How ERISA Litigators Strengthen Plan Compliance and Risk Management – One-on-One with Jeb Gerth [Video]
Strategic ERISA (Employee Retirement Income Security Act) plan design and administration require more than just technical compliance—they call for foresight into how plans will hold up under legal scrutiny.
In this one-on-one interview, Epstein Becker Green attorney Jeb Gerth, an experienced litigator in ERISA cases, joins George Whipple to explore the critical role a litigator plays in reinforcing plan integrity. Jeb explains how incorporating a litigation perspective into the planning and administration process acts as a “stress test,” helping to identify areas that might attract legal challenges or class action claims. He also discusses key vulnerabilities in ERISA plans, such as discretionary decision-making and inadequate documentation, and how addressing them proactively can reduce the risk of costly disputes.
With class actions often resulting in significant judgments and additional exposure through fee-shifting structures, Jeb provides practical, real-world guidance on preparing plans to withstand these challenges. From uncovering hidden risks during early plan administration to enhancing fairness and clarity in plan documents for both participants and courts, this conversation offers essential strategies for leaders looking to protect their organizations from potential litigation while fostering trust and compliance.
SECURE 2.0: Guidance on Roth Catch-Up Contributions
The long-awaited guidance on the provisions of the SECURE 2.0 Act of 2022 (SECURE 2.0) impacting catch-up contributions has been issued and answers questions plan practitioners have been asking. SECURE 2.0 added a requirement that employees who made $145,000 or more in the previous year must designate any catch-up contributions as Roth (after-tax) deferrals.
Plans That Do Not Currently Permit Roth Contributions
The guidance does not require a plan to allow Roth deferrals. However, if the plan does not allow Roth deferrals, the limit on catch-up contributions for those who made $145,000 in the prior year is $0. To pass testing, a highly compensated employee (HCE) who is not subject to Roth catch-up contributions may need to be precluded from making catch-up contributions. This could happen if the top-paid group election is made for the definition of HCE or if a participant is an HCE because the employee is a 5% owner.
Compensation Limit
The guidance specifies that the $145,000 compensation limit is determined based on Federal Insurance Contributions Act wages (FICA wages) for the previous year. This excludes self-employment income, which is not FICA wages. The compensation limit is determined without prorating wages for employees hired midyear. Only wages paid by the common law employer responsible for the employee’s compensation are considered, regardless of whether employers are aggregated under the controlled group rules.
Deemed Roth Elections
After a participant is required to make Roth catch-up contributions, the plan may deem the participant’s pre-tax deferral election to be a Roth deferral election; the plan is not required to obtain a new deferral election. The participant must still be provided the opportunity to change the participant’s deferral election if the participant no longer wants to defer. If a participant makes Roth deferrals during the year equal to the catch-up limit, but before the participant’s deferrals have reached the catch-up limit, the plan may count the amount of the Roth deferrals toward the required amount of Roth catch-up contributions.
Roth Elections for All Participants
If Roth elections are permitted for some participants, they must be permitted for all participants. A plan may not require all catch-up contributions to be Roth contributions. Participants must have a choice between designating deferrals as pre-tax or Roth.
Correction Methods
The guidance provides correction methods for failure to follow the Roth catch-up contribution rules accurately. To follow the correction methods, the plan must have practices and procedures in place to prevent failures, including providing for deemed Roth election at the time catch-up contributions start for affected participants or when deferrals exceed the Code §415(c) limit. The methods and deadlines for correction vary depending on the failure.
Effective Date
For plans that are not collectively bargained, the rules apply for contributions in taxable years that begin more than 6 months after the final regulations are issued. If final regulations are issued before the end of 2025, the rules would apply beginning January 1, 2027. However, plans are permitted to apply these rules to taxable years beginning after December 31, 2023.
For collectively bargained plans, the deadline is extended to the first taxable year beginning more than 6 months after the final regulations are issued or, if later, the first taxable year beginning after the termination of the last collective bargaining agreement related to the plan that is in effect on December 31, 2025, excluding any extensions.
SEC Actions in Review: What Officers and Directors Should Know for 2025
As the regulatory landscape continues to evolve, public company officers and directors must stay abreast of the enforcement priorities and expectations of the Securities and Exchange Commission (SEC). Over the past year, the SEC has brought various enforcement actions that involve the oversight and reporting obligations of management and boards. These cases highlight potential blind spots in corporate compliance programs. This article summarizes recent enforcement actions related to director independence, cybersecurity, insider “shadow” trading, internal investigations, executive compensation beneficial ownership and insider transaction reports, and Artificial Intelligence, which despite the change in administration, public company officers and directors should view as potential areas of continued SEC focus over the upcoming year.
Director Independence
In September 2024, the SEC announced it had settled[1] charges against a director of an NYSE-listed consumer packaged goods company for violation of the proxy rules, for failure to disclose in his D&O questionnaire information about his close friendship with an executive officer, which caused the company to falsely list him as an independent director in its proxy statement.[2] This undisclosed relationship included multiple domestic and international paid vacations with the executive.[3] The director also allegedly provided confidential information to the executive about the company’s CEO search and instructed the executive to withhold information about their personal relationship to avoid the impression that the director was biased toward the executive becoming CEO of the company.[4] The director agreed to a civil penalty of $175,000, a five-year officer and director bar, and a permanent injunction from further violations of the proxy rules.
Takeaway: For directors, this case underscores the importance of being “honest, truthful, and forthright”[5] when completing D&O questionnaires and not treating them as mere formalities that are rolled forward from one year to the next. This enforcement action further shows that material misstatements and omissions in the D&O questionnaire can give rise to a direct violation of the proxy disclosure rules against the director for causing a company’s proxy statements to contain false and misleading statements. The determination of independence can be complex. However, directors are not tasked with making that determination themselves; they merely must disclose all relevant facts in their D&O questionnaires, including social relationships with management.
Cybersecurity
In October 2024, the SEC announced settlements with four issuers for misleading disclosures regarding cybersecurity risks and intrusions. [6] These cases stemmed from an ongoing investigation of companies impacted by the two-year long cyberattack against a software company, which the SEC charged a year earlier for failure to accurately convey its cybersecurity vulnerabilities and the extent of the cyberattack.[7] Each issuer charged by the SEC in October 2024 utilized this company’s software and discovered the actor likely behind the software company’s breach also had accessed their systems, but according to the SEC, their public disclosures minimized or generalized the cybersecurity incidents. Specifically, two of the issuers failed to disclose the full scope and impact of the cyberattack, including the nation-state nature of the threat actor, the duration of the malicious activities, and in one case[8] the number of compromised files and the large number of customers whose information was accessed, as well as in another case the percentage of code that was compromised.[9] The other two issuers failed to update their risk disclosures in SEC filings and instead framed cybersecurity risks and intrusions as general and not material[10] or in hypothetical terms[11] rather than disclosing the actual malicious activities and their impact on the company.
The SEC charged each issuer with violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act (which prohibit misleading statements or fraud in connection with the offering or sale of securities) and Section 13(a) of the Exchange Act and Rules 13a-1, 13a-11, 13a-13, and 13a-15(a) thereunder (rules related to required filings for public companies, including requirements that such filings include any material information to ensure filings are not misleading, and companies have internal controls and procedures over financial reporting). One of the companies also was charged with disclosure controls and procedures violations. While each issuer received credit for cooperating in the SEC investigation, the settlements included civil penalties ranging from $990,000 to $4 million.
Takeaway: When a cybersecurity breach is identified, the board and management must ensure their company’s disclosures are accurate, current, and tailored to the company’s “particular cybersecurity risks and incidents.”[12] Indeed, the SEC’s cybersecurity disclosure rules, adopted on July 26, 2023, specifically require registrants to, among other things, report on Form 8-K any cybersecurity incident deemed to be material and to disclose on Form 10-K the registrant’s processes for assessing, identifying, and managing material risks from cybersecurity threats, the material impacts of cybersecurity threats and previous incidents, and specific information relating to the role of the board and management in identifying and managing such risks.[13] As the SEC stated, “Downplaying the extent of a material cybersecurity breach is a bad strategy”[14] and, as these cases demonstrate, can subject the company to an enforcement investigation and action. Navigating cybersecurity disclosure obligations, however, especially when the breach is ongoing and the origin and impact is not fully understood, presents unique challenges for issuers. And despite the dissenting opinion in the October 2024 cybersecurity enforcement cases by two of the SEC commissioners, who believed the omitted details were not material to investors, the board and management must constantly evaluate whether their company’s cybersecurity risk disclosures, as well as the disclosed scope and impact of any material breach, are sufficiently detailed and remain accurate throughout the company’s investigation.
Insider “Shadow” Trading
In April 2024, the SEC won a jury verdict in an insider trading case based on a “shadow” insider trading theory.[15] Shadow trading involves an insider’s misappropriation of confidential information about the insider’s company to trade in securities of another company where there is a sufficient “market connection” between the two companies. In this case, the SEC alleged, and the jury found, the defendant used confidential information about a potential acquisition of the biotech company he worked for to purchase call options in a second biotech company in the belief its stock price would materially increase after the deal involving his company was publicly announced. What was novel about this case is the lack of commercial connection between the two companies and the fact that the confidential information did not directly relate to the company whose securities the defendant traded in.[16] The nexus between the two companies that served as the basis for the SEC’s insider trading charges was that they were both operating in a field where viable acquisition candidates were scarce, such that the announcement of the sale of the insider’s company was likely to drive up the stock price of the other company.
