ERISA Creditor Protection Extended To Flawed Or Abused Retirement Plans In Gilbert

Most employee retirement plans are governed by the Employee Retirement Income Security Act (“ERISA”), which provides the legal construct and restrictions by which such plans are to be created and administered. Compliant ERISA plans are also awarded with favorable tax treatment under the Internal Revenue Code.

Importantly, at least for us here, ERISA plans are typically protected from creditors by the so-called “anti-alienation” protection found at 29 U.S.C. § 1056(d)(1), which provides simply: “Each pension plan shall provide that benefits provided under the plan may not be assigned or alienated.” If a debtor lands in bankruptcy, this anti-alienation protection has been interpreted to keep the debtor’s ERISA assets out of the bankruptcy estate in most circumstances.

But let’s say that the ERISA plan is flawed for some reason. Will the ERISA anti-alienation protection still keep the debtor’s ERISA plan assets out of the bankruptcy estate, or will they come under control of the bankruptcy trustee? The answer to this question was given to us by the U.S. Third Circuit Court of Appeals in McDonnell v. Gilbert (In re Gilbert), 2024 WL 4560542 (3rd Cir., Oct. 24, 2024).

In 2021, Eric Gilbert filed for Chapter 7 bankruptcy. In Gilbert’s schedules, he disclosed that he had interests in certain retirement plans. However, the bankruptcy trustee (McDonnell) took the time to closely examine how Gilbert’s retirement plans were operated, and significant errors were found. Among other things, the bankruptcy trustee claimed that Gilbert was using his 401(k) Plan as, essentially, just another personal bank account heeding the tax consequences from that activity.

The bankruptcy trustee thus filed a complaint against Gilbert alleging that, because of these flaws, Gilbert’s plans were no longer protected by ERISA and thus the plan asset should be a part of the bankruptcy estate. The U.S. Bankruptcy Court disagreed with the trustee, however, holding that Gilbert’s plans were protected by the anti-alienation provision even if those plans failed to comply with ERISA or the Internal Revenue Code. The bankruptcy trustee thus dismissed the trustee’s complaint with prejudice. The trustee then filed an appeal to the U.S. District Court, which agreed with the bankruptcy court. Finally, the trustee appealed to the Third Circuit, which issued the opinion that we shall next discuss.

Bankruptcy Code 541 essentially states that when a petition in bankruptcy is commenced, all the debtor’s assets become a part of the bankruptcy estate unless they are exempt from creditor collection by “applicable nonbankruptcy law”. This latter phrase typically is used in reference to statutory exemptions of the state of the debtor’s residence, such as the homestead exemption or an exemption for so many head of cattle, but it can also refer to federal law as well ― such as ERISA.

We now come to the salient issue: Will a retirement plan’s violation of ERISA requirements mean that the anti-alienation protection will dissolve? The Third Circuit held that such was not the case. Although a retirement plan which violated the ERISA rules might suffer other consequences, it was still a plan that fell within the ambit of ERISA and thus the anti-alienation protection held its vitality. Thus:

“It cannot be the case that a retirement plan normally governed by ERISA escapes it by brazenly violating its rules …. If extensive violations of a federal law made that law go away, the rules would be chimerical. So we agree with the decisions that conclude plans governed by ERISA are excluded from the bankruptcy estate under § 541(c)(2) because of the statute’s anti-alienation command.” [Internal quotations and citations omitted].

The trustee’s next argument was that because Gilbert’s violations of ERISA caused his plans to lose their tax-qualified status, they must also lose the anti-alienation protection. But the Third Circuit disagreed with this as well, noting that ERISA did not require a retirement plan to be tax-qualified and that if a retirement plan ceased to qualify as a tax-qualified plan it still would be governed by ERISA and, thus, the anti-alienation protection. The opinion then goes on to state:

“This result follows our rules of statutory interpretation. While § 541(c)(2) does not condition exclusion on tax qualification, the Bankruptcy Code allows the debtor to exempt certain retirement benefits if they are qualified under the IRC. [] This shows that Congress knew how to draft the kind of statutory language that the trustee seeks to read into § 541(c)(2) and simply decided not to do so. [] We must implement Congress’s choices as reflected by the language it used in the Bankruptcy Code, not remake them.” [Internal quotations and citations omitted].

The bottom line was that neither a retirement plan’s violation of ERISA requirements nor a violation of the Internal Revenue Code would disable the anti-alienation provision such that Gilbert’s retirement plans would become property of his bankruptcy estate. The decision to dismiss the bankruptcy trustee’s complaint seeking to include Gilbert’s retirement plan assets into his bankruptcy state was thus affirmed.

ANALYSIS

This decision speaks for itself as to whether the assets of a flawed ERISA retirement plan come into the debtor’s bankruptcy estate. There are limitations to this ruling, however, primarily being that it only applies to the bankruptcy courts and only those within the Third Circuit. We’ll have to wait and see whether other U.S. circuits follow this ruling.

The more interesting question is whether this ruling will gain traction outside of the bankruptcy context. As a federal law, ERISA pre-empts contrary state law. This ruling thus has the potential to upend contrary state law.

State law exemptions for retirement plans largely parallel the ERISA protection, but with an important difference: The ERISA protection is, as discussed, an anti-alienation protection which prevents the plan assets from being assigned, voluntarily or involuntarily. This means that the beneficiary of a retirement plan cannot voluntarily pledge her plan assets as collateral for something (such as to purchase a home or car), nor can a creditor involuntarily force an assignment of those assets to satisfy a judgment.

By contrast, a state law exemption for retirement plans is just that: An exemption. This means that the state legislatures have created a statutory carve-out for retirement plans such that their assets cannot be reached by a beneficiary’s creditors.

A key difference between the ERISA anti-alienation protection and the state law exemptions is that ERISA applies to certain retirement plans that are defined in the statute, whereas the state law exemptions are usually determined by whether they are tax-qualified. Thus, if a retirement plan fails under the Internal Revenue Code to be tax-qualified, the state exemption is usually lost.

This ruling has the potential to override the state exemptions for retirement plans since it would not matter if the retirement plan is tax-qualified or not so long as it qualifies as an ERISA retirement plan. Simply put, this ruling could amount to a new arrow in the quiver of debtors to avoid collection by a creditor against a flawed or misused retirement plan.

So it will be interesting to see how this plays out.