Deadlines and Developments Affecting Employee Benefit Plans

Deadlines and Developments Affecting

Employee Benefit Plans

New regulations, some groundbreaking court cases and more developments under the Sarbanes-Oxley Act (“SOX”) will keep the sponsors of employee benefit plans busy for the next several months. This update highlights the key developments and suggests some key issues that corporate sponsors of benefit plans and plan fiduciaries should consider.

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The following are the key developments covered in this update:

• In almost all cases, plan sponsors will be required under new regulations to roll over small

distributions from retirement plans to individual retirement accounts.

• Procedures need to be in place soon for material benefit plans to comply with the internal control rules of SOX.

• Courts continue to hold open the door to liability for plan sponsors and fiduciaries for declines in employer stock held in retirement plans. • There are new rules telling plan sponsors when

and how to find missing persons who leave account balances behind in a terminated plan.

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Beginning on March 28, 2005, companies with tax-qualified retirement plans that automatically distribute benefits greater than $1,000, but not in excess of $5,000 (“Small Amounts”), must roll over those amounts to an individual retirement account (an “IRA”) established by the plan fiduciary for the terminated participant (“Automatic Rollovers”), unless the participant elects a rollover to another retirement plan or a cash distribution. This is a significant change, as currently retirement plans are permitted to pay automatic distributions directly to participants, absent other instructions.

Under current law, tax-qualified retirement plans are permitted to make automatic distributions of benefits of $5,000 or less to terminated participants without their consent and to pay such amounts directly to participants, absent other instructions from participants. Although Automatic Rollovers of Small Amounts were mandated by the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), to prevent a drain of assets from the retirement system, their implementation has been delayed pending final regulations (the “Final

Regulations”) from the Department of Labor

(“DOL”), which were issued on September 28, 2004.1 Therefore, retirement plan fiduciaries have less than six months to comply with the Final Regulations. During this period, they must decide if their plans will continue to make automatic distributions of Small Amounts and, if so, enter into an agreement with an IRA provider, select an investment vehicle for the IRA, amend the plans, and update the rollover notices and summary plan descriptions.

Safe Harbor

The Final Regulations provide a safe harbor for compliance with the Automatic Rollover requirements. Compliance with the safe harbor is not mandatory, as the DOL recognizes that fiduciaries who use other procedures may still satisfy the Automatic Rollover requirements. Fiduciaries that comply with the safe harbor will be deemed to have satisfied their fiduciary duties associated with the selection of an IRA provider and an investment product. To comply with the safe harbor, a fiduciary must:

• Enter into a written agreement with an IRA provider that:

− requires Automatic Rollovers to be invested in a product that preserves principal and provides a reasonable rate of return; − limits fees and expenses to those charged

by the IRA provider for comparable IRAs established for other purposes; and

− gives the participant the right to enforce the agreement against the IRA provider. • Update summary plan descriptions (“SPDs”) and

rollover notices to include the plan’s Automatic Rollover provisions and information on the IRA provider and the initial investment product, including information on fees and expenses associated with the IRA.

Special Exemption to Help Financial Institutions

In connection with the Final Regulations, the DOL issued a prohibited transaction class exemption (the “PTE”) that allows a financial institution that sponsors a retirement plan for its employees to designate itself or an affiliate as the IRA provider for Automatic Rollovers. The PTE also allows financial institutions to use proprietary investment products as the initial investment choice under such IRA and be paid from income earned by the IRA.

The PTE provides an exemption from most of the self-dealing restrictions (the so-called “prohibited transaction rules”) imposed by the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). The PTE prohibits arrangements between fiduciaries of plans sponsored by financial services institutions to each serve as the IRA provider for the other’s Automatic Rollovers.

The conditions of the PTE mirror those of the Final Regulations, except that:

• Fees and expenses associated with the IRA, excluding set-up charges, may be charged only against the income earned by the IRA and cannot be in excess of reasonable compensation. In contrast, such fees may be charged against the principal in the IRA when the IRA is established with an unaffiliated IRA provider.

• Sales commissions in connection with an initial investment in a proprietary product may not be paid from the IRA.

• The affiliated IRA provider must maintain, for six years, records sufficient to substantiate

compliance with the PTE.

