Greenberg Traurig, LLP



GT Alert

Fiduciary Audit® Insurance: Risk management for Post-Enron ERISA Compliance

June 2002
By Jeffrey D. Mamorsky and Terry L. Moore, Greenberg Traurig, New York Office

Click for information on Adobe Acrobat.  View or download the PDF version of this Alert here.

The Enron/Anderson debacle has resulted in a legislative and regulatory examination of whether 401(k) and retirement plan fiduciaries, who are often also executives at the company sponsoring the plan, are equipped for their jobs as fiduciaries either on account of potential conflicts of interest or ignorance about their responsibilities.

Jeffrey D. Mamorsky
"It enables employers to establish self-audit internal control procedures designed to comply with the IRS Employee Plans Compliance Resolution System on a cost-effective basis."

The Employee Retirement Income Security Act of 1974 ("ERISA"), the pension law governing 401(k) and retirement plans, does not require ERISA fiduciaries to have legal, investment or administrative expertise. Their primary responsibility is to "oversee" the plans which includes a duty to demonstrate prudence in the selection and retention of outside experts they hire, ensuring that assets are "prudently" invested and otherwise protecting participants’ interests by making sure that the plans are operated and administered in accordance with their terms and the requirements of ERISA and the qualification provisions of the Internal Revenue Code ("Code").

Problems with the ERISA fiduciary system have been around since its enactment in 1974. This is because ERISA’s statutory provisions allow a corporate officer of a plan sponsor to also serve as a plan fiduciary and enforcement of the law depends on the monitoring of ERISA’s self-dealing and other prohibited transaction provisions by the Department of Labor ("DOL") and the courts. (See ERISA Sections 406(b) and 408(c)(3)). Although the number of fiduciary breach cases brought by the DOL has remained relatively steady in recent years (totaling 2,500 cases for the fiscal year ended Sept. 30, 2001), the number of cases involving 401(k) plans has increased as the result of the recent economic downturn and the growing prevalence of employers becoming delinquent in required contributions and the proper administration of plans. Also, plan participants are complaining more as the stock market slump has sent the value of plans plunging. As more high-profile accounting scandals came to light, from Enron to Global Crossing to Rite Aid, lawyers are expanding the focus of lawsuits to company directors, executives and other plan fiduciaries. Even plan advisors have been particularly hard hit. For example, major actuarial firms have been so hurt by litigation that they have been unable to obtain adequate insurance and are asking plans to accept a liability cap of $250,000 and seeking indemnification from plan fiduciaries.

In addition to the increasing potential for litigation from the DOL and plan participants, the DOL and IRS are increasing their audit activity and examination of 401(k) and retirement plans. In particular, the IRS has made significant policy changes in recent years relating to compliance and enforcement in the qualified retirement plan area. Under the IRS Employee Plans Closing Agreement Program ("CAP"), draconian monetary sanctions can be imposed on the sponsor of a qualified retirement plan for failure to operate its qualified plans in compliance with the qualification requirements of the Code or for failure to follow the terms of plan documents even if the plan operations otherwise comply with the Code’s qualification requirements. In many instances the amount of CAP monetary sanctions will be substantial (possibly millions of dollars) since the required payment amount is based on the total amount of tax that would be imposed on the employer, trust and participants if the plan were disqualified.

A Catch 22 for Bankrupt Employers

The spectre of a government audit and participant litigation is particularly threatening in the event of a bankruptcy or other restructuring situations. For example, the filing of a petition for bankruptcy will trigger the DOL to initiate an audit. Additionally, the filing of an IRS determination letter application for qualification upon plan termination in order to effectuate distributions also triggers an IRS Audit. In fact, the DOL has created an enforcement initiative entitled the "Rapid ERISA Action Team for Bankruptcy" or REACT. Under REACT, the DOL initiates audits based on the filing of the petition, newspaper articles regarding the bankruptcy and/or participant calls with respect to the bankruptcy filings.

