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Employee Benefits Developments May 2005

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Rulings, Opinions, Etc.

EBSA Expands and Simplifies Voluntary Fiduciary Correction Program. In April, the Employee Benefits Security Administration (EBSA) expanded and simplified the Voluntary Fiduciary Correction (VFC) program under which employers may voluntarily correct violations of certain Employee Retirement Income Security Act (ERISA) fiduciary rules. Under the VFC program, employers and plan fiduciaries may avoid penalties for certain violations if they fully correct the violations, restore to the plan any losses or profits with interest, and distribute any supplemental benefits owed to participants and beneficiaries. A “no action” letter is given to plan officials who properly correct violations.

Proposed changes to the VFC program include:

• Three new eligible transactions dealing with delinquent participant loan repayments, illiquid plan assets sold to interested parties, and participant loans that violate certain plan restrictions on such loans;
• Simpler correction methods and an online calculator for figuring out the amount to be restored to plans;
• Streamlined documentation and clarified eligibility requirements; and
• A model application form.

Although the changes were published in proposed form, EBSA has stated the new program is effective immediately and is available during a comment period, which ends June 6. A fact sheet on the revised VFC program is available at http://www.dol.gov/ebsa/newsroom/fsrevisedvfcp.html. The changes were officially published in the Federal Register at 70 Fed. Reg. 17,476 (April 6, 2005).

Bankruptcy Reform Addresses Retirement Asset Protection. On April 20, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“New Bankruptcy Act”). The New Bankruptcy Act answers many questions regarding which retirement assets would become part of an individual’s bankruptcy estate and therefore be available to creditors. The New Bankruptcy Act:

• Allows a debtor to exclude from his or her bankruptcy estate any benefits held under a fund or account exempt from taxation under Internal Revenue Code § 401(a) (qualified plans), § 403 (tax sheltered annuities), § 408 (individual retirement accounts (IRAs) and annuities),
  § 408(A) (Roth IRAs), § 414 (governmental and church plans), § 457 (non-qualified plans of tax-exempt and governmental employers), and § 501(a) (employee contribution plans).
• Limits the amount of the exclusion for IRAs (other than a SEP-IRA or a Simple-IRA) to $1.0 million (to be adjusted for inflation) and does not count amounts rolled into the IRA from employer tax-exempt retirement plans. The Bankruptcy Court would have the authority to increase the $1.0 million exemption for an individual in the interest of justice.
• Amends the rules applicable to participant loans from qualified plans. Plan sponsors will be able to continue to take loan repayments from individual’s paychecks and these participant loans are not subject to discharge in the bankruptcy proceeding.
• Excludes from the individual’s bankruptcy estate salary reduction contributions withheld from an employee’s paycheck but not yet deposited into a plan at the time of the individual’s bankruptcy filing.

The provisions of the new Bankruptcy Act are generally effective for bankruptcy filings commencing after October 17, 2005.

Keep Health Reimbursement Arrangements Tax Free. Following up on Notice 2002-45, the IRS has issued Revenue Ruling 2005-24 dealing with health reimbursement arrangements. The ruling covers employer arrangements that pay for or reimburse an employee for medical care expenses, including expenses of a spouse and/or dependent(s). These arrangements may pay medical insurance premiums or any other expenses that constitute medical expenses under IRC
§ 213. The IRS makes it clear in this ruling that the tax-free treatment of benefits received by an employee, spouse, or dependent is lost if the employee or any other person, including an estate, could receive cash or some other taxable benefit under the arrangement. If the employer arrangement allows for unused amounts credited for an employee to be paid in cash to the employee’s estate after death, for example, then all the medical benefits paid or reimbursed under the arrangement will be taxable, even if in some individual cases there is no unused cash to be paid. The ruling applies to plans or arrangements set up for active employees, retired employees, or arrangements that cover both active employees and retirees. Rev. Rul. 2005-24.