Considerations for Plan Sponsors and Fiduciaries

Even though the timeline for implementing the Final Regulations is short, plan sponsors and fiduciaries should not rush to action. Plan sponsors should first weigh the advantages and disadvantages of amending the retirement plans to eliminate automatic distributions of Small Amounts or, alternatively, to eliminate all automatic distributions. By doing so,

the requirement to comply with the Automatic Rollover provisions is also eliminated. Factors relevant to this decision include the cost and administrative burdens associated with retaining additional terminated participants in the retirement plans (for example, loss of amounts forfeited by missing participants, additional record keeping fees, employee communication costs, and additional PBGC premiums for defined benefit plans).

If mandatory distributions are retained, the fiduciary must determine if it prefers the “comfort” of the safe harbor or another procedure that has not been “blessed” by the DOL. In either case, the fiduciary must select an IRA provider and a default investment. Fiduciaries affiliated with financial institutions must also decide whether to select a third party IRA provider or to rely on the PTE and select an affiliate.

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All public companies must have procedures in place to assure that the internal control provisions of Section 404 of SOX apply to material benefit plans.

SOX requires all companies—both U.S. and non-U.S.—that must file periodic reports with the SEC under the Securities Exchange Act of 1934, as amended, to start focusing more intently on internal financial controls and reporting procedures. Particularly, SOX requires an internal control report to be prepared by management detailing the adequacy of the registrant’s internal financial control structure, describing any material weaknesses in the structure and identifying process controls and procedures for financial reporting.

The registrant’s independent auditors must attest to the adequacy of management’s evaluation of internal controls. Internal control and financial reporting requirements mandated under Section 404 of SOX will become effective for the first fiscal year ending after November 15, 2004 for domestic issuers with a market capitalization of US$75 million or greater. They will be effective as of July 15, 2005 for all other registrants. For most registrants, it is anticipated that the internal control requirements may represent the single most significant compliance aspect of SOX.

Stricter scrutiny of every registrant’s material benefit plans is now unavoidable under the new internal control requirements. As a threshold matter, reporting companies must identify, generally in concert with internal and external auditors, those plans that have a material impact on their financial statements. This determination requires the consideration of both U.S. and non-U.S. plans and would likely cover defined benefit and other retirement plans, retiree welfare

benefit and stock-based compensation plans. This process can be complicated by the fact that plan design and administrative procedures typically vary among countries. Additionally, plan documents being reviewed may be in several different languages and linguistic nuances often get lost when translated into English. Registrants must then identify and review all material processes, documents and contracts applicable to the registrant’s material benefit plans. These include the actual flow and reporting of financial information within and between several internal departments and committees such as actuarial, plan administration, payroll, trustee, and investment and benefits administration committees, as well as the flow of data to and from third-party administrators and service providers.

Then, registrants must issue a report on the process review findings that includes:

• a narrative explaining the process and findings for each plan;

• a flowchart identifying each step and party responsible for maintaining the plan;

• a risk and control chart identifying processes, their potential risk factors, and the control mechanisms in place; and

• opportunities for improved controls.

In the fourth step, the committees of the board of directors also provide narrative reports identifying their roles and responsibilities as directors in maintaining the plan. Finally, the auditor’s report certifies the placement of internal controls.

Ensuring compliance with the internal controls requirements of SOX can be quite complex and very time-consuming. To prepare, benefit managers should commence the process of gaining fuller understanding of a registrant’s global compensation and benefits plans and enhancing oversight and management of all such programs worldwide as promptly as possible.

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In the wake of recent corporate scandals and a declining market, a number of class-action lawsuits have been filed by retirement plan participants alleging fiduciary breaches due to failure to sell or take other actions with regard to employer stock held in a plan.2 _{Not only are such suits being filed, but} they are surviving motions to dismiss. Furthermore, in addition to plan sponsors and fiduciaries, the defendants include members of the sponsor’s board

of directors, members of plan committees and third-party trustees.

Two separate actions—commenced against Sprint Corporation and BellSouth Corporation—are illustrative of these types of suits.3 _{Although both} cases involve 401(k) plans with an employee stock ownership plan component (“ESOP”), the courts’ opinions on recent dismissal motions exemplify the types of issues that fiduciaries of all individual account plans with employer stock funds must address.4 The Sprint Case

The Sprint plaintiffs commenced their action after Sprint stock fell to “near junk-bond status” and asserted claims against:

• Sprint Corporation, as administrator of the plans; • the committees that administered the plans and

their individual members;

• individual members of Sprint’s board of directors; and • the third-party trustee for the plans.

