ABA Section of Business Law

ABA Section of Business Law
Business Law Today
September/October 1998

When the Deposit Isn't Made

Abuse of pension fund accounts is a crime

Lundquist is an officer with Fredrikson & Byron, P.A., in Minneapolis, and Linder is a shareholder at the same firm.

Your client, Gotham Cabinets Inc., is working double shifts to keep up with demand. It has cornered the market on cabinets for high-end homes, both remodeling and new construction. With a red-hot economy propelling the business, things should definitely be looking up.

Lately, however, the president of Gotham has not been sounding too upbeat on the phone. "I've got serious trouble, John. Investigators from the Department of Labor are here and they're talking about a criminal prosecution." What you learn in the next few minutes is that, despite record-breaking sales, Gotham has been experiencing a severe cash crunch for a variety of reasons, including spiraling labor and raw materials costs, insurance and overhead expense, and aging accounts receivable. Cash receipts have not covered expenses, so simple arithmetic has dictated that costs had to be prioritized.

Gotham thought that it had up to 90 days to deposit its employees' 401(k) payroll deductions into the plan, so that seemed like an obvious payment to defer. Over the next six months, Gotham fell into the easy routine of leaving the 401(k) payroll withholdings in Gotham's operating account to use for other more pressing expenses, such as payroll and supplies. Unfortunately, Gotham continued to have difficulty meeting its expenses, including making the 401(k) deposits.

"All the money can be accounted for - if it was not deposited in the 401(k) account, it simply was left in the operating account. God knows I haven't taken any of it for personal purposes since I haven't even drawn a paycheck for the last three months. How can these investigators be talking about a criminal prosecution?"

A number of conversations like this have taken place since May, 1997, when U. S. Attorney General Janet Reno and Department of Labor Secretary Alexis Herman announced a nationwide pension-fraud enforcement initiative. Reno said that the pension crackdown was initiated to protect the integrity of the estimated $3.5 trillion private pension-plan system. "As Americans grow more dependent on retirement income from pensions," she said, "it is important that they feel confident that their investments remain safe and secure."

The pension-plan enforcement initiative was designed to bolster the confidence of pension-plan participants, according to the attorney general. Since that time, dozens of pension prosecutions have been initiated in a manner that bespeaks a coordinated effort to not only bring a greater number of criminal cases, but to extend criminal enforcement to matters that previously would have been handled through administrative mechanisms.

In Minnesota, the government brought three criminal cases in 1997 in connection with the attorney general's initiative. In 1998, the government's aggressive treatment of pension plans has continued with the return of criminal indictments against four more businesses in the state. All of these cases were noteworthy in that the pension funds were not directly diverted to the personal benefit of the business owners but were simply used for general business operating purposes.

In one case, the company's union contract provided that a deduction of 5 percent would be taken from union employees' paychecks and deposited into the union's pension plan. The employees received their paychecks on a timely basis, but the contributions were not made because of cash-flow shortages severe enough to cause the company's banker to appoint a work-out specialist. Only funds critical to day-to-day operations were disbursed, primarily for payroll. The pension contributions were five months in arrears by the time the business closed its doors. Although none of the union contributions had been used directly for the personal benefit of the owner, both the Department of Labor and the U.S. attorney held him responsible for repaying the pension contributions.

So, who is typically liable? In the cases prosecuted by the government, the target is usually the business sponsoring the qualified plan or an officer of the business who is a "fiduciary" under the Employee Retirement Income Security Act of 1974 (ERISA). ERISA defines a "fiduciary" as, among others, any person who exercises discretionary authority and control over plan assets, whether or not that person is named as an official plan trustee. Pension, profit-sharing and 401(k) contributions that are deducted from employees' paychecks constitute plan assets and can be used only for the benefit of the employees. ERISA does not allow businesses to use these plan assets for their own purposes or for the personal benefit of owners.

Until recently, the regulations under ERISA had allowed businesses up to 90 days to deposit amounts deducted from employees' paychecks into the trust for the pension, profit-sharing or 401(k) plan. The regulations now state that those amounts must be deposited by the 15th business day of the month following the month in which they are deducted. That is, however, the maximum amount of time permitted by the regulations. The payroll deductions actually become plan assets "as of the earliest date on which [they] can reasonably be segregated from the employer's general assets." With today's electronic payroll processing, that date might be just a few days after the deductions have been taken from employees' paychecks.

Thus, businesses should promptly deposit payroll deductions into the trust for the pension, profit-sharing, or 401(k) plan to avoid civil and criminal sanctions. Employers can, for example, make arrangements with their payroll processing service to wire transfer the payroll deductions into the trust for the pension, profit-sharing or 401(k) plan to avoid any unnecessary delays.

How serious is this, really? With regard to criminal prosecutions, federal statutes provide felony consequences of up to five years incarceration and up to $250,000 in fines for an individual (and $500,000 in the case of an organization) who is found to have either embezzled or converted any assets of a qualified plan or who makes a false statement or conceals facts in documents required by ERISA. While the key to a successful criminal prosecution typically lies in the government's proof that the defendant sought to cheat or defraud the plan participants, the current initiative stretches that concept by imposing criminal consequences on businesses and their owners who fail to remit contributions when the businesses teeter on insolvency.

According to the government, the pension-fraud enforcement initiative is a joint project of the Department of Labor, the Inspector General's Office of Investigations at the Department of Labor, the Federal Bureau of Investigation, the Internal Revenue Service and the Securities and Exchange Commission.

The charges likely to be brought against putative defendants include theft or embezzlement from employee benefit plans, in violation of 18 U.S.C. §664, and making false statements in relationship to required plan documents, in violation of 18 U.S.C. §1027. Under those statutes, the government's theory is that a fiduciary converts plan assets whenever payroll withholdings are not promptly deposited into the authorized plan account. Any other use is prohibited under ERISA and, therefore, constitutes "conversion" of the assets. Similarly, any document that indicates that employee funds were withheld (and therefore had become plan assets) but remained in the sponsor's operating account, may constitute a false statement.

In addition to prosecuting violations under the criminal laws, the Department of Labor has the authority to pursue the collection of delinquent contributions, plus interest, against businesses and owners. Under 29 U.S.C. § 1132(l) (ERISA § 502(1)), the Department of Labor can also impose a civil penalty equal to 20 percent of the amount recovered on the business owner for breaching his fiduciary duties to the pension, profit-sharing or 401(k) plan's participants. It's clear: The financial costs of falling behind in plan contributions can be significant.

Gotham Cabinets may have valid defenses based on its lack of criminal intent, particularly if the funds were handled honestly in an open fashion without concealment. While these defenses might keep the president out of jail, he most likely will be forced to personally pay the delinquent contributions, interest and penalties. Gotham, like all plan sponsors and fiduciaries, should be careful to avoid even the possibility of an ERISA enforcement action by making the deposit of pension plan contributions a top priority.