IRS Issues Transitional Guidance Regarding Divestiture Rights and A Model Notice

December 2006

by RENAY W. WASHINGTON
and BENJAMIN F. SPATER

On November 30, 2006, the Internal Revenue Service (the "IRS") issued Notice 2006–107 in response to the divestiture requirements of the Pension Protection Act of 2006 ("PPA"). Section 401(a)(35) of the Internal Revenue Code and the parallel provision in Section 204(j) of ERISA were added by Section 901 of the PPA, to provide divestiture rights for participants in defined contribution plans holding publicly traded employer securities. Section 507 of the PPA amends Section 101(m) of ERISA to require employers to distribute a notice to plan participants, beneficiaries and alternate payees describing their divestiture rights, and explaining the importance of diversifying investments in their retirement plans. Notice 2006–107 provides transitional guidance and clarification with respect to the divestiture rights and the notice requirements, and includes a model notice. The divestiture rights and notice requirements mandated by the PPA are generally effective for plan years beginning on or after January 1, 2007. There are special effective dates for plans maintained pursuant to a collective bargaining agreement.

Divestiture Rights

Under the PPA, any participant, alternate payee or beneficiary (an "Applicable Individual") who has an account in a defined contribution or individual account plan that permits participants to invest in "publicly traded employer securities" has certain rights to divest such employer securities and to reinvest an equivalent amount in other investment options. "Publicly traded employer securities" are securities of the employer, or any member of a controlled group of corporations which includes the employer, that are readily tradable on an established securities market. These divestiture rights do not apply to a diversified pooled investment vehicle (e.g. mutual fund), employer securities not allocated to the participant’s or beneficiary’s account, one-participant or partner plans, or an employee stock ownership plan (ESOP) that does not permit elective deferrals or matching contributions.

Divestiture of Employee Contributions

An Applicable Individual must be permitted to immediately divest the portion of their account attributable to elective deferrals or rollover contributions that is invested in employer securities.

Divestiture of Employer Contributions

An Applicable Individual with at least three years of service also has immediate divestiture rights with respect to employer contributions that are invested in employer securities. A participant completes three years of service after the end of his or her third vesting computation period. If the plan credits vesting service using the elapsed time method, a participant completes three years of service on the third anniversary of his or her date of hire.

Investment Options

The plan must offer at least three other diversified investment options with materially different risks and return characteristics. Investment options that satisfy the requirements of Section 404(c) of ERISA (and the regulations thereunder) are treated as satisfying this investment option requirement.

Permitted Restrictions

In general, a plan may not impose restrictions or conditions with respect to the investment of securities that are not imposed on the investment of other assets of the plan (the "Reciprocal Restriction Rule"). However, a plan may impose the following restrictions on divestiture rights:

• The time for making investment choices may be limited, but only to the extent that the plan imposes the same limits on other investment choices;

• Limits may be placed on the amount of a participant’s account balance that can be invested in employer securities;

• An employer’s securities investment fund may be closed to new investments;

• Restrictions to ensure compliance with securities laws may be imposed; and

• Divestiture rights under the plan may be restricted for up to 90 days following an initial public offering of the employer’s stock.

Transitional Relief

Employer Contributions Acquired before January 1, 2007Employers can apply a three-year phase-in transition rule under Section 401(a)(35)(H) of the Code to employer contributions invested in employer securities acquired prior to January 1, 2007. The three-year phase-in rule permits an employer to limit an Applicable Individual’s divestiture rights over a three year period, starting with the first plan year beginning on or after January 1, 2007, to a certain percentage of the previously acquired employer securities in their account attributable to employer contributions. The applicable percentages are:

• 33% for the first plan year;

• 66% for the second plan year; and

• 100% for all subsequent plan years.

Employers can not apply this three-year phase-in rule to participants who have attained age 55 and have completed at least three years of service before the first plan year beginning after December 31, 2005.

Continuation of Existing Restriction or Conditions

Under the transition rules of Notice 2006-107, any existing restrictions and conditions with respect to divestiture rights in effect on December 18, 2006, may be maintained through March 30, 2007.

Grandfathered Investments

Notice 2006–107 also provides the following transition rules for grandfathered investments:

• For purposes of the Reciprocal Restriction Rule, a plan may ignore the lack of restrictions on a stable value fund existing on December 18, 2006, until December 31, 2007; and

• Until December 31, 2007, a plan will not violate the Reciprocal Restriction Rule if the plan, as in effect on December 18, 2006, allows Applicable Individuals the right to divest employer securities on a periodic basis but permits divestiture of another investment on a more frequent basis, provided that the other investment is not a generally available investment (e.g., the other investment is only available to a fixed class of participants).

Notice Requirements

Under Section 101(m) of ERISA, plan administrators subject to Section 204(j) of ERISA must provide a notice to the affected participants, alternate payees, and beneficiaries no later than 30 days before the date on which the individuals are eligible to exercise their rights. The notice must describe the divestiture rights and explain the importance of diversifying investment of retirement account assets. The Notice is required to be written in a manner calculated to be understood by the average plan participant and may be delivered in written, electronic or appropriate form that is reasonably accessible to participants. The failure to distribute the divestiture notice can result in a civil penalty of $100 per day, per participant.

Transitional Rule

Notice 2006–107 clarifies generally that plans with plan years beginning on or after January 1, 2007, but before February 1, 2007, are required to distribute the notice by January 1, 2007. Plans utilizing the transition rule for continuation of existing restrictions or conditions, as described above, must provide the notice no later than 30 days prior to the first date on which the participants are eligible to divest, or no later than March 1, 2007.

Model Notice

In addition to clarifying the notice requirements, Notice 2006–107 includes the model notice issued by the IRS. The model notice may need to be adapted to reflect particular plan provisions, including any transition rules that are being applied.

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