Cash Surrender Value Does Not Equal Fair Market Value—Part 2. New guidance has been issued that will apply to distributions and other transactions involving life insurance and employee plans as well as to transfers of life insurance contracts that require a determination of fair market value. Revenue Procedure 2005-25 should be consulted in connection with any plan transactions involving life insurance when the value of the policy is relevant. Last year, Rev. Proc. 2004-16 proposed “safe harbors” under which the cash value of a life insurance contract, with certain adjustments, could be used as the fair market value of the contract for tax purposes. In Revenue Procedure 2005-25, the IRS has adjusted these safe harbors. These guidelines are directed at abusive transactions in which the IRS believes employee plans have undervalued life insurance contracts for tax purposes. In some cases, the insurance company-stated “cash surrender value” has been significantly less than the replacement cost of the policy or other measures of the contract’s value. The safe harbor formulas are somewhat complex and involve knowledge of a contract’s terminal reserve, the amount of any unearned premiums, estimated dividends, and reasonable charges for mortality. Because the guidelines are applicable to transfers after February 12, 2004, the guidelines are now in effect. In any case involving determination of the fair market value of a life insurance contract, you cannot use the stated “cash surrender value” without carefully checking this procedure. Rev. Proc. 2005-25.

CASES

Supreme Court Addresses IRAs and Bankruptcy. Only several days before the adoption of the New Bankruptcy Act, the U.S. Supreme Court addressed the protections extended to IRAs within bankruptcy under current law. Under bankruptcy law prior to its amendment by the New Bankruptcy Act, an IRA could be includable in an individual’s bankruptcy estate depending on applicable state law. If the IRA was includable in the bankruptcy estate and if the state in which the debtor resided did not “opt out” of the federal exemption scheme, the courts were split on whether an IRA could qualify for an exemption for amounts which are reasonably necessary to support the account holder and his or her dependents. Several courts held IRAs were really savings accounts readily accessible at any time for any purpose and did not represent a right to receive a payment under an exempt stock bonus, pension, profit sharing, annuity, or similar plan or contract on account of age. The Supreme Court ruling holds IRA assets can be exempted from the bankruptcy estate to the extent that such amounts are reasonably necessary to support the account holder and his or her dependents. (Rousey v. Jacoway, U.S. Sup. Ct. 2005).

“Whistleblower” Protection Under ERISA. The U.S. Court of Appeals for the Second Circuit recently ruled an employee who approached company officers about the underfunding of the company’s § 401(k) plan may be protected from retaliation under ERISA § 510. Chrystina Nicolaou served as Director of Human Resources for Horizon Media, Inc. (“Horizon”). Nicolaou discovered a “serious payroll discrepancy” involving underpayment of overtime to employees resulting in the underfunding of the plan. Nicolaou reported the underfunding problem to her supervisors. Concerned by the lack of corrective action, Nicolaou contacted Horizon’s outside counsel, who conducted his own inquiry and confirmed Nicolaou’s findings. Nicolaou and the outside counsel met with Horizon’s president, William Koenigsberg, to discuss the problem. According to testimony, Koenigsberg appeared disturbed and “not at all pleased that this issue was being brought to his attention.” Shortly after the meeting, Nicolaou was demoted, and one month later she was terminated.

Nicolaou filed suit, alleging illegal retaliation in violation of the Fair Labor Standards Act (FLSA) and ERISA §510. The federal district court dismissed Nicolaou’s suit, holding it is not illegal under the FLSA to retaliate against an employee who brings complaints within the firm. The FLSA whisleblower provisions protect only employees who file a formal complaint with a regulatory agency or otherwise participate in a formal proceeding against the employer. The district court also dismissed the ERISA complaint, on the grounds that participation in a purely internal inquiry is not protected under ERISA. Nicolaou appealed the dismissal of her claim under ERISA.

