When two companies merge or a business is acquired through a stock or asset purchase, attention must be paid to the benefit plans and executive compensation agreements of the target. Particularly in a merger or a stock acquisition, the surviving entity or buyer will generally become responsible for the benefit plans of the target, and any liabilities associated with those plans. Even in an asset acquisition, the buyer may be responsible for the seller's liabilities under certain circumstances. Assessing the extent of any potential liability is critical, so that those liabilities are reflected in the price paid, or so that amounts can be escrowed to protect the buyer from the costs of any potential liabilities.
Exposure Depends On Nature Of Transaction
In a stock sale or merger, the acquiring or surviving entity automatically becomes the sponsor of the target's benefit plans, and thus will be responsible for any liabilities associated with those plans. In an asset sale, the purchaser is generally not responsible for the liabilities of a target's benefit plans, unless it explicitly agrees otherwise. There are two exceptions to this general rule, however. First, the purchaser may become liable for required contributions to a defined benefit pension plan if it is considered an alter ego of or successor to the seller.1 Second, an asset purchaser may be required to offer COBRA continuation coverage to the seller's employees.
Understanding The Risks
If the target sponsors one or more qualified retirement plans, the associated risks typically arise from a failure of the target to comply with federal tax and labor laws that apply to those plans. Noncompliance may result in the assessment of tax penalties, the loss of deductions claimed in prior tax years, the need to make additional contributions to plans, additional income tax liability for participants, civil or criminal penalties, or litigation expenses and costs.
If the target participates in a multiemployer pension plan, unique liability issues arise. If the target will either completely or partially withdraw from the plan as the result of the merger or acquisition, the surviving entity or buyer may become liable for multiemployer withdrawal liability payments. Multiemployer withdrawal liability is a liability imposed by federal law on employers who withdraw from an underfunded multiemployer pension plan (that is, a plan whose assets are insufficient to cover all of the plan's vested benefits). The possible exposure to this multiemployer withdrawal liability can make a merger or purchase economically unsound.
When the target provides group health plan coverage to its employees, either the buyer or the seller may be required to provide continued health care coverage to those employees of the target who are losing that coverage as the result of the transaction (and to former employees who are receiving such coverage from the seller at the time of the transaction). These rules derive from the Consolidated Omnibus Budget Reconciliation Act of 1985 ("COBRA"), which requires most employers to offer continued health coverage to persons who would otherwise lose that coverage as the result of certain specified "qualifying events," including termination of employment. The consequences for failing to provide required COBRA coverage (including required notices) include civil penalties up to $110 per day,2 a penalty tax of $100 per day,3 and possible liability for the costs of an affected employee's medical coverage.
In a stock purchase, the acquired entity remains in existence, so the transaction is not a qualifying event in and of itself. However, persons already receiving COBRA coverage and persons who are terminated as a result of the transaction must continue to receive or be offered COBRA. Usually, the group that includes the seller must provide COBRA coverage unless it no longer maintains any health plans as a result of the sale, in which case coverage must be provided by the purchaser.4 In an asset purchase, the transaction is a qualifying event unless (i) the target's employees continue to be covered under a plan of the target, or (ii) the buyer continues the business of the target without interruption or substantial change and also employs the target's employees. Usually, the group that includes the target must provide COBRA coverage, unless it terminates all its health plans as a result of the sale, in which case a buyer who is a successor employer may be liable for that coverage.
Where executive compensation is concerned, a buyer must identify all the plans and arrangements that may provide executives with special compensation, including severance plans, employment contracts, equity-based compensation arrangements, and nonqualified deferred compensation plans. A change in ownership or effective control of a corporation may trigger payments to senior executives or shareholders of the target, which payments may be subject to detrimental "golden parachute" tax rules. To the extent the total of such payments equals or exceeds three times the executive's regular annual compensation, the excess is not generally deductible to the corporation5 and the executive is generally subject to a 20% penalty tax.6 In some cases, it may be possible to structure the transaction to avoid these rules.
Identifying The Risks
A thorough due diligence review of a target's employee benefit plans is a necessary component of any merger or acquisition. Competent employee benefits attorneys must be retained to review the target's plans and their operation, so as to identify any potential liabilities associated with those plans. These attorneys should be involved in the transaction from the very start, but this is particularly key if there are multiemployer pension plans in the picture. Moving Beyond Liability Assessment
After performing the necessary due diligence, buyers must decide how to treat any plans for which they may now be responsible. Depending on the type of plan involved, the buyer might decide to terminate those plans, merge them into the buyer's existing plans, or continue them as stand-alone plans. A number of the more significant issues of each of these approaches is discussed below. In addition, where executive compensation is concerned, the buyer will want to review its benefits and compensation philosophy; compare compensation and benefit levels; analyze the impact of a change of control under the target's plans, develop an integration strategy; provide information to executives; amend current compensation and benefit plans and other agreements; and develop and implement new plans.
