Executive Compensation Plans: Making Sure Your Top Hat (Plan) Fits

Transcription

1 ERISA LITIGATION August 2005 Executive Compensation Plans: Making Sure Your Top Hat (Plan) Fits By Brian E. Casey In an ever-competitive business climate, employers frequently grapple with how to attract and retain skilled executives. Executive compensation plans that provide deferred compensation are often important tools to help build and maintain an employer s core group of senior employees. Many such plans, though, can be subject to significant burdens and limitations imposed by the Tax Code and the federal law regulating employee benefit plans (the Employee Retirement Income Security Act of 1974 or ERISA ). One type of executive compensation plan is the top hat plan, which has become increasingly popular because Congress has exempted it from many of ERISA and the Tax Code s regulatory requirements. However, recent legislation amending the Tax Code, effective January 1, 2005, imposes increased penalties on covered employees whose top hat plan fails to fit inside the statutory exemptions. Therefore, it may be more important than ever for employers to consider the merits of top hat plans and ensure that any such plan is created and maintained consistent with current law, much of which has been the subject of refinement only through litigation and judicial decisions. This article sets out the legal framework surrounding top hat plans and identifies some basic issues to consider in this important but murky niche of employee benefits law. Background The Tax Code places significant limitations on qualified plans. Among other things, the Code prohibits discrimination in favor of highly compensated employees. IRC 401(a)(4). It imposes ceilings on an employee s pension benefits, including 401(k) plans. IRC 415(b)(1), (c)(1), 401(k) and 402 (g). And it restricts the amount of employee compensation qualified plans can recognize. IRC. IRC 401(a)(17). These limitations have caused employers to establish different methods of deferred compensation -- sometimes called supplemental executive retirement plans (SERPs) -- to avoid the limitations on deferred compensation for executives. Garratt v. Knowles, 245 F.3d 941 (7th Cir. 2001). Most qualified pension plans are also subject to ERISA s requirements regarding participation, vesting (including rules about benefit accrual, surviving spouse benefits, joint and survivor benefits, nonalienation of benefits, etc.), funding, and fiduciary requirements. However, ERISA specifically excludes from these requirements any plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees. 29 U.S.C. 1051(2), 1051(a)(3), and 1104(a)(1). Such a plan has become known as a top hat plan. The legislative history behind this language makes it clear that Congress meant to free deferred compensation programs for top executives from almost all ERISA regulation. However, Congress did not explain how to interpret terms like unfunded, primarily, select group, and management or highly compensated employees. BNA Pension & Benefits Rptr., Vol. 24, No. 16, pp (4/21/97). Instead, Congress left it to the Department of Labor ( DOL ) and the courts to interpret these terms. That interpretive process continues still today.

2 Interpretations that: DOL issued its most significant opinion regarding top hat plans back in In that opinion, DOL concluded [I]n providing relief for top hat plans from the broad remedial provisions of ERISA, Congress recognized that certain individuals, by virtue of their position or compensation level, have the ability to affect or substantially influence, through negotiation or otherwise, the design and operation of their deferred compensation plan, taking into consideration any risks attendant thereto, and, therefore, would not need the substantive rights and protections of [ERISA s] Title I. DOL Advisory Opinion 90-14A. As for Congress s requirement that a top hat plan be created primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees, DOL stated that the word primarily refers to the purpose of the plan (i.e., the benefits provided) and not the participant composition of the plan. One can reasonably conclude that a plan which extends coverage beyond a select group of management or highly compensated employees that can negotiate with or at least influence their employer with respect to the terms of the plan may not be a top hat plan and therefore not exempt from many of ERISA s administrative requirements. While this is an important general principle, this DOL opinion provides little help in fleshing out the specifics of the rule it imposes. DOL may not provide additional guidance on this issue because the agency announced recently that advisory opinions generally will not be issued on the status of a particular plan as a so-called top-hat plan within the meaning of [ERISA] because