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Guest Article

Deloitte

(From the June 5, 2006 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Court Voids Pension Amendment as Fraudulent Transfer Under Federal Bankruptcy Law


Pending pension funding reform legislation would prevent pension plan sponsors from enhancing benefits and funding nonqualified deferred compensation plans, and require the sponsors to freeze future benefit accruals when their plans fail to meet certain funding targets. But a recent case from the Third Circuit Court of Appeals is a reminder that current law may limit a plan sponsor's ability to enhance benefits in an overfunded plan before the plan sponsor seeks federal bankruptcy protection. In Re: Fruehauf Trailer Corp., 444 F.3d 203 (3rd Cir. 2006).

Legal Background

The relevant rules are found not in ERISA or the Internal Revenue Code, but in the federal Bankruptcy Code. Specifically, the Bankruptcy Code permits the trustee of a bankruptcy estate to void certain "fraudulent transfers" of property made by the debtor within two years of filing for bankruptcy. The rules apply to cases of "actual" fraud and "constructive" fraud. Actual fraud is when the debtor intentionally transfers property to "hinder, delay, or defraud" a creditor. Constructive fraud is the transfer of property for "less than a reasonably equivalent value" when the debtor was insolvent, or in certain other circumstances. See 11 U.S.C. § 548(a)(1).

What Do the Fraudulent Transfer Rules Have to Do with Pension Plans?

In this case, the bankruptcy trustee used the fraudulent transfer rules to challenge an amendment to the bankrupt company's pension plan. The amendment, which the Board of Directors approved less than one month before the company filed for bankruptcy, used a surplus on the "union side" of the company's pension plan to enhance benefits for a group of 400 mostly management and executive level employees. No union members or non-salaried workers benefited from the amendment. However, the enhanced benefits were substantial for covered management and executive employees. For example, the only two executives who reviewed the amendment saw their pension benefits increase by 200 percent and 470 percent, respectively. The estimated cost of the amendment ranged from $2.4 million to over $4.4 million.

The bankruptcy trustee sought an injunction against the pension plan to stop it from distributing benefits pursuant to the amendment. Basically, the bankruptcy trustee claimed the amendment was a fraudulent transfer because the pension plan's surplus was the company's property, the amendment constituted a transfer of that property to 400 management and executive level employees, and the company did not receive "reasonably equivalent value" for the amendment. The beneficiaries of the amendment argued it was part of an employee retention plan that was needed to make the company more valuable to potential purchasers.

A federal district court agreed with the bankruptcy trustee, and the Third Circuit Court of Appeals upheld that decision. According to the Third Circuit, the pension plan surplus is part of the company's bankruptcy estate because any surplus reverts to the sponsor upon plan termination. ERISA § 4044(d)(1). The Third Circuit's opinion does not discuss the fact that such reversions may be subject to an excise tax of as much as 50 percent (see IRC § 4980), but there is no indication that fact would have changed the Third Circuit's analysis or conclusion. Instead, the Third Circuit focused on the bankruptcy code's broad definition of "property interests" as "all legal or equitable interests of the debtor in property." 11 U.S.C. § 541(a).

The Third Circuit also determined the amendment was a transfer of the company's property interest. Primarily, the court relied on the anti-cutback rule, which prohibits plan sponsors from reducing or eliminating accrued benefits. See IRC § 411(d)(6) and ERISA § 204(g). Because the additional benefits accrued when the Board ratified the amendment, the Third Circuit concluded a transfer had occurred.

Finally, the Third Circuit decided the company did not receive "reasonably equivalent value" for the transfer even though the bankruptcy trustee did not conclusively establish the cost of the amendment or the value the company received in return. According to the Third Circuit, based on the totality of the circumstances, the amendment as an employee retention device "was overpriced, not negotiated at arm's length, accrued substantially to the benefit of corporate insiders, and was not implemented in good faith."

Pending Legislation

As noted, pension funding reform legislation now pending before Congress would limit the ability of plan sponsors to amend their plans to increase benefits, allow future benefit accruals, or fund executive deferred compensation plans. It still is not clear whether that legislation will be enacted.


DeloitteThe information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985,Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Bart Massey 202.220.2104, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2006, Deloitte.


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