Hidden Pension Liabilities in Deals | Norton Rose Fulbright
By the beginning of 2003, industrial giant General Motors’ defined benefit plan was underfunded by more than 137% of the market capitalization for the entire company. In an attempt to make up this shortfall, GM issued more than $13 billion in debt to inject into the defined benefit plan. And GM is not alone in its underfunding problems. The list of companies with defined benefit plans that are underfunded by 50% or more of market capitalization as of the start of this year includes many of America’s top companies such as Delta Airlines and Xerox Corp. — to name a few.
The sheer scale of this underfunding is causing buyers of power projects from distressed merchant power companies to ask whether they face any potential exposure to such liabilities. With liabilities in underfunded pension plans reaching into the billions of dollars, depending on the size of the company, the concern is understandable.
The liability is imposed under a 1974 law called the “Employee Retirement Income Security Act of 1974,” or “ERISA.” Although ERISA has been around for almost 30 years, most people are surprised to learn how far the long arm of ERISA reaches. In an era where over 50% of pension plans are underfunded by more than $300 billion, where many companies are in bankruptcy, and where the Pension Benefit Guaranty Corporation — the United States government agency that insures underfunded pension plans — had a deficit as of April of more than $5.4 billion, perhaps at no time has ERISA’s long arm become more evident.
Two Types of Plans
There are two different types of pension plans that companies can offer their employees: “defined contribution plans” and “defined benefit plans.” Underfunded pension liabilities are potentially a problem for anyone buying a project from a company with a defined benefit plan.
A defined contribution plan provides retirement income to its participants based on the actual value of the assets in the plan at the time of the participant’s retirement. Defined contribution plans are funded by contributions made by the company and its employees. Defined contribution plans usually provide for individual participant accounts so that each participant will know exactly how much he or she has to draw on as retirement benefits at any given time. Typical forms of defined contribution plans are 401(k) plans and employee stock ownership plans.
A defined benefit plan provides retirement income to participants based on a specified formula in the plan. The formula is usually based on a participant’s average compensation over a specified period of years, the participant’s years of service with the company and the participant’s age at retirement. Defined benefit plans do not normally provide for individual participant accounts. Instead, all assets of the plan are combined together. Defined benefit plans must be funded by the company. The amount of funding required for a particular year is determined actuarially under rules in the US tax code and ERISA aimed at ensuring that there will be enough money in the plan to meet the plan’s benefit obligations as they come due. The actuarial assumptions used to determine the annual required funding are also governed by the tax code and ERISA and include assumptions about long-term interest rates, mortality rates, turnover and retirement age.
Many companies adopted defined benefit plans for their employees during the period 1900 through about 1985. During this period, defined benefit plans grew in number from 12 to approximately 112,000 plans. However, starting around 1985, defined contribution plans began to eclipse defined benefit plans in popularity and, in fact, the number of defined benefit plans contracted to a point where there are only about 32,000 such plans today (covering about 44 million workers and retirees). Most companies that still offer defined benefit plans are in the manufacturing and services industries. Also, companies with union workers are more likely to have defined benefit plans. In the United States, more than 80% of companies whose employees are covered by a union contract offer a defined benefit plan.
Controlled Group Liability
Power projects are usually owned by special-purpose companies. It does not matter that the special-purpose company has no defined benefit plan if affiliated companies in the same “controlled group” do.
A controlled group consists of two or more entities that are connected, either directly or indirectly, through ownership of at least an 80% interest. In the case of partnerships, such ownership is measured by at least 80% of the profits interest or capital interest of the partnership. However, the ownership test is not a bright-line test. The Pension Benefit Guaranty Corporation, or PBGC, will review the facts and circumstances to determine whether the 80% threshold has been met. The PBGC has a strong interest in trying to recharacterize debt or other interests as capital or profits interests in order to argue that the 80% threshold has been met.
Under ERISA, a project company is “jointly and severally” liable for any underfunding of defined benefit plans maintained by other members of its controlled group, even if the company’s employees do not participate in the defined benefit plan and even if the company does not have any employees. “Joint and several” liability means that a project company can be held liable for the full underfunding in an affiliate’s defined benefit plan.
Liability for underfunding is triggered when one of three events occurs: 1) when the underfunded defined benefit plan is terminated, 2) when the affiliate with the defined benefit plan fails to make a contribution when due, or 3) when the affiliate fails to pay insurance premiums when due to the PBGC to insure the defined benefit plan.
A company may remain jointly and severally liable for pension benefits even after it leaves a controlled group. Under section 4069 of ERISA, a company may be held jointly and severally liable for certain pension-related liabilities of its former controlled group members, if a defined benefit plan maintained by a former controlled group member is terminated (or contributions or premium payments are missed) within five years after the company leaves the controlled group and the PBGC establishes that a principal purpose of the sale resulting in the company leaving the controlled group is to evade liability under ERISA. Although section 4069 of ERISA — known as the “successor liability” or “sham transaction” provision of ERISA — has rarely been invoked, the PBGC has threatened companies with liability under this section.
How Much Exposure?
Typically, the latest actuarial valuation of the plan is the best source of data for measuring the amount that a defined benefit plan is underfunded. The actuarial valuation is usually part of the latest federal income tax return filed for the plan on Form 5500. Buyers of distressed energy projects should ask for a copy of this form as part of their due diligence. The actuarial valuation shows the assets and liabilities of the plan and its annual costs. It also shows the assumptions used to calculate these liabilities. Buyers should pay careful attention to the assumptions used by the plan, particularly the interest assumption. The interest assumption determines the rate at which plan assets will appreciate. The higher the assumed interest rate, the less likely the plan is to show potential liabilities.