Takeaway: Officers and directors should take note of this case and, pending further judicial developments, should refrain from shadow trading when in possession of material non-public information (MNPI). Indeed, corporate insider trading policies and codes of conduct often prohibit trading in the securities of publicly-traded customers, vendors, and other commercial partners when an insider is in possession of MNPI. Further, the SEC’s success in this civil case, and the existence of criminal penalties for insider trading, creates an additional risk of criminal prosecution. In short, officers and directors should avoid becoming embroiled in allegations of shadow trading, which could be costly to defend, cause reputational damage, and lead to the imposition of significant sanctions.
Internal Investigations
The SEC has made clear that when a company fails to investigate and remediate wrongful conduct, it will hold officers and directors responsible even if they may not have been involved in the underlying violation. And when a board and management take prompt action to investigate, remediate, and self-report, the SEC will “reward [] meaningful cooperation to efficiently promote compliance” in the form of reduced charges and/or sanctions.[17]
In September 2024, the SEC brought unsettled civil fraud charges in federal court against the former CEO, former CFO, and former director and audit committee chair of a bankrupt (formerly Nasdaq-listed) software company for their roles in an alleged scheme that resulted in the company overstating and misrepresenting its revenues in connection with two public stock offerings that raised $33 million.[18] The SEC alleged that while the CEO initiated and directed the fraud, the CFO and director received a complaint from a senior company employee regarding revenue concerns about the main product disclosed in the offering materials, but other than consulting with outside counsel, they failed to investigate the employee’s concerns or correct the potential misstatements. As a result, both signed public filings that contained false and misleading statements and, in connection with the year-end audit, falsely represented to the outside auditors that they had no knowledge of any complaints regarding the company’s financial reporting. The SEC is seeking disgorgement of ill-gotten gains, civil penalties, and officer-and-director bars against each defendant. In its press release, the SEC warned, “This case should send an important signal to gatekeepers like CFOs and audit committee members that the SEC and the investing public expect responsible behavior when critical issues are brought to their attention.”[19]
In stark contrast, in December 2024 the SEC declined to impose a civil penalty in a settled administrative cease-and-desist action against a publicly-traded biotechnology company due to its self-reporting, proactive remediation, and meaningful cooperation.[20] The SEC credited the company’s board for (1) forming an independent special committee, which hired outside counsel to conduct an investigation into two anonymous complaints; (2) adopting the special committee’s remediation recommendations, including appointing an interim CEO, establishing a disclosure committee, and appointing two new independent directors; and (3) self-reporting the results of the internal investigation.[21] The SEC filed separate settled charges against the former CEO and former CFO for misleading investors about the status of FDA reviews of the company’s drug candidates related to a follow-on public offering. Among other sanctions, the CEO and CFO agreed to civil penalties, and the CEO agreed to an officer-and-director bar.[22]
Similarly, in a settled action announced in September 2024, the SEC credited a former publicly-traded technology manufacturer for conducting an internal investigation, self-reporting the investigation results, and implementing remedial measures.[23] Despite the existence of fraudulent conduct by a high-level employee, the SEC charged the issuer with only non-fraud violations of the financial reporting, books and records, and accounting control provisions of the federal securities laws and did not impose any penalty. The SEC explained in its press release that “this kind of response by a corporate entity can lead to significant benefits including, as here, no penalty.”[24] The SEC did bring civil fraud charges against the company’s finance director who perpetrated a fraud related to the company’s financial performance during a three-year period.[25]
Takeaway: When accounting errors or improper conduct are discovered or alleged, a company and its board should take prompt action. Conducting an independent investigation, undertaking prompt remediation, and being transparent with the company’s outside auditors are critical to ensuring accurate disclosures, preventing further errors and misconduct, and mitigating regulatory and legal exposure. Failing to do so will increase business and legal costs, damage the company’s reputation, and expose officers and directors to individual liability. And where appropriate, with the advice of experienced counsel, companies should evaluate the pros and cons of self-reporting, which regulators will credit as a mitigating factor when considering charges, sanctions, and settlements.
Executive Compensation
In December 2024, the SEC announced it had settled charges against an NYSE-listed fashion retail company for failing to disclose within its definitive proxy statements $979,269 worth of executive compensation related to perks and personal benefits provided to a now-former CEO for fiscal years 2019, 2020, and 2021.[26] These unreported personal benefits included expenses associated with the authorized use of chartered aircraft for personal purposes.[27] The company’s failure to disclose these benefits resulted in it underreporting the “All Other Compensation” portion of its then-CEO’s compensation by an average of 94% of the three fiscal years.[28] The SEC charged the company with violations of Sections 13(a) and 14(a) of the Exchange Act and Rules 12b-20, 13a-1, 13a-15(a), 14a-3, and 14a-9 thereunder (which prohibits companies from making false or misleading statements in proxy statements).[29] The SEC imposed a cease-and-desist order and declined to impose a civil penalty, in part due to the company’s prompt remediation and self-reporting.[30]
Takeaway: This case underscores the importance of companies having adequate processes, policies, and controls for identifying perks and personal benefits and ensuring they are included in executive compensation disclosures. SEC rules require, among other things, companies to disclose the total value of such benefits provided to named executive officers who receive at least $10,000 worth of such items in a given year. See Item 402 of Regulation S-K. Transparent disclosure not only fulfills a company’s regulatory obligations but also helps maintain public trust. Failing to fully report non-compensation benefits executives receive can lead to increased government scrutiny, reputational damage, and loss of investor confidence. And when a company falls short, prompt remediation is critical and can result in a reduction of regulatory sanctions.
Beneficial Ownership and Insider Transaction Reports
On September 25, 2024, the SEC announced charges against 23 officers, directors, and major shareholders for violating Sections 16(a), 13(d), and 13(g) of the Exchange Act, which requires reporting information concerning holdings and transactions in public company stock.[31] In addition, the SEC charged two publicly-traded companies for their failure to report these insiders’ filing delinquencies or for contributing to these insiders’ failures to file.[32] In its press release, the SEC explained the importance of complying with these reporting obligations: “To make informed investment decisions, shareholders rely on, among other things, timely reports about insider holdings and transactions and changes in potential controlling interests.”[33] The settlements included penalties ranging from $10,000 to $200,000 for individuals and $40,000 to $750,000 for companies — totaling more than $3.8 million in penalties.[34] The SEC used data analytics to identify individuals and entities with late required reports.
Takeaway: While it is unusual for the SEC to bring so many actions at once, the “SEC’s enforcement initiatives” are not surprising given the SEC’s continued focus on policing compliance.[35] The SEC continues to send a clear signal to insiders and investors that they need to “commit necessary resources to ensure these reports are filed on time” or risk enforcement action.[36] And as the SEC recently warned, “[T]hese reporting requirements apply irrespective of whether the trades were profitable and regardless of a person’s reasons for the transactions.”[37] For public companies that assist insiders in complying with these filing requirements, the SEC actions further make clear companies are not immune and must stay abreast of amendments and ensure their monitoring processes and controls are working effectively to ensure timely reporting.
Artificial Intelligence
The SEC continued its crackdown on “AI-washing” by bringing a settled enforcement action on January 14, 2025 against a restaurant services technology company due to alleged misrepresentations concerning “critical aspects of its flagship artificial intelligence [] product[.]”[38] According to the SEC, AI-washing is a deceptive tactic that consists of promoting a product or a service by overstating the role of artificial intelligence integration.[39] The product at issue in the enforcement action employed AI-assisted speech recognition technology to automate aspects of drive-thru ordering at quick-service restaurants. Among other things, the SEC accused the company of disclosing a misleading reporting rate of orders completed without human intervention using the product.[40] The company was charged with violations of Section 17(a)(2) of the Securities Act and Section 13(a) of the Exchange Act.[41] The SEC declined to impose a civil penalty based on the company’s cooperation during the Staff’s investigation and remedial efforts, with the company consenting to a cease-and-desist order.
While this most recent enforcement against AI-washing led to a cease-and-desist order, the Commission’s enforcement cases in 2024 included steep penalties for violators.[42] In an earlier enforcement action against two investment advisory companies, the SEC levied civil penalties of $400,000 for the company’s false and misleading statements concerning their purported use of artificial intelligence.[43] Specifically, the companies were alleged to have marketed to their clients (and prospective clients) that they were using AI in certain ways when they were not.[44] In the SEC’s press release, Chair Gary Gensler warned, “We’ve seen time and again that when new technologies come along, they can create buzz from investors as well as false claims by those purporting to use those new technologies. . . . Such AI washing hurts investors. . . . [P]ublic issuers making claims about their AI adoption must [] remain vigilant about [] misstatements that may be material to individuals’ investing decisions.”[45]
Takeaway: It is evident that “[a]s more and more people seek out AI-related investment opportunities,” the SEC becomes more and more committed to “polic[ing] the markets against AI-washing[.]” [46] The SEC’s emphasis, that any claims regarding AI must be substantiated with accurate information, makes it essential for companies integrating AI to have clear and accurate ways to measure and assess its AI-supported products and/or services. For directors and executives, this means carefully reviewing public disclosures and press releases related to AI technologies to ensure that all AI-related statements are supported by verifiable information. Without this verifiable information, a company opens itself up to significant penalties from enforcement actions brought pursuant to Section 17 of the Securities Act, which may also result in lost trust from shareholders around a company’s AI-related technologies.