Plaintiffs asserted that the defendants breached their fiduciary duties because:

• Sprint stock was an imprudent investment. • The plans were not amended to reduce or

eliminate the requirement to offer an employer stock fund.

• The defendants (excluding the trustee) made misrepresentations and failed to disclose material information in SEC filings incorporated into the plans’ SPDs and in a Sprint newsletter.

• Sprint and its board of directors failed to monitor the plan committees and appointed members who “lacked the independence necessary to make appropriate decisions”.

Most of these claims survived defendants’ dismissal motion. When considering the motion to dismiss, the court noted, among other things, that, when communicating to participants, fiduciaries are obligated to speak truthfully. Additionally, the court viewed certain misleading statements by board members in a Sprint newsletter used for plan-related communications to be addressing the propriety of investments in Sprint stock. The court also cited the duty of an appointing fiduciary to monitor its appointees and the fact that the appointment of senior executives created a heightened risk of a conflict of interest.

Certain of the claims, however, were dismissed. The amendment claim was dismissed because amending the terms of a plan is not a fiduciary function. The imprudent investment and disclosure claims against

the members of the board of directors also were dismissed because their fiduciary obligations were limited to the appointment of committee members. The BellSouth Case

The BellSouth plaintiffs commenced their action shortly after BellSouth publicly revealed that accounting errors had led to an overstatement of BellSouth’s revenues by $163 million (or about $0.09 per share). The plaintiffs alleged that such accounting errors and BellSouth’s “unusually high-risk” investment in the Latin American communications markets led stock values to trade at artificially high levels and asserted claims against:

• BellSouth Corporation, as sponsor and a named fiduciary of the plan;

• the committees that administered the plan; • individual members of BellSouth’s board of

directors; and

• certain named BellSouth officers, including officers who were signatories to SEC-filed documents. In addition to asserting claims that are similar to those made by the plaintiffs in the Sprint case, the plaintiffs also asserted that the defendant officers and directors breached their duty of loyalty because they would be unlikely to reveal information to plan participants which would discourage investment in BellSouth stock due to the link between the defendants’ salary and company performance.

All of these claims survived the defendants’ motion to dismiss, even though the court recognized that BellSouth’s stock did not lose value due to the accounting errors and expressed doubts regarding the claim that the Latin American investment caused BellSouth stock to be an imprudent investment. The court acknowledged, as a result of recent corporate scandals, that courts are more willing to find an affirmative duty to disclose beyond the disclosure duties specified in ERISA or the common law. Such duty, however, has only been imposed in “special circumstances with a potentially ‘extreme impact’ on a plan as a whole, where plan participants generally could be materially and negatively affected.”5 What Does This Mean for Plan Sponsors and Fiduciaries?

These class-action suits reinforce the potential liability facing fiduciaries of all plans with employer stock funds and the need to take steps to reduce this liability, such as:

• Amending plans to specifically name the employer stock fund as an investment option, so that the decision to include this investment option

can be characterized as a so-called “settlor” decision that is not subject to fiduciary standards. • Retaining an independent advisor to develop an

investment policy and guidelines for the assessment of investment performance.

• Monitoring regularly the performance of all plan investment options and taking appropriate actions based on such performance, such as eliminating underperforming investment options.

• Ensuring that plan communications come from employees responsible for plan administration, and are not combined with non-benefit communications (including those discussing company performance and prospects). • Reviewing information prepared for non-plan

related reasons (such as SEC filings) before incorporating it into SPDs.

• Avoiding potential conflicts of interest that can arise when a sponsor’s executive officers are appointed as fiduciaries.

• Ensuring that fiduciaries with appointment responsibilities monitor the activities of their fiduciary appointees.

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On September 30, 2004, the DOL issued Field Assistance Bulletin No. 2004-02 (the “Bulletin”), which addresses the obligations of a fiduciary of a terminated defined contribution plan to find missing participants. While the scope of the Bulletin is limited,6 _{it sets forth steps that a fiduciary must} undertake in order to satisfy its obligations.

Search Methods

Since certain search methods involve nominal expense while offering significant potential for producing results, the DOL considers them a mandatory part of any search, regardless of the size of the account. Accordingly, a fiduciary cannot cause a plan to dispose of a missing participant’s account unless each of the search methods listed below proves ineffective:

• using certified mail;

• checking other records of the plan;

• checking with a beneficiary designated by the missing participant; or

• using the letter forwarding service of either the IRS or the Social Security Administration.

