way to provide individualized advice, and fee leveling is not workable for many firms. As a result, DOL proposed a class exemption to cover advice arrangements that involve neither a computer remodel nor fee leveling.

The proposal goes substantially beyond the bill passed by the House that was criticized for not being protective of plan participants, and contains detailed conditions to deal with potential self-dealing. The participant or IRA holder must first receive a computer model or general asset-allocation models. Advice provided under the class exemption cannot generate greater income for the adviser than other options of the same class unless the advisor prudently concludes that the recommendation is in the best interests of the participant and explains this to the participant. In addition, the advisor must document the basis for such conclusion, including an explanation as to how the recommendation compares to the computer model or model portfolios previously furnished. The advisor must also provide detailed disclosure of the fees and other compensation it receives as well as of any material affiliation or contractual relationship with those persons who have a role in the selection of investment options. Finally, the advisor must adopt procedures designed to assure compliance with the exemption and must obtain an annual compliance audit.

DOL has made a good-faith effort to provide an advice exemption with adequate safeguards. However, it will likely be criticized by those who think advice with any potential for abuse is bad. Because participants acutely need advice, and the proposal contains many safeguards, DOL should adopt grant the advice exemption. However, in today’s environment, members of Congress may be inclined to condemn any regulatory action that relies on the prudence and good judgment of a financial institution. It would be unfortunate if the advice proposal were the victim of this environment. Participants would be the losers.

9th Circuit Holds San Francisco Ordinance Not Preempted: Is There a Conflict in the Circuits?

Today's decision on the merits by the 9th Circuit in the Golden Gate Restaurant Association v. San Francisco case upholding the employer spending requirements of the San Francisco ordinance as not preempted by ERISA is a most interesting read. 

For most of the decision, the unanimous three-judge panel methodically describes and then disposes of all the arguments made by the GGRA and its numerous amici (including the Department of Labor) in favor of preemption.  The opinion is written as if the court is perfectly aware that its decision is likely to wind up on the steps of the Supreme Court and therefore the court is careful to leave no "t" uncrossed and no "i" undotted.  And yet the final portion of the opinion when the court addresses the 4th Circuit's decision which came to a contrary conclusion regarding the Maryland law (RILA v. Fielder) seems to go in the other direction. 

ERISA preemption groupies will remember that in January when the same panel of the 9th Circuit granted the City's motion to stay pending appeal the District Court's judgment holding the ordinance preempted and ordered the ordinance to go into effect, it was roundly criticized by many commentators for ignoring the impact of the Fielder case.  These commentators obviously expected that the court would fall into line and adopt the 4th Circuit reasoning that an employer expenditure requirement was the same as a benefit mandate (such as that required under the Washington statute found in Egelhoff, one of the key Supreme Court cases that the majority of the 4th Circuit relied on in holding the Maryland law preempted).  However, this time in addressing the merits of the case, the 9th Circuit panel did not ignore the Fielder case. 

GGRA had contended that if the 9th Circuit upheld the San Francisco ordinance, it would create a split among the circuits.  Not so, says the 9th Circuit, the 4th Circuit's analysis is not inconsistent with its analysis of the San Francisco ordinance.  "We neither adopt or reject the analysis of the Fourth Circuit in Fielder.  ... But even under the reasoning of the panel majority, San Francisco's Ordinance is valid."  What distinguishes the Maryland statute from the San Francisco ordinance in the eyes of the 9th Circuit is that "The Maryland law gave nothing in return - either to an employer or its employees - for the employer's payment to the State."  In Maryland, the taxes collected would have gone to the State Medicaid program and presumably only those employees of covered employers (ostensibly Wal-Mart) who were Medicaid beneficiaries would benefit. By contrast, any uninsured individual, including employers who chose not to have ERISA plans, would be covered under the San Francisco program and employees whose employers chose to pay into the program would be eligible for free or discounted enrollment in the HAP (health access plan). 

