How to Handle Settlement Payments on Plan Investments

Recently, some of the SEC and investor lawsuits have settled, requiring mutual fund companies and publicly traded companies to pay money to investors. Many of these investors are retirement plans, and we have seen the settlement checks sent in many different ways. For example, one settlement check was made payable and sent directly to the company. Another settlement check was made payable and sent to the home address of a participant in an individually directed retirement account.

Even if the payor on these checks does not properly identify the retirement plan as the payee, these checks are plan assets and should be treated as such. Checks cashed and kept by the company give rise to a prohibited transaction. The prohibited transaction is the transfer to or use by a disqualified person (the company) of the income or assets of a plan in its own interest. Checks cashed and kept by the participant are a distribution, subject to tax, including the 10% penalty if the participant in under age 59 ½. Additionally, if the participant has not had a distributable event under the plan, then this distribution is not consistent with plan terms, giving rise to an operational error.

Settlement checks should be deposited into the retirement plan account as soon as administratively feasible. If the checks identify a particular participant or participant account then credit that check directly to that participant’s account. However, if the check does not identify a particular participant or participant account, then the company should work with its third party administrator (the “TPA”) to develop a reasonable, prudent and non-discriminatory manner in which to allocate the check amount. You and your TPA may want to review the Department of Labor’s Field Assistance Bulletin 2006-01 (which related to SEC settlements on market timing and late trading activities). In part three of this FAB, the DOL stated that where possible the proceeds should be allocated to the affected participants in relation to the impact of the activity which gave rise to the settlement.

In addition to the FAB, some other allocation options may include the following: (1) allocate the proceeds as income, pro-rata amongst all current participant accounts; (2) if the timing of the source of the proceeds is identifiable, allocate the proceeds as income, pro-rata amongst those participant accounts existing during the time of the source of the proceeds; or (3) if the source of the proceeds is identifiable, allocate the proceeds to the current participant accounts based upon ownership of the source of the proceeds. These options are not exclusive and all but options (1) and (3) may be impractical, if not impossible. Consider the following scenario, the company receives a $1,000 check for the WorldCom settlement. The Company calls the TPA and asks how to allocate the $1,000. The TPA advises that to allocate per the FAB, it would need to review records from over five years ago (assuming that they have all those records) to determine which participants owned WorldCom stock and the ratio of the ownership. The TPA’s quote for this work was in excess of $1,000. The Company then discusses this problem with its attorney who advises that the Company, as a fiduciary must act solely in the best interest of the participants and must act prudently. The Company determined that it would be not prudent to spend to money to research information more than five years old, especially when the TPA could not guarantee that all the prior information was available. The Company and TPA discussed the other allocation methods and chose option (1), above. The Company could not choose option (2) since the old information may not be available and to research it would cost the plan more than the $1,000 benefit. The Company could not choose option (3) since WorldCom no longer exists. Thus, the Company believed it was prudent, reasonable and non0discriminatory to select option (1).

In fact, the DOL acknowledges this dilemma posed in the scenario above. In the DOL’s FAB, it recognized that some of the allocation methods’ costs to the plan may outweigh the benefit to the participants and the DOL suggests that the fiduciary exercise prudence when making its allocation methodology choice. The FAB continues that it may even be prudent for the plan to reject and not accept the settlement proceeds.

As more of these SEC and court cases are settled, our clients will receive more of these settlement checks. You should advise your clients to watch for these checks as they may not be written properly and how to handle these checks so that they avoid any unintended prohibited transactions or impermissible plan distributions with tax consequences to the participants.

Mary J. Giganti
April 2009