On appeal, the Second Circuit reversed the federal district court, noting that the whistleblower language of ERISA §510 is unambiguously broader in scope than that of the FLSA. The court noted ERISA §510 extends its protections to any person who has given information in any inquiry relating to possible violations of ERISA. The federal appellate court then focused on the meeting with Koenigsburg, stating that if Nicolaou could demonstrate that she was contacted to meet with Koenigsberg in order to give information about the alleged underfunding of the plan, her actions would certainly fall within the protection of ERISA §510. Acknowledging that the meeting was “something less than a formal proceeding,” the court nevertheless professed its belief that the meeting rose to the level of an “inquiry” within the meaning of ERISA §510 and remanded the case to the district court for reconsideration. (Nicolaou v. Horizon Media, Inc., 2d Cir. 2005).

“Substantial Compliance” Is No Excuse for Missing Deadlines. Plan administrators in the Second Circuit who fail to meet ERISA deadlines for formally denying disability benefits are unlikely to find refuge in the doctrine of “substantial compliance.” Cecilia Nichols participated in her employer’s long-term disability plan administered by Prudential Insurance Company (“Prudential”). In April 2000, Prudential began paying long-term disability benefits to Nichols. Prudential subsequently notified Nichols that her benefits would be suspended because she was no longer totally disabled. She was also informed of her appeal rights and the need for an independent medical evaluation (IME). Nichols filed a written appeal. Prudential did not acknowledge the appeal until 67 days later, at which time Prudential stated it was performing a review and that Nichols would be contacted within 30 days with a decision. Prudential requested that Nichols submit to an IME. Nichols refused and, following an exchange of letters, filed suit against Prudential. Prudential moved to dismiss the suit for Nichols’s failure to exhaust administrative remedies.

The federal district court dismissed Nichols’s suit, holding that, while Prudential technically did not comply with ERISA’s 60-day regulatory deadline for review of a denial of benefits, Nichols ignored the “spirit” of the regulations. The court found that while Prudential had remained silent for 67 days following Nichols’s appeal letter, Prudential subsequently exhibited good faith efforts to gather new evidence and resolve the appeal—efforts that Nichols resisted. According to the court, these actions placed Prudential in “substantial compliance” with the regulatory deadlines.

On appeal, the U.S. Court of Appeals for the Second Circuit found the doctrine of substantial compliance did not excuse Prudential’s failure to comply with clear regulatory deadlines and remanded the case to the lower district court for review of Nichols’s entitlement to benefits under the plan. The federal district court held the doctrine of substantial compliance may be used to forgive technical noncompliance for purposes of review of a plan administrator’s discretionary decision, but that it may not be used to block or delay a plaintiff’s access to the federal courts. (Nichols v. The Prudential Insurance Co. of America, 2d Cir. 2005).

If the Statement Was True at the Time, It’s Not Necessarily False Later. In 1997, AT&T changed the method for calculating pension benefits in its Management Pension Plan from a traditional defined benefit formula to a cash balance formula. Participants were given the option of switching to the cash balance formula or maintaining the traditional formula subject to a one-time immediate enhancement, after which their retirement benefit would be frozen. AT&T told employees that, in most cases, if they were going to retire in the next four to seven years, the traditional formula with the enhancement would be the better choice. A certain group of middle managers (the Retirees) accepted the enhanced traditional formula for their retirement benefit and subsequently retired in 1997; working beyond 1997 would not have increased their retirement benefit. In 1998, AT&T offered a new, one-time “incentive” pursuant to a voluntary retirement incentive program that would further enhance a participants’ pension benefit. The Retirees were not eligible for this benefit because they had already retired. Subsequently, the Retirees filed suit claiming that AT&T violated its fiduciary duty to employees by falsely representing that the enhanced traditional benefit would provide the greatest benefits to retirees over the next four to seven years, and falsely represented that the accrued benefit under the traditional defined benefit plan would be frozen.

The U.S. Court of Appeals for the Third Circuit affirmed the federal district court’s ruling, holding that AT&T had not breached its fiduciary duty because AT&T believed the statements to be true at the time they were made to the Retirees. AT&T did not know about the voluntary retirement incentive program at the time the statements were made and the information describing the special enhanced pension benefit was accurate at the time it was provided to the Retirees. (Peterson v. American Telephone and Telegraph Co., unpublished 3rd Cir. 2005).