What do you think of this argument and does the 9th Circuit decision create a conflict in the circuits or not?

For those of you who have not yet listened to the oral argument in this case and want to, you can find it on the 9th Circuit's website - one way to locate it is to know that the argument was held on April 17, 2008 - and this "no conflict in the circuits" question was addressed by the City Attorney during that argument.

Phyllis Borzi

Reviewing the Scope of Section 409A Transition

Full compliance with Section 409A is scheduled to be required in less than four months, by January 1, 2009. This deadline is the result of the considered and responsive review by personnel from Treasury, the IRS and the legislative branch last year, as 2007 ran its course. At that time, an extension sought by the market from an impending December 31, 2007 deadline was gratefully granted, ostensibly on the basis that compliance by year-end 2007 would be difficult to achieve, would result in inordinate corporate distraction and would produce a less-than-optimal quality of compliance.

It may be time to review the present state of Section 409A transition. Market circumstances have changed (AC/DC, still alive and rockin', might say things are "all screwed up"), and the financial crisis has thrown a wide range of institutions into total disarray. That situation is not one that was present as little as several weeks ago, and was not so much as a glimmer in anyone's eye when the year-end 2008 extended deadline was established.

It is submitted here that these unexpected and changed circumstances may well justify a reconsideration of the current deadline generally - not because the existing deadline did not confer sufficient time, but because things, simply put, have changed. The need to devote significant attention to Section 409A compliance may be inconsistent with the attention that will have to be devoted to the economic crisis. And, notwithstanding the ongoing bail-out efforts, query whether any exacerbation of the current crisis in the coming weeks might make broader relief downright necessary.

It is worthy of note that a client memorandum from Wachtell, Lipton distributed earlier today (September 24) suggests that it may be time for a reexamination of Section 409A transition. As unfortunate as it may seem, reconsideration of the deadline may indeed now be appropriate.

Regardless of whether a general reconsideration of the Section 409A compliance deadline takes place, it seems as though some continued permitted good-faith compliance would be appropriate. (Wachtell's memorandum makes a similar point here, too.) In this regard, several things have become evident:

- As a result of the complexity inherent (as is now apparent) in Section 409A itself, the 409A Regulations have turned out to be extraordinarily complex, giving rise to an innumerable number of difficult and sometimes imponderable issues. It seems as though every crevice of the rules gives rise to issues and analyses that are much more interesting than one would expect or hope.

- Experts seem consistently to disagree on a host of issues. Reasoning balanced on the head of a pin comes out one way for one practitioner and another way for another practitioner. One wonders whether there aren't important issues as to which there isn't even unanimity among Treasury and IRS personnel.

- New issues continue to arise. It seems as though issue after issue, some sending shockwaves through the practitioner community, continues to emerge on points that hadn't even been widely identified in the market as being problematic.

- Indications are that, as to matters covered by the existing 409A Regulations, further official guidance will not soon be forthcoming. The existing voluntary compliance program does not generally extend to documentary compliance, thus making compliance more challenging, and, as a further indication of how difficult the issues are to deal with, it looks as though it is going to take Treasury and the IRS considerable time just to develop a more extensive voluntary compliance program.

- Key new authority on income inclusion, reporting and withholding, once hoped for in the early part of the summer, is still not out, presumably because of substantive complexity generally, as well as, possibly, the interrelationship between Section 409A and other provisions.

Against this backdrop of substantive uncertainty, complete and total compliance by December 31, 2008, however desirable it may be, seems almost unattainable. One possible approach could be that, for 2009, good-faith compliance with Section 409A and the existing final authority thereunder would be considered compliance with Section 409A. It is not suggested here that the effectiveness of the final rules would be suspended; rather, the suggestion is that reasonable interpretations of the rules should be sufficient to forestall punitive tax results. Essentially, it would be recognized that, against a landscape riddled with substantive uncertainty, taxpayers should not be punished for taking fair positions under incredibly challenging rules, merely because some theoretical ultimate interpretation of those rules might turn out to be adverse.

