As these securities fraud cases and ERISA cases proceed, many will settle.  Since these settlements will involve claims brought by ERISA plans and participants, the parties will be required to consider the Department of Labor’s Prohibited Transaction Class Exemption 2003-39 (Exemption).4  The Exemption provides a prohibited transaction exemption for the settlement of litigation by ERISA plans against the sponsors of those plans.  The exemption contemplates that an independent fiduciary will be retained by the plan to review and approve the settlement in accordance with the terms and conditions of the Exemption.  This article reviews the requirements of the Exemption and, based on the recent experience of the author, offers some practical guidelines on its application to proposed settlements by ERISA plans.5

Background

ERISA prohibits certain transactions between an ERISA plan and a “party in interest.”6  For example, a transaction between an ERISA plan and a fiduciary of the plan is a prohibited transaction, irrespective of the merits of the transaction.  In the context of a proposed settlement of litigation between an ERISA plan and the company sponsor of the plan, the settlement agreement could be deemed a prohibited transaction.7  This is because the ERISA plan is agreeing to release claims against the company sponsor and other parties in interest.8  Accordingly, the Department of Labor (DOL) recently proposed and granted the Exemption, which sets forth certain conditions for the exemption of settlements from ERISA’s prohibited transaction restrictions and from the corresponding monetary sanctions of the Internal Revenue Code.9  The Exemption specifically permits transactions engaged in by a plan in connection with the settlement of litigation with a party in interest, provided the conditions of the Exemption, summarized below, are followed.

Retention of Independent Fiduciary

The plan’s first step in complying with the Exemption will be to retain an independent fiduciary to pass upon and authorize the settlement. As noted by the DOL, “plans must select an independent fiduciary.”10

An independent fiduciary is necessary even in the case of a judicially approved class action settlement.  As noted by the DOL, this is because the court must balance the interests of all litigants in approving a settlement, whereas ERISA requires a fiduciary to make determinations with “an eye single to the interests of participants and beneficiaries.”11  The independent fiduciary must not have any relationship to, or interest in, any of the parties involved in the litigation, other than the plan, that might influence the fiduciary’s judgment.  This does not necessarily disqualify a plan’s existing trustee from serving as independent fiduciary to review a settlement, provided the existing trustee is not a named party to the litigation.  In practice, however, most plan trustees may not be equipped to conduct the review contemplated by the Exemption.  Because the Exemption’s review process is legal in nature, it is likely the independent fiduciary will be an attorney.

The Exemption requires the independent fiduciary to acknowledge in writing that he or she is acting as a fiduciary with respect to the settlement of the litigation.12  In addition, the independent fiduciary must retain all records of his or her review of the proposed settlement for six years.12  These records must be made available for inspection by the DOL, IRS, plan participants, and certain others.  As a practical matter, these conditions of the exemption can be set forth in an engagement letter between the plan and the independent fiduciary. 

Genuine Controversy

The proposed settlement must relate to a genuine controversy involving the plan.14  If the litigation involving the plan has been certified by a court as a class action, a genuine controversy will be deemed to exist.  In the absence of class action certification, an attorney having no relationship to any of the parties, other than the plan, must make a determination that there is a genuine controversy.  In its comments to the Exemption, the DOL specifically notes that the attorney review can be performed by “the independent fiduciary’s in-house attorneys.”   Thus, if the independent fiduciary is a private attorney, the exemption permits the fudiciary or another lawyer from his or her firm to perform this review.  If the independent fiduciary is a bank or trust company, the review could be made by a member of its legal staff or outside counsel.

Reasonableness of Settlement

The independent fiduciary must review the proposed settlement and determine that it is reasonable in light of the plan’s likelihood of full recovery, the risks and costs of litigation, and the value of claims foregone.16  This reasonableness review is the Exemption’s primary substantive consideration.  As noted by the DOL, how these factors are weighed by the independent fiduciary will vary depending on the type of case, but a prudent decision-making process will always be involved.  As the DOL further notes, the same circumstances may give rise to both ERISA and securities fraud claims.  Under these circumstances, the independent fiduciary may authorize the plan’s participation in the settlement of securities fraud claims while preserving or separately settling ERISA claims.17

In assessing the reasonableness of settlement terms, the independent fiduciary will weigh the factors noted above.  First, in considering the likelihood of a full recovery, the independent fiduciary may review the damages claims and defenses of the parties.  Were experts retained to evaluate damages prior to settlement?  What is the likelihood of an adverse final judgment leaving the plan with nothing?  These considerations may dovetail with the independent fiduciary’s analysis of the value of claims foregone.  Finally, in complex securities or ERISA litigation, the risks and costs of litigation are seldom insignificant. 

The independent fiduciary will want to conduct a “due diligence” review of the record leading up to the proposed settlement.  He or she may interview the lawyers for both sides of the case.  He or she will review the various litigation papers, including the complaint and answer, motion papers and supporting memoranda, and any expert analyses regarding damages.  If the parties have engaged in mediation, the independent fiduciary will want to review the mediation statements prepared by the parties and, if permitted, interview the mediator.   A careful review of these papers should give the independent fiduciary a sense that the proposed settlement is the result of a true adversarial process. 

Finally, the independent fiduciary may choose to review other cases approving federal class action settlements.  The factors generally considered by the courts in approving class action settlements are comparable to the reasonableness requirements of the Exemption.  In assessing a class action settlement, the courts generally consider the likelihood of success on the merits if the action were litigated and the potential amount of recovery, balanced against the amount offered in settlement, and taking into account the complexity, expense, and duration of litigation.18  As noted above, this is a uniquely legal review.