Closing
The news for boards and management isn’t all bad; the number of SEC enforcement actions dropped significantly in 2024, and there is reason to believe that this drop may continue into 2025. In 2024, there were 583 SEC enforcement proceedings, compared to between 697 and 862 for each of the prior five years.[47] While the SEC touted record financial remedies for 2024,[48] over half of that amount came from a single case.[49] Signals from the new administration indicate reduced enforcement activity is likely to continue, given the administration’s focus on deregulation and government efficiency, which will likely lead to fewer resources available to the SEC. There also is an expectation that the SEC will avoid “regulation by enforcement” and take a “friendlier” view of certain activities that the outgoing SEC administration sought to reign in, such as with the crypto industry.[50] An additional factor pointing toward changes in enforcement approach is that the SEC is no longer able to try certain cases in administrative proceedings and instead must adjudicate such matters in federal jury trials.[51] This could result in the SEC choosing to pursue fewer actions or lesser sanctions, particularly given that it has historically been less successful in federal courts compared to in-house proceedings.[52] Nonetheless, the SEC’s enforcement actions involving public companies over the past year serve as a reminder to officers and directors of the importance of complying with their duties and obligations and ensuring strong internal controls and reporting practices. Staying ahead of compliance requirements is not just a matter of risk mitigation — it is essential for preserving shareholder trust and corporate integrity.
If you have questions about these and other SEC enforcement actions, contact the authors or your Foley & Lardner attorney.
[1] Typically with settled SEC actions, the settling party neither admits nor denies the SEC’s findings. See 17 CFR § 202.5.
[2] https://www.sec.gov/newsroom/press-releases/2024-161.
[3] See id.
[4] See id.
[5] See id.
[6] https://www.sec.gov/newsroom/press-releases/2024-174.
[7] https://www.sec.gov/newsroom/press-releases/2023-227. In July 2024, most of the SEC’s claims were dismissed; most notably, the court held that charges of internal accounting controls failures do not extend to cybersecurity deficiencies. See https://www.foley.com/insights/publications/2024/08/down-but-not-out-federal-court-curbs-sec-cybersecurity-enforcement-authority/.
[8] See https://www.sec.gov/newsroom/press-releases/2024-174.
[9] See id.
[10] See id.
[11] See id.
[12] Release Nos. 33-10459, 34-82746 (Feb. 21, 2018) (“We expect companies to provide disclosure that is tailored to their particular cybersecurity risks and incidents”).
[13] See Release Nos. 33-11216, 34-97989 (July 26, 2023); see also https://www.foley.com/insights/publications/2023/08/sec-adopts-new-cybersecurity-disclosure-rules/.
[14] https://www.sec.gov/newsroom/press-releases/2024-174.
[15] See https://www.sec.gov/enforcement-litigation/litigation-releases/lr-25970; see also https://www.sec.gov/enforcement-litigation/litigation-releases/lr-25170.
[16] https://www.foley.com/insights/publications/2024/03/sec-v-panuwat-shadow-trading-insider-trading-trial/.
[17] https://www.sec.gov/newsroom/press-releases/2023-234.
[18] https://www.sec.gov/newsroom/press-releases/2024-131.
[19] Id.
[20] https://www.sec.gov/newsroom/press-releases/2024-189.
[21] https://www.sec.gov/files/litigation/admin/2024/33-11332.pdf.
[22] https://www.sec.gov/files/litigation/admin/2024/34-101796.pdf.
[23] https://www.sec.gov/newsroom/press-releases/2024-116.
[24] Id.
[25] Id.
[26] https://www.sec.gov/newsroom/press-releases/2024-203
[27] Id.
[28] Id.
[29] Id.
[30] Id.
[31] https://www.sec.gov/newsroom/press-releases/2024-148
[32] Id.
[33] Id.
[34] Id.
[35] https://www.sec.gov/newsroom/press-releases/2023-219 (press release); https://www.sec.gov/files/33-11253-fact-sheet.pdf (fact sheet); https://www.sec.gov/files/rules/final/2023/33-11253.pdf (final rule).
[36] https://www.foley.com/insights/publications/2014/09/sec-charges-insiders-for-violations-of-section-16a/
[37] https://www.sec.gov/newsroom/press-releases/2024-148
[38] https://www.sec.gov/enforcement-litigation/administrative-proceedings/33-11352-s
[39] See https://www.sec.gov/newsroom/speeches-statements/gensler-office-hours-ai-washing-090424
[40] Id.
[41] Id.
[42] https://www.sec.gov/newsroom/press-releases/2024-36
[43] Id.
[44] Id.
[45] Id.
[46] See https://www.sec.gov/newsroom/press-releases/2024-70
[47] https://www.sec.gov/files/fy24-enforcement-statistics.pdf.
[48] https://www.sec.gov/newsroom/press-releases/2024-186.
[49] See https://www.sec.gov/enforcement-litigation/distributions-harmed-investors/sec-v-terraform-labs-pte-ltd-do-hyeong-kwon-no-23-cv-1346-jsr-sdny.
[50] https://www.nytimes.com/2024/12/04/business/trump-sec-paul-atkins.html.
[51] See https://www.foley.com/insights/publications/2024/06/us-supreme-court-rules-sec-securities-fraud-cases-federal-jury/.
[52] Id.
Carried Interest and Co-Investment Plans: A Primer for Asia-Based Private Fund Managers
This publication is issued by K&L Gates in conjunction with K&L Gates Straits Law LLC, a Singapore law firm with full Singapore law and representation capacity, and to whom any Singapore law queries should be addressed. K&L Gates Straits Law is the Singapore office of K&L Gates, a fully integrated global law firm with lawyers located on five continents.
Management team participation in the performance of the funds they manage—through carried interest and co-investment plans—has long been a regular feature for private equity, real estate, venture capital, and other private funds in the US funds industry. Increasingly in recent years, many Asia-based private fund managers have implemented similar programs.
Fund manager carried interest and co-investment plans offer several advantages, including (a) attracting and retaining top talent, (b) providing “skin in the game” to align participant interests with the interests of the manager and external investors, (c) maximizing upside potential for participants while reducing the out-of-pocket costs and downside risk of higher fixed compensation, (d) fostering a long-term commitment by participants to the manager, and (e) potential tax efficiencies, as further discussed herein.
This article summarizes the key characteristics of fund manager carried interest and co-investment plans from the perspective of an Asia-based manager, including structuring alternatives, key terms and market practice, and tax and regulatory considerations.
Comparison of Carried Interest and Co-Investment Plan Components
Under a “carried interest plan,” each participant shares in the carried interest (i.e., profit distributions) distributed by one or more of the manager’s funds without necessarily needing to make a passive investment. On the other hand, under a “co-investment plan,” the fund manager typically requires each participant to make a passive investment in one or more of the funds managed by the manager, thereby entitling participants to a return of capital and any profits from such investment(s).
Many managers combine the elements of a “co-investment plan” and a “carried interest plan” into a single plan, so that participants would both (a) make a passive investment in one or more of the manager’s funds, thereby benefiting from the investment returns; and (b) hold a right to receive a portion of the carried interest distributed in respect of such fund(s).
Participant Co-Investment Plans vs Limited Partner Co-Investment Rights
The term “co-invest” often has a different meaning in the context of a participant plan as compared to a third-party limited partner (LP)’s co-investment right in a fund. A third-party LP’s “co-investment right” in a fund typically confers on the LP, which will separately hold exposure to a fund’s portfolio investments through its capital commitment to the fund, the option to invest additional capital into specific portfolio investments of the fund. This allows the LP to increase its exposure to certain investments of choice.
In contrast, the term “co-investment” in the context of a participant plan (and as used generally in this article) often refers to a participant’s passive investment in a fund (i.e., its capital commitment), which typically exposes the participant to the performance of all of the fund’s portfolio investments. Similarly, many managers use the term “GP co-invest” to describe the capital commitment (i.e., the “sponsor commitment”) of a general partner (GP) or its affiliates to a fund. Market practice varies on this point, as further discussed in “Fund-Wide vs Deal-by-Deal Participation” below.
Structuring Alternatives
A carried interest and co-investment plan could be structured as either (a) an equity arrangement, where participants hold equity in the vehicle that receives carried interest (the Carry Vehicle); or (b) a contractual arrangement, under which participants are contractually entitled to receive payments of cash based on a fund’s performance.
In an equity arrangement, a participant would subscribe for an interest in a designated Carry Vehicle, which could be either the GP of the relevant fund or another entity established for the specific purpose of receiving the fund’s carried interest and making the team’s investment to the fund. Any such specially formed entity typically would invest into the fund as an LP and would be known as a special limited partner (SLP). A participant’s co-investment pursuant to an equity arrangement typically would also form a part of the GP’s required “sponsor commitment” to the fund.
