Court Rules Severance Agreement is a Top Hat Plan

As you may be aware, ERISA imposes strict requirements on employee benefit plans in four areas: (1) funding, (2) participation, (3) vesting, and (4) fiduciary duties. Top hat plans, however, are exempt from these requirements. A top hat plan is a plan that is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees. The top hat exception to ERISA grants employers flexibility to develop executive compensation programs for key employees and executives. Recently, the Ninth Circuit considered the scope of the terms "deferred compensation" and "select group of management or highly compensated employees." Duggan v. Hobbs, 99 F. 3d 307, 311 (9th Cir. 1996).

In Duggan, the plaintiff did not challenge his status as a highly compensated employee, rather he argued that he was not part of a select group because he "was unable to influence the design and operation of the plan." The Court rejected Duggan's contention and concluded that the "select group" definition has two parts. First the employee must be one of a very small percentage of employees to receive the benefit. Duggan was the only one of 23 employees of the company who secured a severance agreement. Duggan represented less than five percent of the company's employees. The Court suggested that five percent is an appropriate figure to determine a select group and therefore, it concluded that Duggan qualified as a "select group" numerically.

Second, the Court looked to the purpose of the top-hat exception to ERISA ("purpose test"). Employees who "by virtue of their position or compensation level, have the ability to affect or substantially influence, through negotiation or otherwise, the design and operation of their deferred compensation plan," do not need, the Court concluded the protections of ERISA. Based upon this two part analysis the Court concluded that Duggan (1) met the numerical test and (2) through his negotiations with the Company to effectuate his benefit met the purpose test.

Regarding deferred compensation, the Court stated that compensation under a severance pay agreement is deferred compensation within the meaning of ERISA, and under certain circumstances will be considered a top hat plan. The Court concluded that because the payments were received "substantially" after the performance of the services for which the employee was being compensated, the severance program qualified as deferred compensation. This is the same standard used by the Internal Revenue Service ("IRS") in applying the deductibility rules for deferred compensation.

Employers in structuring top hat plans, must insure that such arrangements benefit only a true select group of highly compensated employees taking into account both the purpose test and the numerical test discussed above.