of the inherently factual nature of such requests. DOL Advisory Opinion 98-02A. Courts, therefore, have been left with the task of addressing the definitional questions Congress left open about top hat plans. They have begun to wade gingerly into this area, sometimes with contradictory results. I. Is The Plan Funded? A fundamental question regarding top hat plans is funding. ERISA s definition of a top hat plan requires in absolute terms that the plan be unfunded. In general, whether a plan is funded depends on factors such as: (1) whether assets have been earmarked for payment of benefits under the plan so that they are no longer part of the employer s general assets; (2) whether the funds are subject to the claims of the employer s creditors; and (3) whether plan participants have superior rights over the employer s general creditors or may seek payment of benefits directly from those assets. Reliable Home Health Care, Inc. v. Union Central Ins. Co., 295 F.3d 505 (5th Cir. 2002). Because top hat plans must be unfunded, many employers simply pay top hat plan benefits from their general revenues. However, this funding method can leave an employer s plan members particularly uncertain about the security of their deferred compensation. Some employers have sought to alleviate this concern by funding nonqualified plans such as top hat plans through rabbi trusts. DOL Advisory Opinion 92-13A. A rabbi trust is a grantor trust that is used to secure the company s promise to its executive(s) against the employer s refusal to pay benefits, but it does not provide security against the company s unsecured creditors if the employer becomes insolvent or goes bankrupt. The rabbi trust is so-named because the IRS first discussed this kind of trust when opining on the legality of deferring taxation on income earned by a trust established for the benefit of a rabbi. Bank of America v. Moglia, 330 F.3d 942, 944 (7th Cir. 2003) (discussing IRS Private Letter Ruling (Dec. 31, 1980)). Usually, a rabbi trust contains substantial limitations or restrictions on the beneficiaries access to trust assets. These limitations prevent a plan s beneficiaries from constructively receiving their benefits which would otherwise require them to declare any contribution to the trust or earnings as income in the year made even if the funds were not actually received until later. Treas. Reg (a); Treas. Reg (c). Often, these trusts can include provisions which allow a particular plan participant to obtain his or her benefit at any time (usually subject to some forfeiture provision to prevent all plan participants from being in constructive receipt of the benefits), in the event certain triggering events occur. The IRS has drafted a model rabbi trust which can serve as a helpful starting point for employers seeking to secure their promises to their executives. Rev. Proc Additional IRS rulings and regulations with respect to designing and maintaining rabbi trusts could impact the use of top hat plans in the future.

3 II. What Is A Select Group? ERISA states that a top hat plan must be maintained primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees. According to DOL, the word primarily refers to the purpose of the plan and not to the composition of the plan. DOL Advisory Opinion 90-14A. As a result, a plan which provides benefits to more than a select group of management or highly compensated employees may not be considered a top hat plan by DOL. From DOL s perspective, a top hat plan can only cover individuals with sufficient influence with the employer to meaningfully negotiate the design and operation of the plan. Id. However, the boundaries of what constitutes a select group of management or highly compensated employees remains fuzzy at best. It seems obvious, for example, that a plan covering only one out of 23 total employees is maintained for the benefit of a select group. Duggan v. Hobbs, 99 F.3d 307 (9th Cir. 1996). A closer question arose in Demery v. Extebank Deferred Compensation Plan (B). 216 F.3d 283 (2d Cir. 2000). There, the court concluded that a bank s deferred compensation plan was limited to a select group and therefore was a top hat plan even though the plan offered benefits to over 15 percent of the bank s employees, some of whom earned approximately $30,000 a year. The court acknowledged that top hat plans are typically offered to a very small percentage of an employer s workforce, but it stated that there is no existing authority that establishes when a plan is too large to be deemed select. In doing so, the court chose not to rely on the reasoning in Darden v. Nationwide Mutual Insurance Co., where the court found that 18.7 percent of an employer s workforce was too large a percentage for a plan to qualify as a top hat plan. Compare Darden v. Nationwide Mut. Ins. Co., 717 F. Supp. 388, 397 (E.D. N.C. 1989), judgment aff'd, 922 F.2d 203 (4th Cir. 1991), rev'd on other grounds, 503 U.S. 318 (1992). It is unlikely that a bright line exists between 15 percent and 18.7 percent of an employer s workforce. Rather, the composition of the group covered by the plan, the extent of their managerial responsibility, and the level of their compensation, are more likely to be dispositive. Moreover, ERISA s definition of a select group focuses not simply on the percentage or number of employees covered or even the amount of their managerial responsibility. It also examines those employees ability to affect the contours of the plan itself. In Duggan, the Ninth Circuit noted that the employees covered by a top hat plan must by virtue of their position or compensation level, have the ability to affect or substantially influence, through negotiation or otherwise, the design and operation of their deferred compensation plan. One can imagine situations, particularly in larger corporations, in which even members of senior management may lack the ability to affect the design and operation of their deferred compensation plan. Therefore, it is possible that even a small group of senior-level employees with management responsibilities could fall outside the scope of a top hat plan. The amorphousness of this definition can pose problems for employers seeking to provide additional deferred compensation to its management or highly-compensated employees. The broader the universe of employees eligible to participate in a plan, the greater the potential risk that ERISA s requirements dealing with minimum standards of participation, vesting, funding, and fiduciary duties could be determined to apply if an employer-employee dispute arises. III. What Law Governs Interpretation of Plan Terms? Top hat plans are, among other things, contracts. The question therefore can arise whether they are governed by state contract law. A number of courts have concluded that the terms of top hat plans should not be construed under state law; instead, courts should use federal common law that can be a somewhat ad hoc body of law. How this impacts the interpretation of a particular top hat plan depends. For example, in Kemmerer v. ICI Americas, Inc., the court held that the employer sponsor of a top hat plan could not unilaterally amend or retroactively modify the terms of the plan as applied to two former employees. The court concluded that federal common law governed the interpretation of the employer s contractual obligations, and, under federal law, the employer had no right to terminate the benefits after the employees performance had been completed. 842 F. Supp. 138 (E.D. Pa. 1994), judgment aff'd in part, appeal dismissed in part, 70 F.3d 281 (3d Cir. 1995). Federal common law often incorporates general principles of contract law which may differ from the way contracts are interpreted in a particular state. The issue of consideration is often particularly important in a dispute between an employer and a former employee. For example, in Bennett v. Romo Corp., the Third Circuit held that an amendment to a former executive s severance agreement, significantly reducing deferred compensation benefits under

4 the employer s top hat plan, lacked consideration and thus would not be enforceable against the executive. 275 F.3d 33, 26 Employee Benefits Cas. (BNA) 2469 (3d Cir. 2001) (unpublished). IV. What Is The Standard of Review? Just as contract principles are important when analyzing a top hat benefit dispute, so too is the standard of judicial review. In Goldstein v. Johnson & Johnson, the Third Circuit ruled that the abuse of discretion standard of judicial review, common in cases resolving ERISA benefit disputes, did not apply in a review of the top hat plan administrator s decision. 251 F.3d 433, (3d Cir. 2001). The court acknowledged that discretion may be explicitly written into a top hat plan document, but that such plans should be treated as unilateral contracts where neither party s interpretation should be given precedence over the other s, except in accordance with ordinary contract principles. Some courts do not, however, agree with Goldstein s conclusion on the appropriate standard of judicial review. They give top hat plan administrators more leeway and review their decisions based on the more lenient, abuse of discretion standard. See, e.g., Scipio v. United National Bankshares, Inc., 284 F.Supp. 2d 411, 417 n.10 (N.D. W. Va. 2003); Adams v. Louisiana-Pacific Corp., 284 F. Supp. 2d 331, 336 (W.D. N.C. 2003). Courts will undoubtedly continue providing additional guidance in top hat plan disputes. Over time, those decisions should provide further definition (or conflict) regarding these increasingly important programs. Current Events Recent changes in the Tax Code effective on January 1, 2005 make ensuring that