Terminating The Plans. In order to terminate a plan, the plan documents must contain a provision permitting termination. While this is generally the case with most plans, any plans covering bargaining unit employees generally cannot be terminated without the consent of the union. It is crucial for the purchaser to review all disclosure documents (including Summary Plan Descriptions and Summaries of Material Modifications) to ensure the right to terminate has been properly preserved.
- For welfare plans (such as group health plans, life insurance plans, disability plans, etc.), the buyer must coordinate with any insurance carriers to ensure that coverage continues until the date of merger or acquisition, but not beyond.
- For retirement plans, termination will automatically trigger the right to full vesting of all plan benefits.7 Distributions to plan participants may result in taxable income, unless they are eligible to be rolled over to another retirement plan (including a plan of the buyer) or to an individual retirement account.8
Defined benefit plans. Distributions from plans that are defined benefit plans present special challenges, since these plans frequently pay benefits only in the form of lifetime annuities. When a defined benefit plan is terminated, there is no continuing trust from which to pay the annuity income, and so annuity contracts must generally be purchased from an insurance company, which assumes the payment obligations of the plan. In addition, most defined benefit plans are covered by mandatory government insurance through the Pension Benefit Guaranty Corporation ("PBGC")9 and can only be terminated by following detailed procedures established by the PBGC, including advance notices to the PBGC and participants.10 The funded status of the defined benefit plan will affect the termination process, since underfunded plans may be terminated only with the consent of the PBGC, and employers must decide how to eliminate excess assets in an overfunded plan. The excess assets may be returned to the employer as taxable income subject to an excise tax, used to establish a "replacement plan," or used to provide increased benefits to participants.11
401(k) Plans. Distributions of employee pre-tax deferral contributions are permitted if the plan is terminated. However, distributions may not be made if a member of the plan sponsor's aggregation group sponsors another defined contribution plan (except for an employee stock ownership plan) within one year prior to or after the date of termination.12 Therefore, if the seller waits to terminate the plan until after the transaction closes, and the buyer maintains a defined contribution plan, distributions from the seller's 401(k) plan are not permitted.
Merging The Plans. It is generally not possible to "merge" welfare plans together, particularly if the benefits are provided through contracts of insurance. Merging retirement plans is often avoided, since irregularities in either plan may jeopardize the resulting merged plan. However, if a merger of retirement plans is desired, the buyer must make sure that no "protected benefits," such as vested benefits that participants have accrued, the timing of distributions, and the right to certain forms of distributions, are reduced or amended out of a plan.13 The buyer must also examine the differences between the merged plans (such as differences in eligibility rules, contribution formulas, or vesting schedules) and decide how to resolve them. Advance notice of a merger of retirement plans may be required, if the merger will result in a significant reduction in the rate of future benefit accrual,14 or if participants will be restricted from directing their accounts or receiving loans or distributions for more than three business days ("blackout period").15
Maintaining Separate Plans. Generally, a buyer may elect to separately maintain the plans of the target, although this may create added expense for the company. If separate plans are maintained, the buyer must ensure that each plan satisfies applicable coverage and nondiscrimination rules. Maintaining separate plans may also create human resource issues if the plans provide different levels of benefits. The buyer should carefully review the terms of each plan, particularly the eligibility provisions, to ensure that newly-acquired employees are not inadvertently eligible to participate in the buyer's pre-existing plans and to ensure that existing employees are not inadvertently eligible to participate in the target's plans. For qualified retirement plans, the buyer must recognize a participant's service with the target for both eligibility and vesting purposes.16
Summary
Because the employee benefits issues that exist in a merger or acquisition are extremely complex and can present significant financial liabilities to buyers, it is critical that buyers perform the necessary due diligence. A competent employee benefits attorney who is involved in the transaction from the beginning can protect the interests of the buyer and help avoid some very costly mistakes.
1See, e.g ., Chicago Truck Drivers, Helpers and Warehouse Workers Union (Independent) Pension Fund v. Tasemkin, Inc., 59 F.3d 48 (7th Cir., 1995), and Operating Engineers Pension Trust v. Reed, 726 F.2d 513 (9th Cir., 1984).
2ERISA § 502(c)(1).
3 IRC § 4980B(b).
4 Treasury Regulation § 54.4980B-9.
5 IRC § 280G.
6IRC § 4999 .
7IRC § 411(d)(3)(A).
8 IRC § 401(a)(31).
9 ERISA Title IV, §§ 4000 et seq.
10 ERISA § 4041(b).
11 IRC §§ 4980(a) and (d).
12 IRC § 401(k)(10)(A); Treasury Regulation § 1.401(k)-1(d)(3).
13 IRC § 411(d)(6); Treasury Regulation § 1.411(d)-4.
14 ERISA §204(h) and IRC §4980GF.
15ERISA §§ 101(i); 101(i)(2)(B).
16 IRC § 414(a).
Published July 1, 2005.
