Counsel for Debtors Beware Officers and Directors May Be Personally Liable for the 401(k) Contributions to Employees and Their Health Insurance Claims

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Jul/Aug 2001

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When times are tough and cash flow is tight, owners, directors, officers and/or
employees of a company may be tempted to delay payment of contributions into the
company's 401(k) plan and to delay payment of health insurance claims or premiums
in order to use the withheld money as operating capital. While this approach solves
an immediate problem for the company, it may convert the company's problem into a
problem for the persons who make such decisions if the company is then unable to pay
those contributions and claims.

<h3>ERISA</h3>

The Employee Retirement Income Security Act of 1974 (ERISA) governs, inter
alia, the operation of 401(k) plans and group health plans. The primary purpose
of ERISA is to protect the benefits of employees from abuse by employers and persons
who administer benefit plans. One of the ways this protection is provided is to
designate certain individuals to be fiduciaries of a plan (see ERISA §§3(21)
& 402(a); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §§1002(21) & 1102(a)</a>) and to regulate
the fiduciaries' conduct (see ERISA §§404(a) & 406; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C.
§§1104(a) & 1106</a>), and then to make the fiduciaries personally liable for
breaches of fiduciary duty (see ERISA §409(a); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1109(a)</a>).

How does a director, officer or employee become a fiduciary of an ERISA plan?
A director, officer or employee becomes a fiduciary of an ERISA plan if he (1)
is designated a fiduciary in the plan document (see ERISA §402(a); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S.C. §1102(a)</a>) or (2) if he has authority over the administration of the
plan or its assets (see ERISA §3(21); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1102(a)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
of Trs. of the Airconditioning and Refrigeration Indus. Health and Welfare Trust
Fund v. J.R.D. Mech. Servs Inc., 99 F. Supp. 2d 1115, 1120
(C.D. Cal. 1999)</a>).

What are the duties of a fiduciary? Fiduciaries are required to act (1) solely
in the best interests of the plan participants and (2) with the care, skill,
prudence and diligence that a prudent person familiar with such matters would use.
ERISA §404(a); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §§1104(a)</a> (emphasis added). A plan
fiduciary's role is similar to that of a trustee of a trust or an executor of an
estate.

ERISA expressly contemplates that an officer, employee or other representative
of a company may also serve as a fiduciary of a plan. ERISA §408(c) (3);
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1108</a> (c)(3). Because of the obvious risks arising from their
dual-capacity status, fiduciaries are expressly prohibited from dealing with the plan
assets for their own advantage and from acting on behalf of a party whose interests
are adverse to the participants. ERISA §406(b); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1106(b)</a>.
A fiduciary who does not pay contributions to a 401(k) plan or health insurance
claims in order to pay the company's other creditors may be dealing with plan assets
for his own account (i.e., his investment in the company) and/or acting on behalf
of the interests of the company when its interests are adverse to those of the
participants (i.e., they both want the same money). The fiduciary may also be
construed to be loaning plan assets to the company, which is expressly prohibited.
ERISA §406(a); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §§1106(b)</a>. See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
§4975(c)</a>.

Included in the duty to act in the best interests of the plan participants is a
duty to inform participants of material information regarding their benefits. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
v. E.I. DuPont de Nemours & Co., 237 F.3d 371, 380 (4th Cir.
2001)</a>. This duty obviously includes a duty to inform participants of circumstances
that threaten their interests in a plan. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Nuclear Measurements Corp., 107
F.3d 466, 472 (7th Cir. 1997)</a> (holding that the company and its
officers breached their fiduciary duties by failing to advise employees in a fully
insured health plan that their insurance coverage had lapsed because of the non-payment
of premiums).

When does the company's money become an untouchable plan asset? Much of the
fiduciary liability litigation focuses on determining when the company's money becomes a
"plan asset." Once the money becomes a plan asset, the company can no longer use
the money to pay other creditors, but must use it exclusively to provide benefits to
participants.

