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Second Circuit Expands ERISA "Top Hat" Plan Coverage: A Plan Covering 15% Of Employees Can Qualify As A Top Hat Plan

Margolis, Steven M.

(Fall 2000, Employer Update)


By Steven M. Margolis

In its June 15, 2000 decision in Demery v. Extebank Deferred Compensation Plan (B),1  the Second Circuit concluded that a deferred compensation plan covering more than 15% of the company's workforce, some of whom were neither a select group of management nor highly compensated employees, nonetheless qualified as a “top hat” plan under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).  Under ERISA, a top hat plan is “a plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.”2 If a plan qualifies as a top hat plan, it is exempt from ERISA's participation, vesting, funding and fiduciary responsibility provisions.


There has been very little clear cut guidance interpreting what constitutes “a select group of management or highly compensated employees.”  Rather, in each case analyzed by the courts or the Department of Labor, the facts and circumstances of the particular group of employees covered by the plan was determinative, e.g., composition, responsibility and comparative salary levels of the group members as well as the percentage of employees covered.  For example, plans covering 0.2 percent and 4.6 percent of the respective workforces were found to be sufficiently “select” while plans covering 7.5 percent and 18.7 percent of the respective workforces were found to be too large.3  However, depending on facts and circumstances, a plan covering 4.6 percent of the workforce could be found not to be select and a plan covering 7.5 percent of the workforce could be found to be select.  Based on this uncertainty, many employers have been loathe to expand coverage of  “top hat” plans to all but the most select members of management and/or highly compensated employees.  Now, in light of the Demery decision, some employers may consider being more expansive in determining the composition of the group of employees to be covered by the top hat plan.


Extebank Deferred Compensation Plan (B)

Patrick Demery was an employee at Extebank.  Extebank established the Extebank Deferred Compensation Plan (B) (“Plan B”) in 1987.  Plan B was made available to Extebank assistant vice presidents, managers and other senior officers including Demery, representing approximately 15.34% of Extebank's workforce.  When Extebank was acquired in 1996, Demery and certain other executives terminated their employment with the bank and received a lump sum payment from Plan B that was smaller than the payment they would have received if the payment was made at their retirement age.  These participants sued to have their benefits determined in accordance with certain provisions of ERISA that are inapplicable to top hat plans.  They alleged that Plan B was not a top hat plan under ERISA because (i) more than 15% of the total employees were eligible to participate in Plan B, (ii) some Plan B participants earned as little as $30,000 annually and (iii) a few of the participants were neither “highly compensated” nor a “select group of management.”

“Select Group” of Management

In response to plaintiff's arguments, the Court noted that there is no authority dictating precisely when a plan is too large to be for a “select” group of employees and that such a determination requires more than mere statistical analysis.  The Court stated: “While [15.34% of the Extebank employees] is probably at or near the upper limit of the acceptable size for a 'select group,' we cannot say that it alone made Plan B too broad to be a top hat plan without considering the positions held at the bank by the Plan's participants.”4   In this regard, the Court found that even though those eligible included assistant vice presidents and branch managers and was not limited solely to a narrow range of top executives, all such employees were highly valued managerial employees.  The Court pointed out that a select group of management could include senior management and high-level executives.5

Highly Compensated Employee
The Court also found it significant that, even though Plan B was offered to some Extebank employees earning only approximately $30,000 a year, the Plan B participants' average compensation was still more than twice the average of compensation of the entire Extebank workforce.6  Both the courts and the Department of Labor have generally taken the position for top hat plan purposes that employees appear to be highly compensated “where they earn substantially – approximately two-to-three times – more than employees not covered by the plan.” It is unclear if the Court felt that, given the facts and circumstances, the compensation disparity made those employees “highly compensated employees” based on the Extebank employees in the whole or a “select group” of Extebank employees.