Thus far, regulatory consideration of extended relief apparently is not being actively considered (see, e.g., the lead Washington Item in the September 5, 2008 TMCPJ ); given the responsive and substantial extensions that have been previously conferred, that result is arguably understandable. But market conditions have changed, and the substantive analyses just have not sorted out, and it is suggested here that, for both of these reasons, it may unfortunately be time for the transition question to be reopened.

Looking Back, Looking Forward

While December is when most of us look back on the year coming to end and make plans and resolutions for the year about to begin, September is another one of those times for me. After all, it’s an important month in its own right—the start of the academic year (even if classes now begin in August), the official beginning of the race in election years like this one, the unofficial end of summer with Labor Day and lest we forget, the anniversary of ERISA’s passage.

September also brings a couple of personal anniversaries: Labor Day marks the beginning of another year as a self-described ERISA “geek” and in the middle of month, my third year in Washington at the AFL-CIO begins.

My anniversary musings this year, as you might expect, were influenced by the work of the past year and the significance of the election to come in November

Health care reform is clearly important with many polls ranking it, together with the economy, among the top issues of concern. But, one issue that’s talked about less outside the benefits community is just as critical--the pending retirement security crisis.

Here are just a few facts to consider, most of which are familiar to benefits professionals. Pension coverage remains at about 50 percent of the workforce. The shift from defined benefit to defined contribution plans, primarily 401(k) plans, is leading to a decline in pension wealth. And, according to the latest Retirement Confidence Survey from the Employee Benefit Research Institute, only 18 percent of workers are very confident about having sufficient money for retirement. The 9 point drop from the 2007 survey was the biggest one-year drop in the survey’s history. One bright spot is the continued vibrancy of defined benefit plans in the public sector.

So far, the conventional wisdom seems to be that individual account defined contribution plans or individual retirement accounts (IRAs) are the best way for workers to provide for their retirement. But, is this really true? Should we consider different approaches to defined benefit coverage?

When I was introduced to ERISA more than 25 years ago, there was talk of setting a national retirement income policy. Is it finally time for all of us to have that conversation?

Good Planning or Pension Manipulation?

A front page article in the August 4th edition of the Wall Street Journal outlines a method by which companies are transferring portions of their non-qualified deferred compensation obligations of senior executives into their qualified plans. As reported by the Journal: “In recent years, companies from Intel Corp. to CenturyTel, Inc. collectively have moved hundreds of millions of dollars of obligations for executive benefits into rank-and-file pension plans. This lets companies capture tax breaks intended for pensions of regular workers and use them to pay for executives’ supplemental benefits and compensation.”

In order for a pension plan to qualify for favorable tax treatment (current deduction of employer contributions and tax-deferral on any investment gains), the plan must meet certain requirements set forth in the Internal Revenue Code, including the requirement that neither contributions nor benefits under the plan discriminate in favor of highly compensated employees. According to the Journal article, “benefits consultants market sophisticated techniques to help companies do just that, without running afoul of IRS rules against favoring the highly paid.”

There are significant tax advantages if a company can provide more of an executive’s pension under a qualified plan rather than a non-qualified deferred compensation arrangement. In Intel’s case, according to the Journal, it contributed $187,000 to the qualified plan to fund $200,000 of its deferred compensation liability. The ability to immediately deduct the $187,000 allowed Intel to save $65,000 in taxes according to the Journal. While these benefits were being provided under a non-qualified deferred compensation arrangement, Intel would not be entitled to a tax deduction until the benefits were actually received by an executive.

