CLIENT ALERT – December 16, 2020
During these financially difficult times – with a raging pandemic, sharply reduced revenues, historically low interest rates, and pension contributions slated to increase dramatically – many employers are finding that the skyrocketing costs of funding their pension plans are threatening their viability and ultimate survival. A little-known provision in ERISA, often referred to as the “Business Continuation Test,” could provide an employer with a non-bankruptcy solution to enable it to continue its business operations unsaddled by those pension obligations.
While ending a pension plan may be painful for both the company’s management and its current and former employees, if it comes down to a choice between death of the plan or death of the company, the company’s survival comes first – even under federal pension law.
Plan Termination Options
There are only two ways to terminate a PBGC-covered plan voluntarily: a “standard termination” and a “distress termination.” (In limited circumstances, PBGC can initiate what is called an “involuntary” termination to protect its own interests or those of a plan’s participants.) Because a standard termination requires, among other things, that the pension plan be fully funded (that is, it must have sufficient assets to cover all benefit liabilities), it is out of reach for many employers in today’s economic environment. That leaves a distress termination as the only remaining option.
Distress Termination Tests
To qualify for a distress termination, the plan sponsor and each member of its “controlled group” must meet one of four financial distress tests set forth in Title IV of ERISA. (The companies need not meet the same test.) Generally, a controlled group includes companies related to each other through 80% or more ownership by a parent company or companies, or by the same five or fewer individuals, estates, and/or trusts. The complex Internal Revenue Code rules regarding ownership attribution and the exclusion of stock owned by certain entities require that the facts be carefully scrutinized in order to determine the makeup of the controlled group.
The first and second distress tests apply to controlled group members who are in bankruptcy or similar proceedings. The first distress test requires that the controlled group member be in liquidation under federal or state (or local) law. The second test applies only to a controlled group member that is in reorganization proceedings under federal or state (or local) law. Under this test, the bankruptcy court (or other appropriate court) must determine that, unless the plan is terminated, the controlled group member will be unable to pay all its debts pursuant to a plan of reorganization and will be unable to continue in business outside the reorganization process, and must approve the termination.
Both the third and fourth distress tests apply to ongoing employers that need not be in bankruptcy or similar proceedings. Our focus here is on the third test, which is discussed in detail below. (The fourth test – which applies when the costs of providing pension coverage have become unreasonably burdensome solely as a result of a decline in the workforce covered by the employer’s pension plans – is rarely used, but should always be considered where there has been a significant drop in the covered workforce.)
Business Continuation Test
An ongoing employer seeking to terminate its underfunded pension plan may do so in the context of a Chapter 11 reorganization case, relying on the second distress test. A bankruptcy filing in many cases may be appropriate. However, such a filing can be expensive, time-consuming, and inefficient; in addition, it can disrupt the employer’s customer base and result in a loss of control. For an employer whose non-pension debt is manageable or can be successfully renegotiated, the third distress test (and, in limited circumstances, the fourth distress test) provides the possibility of a more surgical solution to the pension problem.
Under the Business Continuation Test, a controlled group member qualifies for distress if it demonstrates “to the satisfaction of the corporation [PBGC] that, unless a distress termination occurs, such person will be unable to pay such person’s debts when due and will be unable to continue in business.” Substantively, it is similar to the reorganization distress test, but with the determination being initially made by PBGC rather than by a court.
The Business Continuation Test is stringent, but for an ongoing employer facing both the economic consequences of the pandemic and dramatically increasing pension contributions, it could provide an avenue of relief from pension costs that are no longer affordable.
In reviewing any such case, PBGC can be expected to make a searching inquiry into the employer’s financial status and prospects. PBGC rules require the submission of detailed and comprehensive financial and actuarial information, including audited financial statements for the five most recent fiscal years; projections of future revenues, expenses, and cash flow for at least five fiscal years; and pension cost information. The projections should include the costs and details of any alternative, affordable replacement retirement arrangements planned for the future. The necessity of providing detailed projections reflects the fact that the attempted termination of the plan cannot simply be a desperate Hail Mary Pension Pass to PBGC; the employer must have a viable business plan that demonstrates continuation in business without, but not with, an ongoing pension plan.
