Sun Capital Partners was dealt a harsh blow by the United States Court of Appeals for the First Circuit in a recent decision where the court found that this private equity fund could be held liable for the pension withdrawal liability of its portfolio companies. The court essentially espoused the view of the Pension Benefit Guaranty Corporation (PBGC), holding the fund jointly and severally liable for the unfunded pension obligations of its portfolio company based on the theory that the fund is engaged in a “trade or business.” On its face, the instant case is relevant only with respect to pension liability issues, and the approximately $4.5 million liability in question, while not insignificant, is not enough to put a major PE fund out of business. There are, however, other potentially more far-reaching consequences for PE funds.
What is Withdrawal Liability?
Under the Employee Retirement Income Security Act of 1974 (“ERISA”), pension plan withdrawal liability arises when a contributing employer to a multiemployer pension plan stops making contributions to an underfunded pension plan in which it participates. The liability is equal to that employer’s proportionate share of the vested but unfunded benefits. Entities which comprise members of such a defaulting contributor’s “controlled group” (i.e., 80% common ownership) may become jointly and severally liable for this liability if such an entity is engaged in a “trade or business.”
The Sun Capital Cases
When Sun Capital’s portfolio company, Scott Brass, Inc., filed for bankruptcy and defaulted on its withdrawal obligations to a multiemployer pension plan, the plan asserted that the Sun Capital funds holding the investment were jointly and severally liable for these pension withdrawal obligations under the theory that they were engaged in a trade or business and were part of Scott Brass, Inc.’s ERISA controlled group. The District Court for the District of Massachusetts disagreed with the plan, holding that Sun Capital’s investment funds were not “trades or businesses” but, rather, passive investment vehicles, created to pool and receive investment income.
The First Circuit disagreed. While the District Court concluded that the management and consulting activities of the funds’ management company (the General Partner of the funds) were not attributable to the funds themselves and that the funds’ appointment of directors to Scott Brass, Inc.’s board of directors was an action taken in each fund’s role as a passive investor and shareholder of the company, the Circuit Court took the view that an otherwise passive investment may rise to the level of a “trade or business” when combined with other, more active management activities, rights and responsibilities, including, in this case:
- exercising oversight of and participating in management and operations of a portfolio company;
- participating in development of restructuring and operating plans for the company with the intent of implementing operating improvements;
- appointing its affiliates to serve on the Scott Brass, Inc. board; and
- receiving management fees in exchange for business services.
The Bad News for PE Funds
The Sun Capital case involved defaulted multiemployer plan withdrawal obligations, but joint and several liability also applies to a single employer pension plan when a company with its own pension plan becomes insolvent and the PBGC steps in. The implications of this case, therefore, go beyond those instances where a multiemployer pension plan is in place. And because the Circuit Court held that no single factor related to the passive vs. active determination was dispositive, concluding that “the sum of all of these factors” resulted in their holding, private equity funds are left with little guidance as to what types of activities are closely-related enough to the passive activity of investment, rather than active management of a business, to keep them outside of the “trade or business” paradigm.
Broader Implications for the Carried Interest Debate
The characterization of private equity as a passive investment activity is crucial to defenders of the current taxation of carried interest; the capital gains tax treatment of carried interest is largely based on the idea that these funds are not engaged in an active trade or business. While this ruling is limited to ERISA concepts, and the law of pension plans specifically, it is reasonably foreseeable that advocates of carried interest taxation reform will point to this decision as further evidence for their position that carried interest really is ultimately compensation paid for management services and should be taxed accordingly.
How Can a PE Fund Protect Itself?
1. Diligence. PE funds should conduct a thorough diligence review of the pension liabilities of their potential investments and consider avoiding any portfolio company with significant underfunded pension liabilities or, at the very least, incorporate this liability into their pricing and negotiations with the seller(s).
2. Draw Clear Lines and Make a Record. PE fund management should keep their eye on their level of active participation in their portfolio companies and should try to build an evidentiary record of the decision-making process and the distinctions among parties; fund materials may describe analysis and input as to the businesses of their investments but board minutes (or other similar records) should clearly reflect that the final decision-making authority, particularly with respect to day-to-day matters and routine operations, rests with the portfolio company’s executive officers and directors.
3. Divide and Conquer. Because portfolio companies by their nature are generally engaged in trades or businesses, those that are 80% or more owned by a common PE fund may also be part of a single ERISA controlled group. As a result, fund managers should exercise caution when structuring the upper tiers of their investment vehicles so as not to saddle a healthy investment with a significant liability of a faltering company.
 Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, No. 12-2312 (1st Cir. July 24, 2013).