Contributions that have been deposited into a plan are clearly plan assets.
However, in some instances, contributions become plan assets even before they are
deposited into a plan. For example, employee deferral contributions to 401(k)
plans become plan assets as of the earlier of (1) the earliest date that the money
can be segregated from the employer's general assets, or (2) the 15th of the
month after the month the money was withheld from the employee's wages. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
C.F.R. §2510.3-102</a>. See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… States v. Grizzle, 933
F.2d 943, 948 (11th Cir. 1991)</a>. The Department of Labor has made
it clear that the 15th day of the next month is not a safe harbor, but the latest
possible date on which the 401(k) deferrals must be contributed to a plan. See
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… C.F.R. §2510.3-102(f)</a> (providing relevant examples 1, 2 and
3).

In some instances, employer contributions (other than deferral contributions) may
also become plan assets before they are deposited into the plan's trust account if an
underlying wage agreement (e.g., collective bargaining agreement) so provides.
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Med. & Clinical Servs. Fund v. Catucci, 60 F. Supp. 2d
194, 200 (S.D.N.Y. 1999)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Giordano's Rest., No. 94
CIV, 4696 (RPP), 1995 WL 442143, *4 (S.D.N.Y. July 26,
1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Gangloff, 677 F. Supp. 295, 301 (M.D. Pa.
1987)</a>, aff'd., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.2d 959 (3rd Cir. 1991)</a> (holding that
contributions were plan assets pursuant to the terms of the wage agreement).

The authors were personally involved in a case where an ERISA plan filed a
complaint in a former officer's individual bankruptcy proceeding seeking to hold him as
an officer and director of a company liable for contributions that remained unpaid after
the company's bankruptcy. The plan's theory was that the plan contributions became plan
assets on payday pursuant to the terms of the underlying collective bargaining
agreement. The individual defendants, after expensive pre-trial wrestling, chose to
accept an order determining their personal liability and the non-dischargeability of that
debt rather than risk paying their attorneys' fees, the plan's attorneys' fees and the
contributions. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §523(a)(4)</a> (providing that an individual debtor
is not discharged from any debt arising from fraud or defalcation that is committed
while acting in a fiduciary capacity). See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Mechanical Services
Inc., 99 F.Supp. 2d at 1115</a>.

Who is liable for breaches of fiduciary duty, and what are they liable for?
ERISA expressly provides that a fiduciary who breaches his fiduciary duty is
personally liable to make good to the plan any losses to the plan resulting from his
breach of fiduciary duty. ERISA §409(a); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1109(a)</a>;

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Terwilliger, 126 F.3d 34, 40 (2nd Cir. 1997)</a> (holding
that the president of a closely held corporation who diverted paycheck deductions from
a union pension fund to other company creditors was personally liable as an ERISA
fiduciary, where it was undisputed that the employee's contributions were plan assets).

In addition, it is a federal crime for any person to embezzle, steal or
unlawfully and willfully convert to his own use any of the assets of a retirement
plan. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §664</a>. This offense is punishable by a fine of up to a
maximum of $10,000, or imprisonment of up to five years. It is also important
to know that a fiduciary may be liable for another person's breach of fiduciary duty
if he (1) knowingly conceals the other's breach, (2) fails to act prudently and
in the interests of the plan participants and beneficiaries in carrying out his own
duties, thereby enabling the other fiduciary to breach his duty, or (3) he
discovers the breach, but fails to exercise reasonable efforts to remedy it. ERISA
§405(a); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1105(a)</a>.

So what do directors, officers and employees need to watch out for in time of
financial distress? Most company officials are very careful to pay over income taxes
and social security taxes in tight financial times because they know that they are
personally liable for those taxes. All company officials and their lawyers also need
to pay particular attention to ERISA benefits in tight times to avoid personal
liability. Specifically, they need to pay attention to 401(k) plan deferrals by
employees and to health insurance claims under self-insured health plans.

A. Always, always pay into the 401(k) plan 100 percent of the
401(k) deferrals. All 401(k) plans permit participants to defer a portion
of their compensation into the plan on a pre-tax basis. On payday, typically a
company pays the payroll and withholds from the checks the amounts deferred by the
employees. Those amounts are then paid over to the 401(k) plan on payday or
at some regular interval. If those deferrals are not in fact paid to the plan
at all, or are not paid promptly, that is a breach of fiduciary duty for which
the responsible persons may be held personally liable. It is also important to note
that creditors that take over management of the company's money in tight times, but
who fail to or refuse to pay these deferrals and contributions into the plan, may
be fiduciaries over these plan assets and personally liable for the loss to the
plan.