The pension system in the United States is a voluntary system and unless an employer deems it to be in its best interest to establish a plan, it will not do so. Therefore, the tax system provides incentives for employers to establish plans for their employees, including the highly compensated employees. The anti-discrimination and other rules set forth in the Code are designed to assure that the non-highly compensated received adequate benefits vis-à-vis the highly compensated before an employer qualifies for the tax advantages of a qualified plan. The program outlined in the Journal article may very well be reasonable. The IRS should examine this practice to determine whether it violates the anti-discrimination rules. If it does, the IRS should eliminate it administratively or request Congress to pass clarifying legislation. For example, Congress enacted IRC Section 401(a)(19) in order to prevent a perceived abuse of the comparability procedures for testing compliance with the nondiscrimination rules.

A Report on Yet Another Reporting Issue for Private Equity and Other Investment Funds

Section 404(a)(1) of ERISA generally requires a fiduciary to act in the interest of participants and beneficiaries and to act prudently. ERISA also requires, under Section 103(b)(3)(A), an annual report which includes a financial statement containing, among other things, a statement of assets and liabilities "valued at their current value." Current value is to be determined in good faith by a trustee or named fiduciary.

A July 1, 2008, letter from James Benages of the DOL's Boston office has made its way around the market. There, he considers a plan which was invested in a number of alternative investments ("AIs" (no relationship to the Kubrick/Spielberg movie, at least I don't think so)), and which apparently took a fairly common approach to the Form 5500 reporting thereof. For example, one particular AI was valued at cost by the applicable committee "based on the general partner's unaudited Capital Account Balance Statement" for the period in question "and the accompanying audited financial statements." Another was valued according to the general partner's unaudited determination of fair market value.

The July 1 letter states that (i) not only has the committee "failed to establish a process to determine the most accurate fair market value," but cost and fair market value have been "equate[d]," (ii) such failure violates ERISA's "solely in the interest" requirement, and (iii) as a result, in the DOL's view, the committee "is in violation of ERISA and will remain so until it takes corrective action." Before discussing Section 502(l) and the possibility of action by other governmental agencies and third parties, the July 1 letter kindly comforts that, if corrective action is taken, no lawsuit will be brought by the DOL.

The issues implicated by the July 1 letter are significant. Many private equity and other investment funds provide valuations on the bases noted in the letter, and plan fiduciaries would not ordinarily be expected to have the information required to second-guess the available valuations or the expertise to do so even if they had the information.

The DOL's approach seems to raise the specter that making an investment not practically susceptible to ready valuation is somehow a per se violation of Section 404(a)(1) of ERISA. The July 1 letter seems expressly to tie the "sole purpose" requirement to the reporting requirement, although the connection isn't particularly clear. There's also a more oblique reference to the Section 404(a)(1)((B) prudence requirement, not tied specifically to the reporting issue. Is the DOL implying that it is per se imprudent for a fiduciary to invest in a difficult-to-value investment, without special valuation efforts?

What would be the effect of there being a Section 404(a)(1) violation merely because an investment is not subject to valuation? Several alternatives seem possible.

Maybe the plan would demand that the fund provide appraised valuations. A number of funds, however, would presumably not be anxious to engage an appraiser, whether because of an unwillingness to develop and distribute the valuation, an unwillingness to spend the time and money on the valuation or an unwillingness to share the underlying information with the appraiser.

Maybe the plan would do its own analysis. However, any number of plans presumably would not have the time or inclination to do so.

Maybe the plan would ask for additional factual information to facilitate the plan's valuation efforts. It is by no means clear that the fund would provide such information.

Or maybe the plan would simply decide it's not worth the effort. To someone who does not appreciate AIs, maybe this result is somehow acceptable.

But is it? It is not up to non-experts to decide that a class of investments is suboptimal, whether or not there are experts out there who might agree. Clearly, AIs have enthusiastic support as a part of an overall portfolio from a wide range of investment professionals, and it is up to the responsible fiduciary to make the actual investment decision. The fact that support is not unanimous is a fact to be taken into account by the responsible fiduciary.

