A successful corporate merger or acquisition takes into account the target company’s retirement plans, for two reasons: first, the transaction itself is likely to affect any existing benefit plans, and second, retirement plans present a complex array of possible fact patterns that may incur additional costs for the transaction.
The specific legal issues related to retirement plans in an M&A transaction will vary considerably depending on the particular goals of each party and on whether the sale is a stock sale or an asset sale. This article focuses on the issues arising for defined contribution plans, such as 401(k) and 403(b) plans, with an emphasis on the buyer’s point of view.
The Concerns and Opportunities in a Stock Sale
In a stock transaction, the buyer automatically assumes all of the retirement plan liabilities of the seller upon closing, which may be a scary prospect for a buyer who is unaware of the plan’s compliance status or of the expenses involved. With the closing date as the point of no return, careful due diligence is warranted as early in the deal as possible.
A buyer should learn, as early in the deal as possible, how much the retirement benefit is expected to cost each year, and whether there are any large or small compliance failures lurking in the plan’s documentation or operations. Note that if a retirement plan suffers a tax qualification failure, it loses all of its tax benefits, such as deductions for contributions, from the day the failure first occurs until it is fully corrected under the applicable IRS rules. Therefore, a seemingly minor failure left unchecked can jeopardize the plan’s tax benefits for years, requiring ever more expensive correction. However, if caught in time, the buyer can negotiate for the seller to help mitigate the failure and/or plan for the expense of correction after closing.
On the other side of the table, an employer preparing to sell its stock would be well advised to conduct its own internal version of due diligence to keep plan compliance concerns from undermining negotiations when the time comes.
See the list below for a due diligence checklist relevant to most 401(k) and 403(b) plans.
Based on the extent of due diligence permitted by time constraints, and depending on the particular facts revealed in the process, the buyer in a stock sale may decide to require the seller to terminate its retirement plan with an effective date prior to closing. If the seller’s plan is not terminated prior to closing, the seller’s plan will need to be: (i) merged into the buyer’s plan, which will include the transfer of any uncorrected failures, or (ii) maintained separately, either as a frozen plan or an active plan, the latter requiring an alignment of benefits, rights, and features.
An Asset Sale–Key Distinctions from a Stock Sale
In an asset sale, the default rule is that the seller continues as the sponsor of its retirement plan, relieving the buyer of any liabilities for that plan. Alternatively, the buyer may agree to assume the retirement plan as part of the transaction. However, under certain circumstances, even an asset sale can require the buyer to assume certain duties and obligations for the seller’s plan, particularly in situations where the buyer simply continues the seller’s operations after hiring the seller’s (now former) employees.
The successor employer issues would require the guidance of benefits counsel to provide the buyer some certainty about how to proceed. As with a stock sale, the buyer may find that the seller’s termination of the existing plan prior to closing may be the most desirable option.
Due Diligence Checklist for 401(k) and 403(b) Plans
Effective due diligence gives the parties information necessary to ensure that a deal is properly valued and that the appropriate limitations, representations and warranties are included in the final purchase agreement. The buyer in particular should seek the following items during an early phase of the deal, when it has the most leverage to negotiate remediation as needed:
- Signed plan documents since the inception of the plan or since the most recent, if any, individual favorable determination letter, including any amendments and trust documents
- Most recent IRS determination letters, if any, and IRS pre-approval letters
- The three most recent Forms 5500 filed for each plan, together with all attachments, schedules and any related audit reports (or, if applicable, an explanation as to whether a plan is exempt from the filing requirement)
- Summary plan descriptions (SPDs), summary of material modifications (SMMs), summary annual reports (SARs), fee disclosures, and any other employer notices with respect to the retirement plans
- List of covered employees and total number of participants in the plans (including a breakdown of highly compensated and non-highly compensated employees)
- Testing data confirming that the plans comply with Internal Revenue Code § § 410(b) prior to closing (in the event of plan assumption)
- Identification of any tax-qualified retirement plans that are multiple employer plans
- A list of plan contribution data as of closing and information regarding outstanding participant loans
- A list of any plans terminated by the seller (or members of the seller’s controlled group) during the past six years
- Union contracts associated with any plan
- Copies and/or written descriptions of inquiries or correspondence about the plans from the IRS, DOL or any other government agency
- Description of any reportable events or prohibited transactions and copies of any related filings
- Recent trust statements
- A detailed description of any employer entities that are in the same Controlled Group or Affiliated Service Group with the seller, under Code section 414
- Copies of service agreements with all plan vendors including the investment custodian and record keeper, third-party administrator, and registered investment advisor
- Other information that may be relevant, such as the ERISA fidelity bond; fiduciary insurance coverage, if any; a description of any outstanding claims or grievances
Given how valuable employee benefits are, the prospect of assuming a seller’s retirement plan may well be an appealing prospect for a potential buyer; but the old adage that the devil is in the details certainly applies. When the retirement plan issues are addressed, they are less likely to incur hassles, hold-ups and unforeseen expenses for both parties.
We encourage parties to a transaction to hire HR experts and ERISA counsel at an early stage in negotiations, to perform at least a minimum of due diligence on controlled group issues and any retirement plans offered by the seller. ERISA counsel, in addition to corporate counsel, should review the purchase agreement to ensure that the benefits-related representations and warranties protect the client’s interests and intentions as much as possible.