SOLUTIONS IN A FLASH- RETIREMENT PLAN CORRECTION SOLUTION:
THE PENSION PLAN PIRATE

By: Hayden L. S. Herock, Esq.

After years of crime on the high seas, Captain Jack Sparrow and Captain Hector Barbosa laid down their swords and joined forces to create a reputable shipping company, Pirates, Inc. As they grew in size, they decided to sponsor a defined benefit plan for their employees. Usually, the captains share responsibility of the plan. However, Jack takes a leave of absence and goes gallivanting in the Caribbean. While he is gone, Hector is left to run the business from land.

One of Hector’s primary responsibilities in Jack’s absence is the maintenance of the retirement plan. Hector finds himself reminiscing on his past life as a pirate and wishes to relive his glory days. Luckily, he happens across an ad to buy the ship of his dreams, the Black Pearl. In his excitement, he “borrows” $500,000 from the defined benefit plan for the down payment, intending to eventually pay it back. In his haste, Hector fails to get any loan documentation prepared, set up a repayment schedule, or give the plan any security for the loan, which far exceeds his accrued benefit.

Hector soon realizes that keeping a boat seaworthy costs more than he anticipates, and is never able to make any payments on the loan to the plan. In the meantime, the company’s TPA, Elizabeth Swan, discovers this “loan” and brings it to Jack’s attention when he returns to the Mainland.

What is the Problem?

Aside from possibly committing embezzlement (a felony), Hector also engaged in a prohibited transaction. Internal Revenue Code (“Code”) section 4975 and Employee Retirement Income Security Act of 1974, as amended (“ERISA”) section 406 define a prohibited transaction as any transaction that involves certain activities between the plan and a disqualified person (the Code term) or a party in interest (the nearly identical ERISA term). Particularly onerous are activities where a fiduciary deals with the plan assets in their own interest (called “fiduciary self-dealing”). A common way that a fiduciary can engage in self-dealing is entering into transaction involving the plan where their interests are adverse to those of the plan or its participants and beneficiaries. The lending of money by the plan to a fiduciary is self-dealing.

Under the Code, a disqualified person includes more than just fiduciaries.  For example, it also includes people who provide services to the plan, and companies whose employees are covered by the plan. Disqualified persons also include highly compensated employees of the plan sponsor; unions to which employees belong; officers and certain shareholders of the plan sponsor; and certain commonly owned companies or partners or joint venturers of other disqualified persons. The ERISA definition of a party in interest is almost identical to that of a disqualified person, although it considers all employees not just HCEs, to be parties in interest.

Hector, as an owner and officer of the company, and a trustee of the plan, is both a fiduciary and a disqualified person. Therefore, by loaning himself money from the plan to buy the Black Pearl for his own use, he engaged in a prohibited transaction and may be subject to excise taxes imposed by the Code. He also violated his fiduciary duties, creating personal liability for any plan losses.  And, finally, if what he did is found to be embezzlement, rather than a legitimate loan, he may also have to spend some time in the brig (and no amount of whistling will get that dog to give him the key).

Who is on the Hook?

The prohibited transaction rules are intended to enforce the duty of loyalty on those responsible for the plan. A fiduciary has a legal obligation to act in the participants’ and beneficiaries’ best interest and is bound by the duties of care and loyalty, and the duty to monitor those performing services for the plan. As a result, fiduciaries of the plan may be found civilly and criminally liable when prohibited transactions occur.

Hector was assigned the duty of maintaining the plan while Jack was away, and is, therefore, responsible for it and any breaches of his own fiduciary duties. Hector could also be found personally liable if he does not repay the money to the plan. There is also the tax liability if he is determined to have taken a distribution with no reported taxable income.  Jack’s in trouble, too. While non-breaching fiduciaries are usually not responsible for breaches by another fiduciary, they have co-fiduciary liability if they knowingly participate in or conceal the breaching act, they know of the breach and fail to take reasonable efforts to remedy it, or they facilitated the breach by not fulfilling their own duties. Jack, although a non-breaching fiduciary, may be liable for leaving Hector in sole control of the plan or if he fails to make reasonable efforts to remedy the prohibited transaction now that he has been made aware once coming ashore.

Correction

Jack seeks out Elizabeth for help. Elizabeth reminds Jack that as a plan official handling plan assets, he and Hector were required to get a fidelity bond. This bond protects the plan against loss from acts of fraud or dishonesty by a bonded party, including Hector’s theft. Elizabeth reassures Jack that, thank goodness, Hector renewed the bond policy earlier in the year. Further, the prohibited transaction must be corrected.  As a general principle, to correct a prohibited transaction, the plan must be restored to the financial position it would have been in had the violation not occurred, making the plan whole. The rules also go further and require that the fiduciary not benefit from the breach. Therefore, to the extent the profits made by the fiduciary are greater than the amount needed to make the plan whole, those profits must be disgorged to the plan. Those profits could include the money Hector made by operating the Black Pearl and/or any increase in the Black Pearl’s value since he bought it.  This correction must be done to remedy both the prohibited transaction and the breach of duty.

Elizabeth then advises Jack that it is a good idea to remedy and correct this prohibited transaction by filing an application through the Department of Labor’s (“DOL”) Voluntary Fiduciary Correction Program (“VFCP”). This program is available for specific violations identified by the DOL and cannot be used if you are already under DOL investigation. The DOL has specific rules as to how the plan must be corrected and they must be followed precisely, or you risk the rejection of your application. If the application is approved, it will provide relief from DOL enforcement and some prohibited transaction penalties. For more information on the VFCP program and its new self-correction component (which is not available for Hector’s breach) check out the Flashpoint linked here.

While VFCP cannot be used to absolve the breaching fiduciary of criminal activity (if, indeed, Hector has committed embezzlement), Jack, as an innocent fiduciary, may still use this program if they have also reported the crime to the appropriate authorities. If all goes well, and Jack successfully completes the VFCP program, Jack will receive a No Action Letter from the DOL stating that it will not initiate an investigation or impose any additional penalties.

If you or a client has also been a victim of a pension pirate, feel free to contact us about your correction options. After all, we are your ERISA solution!