The Effects of Terminating a Pension Plan in Bankruptcy

Background

The PBGC is a private corporation, wholly owned by the United States, created by Title IV of ERISA, to, among other things, administer the pension plan termination program. When underfunded plans are terminated because sponsors are no longer able to make plan contributions, the PBGC, as the guarantor of vested benefits up to an established limit per person, becomes the trustee of the plan and oversees its administration.

Over 3000 underfunded pension plans were terminated in recent years, due primarily to the large number of corporate bankruptcies and liquidations of large companies, especially those in the steel and airline industries, which have large numbers of retirees as well as current employees. These events, together with a declining stock market and low interest rates, have contributed to the PBGC's deficit of more than $23 billion as of the end of September 2004. The ongoing crisis in the domestic airline industry, which has caused the termination of additional underfunded plans, has only added to the PBGC's already heavy financial burden.

ERISA Plan Funding Obligations

ERISA mandates that employers with defined benefit pension plans make minimum annual plan contributions in quarterly installments and fund any additional amounts within 9 months of the following year. Employers are further obligated to eradicate funding deficiencies over time, usually 3 to 5 years. The obligations to make pension contributions are joint and several as to each member of a “Controlled Group” of entities (as such term is defined in the Internal Revenue Code). When contributions are insufficient and plan deficits are not reduced, the PBGC can assert liens in the amount of the insufficiency, on each controlled group member's property. Provided that the PBGC's lien is perfected prior to the filing of the bankruptcy case, the PBGC will have a secured claim to the extent of the value of assets subject to the lien in each controlled group member's bankruptcy case.

ERISA strictly prohibits the sponsor of underfunded plans from altering earned benefits as a way to reduce deficits, even if the plan beneficiaries would agree to them. Similarly, employers cannot alter eligibility requirements or eliminate lump sum options once granted, as a means to restore the financial integrity of their plans.

Termination of Pension Plans under ERISA

“Termination” is what happens when the PBGC takes over a plan. An employer seeking to terminate a burdensome retirement plan may have the following options:

Voluntary Termination

An employer may voluntarily proceed with a standard termination of its plan any time the plan's assets are sufficient to pay all retirement benefits in full. Practically, this rarely occurs in bankruptcy cases.

Distress Termination By the Employer

In some circumstances, an employer may qualify for a distress termination of its underfunded plan. To effect a distressed termination of a plan in a bankruptcy case, the plan administrator must 1) serve a 60-day advance notice of the intention to terminate on all affected parties and 2) supply certain information to the PBGC; and 3) the bankruptcy court must find that the criteria for a distress termination have been met, ie, the plan sponsors are in liquidation proceedings; or the plans sponsors are attempting to reorganize in bankruptcy or insolvency proceedings, or the plan sponsors require a termination of the plan to enable the payment of debts while staying in business or to avoid unreasonably burdensome pension costs caused by a declining work force.

To determine whether the debtor meets the distressed criteria while in an ongoing reorganization, ERISA sets forth a four-part test for the PBGC to evaluate the debtor's request as of the proposed termination date:

• the contributing sponsor and all members of a Controlled Group have filed petitions seeking reorganization in cases under Chapter 11 or under any similar law of a state or political subdivision;
• the contributing sponsor timely submits to the PBGC a request for the bankruptcy court approval of the proposed plan termination;
• the bankruptcy court (or such other appropriate court) determines that, unless the plan is terminated, the debtor will be unable to pay all of its debts pursuant to a plan of reorganization and will be unable to continue in business outside the Chapter 11 reorganization process and approves the termination; and
• the distress termination does not violate the terms of an existing collective bargaining agreement.

Accordingly, where a collective bargaining agreement requires the maintenance of a defined benefit pension plan, a debtor may not terminate the pension plan unless it complies with the requirements of ERISA, Section 1113 of the Bankruptcy Code and, to the extent the termination affects retirees, Section 1114 of the Bankruptcy Code. The PBGC's position, with which courts agree, is that although a debtor may use Section 365 of the Bankruptcy Code to escape a contractual obligation to maintain a pension plan, it cannot be used in lieu of ERISA procedures to effect plan termination.

Involuntary Termination By the PBGC

Notwithstanding the terms of a collective bargaining agreement, the PBGC may seek to involuntarily terminate a pension plan, if it determines that the plan sponsor has not met the minimum funding requirement, the plan will be unable to pay benefits when due, or the PBGC's overall loss will be substantially higher if the plan is not immediately terminated.

