Deferred compensation arrangements not provided under a tax-qualified retirement plan are a critical component of most executive compensation packages. For the reasons discussed below, employers typically attempt to structure these arrangements within the definition of "top-hat plans" under the Employee Retirement Income Security Act of 1974, as amended (ERISA). ERISA defines a top-hat plan as an unfunded nonqualified retirement plan established and maintained "primarily" for the purpose of providing deferred compensation for a "select group of management" or "highly compensated employees." Because top-hat plans are not subject to ERISA's requirements relating to participation, vesting, funding and fiduciary responsibilities and are subject to limited reporting and disclosure obligations, a top-hat plan allows an employer to provide deferred benefits to executives in excess of that which are permitted under a retirement plan qualified under the Internal Revenue Code of 1986, as amended (the "Code"), without providing such benefits to the rank and file employees.
Neither ERISA nor the regulations thereunder define the phrase "primarily for a select group of management or highly compensated employees." The interpretation of this phrase in the absence of substantial guidance is problematic for companies sponsoring top-hat plans and, unfortunately, being "wrong" could cost the employer dearly.
Historical Interpretation of the Top-Hat Plan Eligibility Standard
The preamble to the Treasury Regulations under Section 414(q) of the Code (which defines "highly compensated employee" for purposes of certain tax-qualified retirement plan tests) specifically provides that the Treasury and the Department of Labor (the "DOL") agree that the meaning of "highly compensated employee" for purposes of Section 414(q) of the Code (generally, $100,000) is not applicable to the determination of the meaning of the same phrase under ERISA. The rationale is that ERISA and the Code, although each contain the identical phrase, have different objectives. Specifically, the Sections of the Code that limit benefits provided to highly compensated employees are intended to encourage employers to maintain tax-qualified plans that provide meaningful benefits to rank and file employees. By contrast, employees that have sufficient skill and ability to negotiate benefits on their own behalf and who are, therefore, not dependent on the protections of the tax qualified retirement plan rules afforded the rank and file employees, are exempt from ERISA's vesting, funding, participation and fiduciary requirements.
Early on, absent any statutory or regulatory guidance on the matter, in addressing the meaning of the phrase "select group of management or highly compensated employees," the DOL frequently compared (a) the number of employees eligible to participate in the top-hat plan to the employer's total number of employees and (b) the eligible employees' average salary in relation to the average salary of the employer's employees as a whole. For example, in DOL Advisory Opinion 75-64, the DOL held that an unfunded deferred compensation plan covering four percent of the sponsoring employer's employees and covering employees whose compensation was 68 percent higher than the company's total workforce, constituted a valid top-hat plan. Notably, the Fourth Circuit Court of Appeals, in Darden v. Nationwide, 922 F.2d 2031 (4th Cir. 1991), following the DOL's methodology outlined above, held that a group of 18.7 percent of a company's workforce was too large to constitute a permissible top-hat group.
In more recent years, the DOL has seemingly moved away from interpreting the meaning of a "select group of management or highly compensated employees" based solely upon the percentages of coverage and the amount of compensation. Specifically, in DOL Advisory Opinion 90-14A, the DOL provided that it is of the view that in providing certain statutory relief for top-hat plans, Congress recognized that some individuals, by virtue of their position or compensation level, have the ability to (a) affect or substantially influence, through negotiation or otherwise, the design and operation of their own compensation packages and (b) understand the significance of the risks associated with such compensation packages. For this reason, the DOL requires an employee to be able to affect or substantially influence the design and operation of a top-hat plan in order for that individual to be considered a member of a select group of management or a highly compensated employee for these purposes. Subsequent courts have applied this same standard and have generally required an analysis of both quantitative and qualitative factors.
Notably, DOL Advisory Opinion 90-14A also provides that "primarily" refers to the purpose of the plan (i.e., the deferred compensation benefits provided) and does not apply to the participant composition of the plan. Thus, according to the DOL, a plan will constitute a top-hat plan only if "all" of the employees eligible to participate in such plan are part of a select group of management or highly compensated employees of the company.
Second Circuit Interprets Top-Hat Plan Eligibility Broadly
In Demery v. Extebank Deferred Compensation Plan (B), 216 F 3d 283 (2d Cir. 2000), the Second Circuit Court of Appeals pushed the envelope in interpreting the parameters of the permissible class of employees that could participate in a top-hat plan. In that case, the Court held that an unfunded deferred compensation plan covering 15 percent of an employer's workforce and covering employees making as little as $30,000 per year qualified as a top-hat plan under ERISA.
