Benefits and Bankruptcy – The Perspective Problem

By Alexander Renfro

I believe an explanation of the policies behind ERISA and the Bankruptcy Code is necessary to truly understand the friction between these two fields of law. It is as a result of each code’s divergent  public policies  that natural tension arises, creating issues both well known and yet to be seen in practice. When one examines the public policies underlying ERISA and the Bankruptcy Code, the conflict between them becomes readily apparent.

Consider, first, one of the major policy goals of the Bankruptcy Code: equal treatment of similarly situated creditors. Notice the focus on creditors in general, as opposed to preferential groups such as employees of a failing business. While it is true that some preferences and priorities are given to certain creditors, the general policy of equivalent treatment of similarly situated creditors takes primacy over such exceptions.

Now consider the goal of ERISA, which is duly articulated by its very title: the Employee Retirement Income Security Act. ERISA exists to protect employees’ retirement income, including from creditors, and ensures that should a business become insolvent, rank and file employees will have funds in trusts which are unreachable by the corporation’s creditors, allowing employees to receive preferential payments despite their employer’s insolvency. One need only look to the Studebaker bankruptcy/pension disaster to understand why such protections were put in place under ERISA. (Alexander, would you summarize what happened in an end note?)

One may clearly now gauge the crux of the tension between ERISA and the Bankruptcy Code. In the Bankruptcy Code, employees are simply another creditor to be treated relatively equally as compared to all other similarly prioritized creditors. In ERISA, employees are prioritized above all merely for their status as service providers to a service recipient on a relatively full-time basis, enhancing their rights and access to funds from which other creditors are explicitly barred. The two perspectives could not be more at odds. Coexistence simply cannot occur between these policies and necessarily creates tension. Not surprisingly, this leads to discord between ERISA and the Bankruptcy Code and headaches for lawyers everywhere.

Failure to observe ERISA’s requirement that employees must be protected before creditors may lead to a terrible tax consequence: a qualification failure. A qualification failure means that the plan will no longer receive the tax advantages a qualified plan normally enjoys. Those advantages include tax deferral for employees and current deductions for employers. If a plan loses its qualification status, the taxes that are deferred on every employee’s 401(k) or traditional pension plan will come due that year, as opposed to the year of retirement. Imagine if your retirement savings were taxed like your wages when they could have been tax deferred for decades, depending on one’s age. That’s a severe tax consequence that comes from qualification failures.

On the other hand, failure to comply with the Bankruptcy Code can result in numerous other penalties, such as unwinding of preferential payments. In essence, when a business declares bankruptcy, its own retirement plans are treated as creditors under the Bankruptcy Code. Thus, excess payments to retirement plans can be treated as preferential payments just the same as if the debtor were paying one bondholder instead of another. In such cases, these preferential payments can be taken back and fought over to the expense and lament of the debtor.

Furthermore, the creditor must always keep in mind that ultimate failure in reorganization is liquidation, and the possibility of liquidation is always looming. Compliance and agreement amongst the creditors of a plan of reorganization is thus paramount throughout the bankruptcy process.

Choosing between obeying ERISA or the Bankruptcy Code results in a cruel game of pick your poison. Discrepancies in the codes, such as treatments of certain retirement assets in the bankruptcy estate of an individual or prioritizing target normal cost of a business attempting a Chapter  11 reorganization. The problem just described is incredibly complex and difficult for businesses filing Chapter 11, but basically, a reorganizing business with a traditional pension may make certain payments to the pension plan during reorganization. The allowed amount is numerically and formulaically different in ERISA and the Bankruptcy Code. When one federal law tells you to go left and another tells you to go right, which is the correct path?

A more detailed look at how these issues are resolved will follow in later columns, but for now, we may take heart in knowing that where such discrepancies have arisen, court decisions (?)have generally given a clue as to how one must proceed to avoid violating one code at the expense of another. Sometimes, the codes themselves give deference to the other. At other times, federal common law or government regulatory guidance provides excellent insight into solutions which avoid the unsavory trap (the trap need to be explained for the ERISA uninitiated) described above.

Can you explain what the context of the problems you now describe? Unfortunately, however, some issues remain to be fleshed out by any authoritative agency, such as the differing definitions of “normal cost” in the Bankruptcy Code and “target normal cost” in ERISA as per the Pension Protection Act of 2006. When it comes to these matters, practitioners must get creative and attempt to satisfy contradictory statutes as best they can. It is my personal hope that as such issues come to light, they will be addressed and add to what can only be a growing body of federal common law addressing similar issues. Needless to say, we will take special interest in these less publicized issues in the future, as I believe they require the most discussion.

The genesis of the problem is thus simple: from different perspectives and policies stem different statutes which naturally conflict with one another. The successful navigation of this legal mine field demonstrates a mastery of understanding concerning both codes, a mastery we will continuously strive to achieve.

Alexander Renfro received his J.D. from SMU Dedman School of Law in Dallas, Texas, where he graduated with honors, and is a current student at the Georgetown University Law Center, seeking an LL. M. in Taxation with a Certificate in Employee Benefits. Mr. Renfro has worked for and continues to assist fellow NACTT contributor Sidney Scheinberg on matters of bankruptcy, replevins, and commercial debt litigation. Mr. Renfro aims to weave his passions for bankruptcy and employee benefits into his practice into the future.

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