Effect of Termination

When a distressed termination occurs, the plan sponsor remains liable to the PBGC for the total amount of the unfunded benefit obligation, which is known as the “Termination Liability.” This obligation discourages the shifting of the financial burden of terminated pension plans to the PBGC and also discourages employers from making unrealistic retirement offers to their workers.

Termination Liability

In an estate in which the pension plan is terminated, the PBGC ordinarily files a claim for the full amount of the “unfunded benefit liabilities” under the plan. This generally includes all fixed and contingent benefits provided under the plan as of the plan termination date. Since members of a Controlled Group are jointly and severally liable to the PBGC for unpaid contributions and plan underfunding, the PBGC typically files claims against each bankrupt entity that is part of that group. Notwithstanding its right to seek payment of its unfunded benefits claim from each member of a controlled group, the PBGC is not entitled to collect more than the amount of its claim.

In calculating its plan termination claim, the PBGC determines the actuarial present value of the future benefit liabilities. It makes this determination by employing the assumptions prescribed in the PBGC's valuation regulations. It is unclear whether such regulations control in bankruptcy. For example, the PBGC uses such regulations to select the discount rate to be used in calculating the present value of future obligations. The discount rate selected by the PBGC can have a substantial effect on the amount of the PBGC's claims, and thus it is often challenged in most bankruptcy cases. The Sixth and Tenth Circuits have both held that the bankruptcy court may fashion its own discount rate by determining the interest rate that a reasonably prudent investor would receive from investing the funds (commonly referred to as the “prudent investor rate”). However, in the first U.S. Airways bankruptcy case, the PBGC's methodology for present valuing its claim was upheld.

When a debtor terminates a pension plan shortly after the bankruptcy filing, the PBGC typically posits that its termination liability claim should be accorded administrative expense treatment because the claim arose pursuant to a post-petition event (ie, the termination of the plan). Courts, typically do not award administrative expense treatment to termination liability claims, despite the fact that the plan termination occurred post-petition, finding that the obligation arose from a pre-petition agreement.

Termination Date

A pension plan's termination date may have a significant impact on the amount owed by the plan sponsor for a number of reasons. First, the employer's minimum funding obligations continue to accrue until the termination date. Second, the employees' benefit accruals continue until the termination date, as well as any additional benefit liabilities that are provided for in the pension plan, such as those that result from a plant shutdown. Conversely, employees lose entitlement to most benefits that are not earned as of the plan termination date. This encourages employees who are close to retirement to leave the debtor's employ prior to a termination of the pension plan. Third, discount rates for present valuing plan liabilities are determined as of the date of plan termination. Fourth, the consistency of the Controlled Group is determined as of that date. Also, under most pension plans, employee benefits are phased in over a period of time. The deferral of a termination date ordinarily results in increased benefits, for which the PBGC may ultimately be liable for as a guarantor. Thus, the fixing of a plan's termination date is often a fundamental strategic concern in a bankruptcy case by both the debtor and the PBGC.

If the PBGC and the plan administrator agree on a termination date for an underfunded plan, the agreed-upon date will be the termination date. Otherwise, if there is no agreement, the court determines the termination date. ERISA does not provide any guidance to the courts in determining the termination date. Most courts require that the termination date not be a date prior to the date that plan participants receive notice that they are no longer accruing benefits. Thus, when determining the termination date, courts attempt to balance the interests of the PBGC, in limiting its obligations, with the participants' reliance interests in the benefits available to them under the applicable pension plan.

Subsequent Restoration of a Terminated Plan

In some instances the PBGC may force the restoration of a terminated plan to its pre-termination status, restoring control of the plan to the employer. This occurred in the first LTV case (Pension Benefit Guaranty Agreement v. LTV Corporation, 496 US 663 (1990)). LTV and its subsidiaries were unable to obtain involuntary or distress termination of their plans because the plans were part of the debtors' collective bargaining agreements. The PBGC prosecuted and obtained an involuntary termination of the debtors' underfunded plan, which relieved the debtors from a significant financial burden. However, LTV's reorganization plan featured new retirement provisions that were “designed to wrap around PBGC insurance benefits to provide substantially the same benefits as would have been received had no termination occurred.” Id. at 636. Ultimately, the Supreme Court held that the mandate granted by ERISA to the PBGC trumped the Bankruptcy Code's power to give financial relief to financially distressed debtors and that the PBGC could, in its absolute and sole discretion, order the reinstatement of a retirement plan.