Exacerbating the audit dilemma is the fact that the Creditor’s Committee in a bankruptcy situation often will not permit distributions to participants from a 401(k) or other retirement plan (leading invariably to litigation and/or complaints to the DOL and IRS) until it receives "iron clad assurances" that the bankruptcy estate will not be held liable in the event the IRS determines that the plan is not tax qualified and/or requires that operational errors be corrected in the future. The debtor is also concerned about the tax-qualified status of the pension, 401(k) or other retirement plan since it is representing to the IRS that the plan is qualified when it issues a Form 1099R to plan participants and the IRS upon distribution of assets to plan participants.

Awaiting receipt of an IRS determination letter upon termination of the plan prior to distributing assets to plan participants will not provide "iron clad assurances" of the plan’s qualified status since the IRS determination letter merely provides assurances that the plan document is in compliance with the Code’s qualification status and does not relate to the operation and administration of the plan being in conformity with the plan documents or applicable law. The only way to obtain "iron clad assurances" is to conduct a Fiduciary Audit® Operational Review of the plan, which qualifies the plan sponsor and plan for coverage under the Fiduciary Audit® Insurance Program through a review and analysis of the plan’s operation to ensure that it complies with all applicable law and plan documentation. The Fiduciary Audit® Insurance Program (more fully discussed below) indemnifies the plan sponsor and plan for any IRS liability or corrections required under a closing agreement with the IRS.

Accounting and Transactional Dilemmas

Problems also abound in the accounting and transactional areas. Employer plan sponsors (and trustees of multi-employer plans) are asked annually by their auditors in their management representation letter to make a representation that the plan sponsor is operating the plan in accordance with the plan document and applicable law. This representation (which appears as a footnote in the plan’s annual financial report) is required by the AICPA in view of the draconian tax sanctions that can be imposed by IRS on the employer/trustee plan sponsor if the plan is not operated in accordance with its terms and applicable law. An identical representation occurs in every corporate transaction where the seller is required to represent to the buyer that the 401(k) and other retirement plans are administered in accordance with their terms and applicable law. The problem is that this is rarely the case since although ERISA lawyers may draft perfect plan documents and obtain a determination letter from IRS, the document rarely accurately depicts all aspects of plan administration which may also be incorrect. A plan sponsor fiduciary can represent the correctness of the plan document and administration if a Fiduciary Audit® Operational Review is conducted to verify that plan terms are consistent with actual operation.

These issues of sanction avoidance, balance sheet enhancement and transactional facilitation also raise the possibility of civil liability for corporate directors who fail to establish procedures for monitoring compliance, particularly where a federal agency such as the IRS and DOL have established a self-audit compliance program that encourages corporations to identify and correct employee benefit violations so as to (i) avoid or mitigate sanctions imposed by IRS for not operating plans in accordance with the Code’s qualification requirements (see IRS Revenue Procedure 2001-17) and (ii) civil and criminal penalties imposed by the DOL and ERISA (see In re Caremark Int’l Inc. Derivative Litig. 698 A.2d 959).

Cash Balance Plans

Over 700 plan sponsor employers (mostly large corporations) have converted traditional defined benefit plans to cash balance plans. The problem is that all applications for a determination letter involving the conversion of a defined benefit plan to a cash balance plan are being sent to the IRS National Office for review. In other words, issuance of determination letters for such converted plans have been effectively suspended.

Also DOL is investigating cash balance plans to determine if employees’ pensions are being underpaid. A list of companies that drastically underpaid pension benefits was recently released by U.S. Representative Bernie Sanders who has introduced legislation in which the DOL would be required to enforce existing rules on cash balance plans and to take enforcement action against the plans already cited for violations. In addition, in many cash balance plans there are issues relating to age discrimination that have come to the attention of the Equal Employment Opportunity Commission.

The IRS has identified a number of concerns including: (1) whether cash balance plans satisfy the benefit accrual rules under Code Section 411(b) (relating to the three methods of accruing benefits under a defined benefit plan), (2) whether the conversion of a defined benefit plan to a cash balance plan violates the "anti-cutback" rule of Code Section 411(d)(6) (relating to the prohibition on reducing benefits that have already accrued under the plan) and (3) whether such conversions to cash balance plans violate the age discrimination rules under Code Section 411(b)(1)(H).