The actuarial valuation also normally shows the accumulated benefit obligation (accrued benefits to date) and the projected benefit obligation (estimated accrued benefits for the plan as it continues). The valuation also shows whether assets would exceed liabilities if the plan were terminated immediately. However, it usually uses actuarial assumptions that suggest a smaller liability than may actually be imposed if PBGC actuarial assumptions were used. The PBGC retests the adequacy of the amounts in the plan after involuntary termination of the plan by the PBGC or a voluntary termination by the plan sponsor. Therefore, buyers should ask that the calculations be redone using PBGC termination rates. However, this calculation is often not available and may not be easily obtained.
Buyers should also check for what purpose the liabilities have been calculated. There are three ways to calculate plan liabilities: 1) for funding purposes, 2) under financial accounting rules, and 3) on a termination basis. Liabilities measured for funding purposes use assumptions that reflect long-term projections and do not necessarily represent current conditions. Therefore, it is possible that a defined benefit plan uses an interest rate assumption that is higher than the current rate. Liabilities measured for financial accounting purposes are typically based on a portfolio of highly-rated corporate bonds. Due to fluctuations in corporate bond rates, there can be considerable volatility in this valuation from year to year. Liabilities measured on a termination basis are calculated by using assumptions set by the PBGC. This liability is based on benefits accrued to the date of a plan termination, without any liability for future salary increases. Additionally, PBGC interest rates are generally lower than those used under the financial accounting method and the funding method. A plan that appears to be fully funded on a funding and financial accounting basis could be substantially underfunded on a termination basis.
The consequences of losing sight of which accounting method was used can be staggering. Consider two large American companies who were recently going through the bankruptcy process and attempted to terminate their defined benefit plans: Bethlehem Steel and US Airways. When Bethlehem Steel terminated its defined benefit plan, its last filing with the US Department of Labor said the pension plan was 84% funded on a current liability basis. However, the PBGC found that the pension plan was only 45% funded on a termination basis, with a total underfunding of $4.3 billion. US Airways had a similar experience. Its last filing with the US Department of Labor said its defined benefit plan was 94% funded on a current liability basis. However, the defined benefit plan was only funded 33% on a termination basis, with a total underfunding of $2.5 billion.
Any buyer who finds there is a defined benefit plan in any company that is a member of the same controlled group as the project company he is purchasing should have an actuary review the financial information reported to the IRS on Form 5500 to assess the risks involved.
Protection From Liabilities
The most important ways a buyer can protect himself from potential defined benefit plan liabilities are doing thorough due diligence and incorporating strong representations and warranties in the purchase agreement.
Due diligence is usually a simple process. Information on the employee benefits of the acquisition company such as current and prior years actuarial reports and Form 5500s should be made available to the purchasing company by the seller. In addition, employee benefit information can be found in the Form 10-K that the seller files with the US Securities and Exchange Commission. Also, older Form 5500s should be reviewed to reflect any changes made to the accounting assumptions.
Do not make the mistake many buyers do of assuming there is no issue because the project company being purchased has no employees and no pension plan. Ask questions about the employee benefits of the controlled group and the capital structure of both the target company being acquired and potentially affiliated companies. Assess whether the PBGC might be able to recharacterize debt instruments as equity in order to bring more companies into the controlled group. The information needed may be hard to obtain due to confidentiality provisions and the lack of access. Regardless of the difficulty involved, with potential liabilities running into the millions or billions of dollars, this step cannot be pushed to the side and should remain one of the top issues when discussing any transaction.
The employee benefits sections of the purchase agreement should contain strong representations, warranties and indemnity provisions. The seller should represent that no defined benefit plan in the controlled group has been terminated in other than a standard termination. He should also represent that all required funding contributions have been made to all pension plans in the controlled group. Other representations might state that the target company is not a member of any controlled group, that no employee of the target company has provided services — for example, under an employee leasing arrangement — to another company in the same controlled group whose employees participate in a defined benefit plan, that no ERISA event has occurred (an event that requires notice to the PBGC) and that could cause every member of the controlled group to be liable for defined benefit plan liabilities, and that no ERISA event is likely to occur. Finally, the buyer should receive the strongest indemnification possible for any breach of the representations.
Relief in Sight?
With the US stock market still struggling and interest rates still low, the total amount of underfunding in all defined benefit plans has hit amounts never seen before. Some estimates have the total defined benefit plan underfunding in the trillions of dollars. ERISA requires pension plans to project future earnings on pension plan assets using the average interest rate on 30-year Treasury bonds over the last four years. The US government has discontinued the 30-year bond. A dwindling number of such bonds is still outstanding. Interest rates on the bonds have fallen to levels below the rates on similarly-rated corporate bonds.
Two years ago, Congress responded to the problem by allowing companies to use 120% of the 30-year Treasury bond rate. However, this relief was temporary. Authorization to use 120% expires at the end of this year. Congress is debating what to do next. Among the options being considered are to use corporate bond rates or a “yield curve.” The yield curve is the interest rate on a bond with a duration equal to the period from the calculation date through the date the average plan participant is expected to retire. This issue is high on the Congressional agenda, but it is possible that only a “stopgap” measure will be passed by the end of the year. And whatever Congress will not eliminate the problem — only change the formula for calculating the amount of underfunding.