I recognize that there are those who will disagree, even vehemently. (I'm ducking already.)  Some have made the argument that there is no possible way that an unvalued/unvaluable investment can be prudent. I would point out that almost by definition such a conclusion has been rejected as a business matter by substantial portions of the market - the investments are in fact being made, often by the most sophisticated of investment professionals. (If Warren Buffett were to offer me the opportunity to invest in a black box of managed investments for a 10-year term with no information and a de minimis fee, would I be imprudent to make the investment? Maybe I'd be imprudent not to do so.)

To me, one of the areas (the only one?!) in which ERISA has consistently been lauded is its use of modern portfolio theory and deference to the expert fiduciaries regarding portfolio choices. Notwithstanding the apparent trend of some in the government to pretend that they are competent to decide what plans can invest in, as evidenced by the recent and possibly continuing commodities-legislation debacle, ERISA arguably has no legitimate role in trying to identify specified types of investments as imprudent per se. ERISA should not be responsible for depriving the most sophisticated managers from being unable to access, on behalf of ERISA plans, the most sophisticated investments.

A potential gut reaction is that this whole issue is a tempest in a teapot - if plans are made unable to invest in AIs in the absence of developed valuation information, the funds will naturally come up with improved information. However, the dust-up of several years ago where governmental investment put funds' confidentiality at risk, resulting in an unwillingness of some funds to accept government-plan investment, shows that there could come a point at which funds will indeed turn their back on money over regulatory issues. Further, even if the market would adjust, there is a question of whether it should have to adjust.

To me, the first step is to limit the analysis to where it belongs. The level of valuation information to be given over time by a fund should be considered another factor, not some super-factor, taken into account by a court in analyzing whether, on all facts and circumstances, the fiduciary has satisfied its Section 404(a)(1) obligations. It is suggested here that the lack of a draconian penalty for violating Part 1 requirements doesn't mean that those violations are somehow magically converted into Part 4 violations (any more so than would be in the case of, for example, a failure to distribute an SPD).

That still leaves Section 103(b)(3)(A), which applies on its face to require fair-value reporting. The reporting obligations help get information out to participants and beneficiaries, and bear upon the plan's funded status. In this latter regard, if the valuation information is inaccurate, the entire funding regime is potentially compromised. If I invest in a company with $100 million in reported assets, and the company assets are "really" only worth $1 million, my investment may well not be all I thought it was.  A plan's funded status could be similarly misrepresented. 

One possible interesting solution would be to focus on the practicalities of the situation (thanks to Andrew Gaines for talking this through with me). As a practical matter, AIs are likely to constitute only a small percentage of a plan's total portfolio, being there to provide a potential large maximum return as to a portion of the portfolio deemed suitable by the experts for investment at higher risks. If a concern is that overreporting of asset value could somehow place a plan at risk (or, in the case of underreporting, give rise to excessive deductible plan contributions), maybe an answer could be to allow reasonable reporting based on information disseminated in accordance with market practice (e.g., historical cost or GP estimates), but only as to a portion of the plan's portfolio not to exceed certain percentages. Presumably, given the role of AIs in most portfolios, this percentage could be made fairly low without excessive market dislocation.

AIs can form a critical part of a plan's investment strategy, and in some cases probably account in part for superior overall performance. The point here is not to argue that AIs are or are not smart investments; rather the point is to argue that the question of investment choice is for the investment professional, and that it would be unfortunate if the reporting rules were to serve as an impediment to the making of an otherwise permissible investment at the direction of a responsible plan fiduciary.

