The Questionable Future of the Prudent-investor Rate Will ERISA Claims DiluteFurtherthe Dividends for Trade Creditors
Much has been written about the "demise" or "hijacking" of chapter 11, where large institutional creditors, undersecured lenders, vultures, claim traders, etc., reportedly carve up the debtor and leave virtually nothing for unsecured creditors. Nevertheless, some chapter 11 cases still offer meaningful dividends for the unsecureds, especially the trade creditors. However, often in such cases, claims asserted by the Pension Benefit Guaranty Corp. (PBGC) for "unfunded benefit liabilities" threaten to dwarf those of other unsecured creditors.
Those PBGC claims may be getting bigger, if a recent bankruptcy court decision is any guide. Although there is "anti-PBGC" law at the court-of-appeals level in the Sixth and Tenth Circuits, this recent case highlights the tension between the traditional analysis and one more focused on the applicable non-bankruptcy rules and regulations. If the "prudent-investor rate" disappears, the PBGC's termination claims will increase dramatically.
In the wake of the sustained bear market of the last few years, a bankruptcy court in a highly publicized mega-case found that the "prudent-investor rate" was inappropriate for determining the claim of the PBGC for unfunded benefit liabilities for a terminated defined-benefit pension plan under the Employee Retirement Income Security Act of 1974 (ERISA). Rather, the court ruled that the federal regulation prescribing the assumptions to value a terminated pension plan's unfunded benefit liabilities was the proper valuation tool. The result: a termination claim that increased from $894 million to $2.084 billion. While this decision may carry little weight within the Sixth and Tenth Circuits, it may have an impact on the determination of PBGC's claims for unfunded benefit liabilities in circuits that have yet to rule on the issue.
The PBGC is a wholly owned U.S. government corporation within the Department of Labor, modeled after the Federal Deposit Insurance Corporation.1 Congress vested the PBGC with the authority to enforce and administer a mandatory government-insurance program that protects the pension benefits of workers who participate in defined-benefit pension plans2 that are governed by ERISA. PBGC collects insurance premiums from covered pension plans, monitors those plans and provides benefits to participants in terminated plans that have insufficient assets to support guaranteed benefits.
The fact is that the PBGC provisions for calculating the unfunded liability after a distress termination arise only in bankruptcy. If the unfunded liability upon a distressed termination is so high, how meaningful is the relief a debtor obtains from such a termination?
Termination of a Pension Plan Under ERISA
A pension plan can be terminated by an employer in one of two ways: "standard" or "distressed." In a standard termination, the plan assets are sufficient to fund future benefits to participants; the employer simply distributes the plan assets to plan participants in the form of annuities purchased from a private insurer.3 There is no question about the right investment rate; that rate is implicitly reflected by the insurers in the annuities market. In a "distressed" termination, the plan assets are insufficient to fund future benefits. The plan assets are turned over to the PBGC, the PBGC assumes responsibility for paying the promised benefits under the plan to the participants as such benefits become due,4 and the PBGC may assert the termination claim described below.
In order to effect a "distressed" termination, the plan administrator must give the PBGC and each affected party at least 60 days' written notice of intent to terminate and set forth the specific proposed termination date.5 Also, the termination must not violate the terms and conditions of an existing collective bargaining agreement.6 Lastly, if the employer is a chapter 11 debtor, the following four conditions must be established:
- As of the proposed termination date, the employer has filed, or has had filed against it, a petition for reorganization under the Bankruptcy Code;
- The case has not, as of the proposed termination date, been dismissed;
- The employer has provided the entity responsible for paying insured benefits any request for bankruptcy court approval of the termination; and
- The bankruptcy court has determined that unless the plan is terminated, the employer will be unable to pay all of its debts pursuant to a plan of reorganization and will be unable to continue in business outside the chapter 11 reorganization process, and approves the termination.7
The reference in 4 above to "a" plan of reorganization does not permit a distress termination simply because a particular plan requires it; rather, the test is whether the debtor can obtain confirmation of any reorganization plan without termination of the retirement plan.8 Consequently, there must be a specific finding by the bankruptcy court that "unless a distress termination occurs, the debtor will be unable to pay its debts when due and to continue in business."9 The statute clearly places the burden of the proof for a "distress" termination on the debtor.10
Claim of the PBGC for Unfunded Benefit Liabilities Under ERISA
Upon the approval of a "distress" termination of a pension plan, the PBGC has a claim against the debtor (employer) for the amount of the unfunded benefit liabilities.11 Under ERISA, the amount of unfunded benefit liabilities is defined as the excess (if any) of the value of the benefit liabilities under the plan (determined as of such date on the basis of assumptions prescribed by the PBGC for purposes of 29 U.S.C. §1344) over the current value (as of such date) of the assets of the plan.12 The regulation to value the liabilities of a terminated pension plan as referenced above was most recently amended in 1993 and is codified at 29 C.F.R. §§4044.41 to 4044.75. The valuation regulation identifies the following assumptions: (1) use of the 1983 General Annuity Mortality table, (2) a discount rate that is updated monthly to reflect current annuity pricing and (3) a table of expected retirement age for plan participants.13 The goal of the valuation regulation is to generate a value that will accurately approximate the cost of single-premium group annuity contracts that would pay the benefits promised under the terminated plan14—in other words, to mimic, more or less, the annuities that would be required under a standard termination.