The Supreme Court's decision in LTV forms the basis of subsequent judicial opinions holding that the PBGC has the absolute and sole discretion to involuntarily terminate any retirement plan, or to refuse to do so, and thereby leave a financially distressed debtor without any ability to alter its retirement plan obligations. Therefore, a debtor should be cognizant of this potential pitfall when choosing to terminate its pension plan; otherwise, it could find itself back in the same position it started.

Conclusion

The recent liquidations of large manufacturing businesses, steel producers and airlines have resulted in the termination of large underfunded pension plans, with the PBGC being exposed for much of the pension plan liabilities. In an effort to reduce its exposure, the PBGC has taken the position, in many cases, that the termination date, with regard to the pension plans at issue, is earlier rather than later. While courts have reached different conclusions, depending on the facts and circumstances of the case, many courts appear to be sympathetic to the PBGC's views as to when a plan should be deemed terminated. With a deficit of well over $23 billion, one should anticipate that the PBGC will continue to do whatever is required to maximize its claim and recovery from Chapter 11 estates of companies whose pension plans it insures and to take actions to reduce its future obligations under those same pension plans.

Claudia Z. Springer is a partner in the Philadelphia office of Reed Smith LLP's Corporate Restructuring & Bankruptcy Group, and can be reached at 215-851-8100 or [email protected]. Daniel A. Zazove is counsel in the Chicago office of Kaye Scholer LLP's Business Reorganization Group and can be reached at, 312-583-2300, [email protected]. The authors would like to thank Scott M. Esterbrook of Reed Smith and Jeffrey E. Altshul of Kaye Scholer for their invaluable contributions.

Oftentimes, one of the largest commitments of a company is its ongoing funding obligations under its pension plan. Contribution obligations to a company-sponsored pension plan will often influence the timing of a financially troubled company's bankruptcy filing. An example of this is the Chapter 11 case of United Air Lines (United) and its affiliates. United viewed its obligations to make significant contributions to its pension plans as somewhat incompatible with its need to create a fiscally strong enterprise so as to effectively compete with low- cost carriers that do not have the same economic burdens.

United is not alone in having to grapple with its significant pension liabilities. Declining stock prices, low interest rates, and fierce corporate competition (both domestic and foreign) are causing other large financially distressed companies to consider bankruptcy as a means to terminate or modify existing pension obligations.

Although the Bankruptcy Code permits the debtor to modify or reject certain ongoing obligations that burden its rehabilitation, the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code limit the bankruptcy court's authority to terminate certain defined benefit pension plans. Under ERISA, the Pension Benefit Guaranty Corporation (PBGC), was created to, among other things, oversee private defined benefit pension plans and to compensate plan beneficiaries in the event that a pension plan is underfunded. As increasing numbers of financially distressed corporations use bankruptcy as a tool to rid themselves of long-standing pension obligations, the PBGC is forced to pick up the tab resulting from the termination of underfunded plans. The PBGC, therefore, is oftentimes a major creditor in large corporate bankruptcies when the debtor has a significant underfunded pension liability. The timing of the termination of a defined benefit plan can have an enormous impact on the administration of the estate and the debtor's ability to effectively reorganize.

Background

The PBGC is a private corporation, wholly owned by the United States, created by Title IV of ERISA, to, among other things, administer the pension plan termination program. When underfunded plans are terminated because sponsors are no longer able to make plan contributions, the PBGC, as the guarantor of vested benefits up to an established limit per person, becomes the trustee of the plan and oversees its administration.

Over 3000 underfunded pension plans were terminated in recent years, due primarily to the large number of corporate bankruptcies and liquidations of large companies, especially those in the steel and airline industries, which have large numbers of retirees as well as current employees. These events, together with a declining stock market and low interest rates, have contributed to the PBGC's deficit of more than $23 billion as of the end of September 2004. The ongoing crisis in the domestic airline industry, which has caused the termination of additional underfunded plans, has only added to the PBGC's already heavy financial burden.

ERISA Plan Funding Obligations

ERISA mandates that employers with defined benefit pension plans make minimum annual plan contributions in quarterly installments and fund any additional amounts within 9 months of the following year. Employers are further obligated to eradicate funding deficiencies over time, usually 3 to 5 years. The obligations to make pension contributions are joint and several as to each member of a “Controlled Group” of entities (as such term is defined in the Internal Revenue Code). When contributions are insufficient and plan deficits are not reduced, the PBGC can assert liens in the amount of the insufficiency, on each controlled group member's property. Provided that the PBGC's lien is perfected prior to the filing of the bankruptcy case, the PBGC will have a secured claim to the extent of the value of assets subject to the lien in each controlled group member's bankruptcy case.

