United States: Bankruptcy Reform Legislation Includes Changes Affecting Employee Benefit Plans and Executive Compensation

On April 20, 2005, President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 into law. This article highlights the most significant provisions of the Act affecting employee benefit plans and executive compensation. These include amendments providing additional protection from creditors for employee contributions to and interests in retirement plans and education savings plans, facilitating employees' repayment of plan loans, and placing significant additional restrictions on pre- and postpetition payments to insiders and on prepetition modifications to retiree health plans.

On April 20, 2005, President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Pub. L. No. 109-8) (the "Act") into law. The Act makes a number of changes affecting employee benefits and executive compensation. Of particular interest, the Act—

• provides additional protection from creditors in bankruptcy for employee contributions to a plan that have been paid by employees or withheld from their wages but not yet transferred to the plan;

• provides additional protection from creditors in bankruptcy for interests in certain retirement plans and education savings plans;

• makes it easier for employees to repay plan loans after bankruptcy filings;

• extends the avoidance period for prepetition transfers to insiders that are considered fraudulent from one year to two years;

• allows a bankruptcy court to set aside certain modifications of retiree welfare benefits made within 180 days before the bankruptcy petition was filed; and

• imposes severe limits on postpetition retention payments and severance payments to insiders.

The main focus of the Act is a reform of rules dealing with individual bankruptcies. However, it includes several provisions that will impact business interests, as well, in addition to those noted above. The Insolvency and Restructuring Group at Pillsbury Winthrop Shaw Pittman has prepared a separate client alert that highlights those provisions.

Unless otherwise indicated, all of the changes discussed below are effective 180 days after the date of enactment, i.e., October 17, 2005, but only with respect to bankruptcy cases commenced on or after the date of enactment.

Current Law − Section 541 excludes from an individual debtor’s bankruptcy estate any beneficial interest of the debtor in a trust if the interest is subject to a transfer restriction that is enforceable under applicable nonbankruptcy law. In Patterson v. Shumate, the Supreme Court held that such restrictions include the restrictions on alienation or assignment of benefits under ERISA for what the court called "ERISA qualified plans." This exclusion is unlimited in amount.

Patterson did not resolve all issues relating to the treatment of employee benefit plans under the Bankruptcy Code. First, it dealt with amounts subject to the anti-alienation provisions of ERISA and thus implied that the protections of Section 541 do not extend to a debtor’s interest in a plan or contract that are not subject to those provisions, such as an IRA, a governmental plan, or a non-electing church plan, or health or other welfare plan, unless the plan or contract contains an anti-alienation provision enforceable under some other applicable law. This has resulted in inconsistent treatment of these plans and contracts. Even for plans and contracts subject to ERISA, it is unclear from the decision whether the protections of Section 541 extend to contributions before they actually are made to the plan or contract. Also, by its terms Section 541 applies only to beneficial interests in a trust, and not all employee benefit plans are funded with a trust.

In addition to the exclusions available under Section 541, Section 522(b) generally allows an individual debtor to exempt from the bankruptcy estate either (1) property listed in Section 522(d) of the federal statute or (2) property exempt under applicable state bankruptcy law.

One of the exemptions under the federal statute is a debtor’s "right to receive . . . payment under a stock bonus, pension, profitsharing [sic], annuity, or similar plan or contract on account of illness, disability, death, age, or length of service, to the extent reasonably necessary for the support of the debtor and any dependent of the debtor". This exemption is not available for payments under a nonqualified plan if the debtor is a director, officer, general partner or "person in control" of the plan sponsor.

This exemption applies to a much broader category of interests than Section 541. For example, it is available (if the other requirements are satisfied) even if a plan or contract is not subject to ERISA. The requirement that payments be made on account of age or certain other events is limiting, but earlier this month in Rousey v. Jacoway the Supreme Court held that this requirement is satisfied by an IRA largely because an IRA is subject to the minimum required distribution rules in Section 401(a)(9) of the Internal Revenue Code and distributions made before age 59½ generally are subject to an additional 10% tax. By implication, a debtor’s interest in any other plan or contract that is subject to these or similar rules, including an annuity contract subject to Section 403(b) and an eligible deferred compensation plan subject to Section 457(b) of the Internal Revenue Code, would satisfy this requirement, as well.