Claim of the PBGC for Unfunded Benefit Liabilities as Determined Under Bankruptcy
Until December 2003, courts were consistent in using the "prudent-investor rate" as the tool for calculating the present value of a claim of the PBGC for unfunded benefit liabilities. The genesis of the "prudent-investor rate" is found in In re Chateaugay Corp., 126 B.R. 165 (Bankr. S.D.N.Y. 1991) (Lifland, J.).15 The prudent-investor rate is the rate of return achievable by a reasonable, prudent, long-term pension fund portfolio investor who seeks to achieve the best long-term return on his investment consistent with preserving its capital and minimizing risk.16 The hypothetical investor would choose investments that would produce a yield reflecting the returns achievable in the market as a whole. Thus, this investor would be an average investor earning average returns or, as currently referred to by the investment community, an index-fund investor.17
In In re CF&I Fabricators of Utah Inc., 150 F. 3d 1293 (10th Cir. 1998), the Tenth Circuit relied on the introductory phrase in 29 U.S.C. §1301—"for purposes of this subchapter, the term"—to conclude that the ERISA definition for unfunded benefit liabilities did not extend to bankruptcy. Thus, the court held that the district court did not err in requiring the bankruptcy court to employ the prudent-investor rate to reach the present value of PBGC's claim for unfunded benefit liabilities. The bankruptcy court used a discount rate of 12.3 percent in determining the present value of the unfunded benefit liabilities of $124 million rather than the $223 million amount that would have resulted from using the valuation regulation.18 The court further noted that if the valuation regulation was used, the cardinal rule that all claims within the same class must be treated equally would be violated because PBGC's discount rate would apply only to it and not any other general unsecured creditor.19
Similarly, in In re CSC Industries Inc. & Copperweld Steel Co., 232 F. 3d 505 (6th Cir. 2000), the Sixth Circuit affirmed the lower-court rulings that the prudent-investor rate was the appropriate valuation tool for calculating the present value of the PBGC's claim for unfunded benefit liabilities, and upheld a ruling that valued the PBGC's claim for unfunded benefit liabilities of $1.8 million based on a discount rate of 10 percent rather than the $49.7 million value that would result from use of the PBGC valuation regulation. As the court noted,20 the bankruptcy court's authority under §§502 and 1123(a)(4) of the Bankruptcy Code to determine the amount of the claims in bankruptcy proceedings and treat creditors in the same class equally gives it the authority to value unfunded benefit liabilities claims using a prudent-investor rate.21
Notwithstanding the foregoing decisions, the court in In re US Airways Group Inc., 303 B.R. 784 (Bankr. E.D. Va. 2003), ruled that the prudent-investor rate was an inappropriate tool for determining the PBGC's claim for unfunded benefit liabilities. In US Airways Group, the debtors and the official committee of unsecured creditors (OCC) objected to the proof of claim filed by the PBGC in the approximate amount of $2 billion for unfunded benefit liabilities arising from the "distress" termination of the defined-benefit pension plan the debtors maintained for its pilots.22 The PBGC argued that since ERISA defines an employer's liability in terms of the valuation regulation, the regulation should control for purposes of determining the amount of the claim. Simply put, the assumptions in the PBGC's valuation regulation should be used (the 1983 General Annuity Mortality table to determine life expectancy, a discount rate of 5.1 percent for the first 20 years and 5.25 percent thereafter, and an expected retirement age of 56). Although the debtors and the OCC conceded that the unfunded benefit liabilities would be at least that much if the assumptions in the valuation regulation were used, they argued that the court is not legally bound by the valuation regulation and is free to make its own findings as to the assumptions that should be used. The debtors, using what they considered to be more reasonable assumptions (a 1994 mortality table to determine life expectancy, a discount rate of 8 percent and an expected retirement age of 60), calculated the present value of the plan's unfunded benefit liabilities as of the plan termination date as no more than $894 million.