ERISA strictly prohibits the sponsor of underfunded plans from altering earned benefits as a way to reduce deficits, even if the plan beneficiaries would agree to them. Similarly, employers cannot alter eligibility requirements or eliminate lump sum options once granted, as a means to restore the financial integrity of their plans.

Termination of Pension Plans under ERISA

“Termination” is what happens when the PBGC takes over a plan. An employer seeking to terminate a burdensome retirement plan may have the following options:

Voluntary Termination

An employer may voluntarily proceed with a standard termination of its plan any time the plan's assets are sufficient to pay all retirement benefits in full. Practically, this rarely occurs in bankruptcy cases.

Distress Termination By the Employer

In some circumstances, an employer may qualify for a distress termination of its underfunded plan. To effect a distressed termination of a plan in a bankruptcy case, the plan administrator must 1) serve a 60-day advance notice of the intention to terminate on all affected parties and 2) supply certain information to the PBGC; and 3) the bankruptcy court must find that the criteria for a distress termination have been met, ie, the plan sponsors are in liquidation proceedings; or the plans sponsors are attempting to reorganize in bankruptcy or insolvency proceedings, or the plan sponsors require a termination of the plan to enable the payment of debts while staying in business or to avoid unreasonably burdensome pension costs caused by a declining work force.

To determine whether the debtor meets the distressed criteria while in an ongoing reorganization, ERISA sets forth a four-part test for the PBGC to evaluate the debtor's request as of the proposed termination date:

• the contributing sponsor and all members of a Controlled Group have filed petitions seeking reorganization in cases under Chapter 11 or under any similar law of a state or political subdivision;
• the contributing sponsor timely submits to the PBGC a request for the bankruptcy court approval of the proposed plan termination;
• the bankruptcy court (or such other appropriate court) determines that, unless the plan is terminated, the debtor will be unable to pay all of its debts pursuant to a plan of reorganization and will be unable to continue in business outside the Chapter 11 reorganization process and approves the termination; and
• the distress termination does not violate the terms of an existing collective bargaining agreement.

Accordingly, where a collective bargaining agreement requires the maintenance of a defined benefit pension plan, a debtor may not terminate the pension plan unless it complies with the requirements of ERISA, Section 1113 of the Bankruptcy Code and, to the extent the termination affects retirees, Section 1114 of the Bankruptcy Code. The PBGC's position, with which courts agree, is that although a debtor may use Section 365 of the Bankruptcy Code to escape a contractual obligation to maintain a pension plan, it cannot be used in lieu of ERISA procedures to effect plan termination.

Involuntary Termination By the PBGC

Notwithstanding the terms of a collective bargaining agreement, the PBGC may seek to involuntarily terminate a pension plan, if it determines that the plan sponsor has not met the minimum funding requirement, the plan will be unable to pay benefits when due, or the PBGC's overall loss will be substantially higher if the plan is not immediately terminated.

Effect of Termination

When a distressed termination occurs, the plan sponsor remains liable to the PBGC for the total amount of the unfunded benefit obligation, which is known as the “Termination Liability.” This obligation discourages the shifting of the financial burden of terminated pension plans to the PBGC and also discourages employers from making unrealistic retirement offers to their workers.

Termination Liability

In an estate in which the pension plan is terminated, the PBGC ordinarily files a claim for the full amount of the “unfunded benefit liabilities” under the plan. This generally includes all fixed and contingent benefits provided under the plan as of the plan termination date. Since members of a Controlled Group are jointly and severally liable to the PBGC for unpaid contributions and plan underfunding, the PBGC typically files claims against each bankrupt entity that is part of that group. Notwithstanding its right to seek payment of its unfunded benefits claim from each member of a controlled group, the PBGC is not entitled to collect more than the amount of its claim.

In calculating its plan termination claim, the PBGC determines the actuarial present value of the future benefit liabilities. It makes this determination by employing the assumptions prescribed in the PBGC's valuation regulations. It is unclear whether such regulations control in bankruptcy. For example, the PBGC uses such regulations to select the discount rate to be used in calculating the present value of future obligations. The discount rate selected by the PBGC can have a substantial effect on the amount of the PBGC's claims, and thus it is often challenged in most bankruptcy cases. The Sixth and Tenth Circuits have both held that the bankruptcy court may fashion its own discount rate by determining the interest rate that a reasonably prudent investor would receive from investing the funds (commonly referred to as the “prudent investor rate”). However, in the first U.S. Airways bankruptcy case, the PBGC's methodology for present valuing its claim was upheld.