Although the scope of this exemption is quite broad, like Section 541 it does not resolve all issues relating to the treatment of employee benefit plans under the Bankruptcy Code. In particular, it is not available to debtors who elect to use the exemptions available under applicable state rather than federal law, and it can be overridden by states that "opt out" of the federal bankruptcy exemption scheme (although similar exemptions are available under some state laws). Furthermore, the exemption is limited to the extent reasonably necessary for the support of the debtor and any dependent of the debtor, and is not available at all to insiders in certain circumstances.

Under the Act − Act § 323 creates a new exclusion for employee contributions (including salary reduction contributions) to (1) an employee benefit plan subject to Title I of ERISA, (2) a governmental plan, (3) a "deferred compensation plan under [Internal Revenue Code] section 457", (4) a "tax-deferred annuity under [Internal Revenue Code] section 403(b)", or (5) a health insurance plan regulated by state law. Act § 225 also adds a new exclusion to Section 541 for funds placed in an education IRA or a Section 529 qualified state tuition program at least one year before the bankruptcy filing.

Act § 224(a) adds a new exemption to Section 522 for "retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a)" of the Internal Revenue Code. The exemption will be available regardless of whether the debtor relies on the exemptions provided under federal law or those provided under applicable state bankruptcy law. The exemption will extend to an eligible rollover distribution from such a plan or account that is rolled over directly, or rolled over within the required 60-day period, to another such plan or account. Act § 224(e) generally limits the exemption for funds held in an IRA, including a Roth IRA, other than a simple retirement account or simplified employee pension, to $1 million, calculated without regard to rollover contributions. The limit can be increased "if the interests of justice so require", and will be adjusted for inflation.

Comments − The changes to Section 541 will extend the protections of Section 541 to employee contributions to any of the listed categories of plans before they are contributed to the plan. Oddly, the listed categories of plans are not quite the same as the categories of plans covered by the existing exclusion. The scope of some categories also is unclear. For example, the category of plans subject to subject to Section 403(b) is limited to "annuities" and thus does not clearly include contributions to custodial accounts and church retirement income accounts.

The changes to Section 522 will, effectively, create a new exemption that is broader than either the existing exclusion for retirement plans addressed in Patterson or the existing exclusion for retirement plans and similar contracts addressed in Rousey. Thus, the new exemption will be available regardless of whether one of the listed plans and contracts is subject to ERISA, regardless of whether the debtor relies on the exemptions provided under federal law (although states will continue to have the right to override the federal exemptions, including this one), regardless of whether the payments are necessary for the support of the debtor, and regardless of whether the debtor is an insider. It also will extend the exemption to eligible rollover distributions that are in the process of being rolled over.

Nevertheless, the exact scope of the new exemption remains unclear. For example, the exemption applies only to "funds [that] are in a fund or account that is exempt from taxation" even though some of the sections listed (e.g., Sections 403 and 457) do not provide a tax exemption for any fund or account, and plans established under some of the sections (e.g., nongovernmental Section 457 plans) might not be funded at all.

Although the changes made by the Act provide additional protection for contributions to IRAs and certain education savings plans, they do not appear to provide any additional protection for contributions to health savings accounts ("HSAs") created under Section 223 of the Internal Revenue Code.

Current Law − Current law provides no particular protection in bankruptcy for funds that have been borrowed from a retirement plan. Nevertheless, debtors generally want to repay their plan loans if they can, to reduce the amount that they must pay to their creditors and avoid adverse tax consequences from a default, and trustees and administrators have a responsibility to encourage repayment in order to preserve plan assets and to comply with the ERISA requirements regarding plan loans.

