When one business buys another, employee benefits are often overlooked. However, carefully analyzing them as part of due diligence and incorporating benefits in the rollout and implementation of the deal can impact the transaction’s ultimate success. Such preparation can also mitigate significant risks and exposure.
Keys to a Successful Diligence Process
A good diligence process should provide critical information. First, it should help the buyer understand what employee benefits programs are in effect for the seller and what post-closing liabilities will exist, as well as a general feel for whether plan administrators have complied with ERISA and Internal Revenue Code requirements. Second, the diligence process should help the buyer to develop the post-closing employee benefits design and assess how best to integrate personnel it will acquire in the transaction to minimize employee relations issues.
As part of diligence, a buyer should review all benefit plan documents, summary descriptions and other required disclosures, notices to participants, annual reports, coverage and nondiscrimination testing results, actuarial reports (for pension and retiree medical plans), and audits (both external and internal). These documents should show whether there are benefit programs with significant financial liabilities — such as underfunded pension plans, multiemployer (union) plans, or ongoing retiree medical plans — and if there are potential regulatory compliance issues.
For example, failure to properly conduct or pass nondiscrimination or coverage testing of a 401(k) plan can usually be detected early in the diligence process. These failures can be remedied through IRS voluntary correction procedures without creating any ongoing liability for the buyer. Other potential exposures include failure to update 401(k) and pension plans for required IRS changes, and to update health-care plans for the Affordable Care Act (ACA). In addition, failure to comply with COBRA continuation coverage requirements or provide required notices to employees (summary plan documents (SPDs), annual 401(k) plan notices, HIPAA privacy notices, etc.) can be dealt with if discovered in the diligence process.
Buyers clearly want to avoid the nightmare faced by a company that discovered — after closing — that the seller had issued exit letters to retirees promising lifetime medical coverage at no cost. That kind of situation leads to expensive and difficult litigation but can be avoided with effective investigation.
Other Significant Risks
Certain benefit plans should raise red flags and cause buyers to dig deeper to understand the potential risk. For example, while defined-benefit pension plans provide a tremendous benefit to employees, they can carry minimum funding requirements that can be significant depending on the plan size and how well the seller maintained it. Plan sponsors are required to produce annual reports about the plan’s funded status, which the buyer should review carefully.
Additionally, with much of the Affordable Care Act now in effect, potential buyers should review a seller’s health-care plan documentation to understand how the seller designed the plan to deal with the employer mandate and other ACA requirements. The buyer should analyze whether changes will be necessary to avoid potential violations and excise taxes.
Multiemployer pension plans are also a red flag for buyers because they have ongoing funding obligations. Terminating participation and avoiding ongoing funding requirements can result in significant withdrawal liability (if it can be successfully negotiated with the union at all).
Withdrawal liability is applied differently depending on whether the transaction is an asset or stock purchase. Where multiemployer pension plans are part of the transaction, buyers should review copies of the collective bargaining agreements, plan documents, and SPDs. Buyers should also obtain the plan’s annual funding notice to assess whether liability is imminent upon plan withdrawal. If the buyer anticipates terminating its plan participation at some point, it will also want to obtain an estimate of withdrawal liability — which the plan is obligated to provide.
Executive compensation plans can also create liability. Employment agreements, including change-in-control, transaction bonus, deferred compensation, stock option, and other equity-based plans, as well as bonus/incentive plans, should be reviewed to determine whether benefits vest or become payable at deal closing. There should also be a clear understanding of which party is obligated to pay change-in-control compensation or other executive pay due as a result of the transaction.
Tax withholding and reporting can also be tricky for these types of payments, particularly where the seller ceases to exist after closing. There should be a clear understanding of how tax requirements will be satisfied, and consulting with outside auditors is smart. The buyer should understand its severance benefit obligations if not all of the seller’s executives will remain. These obligations are often contained in broad-based severance plans, employment agreements, and/or change-in-control agreements.
Although sometimes overlooked in the transaction process, employee benefits can create significant risks but are vital to the overall success of the transaction. Buyers should consider these matters in the diligence process to identify potential risks and liabilities, address them early, and plan the benefit rollout for the post-closing organization.
Scott Austin is a partner in the Atlanta office of Hunton & Williams, LLP, specializing in employee benefits, executive compensation and related tax and ERISA issues.
This article presents the views of the author and do not necessarily reflect those of Hunton & Williams or its clients. The information presented is for general information and education purposes. No legal advice is intended to be conveyed; readers should consult with legal counsel with respect to any legal advice they require related to the subject matter of the article.