Recent Standing Case Promotes Confusion

The U.S. Supreme Court in LaRue, albeit in a footnote, endorsed the holding that participants who cashed out of defined benefit plans did not lose standing to assert claims under section 502(a)(2) for losses to their plans that diminished the amount in their accounts at the time they cashed out.  I'd have thought that the opportunity for mischief in these cases was nearly at an end, particularly in light of the the Third Circuit's thorough and scholarly opinion in Graden v. Connexant, decided just last year.  In that opinion, the court was at great pains  not only to hold that standing existed to bring a case under section 502(a)(2) to restore losses to the plan, but to once and for all reject the dichotomy between a claim for benefits and a claim for losses.  The Court was quite clear that although the the participant might have standing to seek benefits under section 502(a)(1)(B), such a claim was hardly sensible, because the money would have to come from other particpant's accounts, a result that ERISA probably would not permit. The Graden court explained that "...the sensible route is to use section 1132(a)(2) to get the money in the first instance from a solvent party liable to make good on the loss, not from the plan itself." 

So while a participant ultimately seeks benefits, he does so by pursuing a loss to the plan under section 502(a)(2) that must be allocated not merely to those participants who have received no distribution, but to those cashed out with diminished accounts.   If cashed out participants could not share in such a recovery "the plan would recover money that could only properly be allocated to people no longer in the plan."  If a participant or fiduciary pursued such a claim for the plan and no such allocation were possible "it is unclear what the plan would be entitled to do with the money...if we are to take the trust law analogy seriously, then the recovered funds must go to to the people actually sustaining losses."

In short, the dichotomy between a suit to recover losses for the plan and a suit for benefits is a false one.  The participant sues to recover the loss to the plan, relief specifically provided for in ERISA section 409.  He has standing, because any recovery for the plan must be allocated to the affected accounts, regardless of when a participant cashed out, before or during the litigation. 

Notwithstanding the conceptual clarity introduced by the Third Circuit, the Eleventh Circuit in Lanfear v. Home Depot, purporting to agree with Graden ignores its teaching and resorts to the discredited benefits v. damages dichotomy.  While the decision makes clear that the claim asserted by the participants was a breach of duty causing losses to the plan that allegedly diminished participant accounts, just as in Graden, the court says definitively it is claim for benefits, not damages.  This view certainly supports the eccentric Eleventh Circuit view that there must be exhaustion of administrative remedies in fiduciary breach claims, though it is a mystery how such procedures can afford relief against plan fiduciaries, but it does nothing to advance understanding.  As the Third Circuit recognized, meaningful relief must come not from the plan but from breaching fiduciaries (and we would add sometimes non-fiduciaries under Harris); these are claims for the plan that will result in the recovery of money that must, in a defined contribution plan, be used for benefits; they are not literally claims for benefits that could be brought under 502(a)(1)(B).  The courts need to distinguish between their own rhetoric and actual statutory language; the "claim for benefits" rhetoric could cause as much mischief as the "plan as a whole" rhetoric from Russell.  That singular bit of linguistic sloppiness caused years of confusion and took a Supreme Court decision to correct.

Audioconference on Section 409A Proposed Income Inclusion Regulations Set for Sept. 16

On Sept. 16, BNA will host an audioconference with Greta E. Cowart, of Haynes and Boone; Pamela Baker, of Sonnenschein, Nath & Rosenthal; William C. Schmidt, of IRS (invited); and Helen H. Morrison, of Treasury (invited), titled "Section 409A Proposed Income Inclusion Regulations--Revealing the Real Sting of 409A." 

During the audioconference, the panel will provide an overview of the proposed regulations on the calculation of income inclusion for violations of Section 409A, and will address:

• How to calculate income inclusion for different types of nonqualified deferred compensation plans, e.g., nonexempt severance, change in control, different types of nonexempt equity awards, performance and incentive plans, defined benefit wrap around plans, etc.; 
• How to calculate changes in the amount includible from year to year; and
• How to calculate any interest penalties.

Registration information is available at http://legaledge.bna.com, or by calling 800-372-1033.  In the event the proposed regulations are not released by Sept. 16, the audioconference will be rescheduled to a date to be determined.

-- Sarah Stevens, managing editor, BNA Pension & Benefit Publications