Most courts have concluded that a participant’s obligation to repay a loan from his account in an employee benefit plan is not a "debt" and does not give rise to a "claim" within the meaning of the Bankruptcy Code. As a result:

• The obligation is not dischargeable in bankruptcy.

• The plan cannot be a secured creditor with a right to "adequate protection" from the effects of bankruptcy under Section 361 or a claim on property of the estate that is superior to that of other creditors. In particular, in a Chapter 13 case, in which the debtor’s future wages are considered property of the estate, the obligation might not be allowed to be collected through wage withholding, at least if any unsecured creditor objects, and any payments at all, including a reduction in a participant’s account balance to repay a plan loan, might be contrary to the bankruptcy plan and/or reversible as fraudulent transfers.

• Repayments are considered voluntary and not reasonably necessary for a debtor’s support and maintenance and therefore is not protected from the reach of unsecured creditors during the term of a Chapter 13 plan.

Under the Act − Act § 224(b) generally reverses current law and provides that the withholding of income from an employee’s wages to repay a plan loan may continue despite a bankruptcy filing, even in a Chapter 13 case, without violating the automatic stay in Section 362(b). The loan must be from a "pension, profit-sharing, stock bonus, or other plan established under section 401, 403, 408, 408A, 414, 457, or 501(c) of the Internal Revenue Code of 1986, that is sponsored by the employer of the debtor, or an affiliate, successor, or predecessor of such employer" and must be permitted under ERISA or subject to Section 72(p) of the Internal Revenue Code, or be a loan from the Federal Thrift Savings Plan.

Act § 224(c) codifies the majority rule under current law by adding an express exception from automatic discharge in Section 523 generally for "any debt" owed to such a plan that satisfies the same requirements.

Finally, Act § 224(d) amends Section 1322 to provide that a bankruptcy plan may not materially alter the terms of such a loan, and that any amounts required to repay the loan will not constitute "disposable income" under section 1325.

Comments − It is not clear whether the new provisions will stay actions to collect plan loans other than wage withholding. Thus, for example, it might be that reducing a participant’s account balance to repay a plan loan (an action not covered by the new rule) before the end of a Chapter 13 case will be prohibited. Also, although the new provisions clarify that amounts required to repay plan loans are not "disposable income" under Section 1325, they will not foreclose the possibility that they might be considered fraudulent transfers under Section 547 or 548.¹

Current Law − Section 547(b) generally treats as a preference, and allows a bankruptcy trustee to avoid (assuming certain conditions are satisfied), any transfer that is, among other things, made in the 12-month period before the filing of the bankruptcy petition by a debtor to an "insider", i.e., a director, officer, general partner or "person in control" of the debtor, or a relative of an insider, to satisfy an antecedent debt if the debtor was insolvent at the time the transfer was made.

Section 548(a) generally treats as a fraudulent transfer and allows a bankruptcy trustee to avoid any transfer made or obligation incurred by a debtor in the 12-month period before the filing of the bankruptcy petition if the transaction was made with actual intent to hinder, delay, or defraud any entity to which the debtor was (or became), on or after the date that such transfer was made or obligation incurred, indebted, or the debtor received less than reasonably equivalent value in exchange for such transfer, and either the debtor was insolvent at the time of the transaction or the transaction caused it to become insolvent. Section 548(b) generally treats as a fraudulent transfer, and allows a bankruptcy trustee to avoid, any transfer made or obligation incurred by a partnership in the 12-month period before the filing of the bankruptcy petition if the transaction was for the benefit of a general partner and either the partnership was insolvent at the time of the transaction or the transaction caused it to become insolvent. In addition to Section 548, Section 544 of the Bankruptcy Code generally permits a bankruptcy trustee to utilize state-law fraudulent conveyance statutes (which contain similar requirements for avoiding fraudulent transfers as Section 548 of the Bankruptcy Code). Such state statutes typically have a longer "look back" period than the 12-month period contained in Section 548

Under the Act — Act § 1213 clarifies that if a trustee avoids a transfer under Section 547(b) to an entity that is not an insider for the benefit of a creditor that is an insider, the transfer will be avoidable only with respect to the creditor that is an insider.

