Cress Decision Raises the Risk of Underfunded Pension Plans
By Arthur Kohn, Kathleen Emberger & Anthony Randazzo

A recent U.S. district court decision, Cress v. Wilson, [2007 WL 1686687 (S.D.N.Y., June 6, 2007)] raises a risk of liability for directors of companies with underfunded pension plans based on a somewhat novel legal theory. Cress involves claims under federal pension law that directors of Northwest Airlines violated fiduciary duties in regard to the underfunded status of Northwest’s pension plans. Although the decision was merely a denial of the defendant directors’ motion to dismiss and the claims were made against the background of Northwest’s bankruptcy, in which the underfunded plans were a principal issue, the potential ramifications of the decision for other companies are notable.

Participants in the pension plans sponsored by Northwest brought a putative class action lawsuit against members of Northwest’s Board of Directors, Compensation Committee, and Pension Investment Committee alleging that the defendants breached their fiduciary duties under the Employee Retirement Income Security Act of 1974, as amended (ERISA). The complaint alleged that the defendants failed to: 1) ensure that Northwest properly funded its plans; 2) properly investigate the funded status of the plans; 3) take actions to protect participants from the funding deficiencies; and 4) disclose accurate financial information about Northwest and the funded status of the plans to plan participants and other fiduciaries. The complaint alleged, in particular, that these failures were caused by the desire of the defendants to avoid drawing attention to Northwest’s pension underfunding problem because of the defendants’ stock ownership in Northwest and their participation in its stock compensation programs.

For those unfamiliar with pension funding issues, a little background is in order. A pension plan represents a bundle of long-term obligations or liabilities. Traditionally, pension plan liabilities are promises to pay participating employees specified amounts, typically determined by a formula, from the date of each employee’s retirement through death, with continuing payments to surviving spouses. Under federal law, these obligations are required to be prefunded by the employer sponsoring the plan. That is, the employer must make regular periodic contributions to a trust to hold and invest the assets that will be used to satisfy the plan’s future pension payment obligations.

Determining the present value of the obligations involves making significant assumptions and choosing among a number of reasonable methodologies. In fact, there are a variety of different methods and assumptions that are required to be used for different purposes. For example, the funding rules, accounting requirements and certain pension regulatory rules all mandate different methodologies. Under any given methodology, the present value of the liabilities will vary, sometimes considerably, over time by virtue of changes in assumptions and facts. For example, increases in the discount rate used to present value plan liabilities, reflecting increases in market interest rates, will tend to reduce the present value of pension liabilities. Similarly, the value of a plan’s assets will also vary, sometimes significantly, from year to year, reflecting changing market conditions.

Arguably, a plan should be funded and its assets invested with an eye towards meeting the longterm future pension payment obligations of the plan. The law recognizes this argument by not requiring that plans always be fully funded. Rather, the legal funding requirements provide for the “amortization” of certain of the plan’s obligations through contributions over long periods. In fact, there is some cyclicality to the level of pension funding generally: during periods when equity markets are relatively strong and/or interest rates are relatively high, funding appears strong because of high asset values and low liability calculations, whereas low interest rates and/or depressed equity values will tend to result in funding levels that appear generally weak. These fluctuations are taken into account in the rules for amortizing the plan’s obligations, so that funding “gains” and “losses” regularly offset each other.

Key Points in Cress

The decision in Cress arose in the context of a company emerging from bankruptcy in a troubled industry and with plans that were at the time significantly underfunded. It addressed the following principal points:

First, the Court addressed claims concerning the amount of contributions made by Northwest to the plans. The Court discussed prior cases holding that fiduciaries have a duty to ensure that sponsors contribute all amounts that they are obligated by law to contribute to plans. The defendants argued, correctly, that plans could become underfunded without the plan sponsor’s failure to meet ERISA funding obligations and also argued that the complaint did not allege any such failure. The Court noted that the complaint clearly alleged “funding deficiencies that were contrary to ERISA requirements” and held that any dispute about whether Northwest complied with the specific funding requirements of ERISA was a factual question that could not be resolved on a motion to dismiss. Documents publicly filed by Northwest with the SEC state that Northwest received waivers for certain 2003 funding obligations and that as a result of the commencement of Northwest’s bankruptcy the airline did not make minimum cash contributions to its pension plans that were due after Sept. 14, 2005.

Second, the plaintiffs alleged that the defendants failed to provide complete and accurate information about Northwest’s and the plans’ financial health to plan participants. The defendants argued that only the “plan administrator” could be liable for such breaches, but plaintiffs contended that the directors took on the role of administrator during the relevant time period. The Court noted that the duty to disclose or inform is “decidedly case specific,” and due to the existence of several questions of material fact concerning who was an administrator, these claims survived the motion to dismiss. The plaintiffs claimed in addition that the defendant directors failed to disclose adequate information about Northwest’s financial situation to other fiduciaries (i.e., executives of Northwest). That claim also survived the motion to dismiss.

Third, the plaintiffs alleged that the defendants breached their fiduciary duties of loyalty to participants in the plans by putting the interests of Northwest ahead of the participants’ interests with respect to the funding of the plans and because at least one defendant liquidated the majority of his Northwest stock prior to the bankruptcy. The defendants argued that the mere fact that a fiduciary receives compensation in the form of a plan sponsor’s securities, or owns sponsor securities, does not create a conflict of interest under ERISA. The Court concluded that the plaintiffs’ allegations sufficed to state a claim because the plaintiffs alleged more than the existence of a conflict based on defendants’ holding of Northwest securities – plaintiffs alleged that the fiduciaries failed to engage independent fiduciaries and take other protective steps because they wanted to avoid drawing attention to the underfunding of the plans. Northwest’s SEC filings also state that as a result of its bankruptcy filing it appointed an independent fiduciary to pursue claims to recover minimum funding obligations, to the extent that Northwest did not continue to fund the plans due to bankruptcy prohibitions.

Interestingly, there is very little discussion about damages in the decision. The Northwest plans were not terminated in the bankruptcy, and no participant’s pension was actually reduced by virtue of any of the alleged breaches. The decision merely notes plaintiffs’ argument that the defendants’ alleged breaches “left the plans’ participants in a situation in which Northwest is unlikely to be able to make the distributions promised under its plans (although the parties agree that Northwest has not yet defaulted on any of its payments under the Plans).”

Even if the Cress defendants succeed on the merits after factual issues are resolved, the need to litigate the facts is an obvious burden and poses clear risks. Despite Cress’ unique facts involving a bankruptcy setting, the core facts pled are not unusual: directors who are fiduciaries of corporate plans; persistent underfunding over a significant period; and directors who own and transact in the corporation’s securities. In this light, the decision in Cress may serve to highlight for directors that, as plan fiduciaries, they may be subject to the fiduciary standards of ERISA with respect to pension funding decisions. ERISA fiduciary obligations are owed to pension plan participants, rather to the corporation and its shareholders, and may be more stringent than typical corporate law fiduciary obligations of directors. For example, had Delaware standards of fiduciary conduct been applicable, it seems likely that the claims in Cress would have been dismissed based on the business judgment rule. This perspective gives rise to the question of whether plan sponsors are taking all steps appropriate to protect directors against such claims, including providing insurance covering the risk.

About the Authors

Arthur Kohn is a partner, Kathleen Emberger is a counsel and Anthony Randazzo was a summer associate at Cleary Gottlieb Steen & Hamilton, LLP. Contact: akohn@cgsh.com or kemberger@cgsh.com..