In Demery, the deferred compensation plan in question covered senior officers, managers and even vice presidents and assistant vice presidents of a bank. This group represented approximately 15 percent of the bank's workforce. Subsequent to the merger of the bank with another bank, several of the plan participants terminated their employment and, as a result, their benefits under the plan were less than they would have been had they reached retirement age (i.e., age 65), at which time they were to receive a return on their investment at a compounded annual rate of 20 percent (versus 10 percent if they terminated before retirement age). The former participants then brought suit claiming that the plan was not a top-hat plan and that they were therefore entitled to greater benefits than they actually received by virtue of the application of ERISA's funding and vesting rules.
Regarding the issue of which employees are properly considered highly compensated employees, the Court held that the plan was "primarily" for the benefit of a select group of management and/or highly compensated employees and that if some participants were not in fact highly compensated employees, this would not invalidate the group or the plan. Note that this reasoning is in direct conflict with the position taken by the DOL in Advisory Opinion 90-14A (i.e., that "primarily" refers to the purpose of the plan to provide deferred compensation benefits and not to the composition of the plan participants).
In addition, the Court held that 15 percent of the employer's workforce was not too large to constitute a "select group." The Court noted that 15 percent is "probably at or near the upper limit" of the acceptable size for a "select group." Also, the Court pointed out that while the $30,000 salary of the vice presidents did not seem high, the average salary of the class of eligible employees as a group was "relatively" high "in comparison to" the bank employees on a company-wide basis (i.e., such average was twice as much as the average for all bank employees).
Fifth Circuit Imposes Stricter Eligibility Standard; Highlights Effect of Being "Wrong"
In Carrabba v. Randalls Food Markets, 252 F. 3d 721 (5th Cir. 2001), however, the Fifth Circuit Court of Appeals affirmed a federal district court's (the "District Court") ruling ordering an employer to pay $13.6 million to participants in the employer's unfunded deferred compensation plan following the District Court's decision that the plan was not a top-hat plan and, as a result, did not satisfy the funding and vesting requirements of ERISA in making distributions after the plan was terminated.
In this case, Cullum Companies, Inc., a company engaged in the food and drug retailing and distribution business, set up a "Management Security Plan," which the company expressly intended to be a top-hat plan under ERISA. Initially, the plan provided that all salaried employees (all of whom were in management at some level) working in Texas in the company's corporate headquarters department, the retail stores, the warehouses and the fixed operations were eligible to participate in the plan.
The company was later acquired by Randalls Food Markets. Subsequent to such acquisition, Randalls Food Markets, as successor plan sponsor of the plan, exercised its authority to terminate the plan pursuant to a provision that had been included in the plan since its inception. Under the termination provision, the plan sponsor could terminate the plan at any time and, to the extent that it did so, the rights of the participants to the plan's stated benefit formula would no longer be available to any participants who were not then already receiving their benefits. Instead, such participants would only receive the amounts they actually contributed to the plan. Thus, prior to a participant's retirement pursuant to the terms of the plan, the only accrued or vested interest a participant had under the plan was in his or her own deferred compensation contributions. Following the termination of the plan, the affected participants formed a class and filed suit alleging that the plan was not a top-hat plan and, therefore, was required to have been operated in compliance with ERISA's funding and vesting rules.
In interpreting the phrase "select group of management," the Fifth Circuit Court of Appeals held that the words "select group" must be given some meaning. Therefore, a group of "all" management could not, by definition, be viewed as a "select" group of the universe of such management personnel. Significantly, if the Second Circuit had applied this rationale in Demery, it would have been hard pressed to find that "all" assistant vice presidents (and other management personnel of higher rank) constituted a "select" group of the bank's universe of managers.
In reaching its decision, the District Court applied the "select group" test, as expressed in DOL Advisory Opinion 90-14A and as followed by subsequent case law, of whether the group members have such positions of influence with the employer that they can protect their retirement expectations by direct negotiations with their employer. On the facts presented, the District Court was not persuaded that the plan participants had "individual" bargaining power. The District Court then noted that as a "group," the managers could influence the operation of the plan, but also opined that this would be true of any group of employees and, therefore, rejected the notion that the test was to be applied on a group-wide basis. Compare this reasoning with the discussion of the same test in Demery, where the Second Circuit held that the plaintiffs did not present any facts upon which it could find that the plaintiffs did not, as a group of management employees, possess the requisite bargaining power.
Based on the rationale expressed above and the evidence presented, the Fifth Circuit affirmed the District Court's holding and awarded the plaintiff class $13,625,673.82 in damages ($6.7 million for underpayments after applying ERISA's vesting and funding rules, $3.8 million in interest on the underpayments and $3.1 million in lawyers' fees).