After a lengthy evidentiary hearing, the bankruptcy court ruled that the PBGC's claim for unfunded benefit liabilities should be determined using the PBGC valuation regulation. The court stated that it disagreed with the Sixth and the Tenth Circuits23 and, relying on Raleigh v. Illinois Dep't. of Revenue, 530 U.S. 15 (2000), stated that a creditor's claim "in the first instance" is a function of the non-bankruptcy law giving rise to the claim. Since then Congress, by statute, has expressly given the PBGC a present right to recover an amount determined in accordance with the valuation regulation; the regulation should be used to establish the claim amount.24 The court went on to say that so long as all claims are determined in accordance with applicable non-bankruptcy law, there cannot be any genuine issue of disparate treatment under §1123(a)(4) of the Bankruptcy Code.25 Finally, the court stated that "although the amount calculated under the regulation may exceed the amount a hypothetical 'prudent investor' would have to set aside to pay the promised benefits as they become due, the use of a 'prudent investor' rate impermissibly shifts the risk of loss from adverse stock-market performance—such as [what] led to the termination of the US Airways pilots' plan in the first instance—to the retirees. Because the PBGC's valuation regulation gives proper weight to Congress's goal of protecting the health of the nation's private pension system, it is to be preferred over the use of discount rate premised on uncertain projections of future stock market returns."26 The PBGC's claim was allowed in the amount of $2.084 billion, more than double the amount that the debtors and the OCC contended it should be. Undoubtedly, this ruling affected the distributions to all other unsecured creditors—albeit such distributions were minimal and in stock.
At first glance, this dispute sounds like an arcane dispute over investment theories, complete with dueling actuaries. But as the numbers described in the cases above make clear, this is a real issue, with a real, substantive effect on the unsecured creditors generally. In US Airways, for example, the issue meant the difference between $894 million, the number sought by the OCC, and the PBGC's $2.084 billion.
The "right" outcome is not clear. As US Airways notes, the investment returns and risks associated with an investment in the stock market are not the same as those relevant for the essentially risk-free annuities contracts. On the other hand, bankruptcy courts do not look kindly at "applicable non-bankruptcy laws," which say, in essence, that if the debtor files for bankruptcy, the claim automatically increases. The fact is that the PBGC provisions for calculating the unfunded liability after a distress termination arise only in bankruptcy. If the unfunded liability upon a distressed termination is so high, how meaningful is the relief a debtor obtains from such a termination?
How will the four years of a bear market, or accounting and related stock-market scandals earlier this century, affect the acceptance of the prudent-investor rate? The answers to these questions are, at present, unknown and unknowable. US Airways teaches us, however, that the questions are more important than was perhaps realized.
2 A defined-benefit plan is one that sets forth a fixed level of benefits to be paid on a monthly basis to a participant in the plan upon the participant's retirement. See 29 U.S.C. §1002(35). Return to article
9 Id. at 777, referencing 29 C.F.R. §§4041.41(c)(3) and (d)(1). See, also, In re Resol Mfg. Co., 110 B.R. 858 (Bankr. N.D. Ill. 1990) ("the appropriate standard of review...pursuant to §1341(c)(2)(B)(ii) is whether but for the termination of the pension plan, the debtor will not be able to pay its debts when due and will not be able to continue in business"). Return to article
10 The purpose of the legislation is to limit "to cases of severe business hardship" the ability of plan sponsors to terminate their pension plans and thereby shift liability for guaranteed benefits onto other insurance premium payers in the PBGC program and avoid responsibility for the payment of certain non-guaranteed benefits. H.R. Rep. No. 300, 99th Cong., 1st Sess. 279 (1985), reprinted in 1986 U.S.C.C.A.N. 930. Return to article
15 Based on a settlement, the district court vacated its opinion, and the bankruptcy court opinion was ordered "withdrawn." Although the relevant district court order is available through the two main legal-research services, In re Chateaugay Corp., 1993 U.S. Dist. LEXIS 21409, 1993 WL 388809 (S.D.N.Y. 1993), that decision was not "published" per se. This makes the task of evaluating the relevance of the bankruptcy court decision even more difficult. In all events, the use of the prudent-investor rate has survived the settlement and the opinion being vacated. Return to article
16 This formulation, of course, is not much help. Every investor wants the maximum return and the minimum risk. Not every investor makes the same trade-offs between those two factors. The index-fund investor described below, for example, takes a real risk that, over certain "short" periods of time, its capital will not be preserved. To the extent that an investor has as its first rule, "protect capital at all costs," that investor will not be 100 percent in the stock market. Return to article
20 The court gave only nominal attention to a basic principle: A creditor's claim is a function of the non-bankruptcy law giving rise to the claim. The court, however, acknowledged the recent Supreme Court authority for the principle that the validity of a claim is governed by non-bankruptcy law, but in the very next sentence concluded that the bankruptcy court has the authority to determine the allowability and amount of the claim. Return to article
22 The court made, among others, the finding that unless the pilot's pension plan was terminated, the debtors would be unable to pay all their debts pursuant to a reorganization plan and would be unable to continue in business outside the chapter 11 reorganization process. Therefore, the court permitted the debtors to terminate the pension plan, subject to a determination that doing so would not violate the terms and conditions of the collective bargaining agreement. See In re US Airways Group Inc., 296 B.R. 734 (Bankr. E.D. Va. 2003), aff'd. 2004 U.S. App. Lexis 10461 (4th Cir. 2004). Return to article