When a debtor terminates a pension plan shortly after the bankruptcy filing, the PBGC typically posits that its termination liability claim should be accorded administrative expense treatment because the claim arose pursuant to a post-petition event (ie, the termination of the plan). Courts, typically do not award administrative expense treatment to termination liability claims, despite the fact that the plan termination occurred post-petition, finding that the obligation arose from a pre-petition agreement.

Termination Date

A pension plan's termination date may have a significant impact on the amount owed by the plan sponsor for a number of reasons. First, the employer's minimum funding obligations continue to accrue until the termination date. Second, the employees' benefit accruals continue until the termination date, as well as any additional benefit liabilities that are provided for in the pension plan, such as those that result from a plant shutdown. Conversely, employees lose entitlement to most benefits that are not earned as of the plan termination date. This encourages employees who are close to retirement to leave the debtor's employ prior to a termination of the pension plan. Third, discount rates for present valuing plan liabilities are determined as of the date of plan termination. Fourth, the consistency of the Controlled Group is determined as of that date. Also, under most pension plans, employee benefits are phased in over a period of time. The deferral of a termination date ordinarily results in increased benefits, for which the PBGC may ultimately be liable for as a guarantor. Thus, the fixing of a plan's termination date is often a fundamental strategic concern in a bankruptcy case by both the debtor and the PBGC.

If the PBGC and the plan administrator agree on a termination date for an underfunded plan, the agreed-upon date will be the termination date. Otherwise, if there is no agreement, the court determines the termination date. ERISA does not provide any guidance to the courts in determining the termination date. Most courts require that the termination date not be a date prior to the date that plan participants receive notice that they are no longer accruing benefits. Thus, when determining the termination date, courts attempt to balance the interests of the PBGC, in limiting its obligations, with the participants' reliance interests in the benefits available to them under the applicable pension plan.

Subsequent Restoration of a Terminated Plan

In some instances the PBGC may force the restoration of a terminated plan to its pre-termination status, restoring control of the plan to the employer. This occurred in the first LTV case ( Pension Benefit Guaranty Agreement v. LTV Corporation , 496 US 663 (1990)). LTV and its subsidiaries were unable to obtain involuntary or distress termination of their plans because the plans were part of the debtors' collective bargaining agreements. The PBGC prosecuted and obtained an involuntary termination of the debtors' underfunded plan, which relieved the debtors from a significant financial burden. However, LTV's reorganization plan featured new retirement provisions that were “designed to wrap around PBGC insurance benefits to provide substantially the same benefits as would have been received had no termination occurred.” Id. at 636. Ultimately, the Supreme Court held that the mandate granted by ERISA to the PBGC trumped the Bankruptcy Code's power to give financial relief to financially distressed debtors and that the PBGC could, in its absolute and sole discretion, order the reinstatement of a retirement plan.

The Supreme Court's decision in LTV forms the basis of subsequent judicial opinions holding that the PBGC has the absolute and sole discretion to involuntarily terminate any retirement plan, or to refuse to do so, and thereby leave a financially distressed debtor without any ability to alter its retirement plan obligations. Therefore, a debtor should be cognizant of this potential pitfall when choosing to terminate its pension plan; otherwise, it could find itself back in the same position it started.

Conclusion

The recent liquidations of large manufacturing businesses, steel producers and airlines have resulted in the termination of large underfunded pension plans, with the PBGC being exposed for much of the pension plan liabilities. In an effort to reduce its exposure, the PBGC has taken the position, in many cases, that the termination date, with regard to the pension plans at issue, is earlier rather than later. While courts have reached different conclusions, depending on the facts and circumstances of the case, many courts appear to be sympathetic to the PBGC's views as to when a plan should be deemed terminated. With a deficit of well over $23 billion, one should anticipate that the PBGC will continue to do whatever is required to maximize its claim and recovery from Chapter 11 estates of companies whose pension plans it insures and to take actions to reduce its future obligations under those same pension plans.

Claudia Z. Springer is a partner in the Philadelphia office of Reed Smith LLP's Corporate Restructuring & Bankruptcy Group, and can be reached at 215-851-8100 or [email protected]. Daniel A. Zazove is counsel in the Chicago office of Kaye Scholer LLP's Business Reorganization Group and can be reached at, 312-583-2300, [email protected]. The authors would like to thank Scott M. Esterbrook of Reed Smith and Jeffrey E. Altshul of Kaye Scholer for their invaluable contributions.