It can be simpler and less costly to run a carried interest and co-investment plan through the GP entity itself, rather than through an SLP. That being said, using an SLP is more common for established managers because (a) a fund’s GP has unlimited liability for the fund’s obligations, while an SLP (as an LP of the fund) does not; (b) admitting plan participants into an SLP (rather than the GP) allows the manager to keep the economics of the plan separate from the “control”/decision-making rights and function of the GP; (c) a manager may wish to structure the SLP differently (e.g., in a different jurisdiction) from the fund and the GP for administrative or other reasons; and (d) while a new GP should be established for each successive fund, some managers will continue to use the same SLP for multiple funds.
Alternatively, a manager could structure the plan as a contractual arrangement (rather than an equity arrangement) between the manager and each participant, whereby each participant holds a contractual right to receive an amount of cash as determined by reference to the timing and amounts of carried interest or other amounts distributed by the fund. A contractual approach is generally lower cost and administratively more convenient, as a participant’s contractual rights could be memorialized in the participant’s standard employment or consulting agreement, or a simple letter agreement, rather than requiring full-form documentation for an equity interest in a vehicle. However, in certain jurisdictions (including Hong Kong and Singapore), a contractual approach would likely be less tax efficient, as further discussed in “Tax Considerations” below.
Key Terms and Market Practice
A manager should consider the following key terms when structuring a carried interest and co-investment plan:
Source of Funding for Co-Investment
A key aspect of a co-investment plan is the source of funding for each participant’s co-investment, typically among the following options:
The “Standard” Cash Approach
Each participant funds the co-investment out of pocket in the form of capital contributions over time, in the same manner as other investors in the relevant fund(s). This is the simplest approach, but it also could be burdensome for participants and the manager. For example, for a participant with a modest commitment, it may be inconvenient to fund many small capital calls. With this in mind, a common variation would be for each participant to make periodic cash contributions (e.g., quarterly or annually) independent of the fund’s normal capital call schedule.
The “Deemed Loan” Approach
The manager extends a loan to the participant representing all or a portion of the participant’s investment amount. Under this approach, the loan is typically repaid to the manager out of future distributions in priority over payments to the participant until the loan is fully repaid. It is also possible for the loan to be “nonrecourse,” such that the loan is subject to repayment only out of distributions, and the participant would not be required to pay in any capital, even if distributions are insufficient to pay out the loan. Of course, this nonrecourse approach would add more downside risk to the manager.
The “Free Share” Approach
The manager would fund a participant’s co-investment amount on the investor’s behalf, potentially representing a key component of the participant’s compensation package. This approach could align incentives between a manager and a participant by more efficiently tying compensation to fund performance than cash compensation. In addition, vesting conditions could further incentivize the participant to remain with the firm. However, in addition to manager-funded contributions being taxable to the co-investor, this approach also could reduce the likelihood of favorable tax treatment on the participant’s carried interest. See “Tax Considerations” below.
In any case, participants in a co-investment plan will typically be entitled to receive a share of the fund distributions equal to their pro rata interest in the relevant fund(s) in the same manner as other investors, either directly from such fund(s) or indirectly through the Carry Vehicle.
Fund-Wide vs Deal-by-Deal Participation
As noted above, participation in a co-investment plan would typically provide for exposure to the entire portfolio of each relevant fund (i.e., fund-wide exposure) in the same manner as any other passive investor in the fund. However, some co-investment plans—particularly for larger managers—provide participants the option to increase their exposure to specific portfolio investments (i.e., deal-by-deal exposure).
External investors typically would prefer that any participant’s co-investments be fund-wide (and not deal by deal) to reduce conflicts of interest and the perception that a participant could “cherry-pick” exposure only to the best investments. LPs are particularly concerned because the participants typically include the deal team members with the greatest access to information on each investment.
A manager should separately consider whether participation in carried interest would be on a “fund-wide” or “deal-by-deal” basis, though a “fund-wide” approach is much more common for most types of managers. In the case of a fund-wide participation, a participant’s share of the carried interest would be based on the aggregate carried interest of the fund, regardless of which investments such participant has been involved with. In the case of a deal-by-deal participation, a participant would share in carried interest that is allocable to specific investments.
Key factors driving this decision include (a) the size of the firm and the depth of its infrastructure, (b) the number of participants in the program, and (c) whether or not participants are responsible for only specific deals or a fund’s entire portfolio.
A fund-wide program can better incentivize each participant’s efforts toward the performance of the entire fund, whereas deal-by-deal exposure can allow a manager to incentivize each deal team more efficiently. A fund-wide program is easier to manage administratively than a deal-by-deal program, which requires allocating carried interest (calculated with reference to the entire portfolio across deals) across investments and tracking each participant’s exposure separately. Further, actual carried interest distributions are typically backloaded due to a fund’s standard “distribution waterfall,” which can make it prohibitively difficult to determine how much carried interest to allocate to early dispositions until later in the fund’s life. Some managers will offer a hybrid program whereby participants have exposure to all investments and, in some cases, may have additional exposure to specific investments.
Carry Points
A participant’s right to share in carried interest of a fund is typically quantified in terms of “points,” which correspond to a specified percentage of the overall carried interest distributions with respect to the applicable fund(s) or the specific investments in such fund(s).
Market practice varies widely on the portion of the overall carried interest share to be allocated to the pool of participants, on the one hand, and the founder or institutional manager, on the other hand. Key factors typically include the size and type of a firm, the region or country it is based in, and the firm’s organizational structure and culture. For example, state-owned firms or larger firms would often adopt a more conservative approach to profit sharing, resulting in a lesser carry share allocated to participants. In many cases, firms that offer lower fixed compensation (e.g., new managers that may not yet generate significant management fees) often would look to carried interest allocation as a significant element of the participant’s overall compensation arrangement.
In addition to the founders, carry participants typically include senior officers and investment professionals. Some carried interest plans include a broader range of personnel, such as consultants (e.g., venture partners), junior investment professionals, and potentially even administrative and clerical staff. By carefully considering all available factors, managers can allocate carry points in a manner that incentives peak performance while maintaining a collaborative team environment.
Dilution of Carry Points
Participants in a carried interest plan may be subject to dilution in respect of their share of the carried interest, often subject to limits. Some carried interest plans permit a manager to issue additional points in the future without limitation (i.e., an unlimited pool), which would allow for limitless dilution. However, it is also common for a carried interest plan to establish a fixed number of carry points, such that (a) a portion would be issued to initial participants, and (b) a “reserve pool” (i.e., a portion of the initial fixed number of carry points) would remain available for the manager to issue to existing or new participants.
Any carried interest distributions attributable to carry points in the reserve pool that have not been allocated to participants would typically be for the benefit of the principal(s). In addition, any carry points that are forfeited (due to failure to vest or other reasons, as described in “Vesting of Carry Points” below) would be added back to the reserve pool.
Some carried interest plans provide for two classes of interests: one for founders and other senior executives, and another for rank-and-file team members. In such cases, carry points that are attributable to rank-and-file team members often would not be subject to dilution.
Key interests to balance when considering dilution are (a) the manager’s need for flexibility to scale and bring on new talent, and (b) the participants’ desire for certainty as to their percentage interest in the fund’s carried interest. As carry points are typically allocated fund by fund, a manager with multiple funds or frequent successor funds may have more flexibility to manage this issue over time.
Vesting of Carry Points
Carry points are often subject to “vesting,” permitting participants to retain their points and receive the corresponding carried interest distributions only if they remain involved with the manager or the fund over a particular span of years (i.e., vesting period). Accordingly, vesting arrangements are designed to align participants with the long-term performance of the fund(s) that they manage. While vesting terms (or similar provisions) are standard for carried interest plans, co-investments would not be subject to vesting unless funded by the manager (such that the participant has not put capital at risk).
Vesting provisions are typically structured as follows:
For-Cause Departure
If a participant is required to depart involuntarily and for cause, the participant will typically forfeit all vested and unvested carry points.
Voluntary Departure or Involuntary Departure Without Cause
If a participant departs voluntarily or involuntarily without cause, the participant typically would be entitled to retain any vested carry points but would forfeit any unvested carry points.
Death or Permanent Disability
In the unfortunate event of a participant’s death or permanent disability, the participant (or his or her estate) would typically retain all vested carry points, and all or a portion of any unvested carry points might be deemed vested and retained.
The duration and schedule of vesting periods vary significantly across funds. Conceptually, the vesting period should correlate with the time during which a participant contributes meaningfully to the establishment and ongoing operations of the fund and its investments. Arguably, this period often spans from the start of the fund’s marketing activities to its liquidation date. However, many carried interest plans provide for a vesting period commencing at a fund’s initial closing and ending around the end of the fund’s investment period.
While some vesting schedules provide for “straight line” vesting, whereby entitlements vest in equal instalments over time, other arrangements (e.g., cliff vesting) are also common. For example, some funds would provide for 15% vesting over the first four years (i.e., 60% total), followed by 20% vesting over each of years five and six (i.e., the remaining 40%).
In lieu of a vesting arrangement, some carried interest plans provide for a buy-back mechanism, giving the manager an option to repurchase a participant’s carry points (and, potentially, co-investment) based on a preagreed formulation upon certain triggering events (e.g., the participant ceases to be involved in the management of the relevant portfolio investments).