While the relative participation and compensation percentages of the "store managers" and "assistant vice presidents" compared with the non-eligible employees were quite similar (15 percent participation in both and approximately $30,000 of indexed compensation to the lowest paid members of each class) in the Carrabba and Demery cases respectively, the applicable courts utilized much different factors in reaching contrary results. Specifically, in Carrabba, the main inquiry the District Court undertook was whether each of the eligible employees would be said to have had individual influence over the employer in negotiating benefits, whereas the Second Circuit, in Demery, focused most of its attention on a comparison of the composition of the eligible employees to the bank's workforce as a whole, in terms of participation and compensation. Although the District Court in Carrabba laid out several facts regarding eligible participants' salaries and participation percentages, it did not specifically utilize them to support its holding that the plan was not a top-hat plan (compare with the Second Circuit's primary rationale that 15 percent was not an excessive percentage of employees eligible to participate in the plan and that $30,000 was not an excessive average salary in comparison to the salaries of non-participating employees).
Sixth Circuit Follows the Lead of the Fifth Circuit in Focusing on "Qualitative" Factors
In Bakri v. Venture, 473 F.3d 677 (6th Cir. 2007), the Sixth Circuit held that a deferred compensation plan was not a top-hat plan and therefore was not excepted from ERISA's vesting and nonforfeitability requirements because its participants did not meet ERISA's selectivity requirements (i.e., participation was not limited to a group of employees with substantial influence over the design and operation of the plan).
In Bakri, the plantiff was a long-term employee of Venture Mfg. Company ("Venture") to whom Venture refused to pay the money that was owed to her under the terms of Venture's nonqualified deferred compensation plan upon the termination of her employment. Bakri sued Venture alleging, among other things, that the plan did not qualify as a top-hat plan and was thus subject to ERISA's vesting and nonforfeitability requirements. Venture moved for a summary judgment on Bakri's claim and the district court granted the motion.
Bakri appealed the district court's decision, claiming that the district court erred in concluding that Bakri was a participant in a top-hat plan. In this regard, Bakri asserted, among other things, that: (1) the plan was created so that long-term loyal salaried employees would have a retirement plan and that hourly employees participated in a separate company-funded tax-qualified retirement plan, (2) top-level Venture executives did not participate in the deferred compensation plan, (3) certain employees who were promoted to top management ceased to participate in the plan upon promotion and (4) participation was not limited to top management or even high-level positions (e.g., it included secretarial/administrative positions and individuals with manager titles who did not supervise any other employees).
To determine whether or not the plan was a top-hat plan, the Sixth Circuit relied on the Fifth Circuit's holding in Carrabba and the Department of Labor's position in Advisory Opinion 90-14 and considered both qualitative and quantitative factors, including: (1) the percentage of Venture's total workforce invited to join the plan (quantitative), (2) the nature of the eligible employees' employment duties (qualitative), (3) the disparity in compensation between plan participants and non-participants (qualitative) and (4) the plan language (quantitative). In doing so, the Sixth Circuit pointed out that top-hat plans are only exempt from certain requirements of ERISA because they are made available to persons who, because of their high salaries or executive positions within a company, exercise substantial influence over the design and operation of their plans.
Based upon the above facts and representations and accepting Bakri's representations as true for purposes of Venture's motion for summary judgment, the Sixth Circuit held that the "selectivity" element of the top-hat exception to coverage was not present. This conclusion was based on the allegations that the plan covered employees who had no supervisory, policy making or executive responsibility and had little ability to negotiate pension, pay or bonus compensation. Accordingly, the Sixth Circuit reversed the district court's decision and remanded the case for further proceedings.
When issued, the Second Circuit's favorable holding in Demery attracted a substantial amount of attention and gave employers incentive to and belief that they could, push the limits as to the class of employees eligible to participate in their unfunded deferred compensation plans. Comparing the Demery holding with the holdings in Carrabba and Bakri, illustrates the potential confusion an employer faces in setting up and maintaining its deferred compensation plan in an attempt to qualify such plan as a top-hat plan under ERISA's requirement that such a plan be established and maintained primarily for a select group of management or highly compensated employees.
The Carrabba case also presents an important illustration of the potentially devastating ramifications of interpreting a top-hat plan's permissible class of eligible employees too broadly. Specifically, eligible employees should be identified based on their rank, position, management characteristics and their ability to influence their compensation levels. In addition, an employer should focus on the rate of compensation and eligibility percentages compared with the company's overall employee make-up. In light of the uncertainties surrounding the top-hat eligibility determinations, employers should work closely with employee benefits counsel in connection with any establishment, amendment or maintenance of an unfunded deferred compensation plan that the company intends to operate as an ERISA qualified top-hat plan.