The employer bears the burden of demonstrating that the Business Continuation Test is met. To do so, the employer needs to show that all other reasonable cost-cutting measures have been implemented and that plan termination is the last resort to prevent the company’s demise. Relevant evidence would include a showing that loans have been renegotiated to the extent possible; contracts with employees and suppliers have been renegotiated where appropriate and feasible; capital expenditures have been cut or postponed to the maximum extent prudent; executive compensation has been reduced and perquisites curtailed or eliminated to the extent feasible, taking into account the need to offer competitive compensation packages; inefficiencies have been identified and corrected where possible; and non-performing business units have been sold or closed.
PBGC may also require the submission of any additional information it deems relevant, such as evidence that the employer will be unable to obtain financing or capital investment absent plan termination and analyses regarding the feasibility and impact of a plan freeze, of minimum funding waivers from the IRS, or of changes (where permitted) in actuarial assumptions.
Plan Termination Liabilities
If distress is found under the Business Continuation Test and the plan terminates, the plan sponsor and the members of its controlled group are each liable, on a joint and several basis, for amounts that, in the aggregate, often represent their largest liability: (1) the plan’s unfunded plan benefit liabilities; (2) any unpaid minimum funding contributions; (3) any unpaid annual PBGC premiums and related penalty and interest charges; and (4) a sizeable “termination premium” of $1,250 per participant, per year, for three years following plan termination. Significantly, for purposes of determining whether or not the Business Continuation Test is met, the projections regarding plan costs that PBGC rules require include not only the projected cost of meeting minimum funding standards but, also, on an alternative basis, the cost of plan termination based on payment of projected plan termination liabilities. The employer’s projections regarding termination liabilities should reflect a reasonable resolution of those liabilities.
The need to present what is essentially a payment plan regarding potential liabilities to PBGC highlights the fact that a successful termination case under the Business Continuation Test will also involve a resolution of the resulting termination liabilities. Thus, if the distress termination is approved, the employer’s pension debt can be restructured so that it becomes affordable and can be paid without threatening the employer’s viability going forward. PBGC has broad authority to settle these liabilities with employers, and is unlikely to approve a distress termination based on the need to ensure that an employer can continue in business, and then insist on a settlement structure that would result in the employer being unable to continue in business.
Need for Prompt Action
It is important to assess the situation promptly and carefully. Indeed, consider the following very near-term example: many employers are now facing a very large and unaffordable contribution that must be made by January 4, 2021, pursuant to the contribution deferral provision in the CARES Act.
If it appears that plan termination is appropriate, the process should be initiated as soon as prudently possible and liability issues should be addressed proactively. As long as the plan continues, its costs will mount. For example, statutorily-required minimum funding contributions will continue to accrue. Moreover, if required but unaffordable minimum funding contributions are missed, liens enforceable by PBGC under Section 430(k) of the Internal Revenue Code will arise once the total amount (including interest) exceeds $1 million, and any failure to satisfy the minimum required contribution for a plan year will result in excise taxes under Section 4971 of the Internal Revenue Code. Once it is no longer possible to satisfy at least enough of a required contribution to avoid a lien or an excise tax, the path forward becomes more challenging. That said, even after liens and/or excise taxes arise, there are steps that can be taken to work with PBGC to lessen the impact of a lien and to resolve PBGC pension liabilities, and to work with PBGC and IRS to resolve excise tax liabilities.
If timely invoked, the Business Continuation Test could be the key that enables a company to turn around its troubled business. Successfully navigating the thicket of ERISA’s distress termination rules is challenging, but it is doable; indeed, it may be essential for an employer’s survival.
Employers or their professional advisors who would like to discuss issues relating to distress terminations may contact any of our professionals at 202-558-5150.
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