Employee Benefits and Executive Compensation Update

BACKGROUND:

The U.S. Court of Appeals for the Ninth Circuit recently held that Xerox Corporation's "phantom account" method of reducing employees' retirement benefits by the amount of previously distributed benefits violated the actuarial equivalency requirements of ERISA. In Miller v. Xerox Corporation Retirement Income Guarantee Plan, three employees who had terminated employment with Xerox and were later reemployed challenged a drastic reduction in their final retirement benefits caused by the subtraction of their prior distributions. During the plaintiffs' initial employment term, they participated in a floor-offset hybrid retirement plan, which guaranteed a minimum payment from the defined benefit portion of the plan as well as any additional benefits above that amount from the defined contribution portion of the plan. When the employees terminated employment with Xerox in 1983, they received a lump-sum payment entirely out of funds in the defined contribution portion of the plan, because the accrued amount in that portion exceeded the floor value in the defined benefit portion of the plan.

Xerox altered its retirement plans in 1989, after the plaintiffs began their second terms with the company. Xerox consolidated the entire plan under the name "Income Guarantee Plan," which had previously been the title of only the defined benefit portion of the prior hybrid plan. The new plan had three accounts: modified forms of the defined contribution portion and defined benefit portion of the prior hybrid plan, and a cash balance account. Similar to the prior hybrid plan, participants would receive the largest of the three account balances in the form of an annuity upon retirement.

For employees like the plaintiffs, who had already received a distribution of pension benefits, Xerox reduced their final benefits to account for the earlier distribution using "phantom accounts." Phantom accounts were calculated for the cash balance account and the new defined contribution account as the amount distributed at the first termination of employment plus the investment return calculated as if that amount had remained in the plan. The defined benefit portion of the plan did not have an associated phantom account. At the employee's subsequent termination of employment, he received the amount in either the defined benefit portion, the cash balance account plus its phantom earnings, or the defined contribution account plus its phantom earnings, whichever was largest. The phantom account was then subtracted from the largest of these three benefits to yield the actual benefit. Even though the defined benefit account did not have an associated phantom account, if it yielded the largest benefit, it would be reduced by the defined contribution phantom earnings. In 1997 and 1998, after requesting a benefit summary, the plaintiffs learned that this process drastically decreased their monthly benefits between 81% and 95%.

ANALYSIS AND RULING:

In reversing the district court, the Ninth Circuit held that this phantom account process violated the ERISA requirement of actuarial equivalency between the actual distribution and the accrued benefit for which it was substituted. The court found that Xerox overestimated the value of the distributions made at the previous termination and, therefore, the corresponding reduction in benefits upon retirement, declaring that "[t]he applicable regulations permit a plan to subtract from a final defined benefit only the 'accrued benefit attributable to the [prior] distribution.'"

The Ninth Circuit first reasoned that, although the employees only received lump-sum distributions from the defined contribution portion of the hybrid plan when they first terminated employment with Xerox, they actually received two distributions: the maximum floor amount under the defined benefit portion and the excess of that amount produced by the defined contribution portion. Because the plaintiffs were receiving final retirement benefits from the new "Income Guarantee Plan," the court stated that the excess defined contribution distribution, and any change in its value, should not affect the amount of the accrued benefit that was attributable to the original "Income Guarantee Plan" distribution (i.e., the defined benefit distribution at the time of the employee's first termination of employment). To meet the Ninth Circuit's standards, it appears that Xerox could only subtract the value of the original defined benefit distribution, without taking into account any of the defined contribution distribution in excess of that amount.

The Ninth Circuit then held that Xerox overstated the prior distribution's value by including its "phantom" investment increase, stating that "nothing in the statute or in logic permits this revisionist approach to already-distributed accrued benefits." In order for the lump-sum retirement distribution to be actuarially equivalent to the benefit earned, as required by ERISA, the court held that Xerox may only subtract out the "actual" value of the prior distribution, not the prior distribution's hypothetical value at final retirement. To meet the court's standards, Xerox should only have subtracted the nominal value of the original defined benefit distribution, without taking into account any interim rate of return.

For more information on this matter, please contact a member of the Schiff Hardin Employee Benefits and Executive Compensation Group.

Sixth Circuit Rules Stock Options Can Be Employee Benefits Under ERISA

BACKGROUND:

In Kolkowski v. Goodrich Corp., the U.S. Court of Appeals for the Sixth Circuit recently ruled that stock options could be considered employee benefits for the purposes of Goodrich Corporation's ERISA severance benefit plan. A former Goodrich employee sought severance payments because an acquiring company did not offer him a benefit package comparable to that which he had been receiving from Goodrich. Kolkowski was a participant in Goodrich's stock option plan, performance based incentive plan, and Employee Protection severance plan (EPP). His division was transferred via merger to PMD Group. This change of control would trigger Kolkowski's EPP severance benefits if PMD's employment offer included either (1) a decrease in base salary or (2) employee benefits that were not comparable to those he had been receiving from Goodrich. Kolkowski decided not to accept PMD's offer because, in his estimation, it lacked comparable employee benefits, specifically a stock option plan, a specific performance-based incentive plan, and a change in control severance agreement. He then applied to Goodrich for EPP severance benefits, which Goodrich denied because, in its view, the PMD employment offer provided benefits comparable to Kolkowski's benefits at Goodrich.

ANALYSIS AND RULING:

In overturning a district court ruling for Goodrich, the Sixth Circuit focused exclusively on the stock option plan. Goodrich had argued that stock options are compensation, not employee benefits, and pointed to two sections of the EPP for support: the "Employee Protection Benefits" section, which omits stock options in its listing of benefits qualifying for severance protection, and the "Payment Limitations" section, which refers to stock options as compensation. Kolkowski argued that options are ordinarily understood to be employee benefits, and that the plan's omission of options in the Employee Protection Benefits section was not conclusive. The Sixth Circuit agreed with the district court on the reasonableness of these two interpretations, and determined that the EPP's use of the term "employee benefits" was ambiguous.

Because of this ambiguity, the Sixth Circuit looked to extrinsic evidence, giving special weight to Goodrich's communications to its employees, considered crucial to the average employee's understanding of the role of stock options. The court focused on an "EPP Summary" distributed to employees, which referred to stock options as "other benefits to which a covered employee may be entitled." The court concluded that Goodrich employees would consider stock options to be employee benefits on the basis of this summary. Therefore, the absence of stock options in the PMD offer triggered the involuntary termination severance benefits under the EPP.

In holding for Kolkowski, the Sixth Circuit rejected the specific reasoning of the district court. Although a "Benefits-At-a-Glance" brochure did not mention stock options in its list of employee benefits, the court considered this a non-exhaustive list, pointing out that both sides considered Goodrich's cash incentive plan to be an employee benefit despite its similar absence from the brochure. The Sixth Circuit also dismissed the fact that stock options were administered by Goodrich's Compensation Group, rather than a benefits department, as irrelevant to the court's duty to interpret the EPP language as understood by the average plan participant. Finally, the Sixth Circuit quickly rejected the district court's effort to find a categorical rule in case law that stock option plans are considered compensation.

This case serves as a reminder to avoid unnecessarily specific language when drafting change of control severance agreements. Using language such as "comparable employment," instead of "comparable employee benefits," should prevent a court from evaluating each facet of an employee's benefit plans individually.

For more information on this matter, please contact a member of the Schiff Hardin Employee Benefits and Executive Compensation Group.

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