Employers should note that, in contrast to the Internal Revenue Code (the “Code”), there is no definition of “highly compensated employee” under ERISA for purposes of top hat plans.7 Further, the Preamble to the Treasury Regulation to Code Section 414(q) (defining highly compensated employee) made clear that the Department of Labor is not bound by the definition contained in the Code, specifically providing that the IRS definition of highly compensated employee is not determinative with respect to provisions of Title I of ERISA.8   However, some practitioners have used the Internal Revenue Code highly compensated employee limitations as a minimum threshold in determining top hat plan eligibility.  In any event, the Demery decision makes it clear that having top hat participants with compensation below the highly compensated employee limits set forth in the Code will not necessarily disqualify a top hat plan.

“Primarily for the Purpose” Requirement

Employers have often been advised that, for precautionary purposes, having even one participant who is neither one of a select group of management nor a highly compensated employee can disqualify a top hat plan.  However, in Demery, the Court rejected the former executives' claim that all participants must constitute a select group and that, in fact, some of the participants in Plan B were neither “key executives nor highly compensated,” which inclusion should have disqualified Plan B from being a top hat plan.  The Court noted that the statute defines a top hat plan as “primarily” designed to provide deferred compensation for certain individuals who are management or highly compensated and that the language of the statute suggests that a top hat plan would not be disqualified from top hat status simply because a very small number of the participants did not meet those criteria, or met one of the criteria but not the other.  The Court expressly wrote: “we do not find plaintiffs' focus on the two or three employees who were arguably not 'highly compensated' or 'a select group of management' to be dispositive.”9

Conclusion

At least within the Second Circuit, the Demery decision clarifies several points with regard to top hat plan participation that were not necessarily clear before: (i) depending on the
particular facts and circumstances of the participants, a top hat plan can cover as much as 15 percent of the employer's employees, and (ii) including plan participants in a top hat plan who are neither a select group of management nor highly compensated employees will not necessarily disqualify a top hat plan.  Employers who have or wish to adopt a top hat plan should consider eligibility for participation in light of this pronouncement.



1.  Demery v. Extebank Deferred Compensation Plan (B), 216 F.3d  283 (2d Cir. 2000).
2.  See ERISA Sections 201(2), 301(a)(3) and 401(a)(1).
3.  See, e.g., Gallione v. Flaherty, 70 F.3d 724, 726 (2d Cir. 1995) (plan covering 0.2 percent of the total union membership, although constituting 22 of the 68 union managers, was sufficient); Belka v. Rowe Furniture Corp., 571 F. Supp. 1249, 1252 (D. Md. 1983) (plan covering 4.6 percent of theworkforce was sufficient); DOL Opinion Letter 85-37A (plan covering 7.5 percent of workforce did not constitute a top hat group because it was offered to, among others, foremen, an assistant in the cost department, an order clerk and an expediter); Darden v. Nationwide Mutual Ins. Co., 717 F. Supp. 388, 397 (E.D.N.C. 1989), aff'd, 922 F.2d 203 (4th Cir. 1991), rev'd on other grounds, 503 U.S. 318 (1992) (plan covering 18.7 percent of workforce was too large).

4.  Demery, 216 F.3d at 289.
5.  Demery, 216 F.3d at 289.
6.  Demery, 216 F.3d at 286.
7.  Section 414(q) of the Internal Revenue Code defines “highly compensated employee.”  In 1987, the year Plan B was established, “highly compensated employee” included any employee whose compensation was in excess of $75,000 or any employee whose compensation was in excess of $50,000 and who was in the “top paid group”; the amounts rose with cost-of-living adjustments to $100,000 and $66,000, respectively, in 1996, the year Demery and the other appellants’ employment with Extebank was determined.
8.  See T.D. 8173 (Feb. 18, 1988), the Preamble to Treas. Reg. 1.414(q)-1T, which provides, in part:  “[T]he Department of the Treasury would like to clarify its understanding that section 414(q) is not determinative with respect to provisions of Title I of ERISA . . . .  The Departments of Treasury and Labor concur in the view that a broad extension of section 414(q) to determinations under sections 201(2), 301(a)(3) and 401(a)(1) of ERISA would be inconsistent with the tax and retirement policy

objectives of encouraging employers to maintain tax-qualified plans that provide meaningful benefits to rank-and-file employees.”
9.  Demery, 216 F.3d at 289.
   
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