Act § 1402 extends the avoidance period in 548(a) and (b) from one year to two years. Unlike the other provisions of the Act, this change is effective with respect to bankruptcy cases commenced more than one year after the date of enactment, i.e., after April 20, 2006. It also clarifies that the transactions potentially covered by Section 548(a) include transfers and obligations to or for the benefit of an insider under an employment contract, and allows a transaction to be avoided regardless of its effect on the debtor’s solvency if the transfer was made or the obligation was incurred under an employment contract and "not in the ordinary course of business." Unlike the other provisions of the Act, this change is effective with respect to bankruptcy cases commenced on or after the date of enactment.

Current Law − Section 1114 provides that a debtor filing under Chapter 11 may not unilaterally terminate or modify retiree welfare benefits that it is legally obligated to provide without first negotiating with a representative of the retirees. Once a Chapter 11 petition is filed, retiree benefits that are subject to Section 1114 must continue unchanged until a modification or termination is agreed to or ordered by the court.²

Under the Act − Act § 1403 permits bankruptcy courts to set aside modifications of retiree welfare benefits made within 180 days before the bankruptcy petition was filed "unless the court finds that the balance of the equities clearly favors such modification."

Current Law − Section 503(b) generally treats as administrative expenses and allows to be paid wages, salaries and commissions for services rendered after the bankruptcy petition was filed.

Severance benefits that are based on length of service generally are viewed as having been earned over the entire period of service, and are entitled to priority status only to the extent that service is performed after the bankruptcy petition is filed. The extent to which other severance benefits are attributable to postpetition service and thus entitled to priority status depends on the facts and circumstances.

It is common for debtors in Chapter 11 cases to seek court approval of a Key Employee Retention Plan ("KERP") that provides stay bonuses and severance payments to rank-and-file employees as well as to senior management. If the court approves the KERP, the payments promised to employees are treated as administrative expense claims with priority over prepetition claims.

Under the Act − Act § 331 amends Section 503 to prohibit the payment of (1) retention bonuses and severance benefits paid to insiders (i.e., directors, officers, general partners and "persons in control" of the debtor, and their relatives) unless they satisfy certain strict requirements relating to the amount and reasonableness of the payments, and (2) any "other transfers or obligations that are outside the ordinary course of business and not justified by the facts and circumstances of the case, including transfers made to, or obligations incurred for the benefit of, officers, managers, or consultants hired after the date of the filing of the petition."

For a retention bonus to be allowed, (1) it must be essential to retaining the insider because he or she has received a "bona fide job offer from another business at the same or greater rate of compensation," (2) the insider’s services must be "essential to the survival of the business," and (3) the amount of the bonus must be limited either to 10 times "the mean transfer or obligation of a similar kind given to nonmanagement employees for any purpose" during the same calendar year or, if no such transfers were made or obligations were incurred, to 25% of the amount of "any similar transfer or obligation made to or incurred for the benefit of such insider for any purpose" during the previous calendar year.

For a severance payment to be allowed, (1) it must be made under a "program that is generally applicable to all full-time employees" and (2) the amount of the payment must be limited to 10 times "the mean severance pay given to nonmanagement employees" during the same calendar year. These restrictions appear to apply even if the insider’s employment was terminated before the commencement of the bankruptcy case and the payment was deferred.

Comments − The changes to Section 503(b) will severely limit the use of KERPs and put severance payments at risk even if they are paid on account of prepetition terminations unrelated to the bankruptcy filing. Certain aspects of the changes also are not clear. For example, many of the terms used are vague and will require an extensive analysis of the facts.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.