ERISA's Anti-Cutback Rule Bars Elimination of 401(k) Put Option

According to U.S. District Judge J. Michael Seabright of the U.S. District Court for the District of Hawaii, the put options for in-kind distributions of nonpublic stock that were distributed from Innovative Technical Solutions (ITS) employees’ 401(k) plans were an “optional form of benefit” that had protection under ERISA’s anti-cutback rule. The court further said that ERISA allows employers to eliminate an optional form of benefit, but bars taking away benefits that are considered a “valuable right” of plan participants.

The company established a retirement plan in 1998 that had both a 401(k) profit-sharing and Employee Stock Ownership Plan (ESOP) component., according to the ruling The two components were administered as a single trust with two sub-trusts – the 401(k) funds and the ESOP funds. However, ITS never made any discretionary contributions to the ESOP portion of the 1998 plan, nor arranged for any loans, and that portion of the plan was apparently never funded.

Under the ESOP, distributions of ITS stock would take the form of either in-kind stock distributions or cash. The plan participants had the right to ask that the cash distributions be in-kind distributions. The 1998 plan included a put option that allowed participants to require ITS buy back the distributed in-kind stock at fair market value.

When the company’s board of directors replaced the 1998 plan with a new plan in 2004, they eliminated plan participants’ put option right for in-kind distributions of ITS stock from the 401(k) portion of the plan, but still allowed them for ESOP distributions. This meant that participants were left holding a stock certificate that showed ownerships of shares that could not be exchanged for cash unless ITS became public or if the company decided to repurchase the shares.

The ruling said that the 2004 plan revoked that right, so that the plan participants who once had control over their 401(k) investments in the form of the put option no longer had the right to cash in their shares, prompting 11 former employees of ITS to file a lawsuit, claiming that the elimination of the put option from the 401(k) plan violated ERISA.

According to Seabright, a put option allows participants to access a cash market for their stock at a set sale price – or strike price. So, by eliminating the put option from the 1998 plan, Seabright said the company created a different distribution form, namely the in-kind distribution form provided in the 2004 plan, which denied participants a cash market for their stock.

ITS also argued that because the 1998 plan had separate 401(k) and ESOP portions, its distribution rules overlapped both, and as a result, the company’s removal of the put option right was allowed under the ESOP exception, which says that an ESOP “shall not be treated as failing to meet the requirements of [the Anti-Cutback Provision] merely because it modifies distribution options in a nondiscriminatory manner.”

However, Seabright contended that the overlapping distribution rule doesn’t apply, because the 401(k) portion and the ESOP portion of the plan are “separate and distinct,” and that the “401(k) portion does not convert to an ESOP simply because it was established in the same overarching plan as the ESOP portion.”

The case is Goodin v. Innovative Technical Solutions Inc.,D. Haw., No. 06-00344 JMS/BMK, 4/27/07.