Restrictive Covenants
Participants in carried interest and co-investment plans are often subject to restrictive covenants that are similar to those commonly included in employment or consulting agreements, typically including (a) noncompete and nonsolicitation provisions, often surviving for six to 12 months following termination of employment; (b) nondisparagement provisions, which prohibit participants from speaking negatively about the firm or its management; and (c) confidentiality obligations. Nondisparagement and confidentiality restrictions often remain in effect for years.
A breach of these restrictive covenants would typically be a “cause” event that, as discussed above, would trigger forfeiture of all vested and unvested carried interest, among other consequences. Even a former participant who had previously ceased to be involved with the manager and the fund on good terms could forfeit any retained carried interest upon subsequent violation of any such restrictive covenant. In addition, such a breach often triggers an option for the manager to repurchase any co-investment interest held by the participant.
Discounts on Management Fee and Carried Interest for Participant Co-Investments
Many managers reduce, or waive entirely, the amount of management fee and carried interest to be borne by the participants in respect of their co-investments, taking the view that it is beneficial for the fund and the manager to have greater team participation. Some larger managers will follow a hybrid approach, offering reduced/waived fees and carried interest for participants for only the funds they are involved in, or only up to a certain investment size.
Compliance With Fund Documents and LP Side Letters
Fund investors will often expect to see provisions in a fund’s governing agreement (e.g., a limited partnership agreement (LPA)) or may proactively request side letter provisions, which restrict or otherwise influence certain dynamics of a carried interest and co-investment plan, as follows:
Minimum Sponsor Commitment
A fund’s LPA typically will require that the manager and its related persons make capital commitments to the fund of at least a specified percentage of the fund’s aggregate commitments. The minimum is often in the range of 1%–5% but could be higher depending on the type of fund and the extent to which the manager is also viewed as a capital partner. A key benefit of a carried interest and co-investment plan is that participant co-investments typically would count toward this minimum sponsor commitment amount.
Clawback Guarantees
A fund’s LPA typically will provide that if the fund receives more carried interest than it should have, measured over the fund’s lifespan, the carried interest recipient(s) must return any excess (net of taxes) for distribution to the fund’s LPs. Often, the LPA will also require that the fund’s GP require each indirect recipient of carried interest to guarantee such recipient’s portion of this obligation. Accordingly, many carried interest plans will require each participant to agree to a “back-to-back” guarantee with respect to such participant’s share of the carried interest.
Change-of-Control Provisions
Some investors in the market will ask the fund’s GP to agree that one or more named persons—or categories of related persons—continue to hold the right to receive a minimum (e.g., 50% or 75%) of the carried interest, in addition to maintaining decision-making control over the GP itself. Such provisions, including whether specific carried interest plan participants would be considered part of this permitted control group, need to be accounted for when budgeting for the future allocation (or transfers) of carried interest rights under the plan.
Anchor Investor Rights
Some investors in the market, in consideration of making a large investment in the fund (e.g., 20% or more of the manager’s first fund), will request to share in a portion of the carried interest borne by all of the fund’s other investors. Similar to the change-of-control provisions described above, a manager will need to account for any such anchor investor allocation when budgeting for future allocation (or transfers) of carried interest rights under the plan.
Tax Considerations
In many jurisdictions, including Hong Kong and Singapore, the tax treatment of income derived by participants from carried interest and co-investment plans can vary based on the structure of such plans and the specific circumstances.
While income in consideration of services is taxable in Hong Kong and Singapore, capital gains are not taxable in Hong Kong or Singapore (unlike in the United States, where capital gains are taxed at a reduced rate).
Accordingly, returns derived from a Hong Kong or Singapore participant’s passive investment (i.e., co-investments funded by the participant) generally should not be taxable in Hong Kong or Singapore (as applicable), though co-investments funded by the manager rather than by the participant (via a deemed loan or free share approach) could raise unique tax issues. Similarly, carried interest often takes the form of a return on investment, the income of which could potentially be treated as capital gains.
Under a contractual approach where a participant holds a contractual right to share in the carried interest, any such distributions would likely be deemed income constituting compensation for services—rather than as return on investment—which would be taxable in Hong Kong and Singapore. An exception for Hong Kong participants is that carry returns allocated to them may be exempt from salaries tax under Hong Kong’s tax concession regime for carried interest, provided the relevant conditions are met. Singapore, however, does not have any similar tax concession regime.
In addition, the timing of granting carried interest rights to a participant (e.g., before or after (a) the fund has made investments, (b) appreciation in value of investments, and (c) distributions) can affect the tax analysis. Managers and participants should also consider the relationship between any vesting provisions and the relevant tax treatment.
The considerations described above similarly impact how carried interest is taxed in Japan, although a manager should discuss any specific Japan tax issues with its Japan tax advisor.
In any case, it is important for both managers and participants to consult with their tax advisors to ensure compliance with local regulations while maximizing the tax efficiency of their carried interest and co-investment plans, taking into account the applicable jurisdiction(s) and the specific facts and circumstances.
Regulatory Considerations
Depending on the structure of the carried interest and co-investment plan, regulations governing the licensing of fund managers and the offering of plan interests may apply in certain jurisdictions. For example, each of Hong Kong, Singapore, and Japan have licensing rules and investor suitability tests that can apply with respect to carried interest and co-investment plan participants depending on the specific circumstances. These rules would not necessarily limit a manager from inviting participants into a plan, but they should be considered on a case-by-case basis with advisors.
Conclusion
As the private funds sector in Asia continues to grow, understanding the nuances of structuring carried interest and co-investment plans is crucial for managers to implement effective team incentive programs. By navigating key terms and tax considerations effectively, managers can establish robust incentive structures to retain top talent, align participant interests with the manager’s long-term goals, and drive growth in an increasingly competitive market.
Court Holds That Contingent Remainder Beneficiary Has Standing To Sue Trustee For Breach Of Fiduciary Duty
In In re Est., the court of appeals dealt with whether a contingent beneficiary can file claims against a trustee. No. 02-23-00104-CV, 2024 Tex. App. LEXIS 1878 (Tex. App.—Fort Worth March 14, 2024, no pet.). The court held that contingent beneficiaries do have standing:
We conclude that James is within the class of persons authorized to sue the Trustees. First, we reject the assertion that a trustee can never be sued by a contingent beneficiary… Texas also allows a contingent or vested beneficiary to sue a trustee for breach of fiduciary duty. See Tex. Prop. Code Ann. §§ 111.004 (defining “beneficiary” and “interested person”), 115.011(a) (authorizing any “interested person” to bring suit relating to trust administration); Berry, 646 S.W.3d at 527-28 (applying Texas Property Code Sections 111.004, 115.001, and 115.011 in analysis of whether contingent trust beneficiary was authorized by statute to bring her breach-of-fiduciary-duty claims and concluding that she was). Even at the time that Mary Sue transferred the money, James had a contingent interest in the Trust subject only to Claude’s power of appointment. See Berry, 646 S.W.3d at 529. Second, and more importantly, in this case regardless of whether the applicable laws or the terms of the Trust would have restricted James’s ability to sue the Trustees while Claude was alive, by the time that he did sue, his interest was no longer contingent. James now unquestionably has a right to at least a share of the Trust’s assets, and he contends that Mary Sue’s improper action reduced those assets. Accordingly, James was within the class of persons authorized to bring his claims. See Ala. Code §§ 19-3B-101, 19-3B-1001-02; Tex. Prop. Code Ann. §§ 111.004, 115.011(a); Berry, 646 S.W.3d at 527.
…
In their reply brief, the Trustees argue that Section 115.011 does not authorize James to bring his suit because although that provision allows an “interested person” such as a beneficiary to bring claims under Section 115.001, a claim under Section 115.001 does not include tort claims, and thus Section 115.011 does not authorize James to sue for breach of fiduciary duty. The Trustees do not, however, discuss Berry, in which the Texas Supreme Court applied Sections 115.001 and 115.011 in its analysis of whether a contingent trust beneficiary was within the class of persons authorized to sue the trustee for breach of fiduciary duty. Berry, 646 S.W.3d at 527-30. We therefore disagree that those Property Code sections have no relevance to an analysis of who may sue a trustee for breach of fiduciary duty. Thus, even applying Texas law, we conclude that James was authorized to bring his breach-of-fiduciary-duty claims. We reject the Trustees’ challenge to James’s standing and capacity.
Id.
Direct Employer Assistance and 401(k) Plan Relief Options for Employees Affected by California Wildfires
In the past week, devastating wildfires in Los Angeles, California, have caused unprecedented destruction across the region, leading to loss of life and displacing tens of thousands. While still ongoing, the fires already have the potential to be the worst natural disaster in United States history.
Quick Hits
Employers can assist employees affected by the Los Angeles wildfires through qualified disaster relief payments under Section 139 of the Internal Revenue Code, which are tax-exempt for employees and deductible for employers.
The SECURE Act 2.0 allows employees impacted by federally declared disasters to take immediate distributions from their 401(k) plans without the usual penalties, provided their plan includes such provisions.