B. Be sure there is money to pay claims under self-insured health plans or
that participants are fully informed of the risk that their claims may not be
paid. Many companies pay the health insurance claims of their employees directly from
the company's funds. In these health insurance plans, the company itself bears the
risk of covering the medical claims of its employees, instead of paying premiums
to a health insurance company so that the insurance company will bear this risk.
This type of group health insurance plan is commonly called a "self-insured plan."
Although self-insured health plans typically do purchase an insurance policy to pay
catastrophic claims (i.e., a stop-loss policy), the company must pay from its
own coffers all claims up to a certain dollar amount each year. Most of these
self-insured health plans do not have cash reserves or a trust set aside to cover
claims in bad financial times or after shutdown or sale of the company or its
assets.

In times of financial distress, companies are first tempted to delay payment of
medical claims and divert the cash to pay creditors, and then they may completely fail
to pay the claims. If the company's assets are going to be bought as part of a
workout, critical issues arise concerning health insurance claims in self-insured health
plans. If the purchaser is not going to assume the medical claims, and the seller
has no reasonable basis to believe that it will be able to pay the medical claims,
then the directors and officers of the seller must decide whether to (1) tell the
employees that there is probably not enough money to pay their health insurance claims
or terminate the plan, or (2) say nothing. If they tell the employees that they
may not really have health insurance, or if they terminate the health plan, morale
will be severely damaged and employees may look for other jobs just when the company's
chance of survival depends on their staying and being more productive than ever. If
the directors and officers say nothing and do nothing, then the participants will
assume that they have real health insurance that pays real claims, and they may incur
discretionary medical expenses or fail to enroll in other medical insurance that is
available to them (e.g., through their spouse's employment). One can argue that
silence of directors and officers at a time like this is a fraud upon the
participants.

Fiduciaries are not required to personally guarantee the payment of benefits to
participants or the continuation of any particular benefit, but they are required to
use the employee's contributions to the plan to pay the benefits of the plan, and
they are required to advise the employees of material facts regarding the ability of
the plan to provide the promised benefits. When the fiduciaries know that there is
a substantial risk that the benefits of the plan (i.e., the medical claims of the
employees) will not be paid (because there is simply not money available, or the
creditors will not permit the claims to be paid, or the company negotiating to buy
the assets will not agree to pay the medical claims), then the fiduciaries must
either bluntly communicate the true, but painful, facts to the participants, terminate
the health insurance plan or face the risk of personal liability for medical claims
incurred.

When negotiating with creditors or buyers of assets in a workout, the company may
want to have a health actuary calculate the dollar amount of the claims reasonably
expected to be incurred prior to termination of the plan based on prior claims
experience and the age and health of the participants in the plan. In turn, the
company, the creditors and a buyer of the assets should be able to safely rely on
those calculations and set aside the calculated dollar amount to pay claims. All
persons should then be protected from liability even if the money set aside turns out
to be insufficient to pay the claims actually incurred because of unexpectedly large
claims, provided participants are clearly informed that the plan is self-insured and
that the company has set aside the amount calculated by the plan actuary, but that
the company cannot be sure that the amount set aside is adequate to pay all claims
because no one can determine with certainty what claims will in fact be incurred over
any time period. At a minimum, claims must be paid equal to the amounts the
employees have paid to the company for health insurance (including COBRA premiums)
for the relevant time period.

<h3>Conclusion</h3>

Directors, officers and employees who administer ERISA plans for their employers
must always remember that in addition to the duties owed to the company in tough
financial times, they owe a duty to the participants in their ERISA plans to act
in their best interests, to use the employees' money to provide the benefits promised,
and to ensure that the participants have all of the facts necessary to make sound
decisions regarding their benefits. A failure to meet these fiduciary responsibilities
could lead to expensive and protracted litigation and ultimately to personal liability.

Journal Authors

Journal Date

Sunday, July 1, 2001 - 12:00

Bankruptcy Rule

2001