If these search methods fail, others may be used. While reasonable expenses related to locating a missing participant may be charged to that participant’s account, the amount must be reasonable and the method of allocation consistent with the plan and the fiduciary’s duties. Therefore, to determine the appropriate action, a fiduciary should consider the size of the participant’s account, relative to the cost of attempting to locate the participant.

Distribution Options

If efforts to locate participants in a terminated defined contribution plan fail, the fiduciary must distribute their assets in accordance with the Bulletin.

Individual Retirement Accounts

The Bulletin provides that establishing an IRA is the preferred distribution option for missing participants’ accounts. A fiduciary will satisfy its duties under ERISA if it complies with the relevant requirements of the Automatic Rollover safe harbor for distributions from a terminated defined contribution plan to missing participants or those who fail to elect a method of distribution. A distribution pursuant to the Bulletin in excess of $5,000 will not fail to comply with the Final Regulations, assuming all other relevant requirements are met. However, the PTE will not exempt distributions in excess of $5,000 made to an affiliated IRA-provider or invested in a

financial product of an affiliate from ERISA’s prohibited transaction rules.

Alternative Distribution Options

If an IRA provider is not willing to accept these rollovers, a fiduciary may consider distributions to federally insured bank accounts or transfers to state unclaimed property funds in the state of each participant’s last known residence or work location. The permitted distribution alternatives do not include 100% withholding because such practice would not necessarily result in the withheld amounts being matched to the missing participant’s income tax liabilities.

Considerations for Plan Fiduciaries While termination of a defined contribution plan is not an everyday occurrence, a fiduciary could be held responsible for amounts not distributed in accordance with the Bulletin. Therefore, a fiduciary should: • Follow the procedures in the Bulletin and

maintain records of all actions taken, including the rationale for such action, in connection with missing participants’ accounts.

• Exercise caution when using an affiliated IRA provider or a financial product of an affiliate, since the PTE will not cover rollovers in excess of $5,000. • Review applicable state laws before transferring

an account to an unclaimed property fund.

ENDNOTES

1. Fiduciary Responsibility Under the Employee Retirement Income Security Act of 1974 Automatic Rollover Safe Harbor; Final Rule, 69 Fed. Reg. 58018 (2004) (to be codified at 29 C.F.R. pt. 2500).

2. See, e.g., Howell v. Motorola Inc., N.D. Ill., No. 03 C 5044 (Sept. 23, 2004); In re WorldCom Inc. ERISA Litigation, S.D.N.Y., No. 02 Civ. 4816 (DLC), brief filed Jan. 16, 2004.

3. In re Sprint Corp. ERISA Litigation, D. Kan., No. 03-2202-JWL, May 27, 2004; Hill v. BellSouth Corp., et al., N.D. Ga., No. 1:02-CV-2440-JOF (Mar. 30, 2004).

4. Although the plaintiffs and defendants disagreed in the Sprint case on whether the plans were ESOPs, the court assumed they were ESOPs for purposes of the dismissal motion.

5. See BellSouth Corp. at 13 (quoting In re Enron Corp., 284 F. Supp. 2d 511, 559).

6. The Bulletin does not apply to defined benefit plans, as Title IV of ERISA includes the PBGC’s rules regarding missing participants applicable to defined benefit plans subject to Title IV. Additionally, the Bulletin assumes that the terminated plan does not provide an annuity option and there are no other defined contribution plans in the controlled group to which account balances from the terminated plan could be transferred.

This memorandum is intended only as a general discussion of these issues. It should not be regarded as legal advice. We would be pleased to provide additional details or advice about specific situations if desired. For more information on the topics covered in this issue, please contact:

Henry C. Blackiston, III New York (+1 212) 848-7001 [email protected]

John J. Cannon, III New York (+1 212) 848-8159 [email protected] Jeffrey P. Crandall New York (+1 212) 848-7540 [email protected] Kenneth J. Laverriere New York (+1 212) 848-8172 [email protected] Doreen E. Lilienfeld London (+44 (0) 20) 7655-5942 [email protected] Linda E. Rappaport New York (+1 212) 848-7004 [email protected] www.shearman.com

©2004 SHEARMAN & STERLING LLP 599 Lexington Avenue, New York, NY 10022

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