Merger and Acquisitions and the Bad Apple Rule

If an entity purchases another division and wants to merge the existing 401(k)/retirement plan into their existing plan, what steps can they take to limit the purchasing entities fiduciary and liability exposure if the merging plan was not run correctly?

SEM, your question is not clear. You have a purchasing entity (which I understand), but what exactly are they buying? Another company's stock, another company's assets or part of the assets (such as a division)? 

Hire an attorney to do a full audit/due diligence review.  Terminate the plan before they merge and DO NOT MERGE it. I am sure others can provide much more detail but most of the time, attorneys will recommend the second option.  Why would you want other peoples problems?

3 minutes ago, JackS said:

Hire an attorney to do a full audit/due diligence review.  Terminate the plan before they merge and DO NOT MERGE it. I am sure others can provide much more detail but most of the time, attorneys will recommend the second option.  Why would you want other peoples problems?

You are going to inherit the "other people's problems" in a stock sale whether you terminate the plan pre-merger or not.  That is why I asked. You can always quantify the risk in dollars and it brings down the purchase price or you may have a hold back provision in merger agreement. Either way, agree with JackS that due diligence is required.

The client would be purchasing a division or an entity including building employees etc..

1 hour ago, SEM said:

The client would be purchasing a division or an entity including building employees etc..

It sounds like your client, the purchasing entity, is purchasing certain assets (division) of an unrelated company. The good news in an asset deal is that your client can pick and chose which assets/liabilities it wants. If you have serious concerns about the seller's operational compliance with the terms of its 401(k) plan, the easiest answer is to have your client not assume the plan and its potential liabilities. The employees that are transferring over along with the sale of assets may enroll in your 401(k) plan. The seller can chose what it wants to do with its own 401(k) plan.  

Agree with Former Esq.  Also, with the asset sale, the employees who leave the seller and are hired by the purchaser would, absent other facts, have a severance from employment with the seller and, as such, would have a distribution right.  They could elect a distribution and roll the distribution into the purchaser's plan without risk of the purchaser's plan being tainted by the sins of the seller, if any.  The seller and purchaser could agree to permit loans to be rolled over also, if plans permit (could amend plans to permit if desired/necessary).

From an operational side, you can obtain elections from employees who wish to rollover and then bulk roll everyone over. Further you also may want to address any plan loans and if need be roll them over as well. However keep in mind the loans will need to be reamortized  as they will probably miss a deduction or two.

Plan mergers are usually not as bad as some of the above makes them sound. The main reason to merge plans is to make the acquirer's plan bigger which may improve its ability to lower fees with vendors. Also, occasionally the acquirer will not want to improve the target's employees job mobility by giving them access to their 401(k) accounts. Problems that turn up with the target plan post-merger can be fixed in VCP, and the financial cost of fixing could be covered by the seller's warranties. Finally, if from an HR standpoint the acquirer wants the target's employees to feel like they are just continuing in their job, a plan merger is better.

Having said that, acquirers almost always end up not merging the plans, but going the pre-signing termination route. Fear of gf the unknown, I guess. As pointed out by Optimatum, plan loans can be handled through rollovers.

To balance a buyer’s desire not to merge-in a seller’s plan with some practical points (including some Luke Bailey describes), I remember a method that went like this:

The seller, if it expects it will have no employee after the transaction date, terminates its retirement plan.  The plan provides that the final distribution is a single-sum distribution.

For that final distribution, a distributee’s choices are:

a direct rollover to the buyer’s plan (unless the distributee is not eligible for that rollover);

a direct rollover to another eligible retirement plan the distributee specifies;

a payment of money.

The revised summary plan description, notice about the plan’s termination and final distribution, and distribution form explain that the default, if the distributee does not specify her choice, is a direct rollover to the buyer’s plan (or, if the distributee is not eligible with the buyer, to an IRA).

This resulted in about 95% of the seller plan’s assets going into the buyer’s plan.

But my experience with this is more than a few years ago.  (Among my clients, deals are stock deals, for business reasons unrelated to ERISA or tax law for retirement plans.)

When a buyer won’t accept the seller’s plan, are people still doing the default direct rollover I remember?

On 10/22/2020 at 6:02 PM, FORMER ESQ. said:

You are going to inherit the "other people's problems" in a stock sale whether you terminate the plan pre-merger or not.  That is why I asked. You can always quantify the risk in dollars and it brings down the purchase price or you may have a hold back provision in merger agreement. Either way, agree with JackS that due diligence is required.

I definitely agree that due diligence is required in M&A situations, but the one advantage of the "terminate and do not merge" answer is that while you may still inherit the acquired plan's problems in a stock sale, they are limited to a smaller group of participants and amount of plan assets.  If you merge the problem plan into another plan, the leverage regulators would have over the plan sponsor is greater.

Does the "one bad apple" rule happen in practice?

Suppose two plans merge.  The smaller of the plans, which held 10% of the combined plan's assets, came from a recent acquisition administered by staff other than the current employer's h.r. department.  The larger of the plans, which held 90% of the combined plan's assets, is the employer's ongoing plan, administered by the h.r. department for many years.  The IRS detects a compliance problem with the smaller of the two plans from a plan year before the acquisition closed and before the plans were merged.  Has anyone ever witnessed a situation where the IRS imposed greater sanctions because the plans had merged than the IRS would have imposed if the plans had not merged?

I've had a long career and I have never witnessed such a situation.  I am employed by a large consulting firm and have asked many co-workers this question and have never heard of a situation when the IRS was harsher because the plans were merged.  Yet I've heard scare talk of "tainted asset" and "one bad apply" numerous times. 

I've started telling clients that merging the plans poses a theoretical risk that one has tainted a larger pool of assets but that I've never witnessed it making a difference in practice.

MWeddell, while I don't express my opinion to clients quite that strongly, what you describe is typical to what I tell people.

They still usually go with the plan termination. I am guessing part of the reason for that is that it's easier to explain to their auditor and to their boss.

1 hour ago, Luke Bailey said:

They still usually go with the plan termination. I am guessing part of the reason for that is that it's easier to explain to their auditor and to their boss.

Yep.  Another reason might be who pays any admin costs.  Good documentation will include this.

1 hour ago, david rigby said:

Yep.  Another reason might be who pays any admin costs.  Good documentation will include this.

Right. And something else I thought about a few weeks ago representing a buyer. The seller may want a termination because that probably cuts off its exposure sooner. It will typically indemnify the buyer regarding plan compliance, whether the plan is terminated or merged, and the indemnities may last a couple of years. The seller's exposure on those indemnities will typically cut off, as a practical matter, sooner if the plan is terminated.