As impacted communities band together and donations begin to flow to families in need, many employers are eager to take steps to assist employees affected by the disaster.
As discussed below, the Internal Revenue Code provides employers with the ability to make qualified disaster relief payments to employees in need. In addition, for employers maintaining a 401(k) plan, optional 401(k) plan provisions can enable employees to obtain in-service distributions based on hardship or federally declared disaster.
Internal Revenue Code Section 139 Disaster Relief
Section 139 of the Internal Revenue Code provides for a federal income exclusion for payments received due to a “qualified disaster.” Under Section 139, an employer can provide employees with direct cash assistance to help them with costs incurred in connection with the disaster. Employees are not responsible for income tax, and payments are generally characterized as deductible business expenses for employers. Neither the employees nor the employer are responsible for federal payroll taxes associated with such payments.
“Qualified disasters” include presidentially declared disasters, including natural disasters and the coronavirus pandemic, terrorist or military events, common carrier accidents (e.g., passenger train collisions), and other events that the U.S. Secretary of the Treasury concludes are catastrophic. On January 8, 2025, President Biden approved a Major Disaster Declaration for California based on the Los Angeles wildfires.
In addition to the requirement that payments be made pursuant to a qualified disaster, payments must be for the purpose of reimbursing reasonable and necessary “personal, family, living, or funeral expenses,” costs of home repair, and to reimburse the replacement of personal items due to the disaster. Payment cannot be made to compensate employees for expenses already compensated by insurance.
Employers implementing qualified disaster relief plans should maintain a written policy explaining that payments are intended to approximate the losses actually incurred by employees. In the event of an audit, the employer should also be prepared to substantiate payments by retaining communications with employees and any expense documentation. Employers should also review their 401(k) plan documents to determine that payments are not characterized as deferral-eligible compensation and consider any state law implications surrounding cash payments to employees.
401(k) Hardship and Disaster Distributions
In addition to the Section 139 disaster relief described above, employees may be able to take an immediate distribution from their 401(k) plan under the hardship withdrawal rules and disaster relief under the SECURE 2.0 Act of 2022 (SECURE 2.0).
Hardship Distributions
If permitted under the plan, a participant may apply for and receive an in-service distribution based on an unforeseen hardship that presents an “immediate and heavy” financial need. Whether a need is immediate and heavy depends on the participant’s unique facts and circumstances. Under the hardship distribution rules, expenses and losses (including loss of income) incurred by an employee on account of a federally declared disaster declaration are considered immediate and heavy provided that the employee’s principal residence or principal place of employment was in the disaster zone.
The amount of a hardship distribution must be limited to the amount necessary to satisfy the need. If the employee has other resources available to meet the need, then there is no basis for a hardship distribution. In addition, hardship distributions are generally subject to income tax in the year of distribution and an additional 10 percent early withdrawal penalty if the participant is below age 59 and a half. The participant must submit certification regarding the hardship to the plan sponsor, which the plan sponsor is then entitled to rely upon.
Qualified Disaster Recovery Distributions
Separate from the hardship distribution rules described above, SECURE 2.0 provides special rules for in-service distributions from retirement plans and for plan loans to certain “qualified individuals” impacted by federally declared major disasters. These special in-service distributions are not subject to the same immediate and heavy need requirements and tax rules as hardship distributions and are eligible for repayment.
SECURE 2.0 allows for the following disaster relief:
Qualified Disaster Recovery Distributions. Qualified individuals may receive up to $22,000 of Disaster Recovery Distributions (QDRD) from eligible retirement plans (certain employer-sponsored retirement plans, such as section 401(k) and 403(b) plans, and IRAs). There are also special rollover and repayment rules available with respect to these distributions.
Increased Plan Loans. SECURE 2.0 provides for an increased limit on the amount a qualified individual may borrow from an eligible retirement plan. Specifically, an employer may increase the dollar limit under the plan for plan loans up to the full amount of the participant’s vested balance in their plan account, but not more than $100,000 (reduced by the amount of any outstanding plan loans). An employer can also allow up to an additional year for qualified individuals to repay their plan loans.
Under SECURE 2.0, an individual is considered a qualified individual if:
the individual’s principal residence at any time during the incident period of any qualified disaster is in the qualified disaster area with respect to that disaster; and
the individual has sustained an economic loss by reason of that qualified disaster.
A QDRD must be requested within 180 days after the date of the qualified disaster declaration (i.e., January 8, 2025, for the 2025 Los Angeles wildfires). Unlike hardship distributions, a QDRD is not subject to the 10 percent early withdrawal penalty for participants under age 59 and a half. Further, unlike hardship distributions, taxation of the QDRD can be spread over three tax years and a qualified individual may repay all or part of the amount of a QDRD within a three-year period beginning on the day after the date of the distribution.
As indicated above, like hardship distributions, QDRDs are an optional plan feature. Accordingly, in order for QDRDs to be available, the plan’s written terms must provide for them.
Employer Benefit Plan Assistance FAQs: California Wildfires
In the wake of the horrific wildfires in Los Angeles (which are ongoing as of today), employees based in the Los Angeles area may have questions about available support from employer-sponsored 401(k) plan accounts and other impacts on benefits. Below are some considerations for employers about making 401(k) plan funds available to employees and related issues during this extremely challenging time.
Can employees withdraw money from 401(k) plan accounts for wildfire-related expenses? This depends on the terms of the underlying plan, but most 401(k) plans provide some type of withdrawal right on account of hardship. By way of quick background, participants usually cannot take distributions from a 401(k) plan account until a distribution event, such as severance of employment, attainment of age 59½, or disability. However, many 401(k) plans provide exceptions to this rule whereby a participant can take an in-service withdrawal before a distribution event under the following circumstances:
Hardship distributions. Plans may allow in-service distributions to participants who experience a covered hardship that creates an immediate and heavy financial need that cannot be met from other assets reasonably available to them. Covered hardships relevant to the wildfires include expenses and losses (including loss of income) related to a major disaster if the participant lived or worked in the disaster area designated by FEMA for individual assistance, expenses for repairs to the participant’s primary residence, and purchase of a new principal residence. As there is already a federal disaster declaration in place for the wildfires, impacted participants should generally be eligible for a hardship distribution to the extent permitted by the plan. Hardship distributions are typically subject to income tax in the year of distribution and an additional 10% early withdrawal penalty if the participant is under age 59½. To qualify, the participant may self-certify to the plan administrator that they experienced a covered hardship, the distribution does not exceed the amount of need, and they do not have other assets reasonably available to meet the need.
Qualified disaster recovery distributions. SECURE 2.0 created a new in-service distribution option for losses sustained because of a federally-declared disaster—qualified disaster recovery distributions. If a participant’s principal residence is in a qualified disaster area and the participant sustains economic loss due to the disaster, the participant may request one or more in-service distributions totaling up to $22,000 (which is measured across all plans and IRAs owned by the employee). These distributions generally must be requested within 180 days after the event. Unlike hardship distributions, qualified disaster recovery distributions are not subject to the 10% early withdrawal penalty, and are included in income for tax purposes ratably over a three-year period (unless the participant elects to include the full amount in the year of distribution). More on qualified disaster recovery distributions may be found here.
Emergency personal expense withdrawals. SECURE 2.0 also created an in-service distribution option to cover unforeseeable or immediate financial needs relating to necessary personal or family emergency expenses. These distributions are limited to the lesser of $1,000 or the participant’s vested balance minus $1,000 and may only be taken once per calendar year. These distributions are exempt from the 10% early withdrawal penalty but are generally subject to income tax in the year of distribution. The IRS issued FAQs on emergency personal expenses, which can be found here.
Plan loans. Plans may allow a participant to take a loan from their 401(k) plan account, up to the lesser of 50% of their vested balance or $50,000; this limit is reduced for any outstanding loans. Under SECURE 2.0 disaster relief, participants residing in a qualified disaster area may increase the loan limit up to the lesser of 100% of their vested balance or $100,000 (again, reduced for any outstanding loans).
Can an employee pay back amounts withdrawn for wildfire expenses to her 401(k) plan account? Possibly—that will depend on the nature of the withdrawal. Hardship withdrawals cannot be repaid, subject to a limited exception for withdrawals taken to construct a new primary residence that could not be used because of a qualified disaster. However, if a participant took a qualified disaster recovery distribution, emergency personal expense distribution, or plan loan, those amounts are generally eligible for repayment as summarized below:
Qualified disaster recovery distributions and emergency personal expense distributions may be recontributed to an eligible retirement plan (including the employer’s 401(k) plan) within three years after the distribution date. If the participant takes an emergency personal expense distribution, the participant is not eligible to take another emergency personal expense distribution during the three-year repayment period until they have recontributed the full amount of the prior distribution to the plan.
Plan loans are generally repaid through payroll deduction over a period not to exceed five years (the repayment period may be extended if the loan was for the purchase of a principal residence). If a plan loan is not repaid within the repayment period, the outstanding balance is a deemed distribution and subject to income tax. Under changes made by SECURE 2.0, to the extent permitted by the underlying plan, participants residing in a qualified disaster area with an outstanding loan due during the period from the first day of the incident period (i.e., the period when the disaster occurred) up to 180 days after the incident period may delay repayment on any outstanding loan for up to one year.