a top hat plan complies with the law more important than ever. See IRC 409A, enacted as part of the American Jobs Creation Act of 2004, Pub L No , 118 Stat 1418, October 22, 2004, 885. Tax Code Section 409A imposes new, stiffer taxes on recipients of non-qualified deferred compensation from plans which have violated various provisions of the Tax Code. With the enactment of IRC 409A, employers face a new set of tax rules that add an additional layer of regulatory requirements to an already complicated body of law. See, e.g., IRS Notice This increased regulatory attention to non-qualified deferred compensation plans could influence employers future use of top hat plans. Practical Pointers The competitive market for executives and the regulatory limitations of the Tax Code and ERISA make deferred compensation vehicles like top hat plans helpful tools for employers to use when building and maintaining their talent pool. On the other hand, the fuzziness of some key definitions of what a top hat plan is can leave employers with difficult choices as to how to design and maintain such a plan. Unfortunately, sometimes the vulnerabilities of a particular top hat plan only come to light after an employee or spouse (or even DOL) has instituted legal proceedings claiming that the employer failed to comply with one of the many ERISA requirements from which top hat plans are exempt. For employers who are considering establishing a top hat plan but have not yet done so, the potential advantages of such a program should be weighed against the risk that the program could give rise to regulatory or litigation problems later. Employers with one or more top hat plans already in place would be prudent to review both legal and operational developments periodically to determine whether any changes have altered the legal or human resources considerations affecting those plans. An operational review could include an analysis of the extent to which the plan s inclusion of non-executive employees could jeopardize its top hat status. Where warranted, changes could be made to existing programs to reduce the risk of a dispute over whether the plans are limited to a select group of management or highly compensated employees. Such changes could include: splitting the plans along business operation lines, demographic lines, or on other relevant distinctions; freezing the program and allowing no new entrants; or terminating the program and paying all accrued benefits. A legal review could include consulting with experienced counsel about the existence of any pertinent developments in ERISA or the Tax Code (including their implementing regulations and any relevant agency pronouncements) or caselaw construing those statutes and regulations.

5 Top hat plans can be an important means to defer the compensation of an employer s senior executives without the increased compliance burden of ERISA s participation, vesting and accrual, and fiduciary requirements. However, ensuring that top hat plans are designed and administered within the imposing regulatory frameworks of ERISA, the Tax Code, and the evolving caselaw also can be challenging. Employers considering or already maintaining such plans may be well-advised to do so with the assistance of counsel experienced in these specialized niches. PENSION & BENEFITS LITIGATION PRACTICE GROUP Barnes & Thornburg LLP regularly represents clients in ERISA and other pension and benefit litigation cases. Our Pension and Benefits Litigation Practice Group includes federal practitioners and ERISA attorneys who often work in tandem to attack and defend claims. The members of our Pension and Benefits Litigation Practice Group litigate pension and benefit matters, including benefit claims, fiduciary claims, withdrawal liability issues, multi-employer plan issues, cash balance pension litigation, ERISA class actions, interpleader actions, Section 510 claims, and QDRO litigation. Our breadth of representation in ERISA litigation and other pension and benefit matters ranges from Fortune 500 companies to privately-held businesses. Our practice is national in scope and includes representing clients in cases before the United States Supreme Court. The attorneys who comprise the Pension & Benefits Litigation Practice Group include the author of the leading ERISA treatise published by West, ERISA Practice & Litigation. Brian Casey is an attorney in Barnes & Thornburg s South Bend office. For more information on this article, please contact him at or brian.casey@btlaw.com. This Barnes & Thornburg LLP publication should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer on any specific legal questions you may have concerning your situation. If you would like to receive future Alerts by , please send your address or address changes to jennifer.whitley@btlaw.com. Brian Casey 2005 ALL RIGHTS RESERVED