In re Verity Health System of California, Inc., 2021 WL 4189652 (Bankr. C.D. Cal. Sept. 14, 2021).

The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., ret.), analyzing a recent decision of interest:

A Bankruptcy Court in the Central District of California (the “Court”) recently ruled that the unfunded liability of a defined benefit pension plan was not an administrative priority expense of reorganized Chapter 11 debtors, but rather would be paid pro rata with other unsecured prepetition liabilities. In re Verity Health System of California, Inc., 2021 WL 4189652 (Bankr. C.D. Cal. Sept. 14, 2021).

To view the opinion, click here.

FACTS

Verity Health System of California, Inc. and affiliates filed chapter 11 proceedings in 2018. The debtors had established the Retirement Plan for Hospital Employees (the “RPHE”) as a multiemployer defined benefit pension plan under § 401 of the Internal Revenue Code, subject to the requirements of ERISA. The multiple debtors confirmed a chapter 11 plan which set aside a substantial reserve for payment of administrative priority claims on the effective date of the plan or as soon thereafter as such claims had been allowed. The plan had provisions for administrative priority claimants to make post confirmation applications for payment of such administrative priority expenses.

The RPHE made such application, seeking administrative priority status for all liabilities owed to it by the debtors. The Liquidating Trustee, in charge of making distributions to administrative claimants from the reserve, challenged certain components of the RPHE claim, asserting that only some elements of the claim were entitled to this high priority (administrative priority claims are essentially paid first, before any other unsecured obligations of reorganized debtors). This dispute was addressed in a motion before the Court, which was resolved by the Memorandum Decision being reviewed here.

The claim asserted by the RPHE had three distinct categories of costs arising from the expenses the employers’ contributions must satisfy. First, the contributions are used to pay for the expenses of administering the plan, including investment advisors and legal fees. Second, they are used to pay for the value of the new benefits that accrued for participants each year. These are referred to as “normal costs.” And, third, if any funds remain, they are used to satisfy underfunding or to create or increase a surplus. Underfunding of such pension plans is common, as the annual contributions are based on actuarial estimates of what an employee will be owed under the plan provisions, perhaps over his or her remaining life, after retirement. The accuracy of such estimates is dependent on predicting long term investment returns, the age at which employees will retire and their predicted lifespans, and other highly volatile elements. Because many workers are retiring earlier and living longer than anticipated, those factors alone result in almost every defined benefit pension plan or similar annuity being underfunded.

In the matter before the Court, the parties all agreed that the administrative expenses and the normal costs of the fund were administrative priority claims. The Court was tasked with determining whether the $23.5 million of unfunded liabilities of the debtors to the RPHE was entitled to administrative priority status. The Court in a lengthy Memorandum Decision concluded they were not.

REASONING

In its ruling the Court described the RPHE as follows:

Defined benefit pension plans…are employer-funded retirement plans created for the benefit of both active and inactive participating employees. Under a defined benefit pension plan, a pension fund is obligated to pay a specified benefit to employees covered by the plan upon their retirement and in accordance with the terms of the plan document. Thus, as employees earn their retirement benefits over time, the pension fund is accumulating fixed liabilities that will become due as employees retire and begin collecting their pensions.

In early times, all employees of the debtors were plan participants with accruing future benefits. In 2011 the RPHE plan was amended to freeze all future benefit accruals for certain non-collectively bargained employees. These employees were entitled to retain their previously earned benefits, but did not earn any more for future work. In 2013, a further amendment froze benefits for all unionized employees except for CNA members employed at certain hospitals. Of the $23.5 million unfunded liability, about $3.3 million was owed to the CNA members. Among other things, the Court had to determine whether the unfunded liability which related to employees who continued to earn further benefits while working postpetition should be treated any differently than the remaining liability.

The Court’s analysis began with § 503(b) of the Bankruptcy Code which provides for administrative priority status for expenses, including “the actual, necessary costs and expenses of preserving the estate.” Under well-established case law, administrative status is allowed when a claim (1) is incurred postpetition, (2) directly and substantially benefits the estate, and (3) is an actual and necessary expense. After considering these criteria, the Court analyzed the cases offered by the RPHE, including a 1988 district court decision from Massachusetts which cited a Ninth Circuit opinion from 1983, In re Pacific Far East Lines, 713 F. 2d 476 (9th Cir. 1983), but found the Ninth Circuit authority was not on point about this type of unfunded liability. The Court instead cited with favor a Sixth Circuit case, Pension Ben. Guaranty Corp. v Sunarhauserman, Inc. 126 F. 3d 811 (6th Cir. 1997), which held that underfunding liability did not qualify as an administrative expense. That case focused on the timeframe in which the accrual of the underfunding occurred, determining it was not a post-petition expense because it was underpayment prepetition which created the liability. The Court here provided similar reasoning, finding it particularly applicable for the underfunding for those employees whose benefits had been frozen years earlier and whose post-petition employment had no effect whatsoever on the underfunding.

The last challenge was determining whether the CNA underfunding was entitled to administrative priority, since those employees continued to earn new benefits post‑petition. But those new benefits were the undisputed normal costs. The underfunding was primarily based on the fact that the contributions made prepetition were insufficient to cover all of the expected future expenses of the plan. Therefore, the Court concluded that those costs also were founded on prepetition events and not entitled to priority.

AUTHOR’S COMMENTS

The Court here had very little case law to guide its conclusions. Reliance on the Sixth Circuit case, which has been followed by other bankruptcy courts around the country, does seem sound. Underfunding is an accruing problem, not something that exists because of the continuing business operations and the post-petition employment of the participants. Nothing about the underfunding was a necessary or reasonable expense of the present business operation, particularly for those whose benefits were frozen years ago. For those employees still accruing benefits, an argument could be made that the continuing promise to them that these new benefits would eventually be paid could be considered postpetition compensation and therefore entitled to administrative priority. None of the existing cases explore that issue and the Court’s conservative ruling makes sense. It will be interesting to see whether that issue—or any raised by this decision—will be appealed and, if so, exactly what the appellate courts decide.

This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., ret.), a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.