Pension Reform Act I: Accounting Industry Reform Act Enacted; Next Step: Pension Reform Legislation

Article by Joshua H. Sternoff and Nicole K. Watson

President Bush signed the Sarbanes-Oxley Act of 2002, commonly known as the Accounting Industry Reform Act (the "Act"), into law on July 30, 2002. The Act was adopted in the wake of highly publicized corporate accounting scandals at Enron, Worldcom, and several other major public companies to protect investors by improving the accuracy and reliability of corporate accounting and securities law disclosures. The Act had been approved with overwhelming support on July 25, 2002, by the House (423-3) and the Senate (99-0).

The primary features of the legislation, relating to accounting reform and tougher regulation of securities law disclosures, have been much publicized. Here we focus on the provisions of note that relate to pension reform, although, as discussed below, the lion’s share of the employer stock/pension reform proposals that flooded Congress in the aftermath of Enron have yet to be enacted. What follows is a brief summary of the provisions of the Act that relate to pension reform and executive compensation, as well as a summary of key pension reform proposals that are still on the table and are widely expected to be taken up again by Congress in the near future.

The Act contains several pension reform provisions, including new rules establishing limitations on "blackout periods" during which employees are restricted from selling employer stock held in their individual employee benefit plan accounts. The blackout period issue has figured prominently in participant lawsuits involving Enron and other similar cases.

The Act requires a plan administrator to give individual account plan participants 30 days advance written notice of a blackout period. For this purpose, a blackout period occurs when an individual account plan participant is prohibited from making changes to his or her individual account investment elections for more than 3 consecutive business days.

The notice must be "written in a manner calculated to be understood by the average plan participant," and must include the following information: (1) the reasons for the blackout period, (2) the identification of the investments and other rights affected, (3) the expected beginning date and length of the blackout period, and (4) a statement describing the importance of investment diversification. The plan administrator would also be required to provide timely notice to the employer whose securities are subject to the blackout period.

The Act provides limited exceptions to the advance notice requirement (e.g. for events that are unforeseeable or beyond the reasonable control of the plan administrator or necessitated by a merger, acquisition, divestiture or similar transaction involving the plan or the plan sponsor).

The Act requires plan administrators to notify participants of changes in the beginning date or the length of the blackout period as soon as reasonably practicable.

The Department of Labor may assess a civil penalty of $100 per day per participant against a plan administrator for failure or refusal to comply with the notice requirements described above.

The Act also prohibits corporate directors and officers from purchasing or selling company stock acquired in connection with their employment as a director or officer during any blackout period applicable to the company’s individual account plan participants. For such purposes, a blackout period is defined as a period of more than 3 consecutive business days during which an employer or a plan fiduciary temporarily suspends the ability of 50% or more individual account plan participants to transfer employer stock held in the plan.

An employer (or any shareholder, if the employer fails to bring suit within 60 days of such shareholder’s request) may recover any profit realized by a director or officer from the transfer of company stock during a blackout period, without regard to the intent of the corporate insider. The suit must be brought within 2 years after the date on which the profit is realized.

The Act also toughens criminal penalties for failure to comply with the reporting and disclosure requirements of ERISA. In the case of a conviction of a person who willfully violates such reporting and disclosure requirements, the penalty is increased from a maximum of $5,000 to a maximum of $100,000, and from a maximum one year prison term to a 10 year maximum. In the case of a violator who is not an individual, the penalty imposed is increased from a maximum of $100,000 to a maximum of $500,000.

The Act also generally prohibits companies from making personal loans to their directors or executive officers. This prohibition also applies to material modifications, including renewals, of any existing loans or extensions or credit. A more comprehensive discussion of this provision is beyond the scope of this Alert.

As indicated above, the Act does not encompass the numerous pension reform legislative proposals that were initiated in response to Enron and similar cases involving large losses by employees arising out of 401(k) plan employer stock investments. It is widely anticipated, however, that pension reform legislation will be enacted as soon as September. In this regard, the Senate will work to reconcile a proposal sponsored by Senator Grassley and approved by the Senate Committee on Finance with a proposal sponsored by Senators Kennedy and Bingaman that passed the Senate Committee on Health, Education, Labor and Pensions. The Senate proposal must then be reconciled with the reform package adopted in the House on April 11, 2002. What follows is a summary of the key pension reform provisions of the House bill and the competing Senate proposals:

The House bill adopts the legislative proposal long championed by House Education and Workforce Chairman Boehner to increase participant access to professional investment advice. Under this proposal, a financial institution generally would be permitted to provide plan participants with investment advice, including advice that could lead to investment in the financial institution’s products, without violating ERISA if certain conditions are satisfied. The House bill would not require the financial institution to hire an independent expert to develop investment recommendations. The investment adviser would be subject to ERISA’s fiduciary standards of loyalty and prudence and could be held liable for participant losses suffered as a result of its investment advice. However, the employer would be relieved of liability resulting from losses on investments made on the advice of the investment adviser. Nonetheless, consistent with ERISA fiduciary principles, employers would be required to prudently select and monitor the investment adviser. The Senate proposals differ from the House bill in that they do not include a prohibited transaction exemption for advisers offering 401(k) plan investment advice, necessitating the independence of investment advisers from the investment alternatives provided under the plan.

Under current law, defined benefit plans may not invest more than 10% of plan assets in employer stock. However, this 10% limitation does not apply to defined contribution plans such as 401(k) plans. Although absolute caps on the amount of employer stock a defined contribution plan can hold were discussed in early post-Enron proposals, the House bill and the competing Senate proposals would not limit plan investment in employer stock. However, the Kennedy-Bingaman proposal would prohibit employers from making matching contributions in the form of employer stock if the plan permits participants to invest their elective deferrals in employer stock unless the employer also maintains a defined benefit plan.

Under current law, individual account plans may restrict a plan participant’s ability to sell employer stock held in the plan. The proposed legislation would set limits on a plan’s ability to restrict employees from selling company stock held in the plan.

The Senate and House proposals would require individual account plans to permit participants to immediately diversify elective salary deferrals that are invested in employer stock.

Diversification of employer stock contributed to an individual’s account as an employer contribution (including a matching contribution) is also addressed in both the House and Senate proposals. The House bill would permit a plan to restrict a participant’s sale of employer stock acquired as an employer contribution either (i) until the participant has completed three years of service or (ii) until three years after the end of the plan year in which the stock acquisition was made. The Senate proposals would permit the plan to restrict the sale of employer stock acquired as an employee contribution until after the participant has completed three years of service.

Both the House bill and the competing Senate proposals would remove the employer liability shield created by ERISA Section 404(c) during blackout periods. However, under the House bill, employers would not be liable for a loss suffered during a blackout period that results from a participant’s exercise of control over his or her account prior to the restriction, if the restricted period is reasonable and the employer has provided participants with the required notice. The Grassley proposal would require the Department of Labor to issue regulations that would provide a safe harbor by which fiduciaries could satisfy their obligations during a blackout period.

Both the House bill and the competing Senate proposals would require employers to provide participants with quarterly benefits statements, including the value of the plan assets held in employer stock, an explanation of the limitation on a participant’s right to direct a plan investment, and a statement regarding the benefits of diversification in a well-balanced investment portfolio. The Kennedy-Bingaman proposal would also require the plan sponsor to provide participants with all information disclosed to investors under the securities laws.

© 2002 Paul, Hastings, Janofsky & Walker LLP