Would an employer or plan sponsor need to amend its 401(k) plan to permit the relief described above? Potentially. Many 401(k) plans already permit hardship withdrawals, qualified disaster recovery distributions and plan loans. For those plans, a plan amendment is not necessary. If a 401(k) plan does not currently permit in-service withdrawals under the circumstances noted above and an employer desires to add them in response to the L.A. wildfires, the sponsor should coordinate with its recordkeeper to confirm those options can be implemented for the plan, with the understanding that any required plan amendment would be adopted by the applicable deadline.
Plans adopting the SECURE 2.0 disaster relief noted above must be amended for such purposes by December 31, 2026 (December 31, 2028 for collectively bargained plans). However, if a plan makes a discretionary change unrelated to SECURE 2.0 (e.g., implementing in-service hardship withdrawals for the first time), that amendment would be due by the end of the plan year.
We don’t have regular access to our workplace because of the wildfires. Is there any relief for an employer or plan sponsor that misses required benefit deadlines—for example, sending out COBRA election notices or other required notices? At this admittedly early moment in time, the government agencies have not announced any specific tolling relief that would apply to benefit administration. In the past, as covered in our blog post here, the agencies have offered limited relief for plan sponsors and fiduciaries who fail to timely provide a notice or other document that must be furnished to plan participants during a set relief period, provided that the fiduciary acts in good faith and does so as soon as administratively practicable under the circumstances. That agency guidance also typically extends benefit plan deadlines for individuals affected by natural disasters. While our expectation is that the agencies would issue something similar in response to the L.A. wildfires, that is not guaranteed and it is unclear at this point whether such relief will be issued.
Final thoughts on employee relief? Given the wide range of in-service distributions theoretically available to participants, most 401(k) plans are positioned to make relief available to eligible participants. For 401(k) plans that currently permit hardship distributions, other in-service distributions or plan loans, the next step may be publicizing the relief already available to impacted participants. Plan sponsors who have not adopted these features—or who are looking to expand or modify distributions options in response to the L.A. wildfires—should coordinate with their recordkeepers regarding the implementation steps and timeline.
Delaware Bankruptcy Court Denies Healthcare Debtors’ Request to Enter into Nonbinding Commitment Letter (US)
The goal of a sale process under section 363 of the United States Bankruptcy Code is for a debtor to maximize the value of estate property for the benefit of all parties-in-interest. But what happens when the only party that is interested in purchasing the estate property is a former insider who is unwilling to submit a binding offer without certain bid protections, such as a breakup fee and expense reimbursement? This is the predicament that the Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”) recently faced, ultimately denying such protections without prejudice. The decision serves as a helpful reminder of how debtors should conduct a bidding process, evaluate bids, and what terms interested parties should expect a bankruptcy court to find improper.
Background
Between September 19, 2023, and October 20, 2023, UpHealth Holdings, Inc. and six of its affiliates (collectively, “UpHealth”) filed chapter 11 bankruptcy petitions in the Bankruptcy Court. On July 17, 2024, UpHealth filed a bidding procedures motion to market, auction, and sell its equity interests in a non-debtor subsidiary, TTC Healthcare, Inc. (“TTC”), which provides behavioral inpatient and outpatient treatment programs and was previously referred to as UpHealth’s “crown jewel.” However, UpHealth had no stalking horse bidder for TTC, so it enlisted the help of its investment banker to market TTC’s equity. The Bankruptcy Court approved the bidding procedures motion on August 6, 2024.
NewCo’s Commitment Letter
Unfortunately, despite contacting over 150 prospective buyers and executing 50 non-disclosure agreements, UpHealth only reported one meaningful indication of interest (the “Commitment Letter”) before the September 12, 2024, bid deadline. The Commitment Letter was from a newly organized special purpose acquisition entity (“NewCo”) formed by UpHealth’s former CEO and TTC’s former chairman, Martin S.A. Beck, and Freedom 3 Capital. NewCo proposed to purchase TTC’s equity for a cash purchase price of $11 million.
Unlike a traditional qualified bid to purchase a debtor’s marketed assets under section 363 of the Bankruptcy Code, NewCo’s Commitment Letter was not a binding commitment. Instead, the Commitment Letter stated that NewCo’s “goal is to execute a definitive share purchase agreement,” and contained the following terms:
Exclusivity Period: For up to four weeks after execution of the Commitment Letter, UpHealth and TTC shall not solicit, discuss, negotiate, facilitate any submission of a proposal, or consummate any agreement related to TTC’s equity with any other party other than with NewCo.
Right of First Refusal “ROFR”: NewCo has the right of first refusal related to any competing bid UpHealth receives for TTC’s equity during the Exclusivity Period.
Prior Approval: Before executing any definitive share purchase agreement, Freedom 3 Capital must first obtain final approval from its Investment Committee.
Breakup Fee: $750,000.
Expense Reimbursement: $500,000 cap.
On September 22, 2024, UpHealth filed a supplement to its bidding procedures motion requesting that the Bankruptcy Court authorize UpHealth to enter into, and perform under, the Commitment Letter and for the Commitment Letter to be binding on UpHealth (the “Private Sale Supplement”).
U.S. Trustee’s Objection to Private Sale Supplement
On October 7, 2024, the United States Trustee (the “U.S. Trustee”) objected to the Private Sale Supplement. In its objection, the U.S. Trustee argued that the breakup fee and expense reimbursement are (i) a “poison pill” meant to “chill the bidding process,” (ii) “value-destructive to the estates,” and (iii) “serve as a penalty against [UpHealth] for evaluating any other late materializing interest.” Moreover, the objection cited Third Circuit caselaw in support of the position that breakup fees are only allowable when such fees are “necessary to preserve the value of the estate” and an inducement for a party to negotiate an agreement, conduct due diligence, and submit a bid. In this case, the U.S. Trustee asserted that no such inducement was necessary because (i) the marketing process for TTC’s equity concluded with “no other actionable proposals identified” by UpHealth, and (ii) as TTC’s former chairman and UpHealth’s former CEO, Mr. Beck, “did not need to undertake any due diligence to make a bid, did not need an incentive to make a bid, and does not need expense reimbursement.”
Denial of Private Sale Supplement
At the October 9, 2024 hearing, the Bankruptcy Court denied UpHealth’s proposed Private Sale Supplement. Siding with the U.S. Trustee, the Bankruptcy Court found the breakup fee, expense reimbursement, Exclusivity Period, and ROFR “too rich” for an “uncommitted” indication of interest subject to further diligence.
Specifically, the Bankruptcy Court stated that it had not seen a “no shop” provision, i.e., the Exclusivity Period and ROFR, since the 1980s and did not understand why such provision was necessary. Moreover, the Bankruptcy Court noted that Mr. Beck’s Commitment Letter was “problematic” from a “bankruptcy court systemic perspective,” given Mr. Beck’s status as a former insider. Accordingly, the Bankruptcy Court concluded that UpHealth had not demonstrated that the Commitment Letter’s bid protections were necessary to preserve the value of the estates, declined to approve such protections, and noted that the parties could come back to seek approval of the bid protections after NewCo signs a definitive agreement or there is an alternative transaction.
On November 29, 2024, NewCo notified UpHealth that it was discontinuing its efforts to purchase TTC and no sale of TTC or any portion thereof was consummated, resulting in TTC’s operations being shut down.
Takeaways
This decision demonstrates the limitations of nonbinding bids to purchase estate property. Receiving no offers for assets that were formerly referenced as an estate’s “crown jewel” is disappointing to say the least. Although it is unclear why NewCo’s bid was not binding, it is possible that after a dismal marketing process, Mr. Beck, as TTC’s former chairman, agreed to publicly disclose an indication of interest in the hope of encouraging at least some of the 50 parties that executed non-disclosure agreements to reconsider whether to submit a bid. Not only would a binding bid liquidate one of UpHealth’s remaining assets, but it would also likely produce a public benefit by keeping a treatment facility open for its patients who may not have access to alternative healthcare services. Indeed, the continuation of TCC as a going concern is likely far superior to the alternative—liquidation and reduced healthcare services to the impacted community. As a court of equity, this is likely one factor the Bankruptcy Court considered before denying UpHealth’s requested relief.
Regardless of the parties’ intent, and notwithstanding potential public health benefits, future debtors can take heed that a court will not likely approve the entry of an order allowing a debtor to enter into a nonbinding commitment letter that (i) is contingent on further diligence and third-party approval, (ii) is from a former insider that does not need to conduct diligence, (iii) stems from a bidding process where no party submitted a bid for the assets, and (iv) when the case is over one year old, there is no conceivable need to rush the process, and the parties-in-interest can afford to grant a prospective bidder more time.
Moreover, even if the Commitment Letter had been binding, the Bankruptcy Court took issue with NewCo’s requested bid protections, the Exclusivity Period, and ROFR. First, when requesting bid protections, especially if the bidder is a former insider, the bidder should ensure that the breakup fee and expense reimbursements are arguably “necessary to preserve the value of the estate” and a percentage of the purchase price that aligns with recent comparable sales. Potential bidders and debtors should question whether the protections are necessary on account of the interested party’s diligence and negotiation expenses, or if the party will incur minimal expenses. Furthermore, bidders should be thoughtful before incorporating an Exclusivity Period or ROFR, as such provisions may be scrutinized by a court, especially in the context of a non‑binding bid.