Arm’s-Length Terms and Conditions

The Exemption next requires that the terms and conditions of the settlement be no less favorable to the plan than comparable arm’s-length terms and conditions that would have been agreed to by unrelated parties under similar circumstances.19  In making this determination, the independent fiduciary may consider the adversarial posture of the proceedings.  If all parties are represented by experienced counsel, and have engaged in significant discovery and motion practice, the likelihood of a collusive settlement agreement is lessened.  Further, if the parties have engaged in mediation to reach a settlement, this process provides assurance of the arm’s-length nature of a settlement.  These factors may indicate that a proposed settlement results from a genuine adversarial process and is, therefore, an arm’s-length agreement.

No Agreement, Arrangement, or Understanding

The Exemption provides that the settlement must not be part of an agreement, arrangement, or understanding designed to benefit a party in interest.20  As noted in the comments to the Exemption, the intent of this condition is to exclude transactions that are part of a broader overall agreement, arrangement, or understanding designed to benefit parties in interest.21  The independent fiduciary again may look to the adversarial proceedings that the parties have engaged in to gain assurance that the proposed settlement is not part of a collusive agreement that really is for the benefit of parties other than the plan.

Settlement Terms Must Be in Writing

The Exemption requires that the terms of the settlement must be spelled out in a written agreement or consent decree.22

Credit Terms; Non-Cash Payments

If the proposed settlement involves an extension of credit by the plan to a party in interest, the credit terms must be reasonable, taking into consideration the credit worthiness of the party in interest and the time value of money.23  The DOL encourages independent fiduciaries to seek security for an extension of credit to protect the plan against the risk of default.24  It is not a requirement, however, that any extension of credit be secured by property or a letter of credit.

The Exemption provides that assets other than cash may be received by a plan from a party in interest in connection with a settlement only if (1) necessary to rescind a transaction that is the subject of the litigation, or (2) such assets are securities for which there is a generally recognized market.25  This restriction does not preclude a settlement including a written agreement requiring a party in interest to make future contributions to a plan, adopt amendments to a plan, or provide additional employee benefits.26  For example, a recent settlement included provisions to amend a plan allowing participants to make earlier diversification from company stock to other investments.

Conclusion

Litigation involving ERISA plans and other parties in interest are increasingly common.  Most of these cases will be settled.  If the parties to the settlement agreement want to make certain that the settlement will not constitute a prohibited transaction subject to rescission and tax penalties,27 the terms and conditions of the DOL’s Prohibited Transaction Class Exemption 2003-39 will have to be followed.  By retaining an independent fiduciary and complying with the Exemption, the parties will achieve greater finality for their settlement agreement. 

2 See, e.g.,  In re Xcel Energy, Inc. Securities Derivative and ERISA Litigation, 312 F. Supp. 2d 1165, 1172 (D. Minn. 2004) (“these actions stem from a drastic reduction in the market value of Xcel Energy, Inc....”).

3 See id. at 1176 (“[t]he duty of disclosure under ERISA has been described as ‘an area of developing and controversial law…’”) (Judge Doty quoting In re Enron, supra, at 555).

4 Class Exemption for the Release of Claims and Extensions of Credit in Connection with Litigation, Prohibited Transaction Exemption 2003-39, 68 Fed. Reg. 75632-01 (Dec. 31, 2003).

5 Recently, the author served as legal counsel to his colleague David Kelly who was retained as an “independent fiduciary” to determine whether proposed settlements of an ERISA plan’s securities fraud and ERISA claims against the plan’s sponsor and other plan fiduciaries satisfied the requirements of the Exemption.

6 See ERISA § 406(a) regarding prohibited transactions. The term “party in interest” is defined in ERISA § 3(14).

7 As noted by the Department of Labor, “the exemption is being granted in response to uncertainty expressed on the part of plan fiduciaries charged with the responsibility under ERISA for determining whether it is in the interests of a plan’s participants and beneficiaries to enter in a settlement agreement with a party in interest.”  See Exemption – Discussion of Comments Received, paragraph A.

8 ERISA, including its prohibited transaction exemptions, was signed into effect by President Gerald Ford on Labor Day, 1974.  Until recently, few practitioners would have considered settlements of claims by plans against sponsors and other parties in interest to be prohibited transactions.  The Department of Labor flagged the issue by proposing and granting the Exemption in 2003.

9 ERISA § 406(a); Internal Revenue Code § 4975.

10         Exemption – Discussion of Comments Received, paragraph D.

11         Quoting Donovan v. Bierwirth, 680 F.2d 263, 271 (2d Cir. 1982), cert. denied, 459 U.S. 1069 (1982).

12         Exemption – Section III(f).

13         Exemption – Section III(g).

14         Exemption, Section II(a).

15         Exemption – Discussion of Comments Received, paragraph B.

16         Exemption – Section II(c).

17         Exemption – Discussion of Comments Received, paragraph M.

18         See 6A Federal Procedure (Lawyers Edition) at § 12:379; see also Grunin v. Intern’l House of Pancakes, 513 F.2d 114, cert. denied, 426 U.S. 864 (8th Cir. 1975).

19         Exemption – Section II(d).

20         Exemption – Section II(e).

21         Exemption – Description of the Exemption, paragraph A.

22         Exemption – Section III(b).

23         Exemption – Section II(f).

24         Exemption – Description of the Exemption, paragraph A.

25         Exemption – Section III(c).

26         Exemption – Section III(e).

27         See note 9, supra.