Warding off COBRA surprises in dealership buy-sells

NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because changes in the law from the date shown at the end of the article. This article is not up to date with regard to developments in COBRA law since it was written. The IRS regulations referred to in the article were enacted and they clarified the issue of successor liability (click here for an article discussing COBRA successory liability), and there have been many other COBRA changes. California also now has CAL-COBRA which can extend the period of COBRA coverage and which changed the minimum number of employees in a business to which it applies. See http://www.healthhelp.ca.gov/library/reports/news/ccfaq.pdf for a summary of CAL-COBRA. The article continues to be helpful, however, in analyzing COBRA issues in buy/sell agreements. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided.

When dealership buy-sell attorneys negotiate warranties and indemnifications, COBRA should be on the agenda. Although COBRA has been with us for approximately 10 years, its operation is still quite mysterious to most employers, especially when buying or selling a business. COBRA is fertile ground for possible claims against both buyers and sellers. It is easy to make a mistake in administering COBRA because of its many technical rules regarding giving the right notifications to the right people in the right way. If COBRA is not administered correctly by the employer, serious claims may be brought against the employer resulting in liability for large medical expenses of an employee or an employee’s dependents. The employer may or may not have insurance coverage for COBRA errors.

COBRA gets its name from the first letter of each word of the Consolidated Omnibus Budget Reconciliation Act of 1985 which enacted the COBRA law. It applies to employers who provide health coverage to their employees and who have employed 20 or more employees on 50% of the business days in the preceding year. COBRA amended the Employee Income Retirement Act of 1974 (ERISA) and also the Internal Revenue Code and the, Public Health Services Act to include provisions protecting employees and dependents when they lose coverage under a group health plan.

Employers subject to COBRA are generally required to allow certain persons, called “qualified beneficiaries,” to continue their medical plan coverage even in the wake of events that would otherwise terminate coverage. These events, known as qualifying events, include termination of employment or a reduction in hours of employment (including a leave of absence). Dependents also become qualified beneficiaries under certain qualified events, such as the death of an employee or a divorce.

Employers must give qualified beneficiaries specified COBRA notices which offer them the right to elect continued group medical plan coverage for a charge not to exceed the group rate plus a small percentage. The length of time one is allowed to continue coverage under COBRA usually runs for up to 18 months, but can run as long as 29 months under a Social Security disability.

Among other events, two important circumstances generally cancel the right to COBRA coverage. The first is where the employee becomes covered under another group medical plan (“new plan”). The second is where the employer stops maintaining any group medical plan at all (“no plan”)

In buy-sells where ownership of the dealer corporation changes hands (a stock buy-sell), the COBRA liabilities of the corporate entity remain the same both pre- and post- closing. Generally, the buyer will require the stock seller to indemnify the corporation or otherwise make allowances for all pre-closing COBRA violations. However, any employees let go at closing in a stock buy-sell would be entitled to COBRA.

In asset buy-sells, however, the seller generally terminates all employees at the time the buy-sell closes. COBRA’s new plan exception would apply to those employees, if any, who are hired by the buyer and covered by the buyer’s group medical plan. But buyers generally reserve the right not to hire any of the seller’s employees. For the seller’s employees not hired and covered by a new plan, would the “no plan” exception nevertheless relieve the seller from providing COBRA notices and benefits to the employees terminated at closing? Of course it would not if the seller maintained a medical plan after closing.

But in most cases, the seller will terminate its plan at or immediately prior to closing. When an employer maintains no group medical plan, COBRA rights cease, not only as to employees terminated at that time, but also as to all ex-employees and other qualified beneficiaries already on COBRA at the time of the plan termination. Although the law seems to make plan termination a clear way out of COBRA for the seller, arguments to the contrary based on notions of “successor plans” should be expected from savvy benefits lawyers.

Based on verbiage in IRS regulations that were proposed, but never officially adopted, the argument to give the terminating seller’s employees COBRA rights, regardless of the no plan exception, is that when the buyer buys the business and starts up his own group medical plan, that plan is a successor to the terminated plan of the seller. Question 38 of the proposed regulations states that the period of COBRA coverage expires on “the date upon which the employer ceases to maintain any group plan (including successor plans).” If the seller terminates its group health plan on the date of closing and the buyer establishes a plan on that same date (or maintains an existing plan), it can be argued that the buyer’s plan is the successor of the seller’s plan, and that both seller and buyer have responsibility for continued COBRA coverage for existing qualified beneficiaries. This may not, however, be a strong argument.

Taken a step further, the successor plan argument pins the seller’s COBRA responsibilities and liabilities on the buyer, even though the buyer clearly disclaimed in the buy-sell any assumption of seller liabilities. Question 5 of the proposed regulations asks “What is the employer?” The answer is stated as follows: “…the term ‘employer’ refers to … any successor of .. the employer….” A successor employer may consequently be an employer who has purchased assets because in a stock sale the employer remains the same. If this proposed regulation were to be deemed binding, and interpreted in this way, the buyer in an asset sale would be treated the same as if the buyer had purchased the seller’s stock, i.e., the buyer takes on all of the seller’s COBRA liabilities just as in a stock sale.

The proposed regulation does not define when a buyer would be treated as a successor. If a successor is one who follows the other in a business enterprise, then by dictionary definition, the buyer of assets would be a successor, particularly if the business is conducted at the same site, with most of the same employees, and operating in the same manner.

Some courts have stated that the IRSs proposed regulations do not have to be followed because they are only “proposed regulations” and not yet adopted. Others argue that Congress agreed with the IRS view regarding successor liability when Congress adopted the excise tax sanction for COBRA violations. In the sanctions provisions, the employer’s maximum liability is calculated with reference to a “predecessor” employer’s claims paid or incurred. The argument is that if a successor liability did not apply, the statutory reference would not have much meaning. There have been several court cases which can be interpreted to uphold the IRS view regarding successor liability, but if the matter were litigated under ERISA, a different result might occur. And, as mentioned above, several courts have stated that the IRS proposed regulations do not have the force of law and may not even be relevant.

Because of uncertainty regarding successor liability in an asset sale, the buyer and seller should each try to protect themselves by appropriate provisions in the buy-sell agreement, backed up by the requisite due diligence. A buyer will not want to be put to additional COBRA expenses if the buyer is held to be a successor. If the buyer’s medical insurance provider agrees to cover any and all COBRA qualified beneficiaries for which the buyer at any time becomes legally responsible, then the buyer’s liability is at least limited because those on COBRA pay for their own coverage. If the buyer’s insurance company will not assure the buyer of this, the buyer may want to assess the maximum exposure that could be involved and obtain indemnity from the seller with regard to COBRA issues.

Sellers, on the other hand, do not usually seek indemnification from the buyer because they see themselves as discontinuing operations respecting the sold business, and thus are not even remotely assuming any obligations of the buyer. However, as stated above, the many open issues surrounding the successor/predecessor argument may expose the seller to a claim of joint liability with the buyer as to COBRA compliance by the buyer under the buyer’s successor” medical plan.

In view of the discussion above, in any buy-sell agreement, COBRA issues must necessarily be considered. The parties will want to determine the rights of the seller’s employees who are already on COBRA and those employees of the seller who may be in the COBRA election period at the time of the sale. The buyer will also want to consider the consequences of any COBRA violations of the seller and seek an appropriate indemnification clause in the buy-sell agreement. The advice of competent counsel is important so that appropriate protections are given to the seller and buyer.

This article was written in 1995.