Solo Aging: Planning for Your Best Life
More and more of the clients I see lately are solo agers. A recent study found that 34 percent of older adults do not have a spouse, significant other or children who can provide their care. Although historically children and close relatives were the primary support for aging adults, there are many ways to fill that gap. Whether through informal networks of friends and “found” families, or through the guidance of professionals like our firm, it is important to plan.
When you live alone, you need to plan for aging differently than someone who is married or has a life-partner. In most instances, those with a partner can rely on them to help out with expenses and be a caregiver, if they should become ill. However, when you are single, especially if you do not have close family, you need to plan in advance and you need to plan better.
Most important of all: make sure that decisions about your health and well-being are made the way you want them to be made, if there comes a time you are not able to make them for yourself. That means picking a person you trust and giving them everything they need to act on your behalf. Your surrogate needs to know about your finances, your health information, your values and goals, so they can step into your shoes.
New Jersey law provides several tools to allow individuals to plan for their future and legacy wishes. In addition to a Will, POA, and health proxy, revocable trusts and health care instruction directives can be very useful for directing your surrogate as to how and where you want to be cared for if you need long term care. Solo agers will be best served if they think beyond basic formulaic legal documents. Because New Jersey does not have required statutory forms, estate planning documents can build in protections against financial exploitation such as trust protectors or advisors, POA monitors or tie-breakers, or trusted contacts. A POLST (Practitioner Order on Life Sustaining Treatment) is another great tool in New Jersey to ensure your treatment wishes are followed. Because it is a medical order, it is more likely to be honored than a Living Will. New Jersey also allows individuals to name a Funeral Representative in their Wills which can be essential for those who want to designate someone other than their next of kin to handle their arrangements.
Getting estate planning documents completed is important but it is not the only thing to consider. You need a care plan which addresses emergencies as well as a financial plan. You may want to consider long term care insurance. Someone turning 65 has a nearly 70% chance of needing long-term care in their remaining years. Solo agers are more likely to need to rely on paid professional caregivers. It’s important to consider your options for care before you need it. You also should discuss these issues with your friends or family who you have nominated to make decisions for you, so they know your wishes. No one likes to think about these issues, but studies show that individuals who have not created a care plan and designated a surrogate often end up receiving care they did not want and are more likely to end up in an institutional setting.
There are a growing array of resources and options available to individuals who are ready to put together an aging life care plan and a team to support them along the way. Being proactive will give you the peace of mind to know you do not have to face aging and illness alone.
What Private Equity Investors and Real Estate Investment Trusts Need to Know About the Newly Enacted Massachusetts Health Oversight Law
On December 30, 2024, the Massachusetts state legislature passed House Bill 4653 (the Act), which significantly enhances regulatory oversight in the Massachusetts health care market. As signed into law by Governor Maura Healy on January 8, the Act will have profound effects for private equity (PE) investors and real estate investment trusts (REITs) engaging with the Massachusetts health care market. Passage of the Act comes on the heels of prominent PE-backed hospital failures in Massachusetts.
The Act Expands Existing Law and Government Infrastructure to Address Issues in Health Care Quality and Affordability
The Act overhauls the functions of, and increases coordination among, certain state agencies, including the Health Policy Commission (HPC), Department of Public Health (DPH), and the Center for Health Information and Analysis (CHIA). In addition, the Act expands the investigatory and enforcement powers of the Massachusetts Attorney General (MA AG) as it relates to health care activities, with particular attention to private equity investors, REITs, and management services organizations (MSOs). The Act does the following:
Increases HPC Oversight for PE Investors, REITs, and MSOs
The HPC is a Massachusetts government agency charged with monitoring health care cost trends and reviewing certain “material changes” to health care providers (e.g., proposed changes in ownership, sponsorship, or operations by health care providers). The Act broadens the scope of the HPC cost trend hearings to encompass a review of pharmaceutical manufacturers, pharmacy benefit managers (PBMs), PE investors, REITs, and MSOs. Additionally, Registered Provider Organizations (RPO) now must disclose ownership information about PE investors, REITs, and MSOs to HPC.
The bill amends the HPC Material Change Notification (MCN) process and now stipulates that the following activities are material changes for providers and provider organizations, in addition to certain mergers, affiliations, and acquisitions:
Significant expansions in capacity.
Transactions involving a significant equity investor which result in a change of ownership or control.
Significant transfers of assets, including, but not limited to, real estate sale leaseback arrangements.
Conversion from a non-profit to a for-profit organization.
In addition to expanding the scope of the MCN process, the Act allows the HPC to make and refer to the MA AG a report on certain proposed material change transactions, which creates a rebuttable presumption that the provider or provider organization has engaged in unfair or deceptive trade practices. Upon receipt of such a report, the MA AG is permitted to seek legal redress, including injunctive relief, and the proposed material change cannot be completed while that legal action remains pending.
Expands CHIA Oversight of PE Investors, REITs, and MSOs
CHIA is an existing Massachusetts government agency that is generally charged with improving transparency and equity in the health care delivery system. Significant among CHIA’s responsibilities is the collection, evaluation, and reporting of financial information from certain health care organizations. The Act expands CHIA’s oversight in the following ways:
As with the HPC, expands RPO reporting requirements to include PE investors, REITs, MSOs, and certain other entities.
Increases financial penalties for failure to make timely reports to CHIA.
Expands hospital financial information reporting and monitoring requirements as to relationships with significant equity investors, REITs, and MSOs.
Requires CHIA to notify HPC and DPH of failures to comply with reporting requirement which, in turn, will be considered by HPC and DPH in their review and oversight activities.
Increases DPH Oversight and Authority to Include Hospitals with PE Investor or REIT Relationships
The Act expands DPH health facility licensure and Determination of Need (DON) oversight and authority in a variety of ways:
Charges DPH with establishing licensure and practice standards for office-based surgical centers and urgent care centers.
Directs that the Board of Registration in Medicine be under the oversight of DPH in certain ways.
Amends the DON review process for projects, which will be guided by considerations that include the state health plan, the state’s cost-containment goals, impacts on patients and the community, and comments and relevant data from CHIA, HPC, and other state agencies. DPH may impose reasonable conditions on the DON as necessary to achieve specified objectives, including measures to address health care disparities to better align with community needs. The DPH may also consider special circumstances related to workforce, research, capacity, and cost. These special needs and circumstances may pertain to a lack of supply for a region, population, or service line as identified in the state health plan or focused assessments.
Prohibits DPH from granting or renewing a license for an acute care hospital if its main campus is leased from a REIT. However, any acute care hospital leasing its main campus from a REIT as of April 1, 2024, is exempt from this prohibition.
Prohibits DPH from granting or renewing a hospital license unless all documents related to any lease, master lease, sublease, license, or any other agreement for the use, occupancy, or utilization of the premises are disclosed to DPH.
Prohibits DPH from granting or renewing any hospital license unless the applicant is in compliance with all CHIA reporting requirements.
Permits DPH to seek an HPC analysis on the impact of a proposed hospital closure or discontinuation of services.
Expanded MA AG Authority Over PE Investors, REITs, and MSOs
In addition to the MA AG authority noted above in seeking to enjoin transactions that create concern for the HPC, the Act expands the MA AG’s investigatory powers pertaining to false claims to encompass document production, answering interrogatories, and providing testimony under oath by provider organizations, significant equity investors, health care REITs, and MSOs. Similarly, and significantly, the MA AG’s authority to seek civil monetary penalties for health care false claims act violations is expanded to include those parties that have an ownership or investment interest in a violating party.
Key Takeaways
The Massachusetts legislature aims to improve the quality and affordability of health care in the Commonwealth by increasing transparency of private investment in the health care market. The Act overhauls and increases coordination among state agencies like the HPC, DPH, and CHIA, and expands the investigatory and enforcement powers of the MA AG. For-profit investors and REITs must be aware of the following provisions of the Act to avoid civil penalties and state-sanctioned injunctions, and in planning for transactions and investments in Massachusetts:
Increased HPC Oversight: The HPC’s annual cost trend includes reviews of pharmaceutical manufacturers, PBMs, PE investors, REITs, and MSOs. New MCNs (significant expansions, equity investor transactions, asset transfers, and organizational conversions) must be reported to HPC in a timely manner.
Increased CHIA Oversight: CHIA’s scope of oversight for RPOs includes PE firms, REITs, and MSOs. The Act increases financial penalties for providers’ noncompliance and enhances hospital financial reporting. CHIA must inform HPC and DPH of providers’ reporting failures, which will influence HPC and DPH oversight activities.
Increased DPH Authority: DPH’s oversight now includes development and implementation of licensure standards for surgical and urgent care centers. DPH may not issue or renew licenses for acute care hospitals leasing their main campus from an REIT, subject to the April 1 exemption, or to a party not in compliance with CHIA reporting requirements. DPH also has increased authority to require information regarding leasing and other operational contracts prior to issuing a hospital license.
Increased MA AG Authority: The MA AG’s powers are expanded to include investigatory and enforcement actions against false claims involving PE investors, REITs, and MSOs.
Listen to this article