The IRS has indicated that relief from plan disqualification and penalties would be provided to any cash balance plan which has received an IRS determination letter. However, if the IRS finds that there are significant problems with the cash balance plan concept, retroactive correction may be required. This means that plan sponsor employers may be required to make additional contributions to the plan to make participants whole. Also, there may be ERISA fiduciary issues relating to the conversion that the IRS cannot address. If this is the case, any relief from ERISA fiduciary responsibilities must be handled by the DOL.

A Recent Success Story

An excellent solution to a number of problems enumerated above can be illustrated by the recent dilemma of a not-for-profit Hospital which maintained two defined benefit pension plans that had been converted to cash balance plans. Both plans were terminated in 2001 on account of the bankruptcy filing by the Hospital whose assets were eventually liquidated. Both cash balance plans were overfunded at termination. After distributions were made to all plan participants, the excess plan assets were used by the Hospital to pay its creditors. Such reversion of plan assets was not subject to the 50% excise tax on reversion of plan assets to the employer plan sponsor since the Hospital is a tax-exempt organization.

Upon termination of the plans, an application for a determination letter from the IRS was sought for each plan that such plan continued to satisfy the requirements for tax qualification under the Code. The IRS did not issue the requested letter in accordance with its policy which requires technical advice to be sought through the IRS National Office with respect to any determination letter request or examination case involving a conversion of a plan to a cash balance plan.

Fiduciary Audit® Insurance Program

Since the plans were unable to obtain an IRS determination letter or any other assurance on the qualified status of the plans, the Hospital was concerned about its representation to IRS and participants about the plan’s tax qualified status when it issues a Form 1099R upon distribution of plan asssets to participants and the Hospital’s creditors were concerned about liability to the bankruptcy estate in the event the IRS determined that the plan was not qualified. The solution for the Hospital was to obtain insurance coverage for itself and the plans under the Fiduciary Audit® Insurance Program which indemnified the Hospital and the plans for any IRS monetary sanctions and the cost of correction of disqualifying errors imposed on the Hospital as the result of entering into a closing agreement with IRS under CAP.

Coverage under the Fiduciary Audit® Insurance Program is conditioned on a Fiduciary Audit® Operational Review by our Employee Benefits Group to determine if a plan is qualified based on the terms of the plan document and the actual day-to-day operation of the plan. The Fiduciary Audit® Operational Review consists of:

  1. completion of a Fiduciary Audit® Investigative Questionnaire and Operations Manual which is designed to ascertain how a plan is being administered through a series of easy to respond to questions on each aspect of plan administration and legal compliance;
  2. a comparison of the completed Investigative Questionnaire with all plan documents, summary plan description booklets and employee communications to make sure that plan documents properly reflect the operation and administration of the plan;
  3. in some cases the testing of internal control procedures through a "sampling" or "pre-IRS audit" of participant files; and
  4. the preparation of the Fiduciary Audit® Annual Report which describes our findings and recommendations for correction of any plan document or operational failures that are identified by the Fiduciary Audit® Operational Review.

The Fiduciary Audit® Insurance Program is truly a panacea for post-Enron compliance since it enables employers to establish self-audit internal control procedures designed to comply with the IRS Employee Plans Compliance Resolution System set forth in Rev. Proc. 2001-17 on a cost-effective basis and obtain insurance for any IRS liability and required cost of correction that might occur as the result of an audit by IRS.


© 2002 Greenberg Traurig

Additional Information:

For more information, please review our Executive Compensation & Employee Benefits Group description, or feel free to contact one of our attorneys.

This GT ALERT is issued for general purposes only and is not intended to be construed or used as legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs. The Firm’s responsive approach to client service often cuts across legal subject matter, applying the right experience and resources to provide cost-effective solutions.