March 26, 2015
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March 24, 2015
Recent Case Suggests How Private Equity Funds Can Protect Against Unfunded Pension Liabilities of Portfolio Companies
A significant objective for a private equity (PE) fund when making an investment is to avoid exposing itself to portfolio company liabilities. Generally, corporate law would protect the purchaser of a controlling interest in an acquired corporation against portfolio company liabilities as long as the acquired company is operated independently of the purchaser. However, special considerations apply under the Employee Retirement Income Security Act (ERISA), the federal law that governs employee benefit plans. ERISA makes all members of a controlled group liable on a joint and several basis for any pension-related liabilities of single employer and multi-employer pension plans. The Pension Benefit Guaranty Corporation (PBGC), the federal agency responsible for overseeing these pension plans, has been aggressive in broadly interpreting what is a “controlled group” for this purpose and in pursuing PE funds for pension liabilities incurred by portfolio companies. But a recent case out of the U.S. District Court for the District of Massachusetts signals that courts may not agree with the PBGC’s broad assessment of pension liability for PE funds.
In a recently decided case, Sun Capital Partners III L.P. v. New England Teamsters and Trucking Industry Pension Fund, D. Mass., No. 1:10-cv-10921-DPW, 10/18/12, the U.S. District Court for the District of Massachusetts became the first court to reject a multi-employer pension plan’s attempt to rely on PBGC precedent to assess a PE fund with a portfolio company’s unfunded pension liabilities. While this likely is not the last word on this subject, the Sun Capital Partners case offers a roadmap for how a PE fund may take a position to avoid controlled group liability for single employer and multi-employer pension liability.
Title IV of ERISA imposes joint and several liability with respect to a broad array of pension liabilities, including an employer’s minimum funding contributions to a single employer pension plan, unfunded pension liabilities upon plan termination, PBGC premium payments and withdrawal liability under a multi-employer pension plan. Under ERISA, joint and several liability applies to any entity under common control with the employer sponsoring the pension plan.
- The definition of “common control” is interpreted under federal tax rules that are applicable to tax-qualified plans under Section 414 of the Internal Revenue Code (the Code).
- These Internal Revenue Service (IRS) regulations have long provided that entities are under common control if they are “trades or businesses” that share common ownership of 80 percent or more (by vote or value).
- In the 1987 case of Commissioner v. Groetzinger, the Supreme Court of the United States established a test for when an activity constitutes a “trade or business” for these purposes. Under Groetzinger, for a person to be engaged in a trade or business, the primary purpose of the activity must be income or profit, and the activity must be performed with continuity and regularity.
In 2007, the PBGC issued an opinion (PBGC Appeals Board opinion dated September 26, 2007) finding that a PE fund was engaged in a trade or business. According to the PBGC, the PE fund subject to the opinion was engaged in a “trade or business” because it had a stated purpose of creating a profit; provided investment services; and had a general partner that received management fees, a carried interest and consulting fees (i.e., the PE funds did not receive just investment income as a passive investor similar to an individual investor). The PBGC stated that this activity was regular and continuous because of the size of the PE fund and its profits.
The Sun Capital Decision
In the Sun Capital Partners case, the court determined that the one-time investment of capital by a PE fund into a portfolio company was a passive investment and did not result in the PE funds engaging in a trade or business. The investment was structured such that the portfolio company was owned by two PE funds in a 70/30 split. Each PE fund had a general partner, and each general partner had a management company that performed consulting and advisory services. The PE funds, as shareholders, could appoint members of the board of directors of the portfolio company.
In its decision, the court determined that receipt of non-investment compensation in the form of consulting, management or advisory fees and carried interest by the management companies and the general partners could not be attributable to the PE funds. The non-investment income was a result of a contractual relationship between the management companies, the general partners and the portfolio company. The court found that the receipt of this non-investment income did not mean that the PE funds themselves were engaged in the full range of the general partners’ activities. The PE funds themselves did not perform any consulting, advising or management services, and did not have employees, own any office space, or make or sell any goods. In fact, on tax returns, the PE funds reported only capital gains and dividends, both sources of investment income. Further, the court held that the ability of the PE funds to appoint the board of directors of the portfolio company did not mean that the funds were engaged in a trade or business, because such appointments were made in the PE funds’ capacity as shareholders of the portfolio company. The court also noted that the fact that the same persons signed the management agreements representing both sides of the contract was not persuasive evidence of engaging in a trade or business, since officers of different entities can sign in different capacities.
The court in the Sun Capital Partners case expressly considered and declined to rely on the 2007 PBGC opinion. Importantly, the court held that the 2007 PBGC opinion had misapplied the theory of agency and incorrectly imputed the management companies’ or general partners’ actions to the PE funds. In addition, the court held that, as a matter of law, the PBGC had misapplied the Groetzinger test and other relevant tax law precedent.
Finally, the court determined that the structuring of the PE funds’ investment in the portfolio company (using multiple funds each owning less than 80 percent of the portfolio company) did not violate ERISA provisions allowing certain transactions to be undone if they were undertaken to evade or avoid ERISA liabilities. Although the PE funds admitted that one of the reasons that the investment was structured to be two funds with a 70/30 split was in order to minimize pension liability risk, the court found that ERISA’s evade-or-avoid provisions did not apply in this context, because such provisions were meant to apply to sellers rather than first-time investors. Indeed, as the court noted, if the investment was undone and the controlled group determined without regard to the investment as contemplated under ERISA, the PE funds would still not be liable. Thus, application of the evade-or-avoid provisions did not make sense in this context.
Most importantly, this decision provides support for the widely held position that a PE fund is not engaged in trade or business and cannot be determined to be under common control with its portfolio companies under Code Section 414. Under this interpretation, no PE fund could be held liable for withdrawal liability under a multi-employer pension plan, or unfunded benefits liabilities upon termination of a single employer plan (or minimum funding or contractually required ongoing contributions to such plans), because PE funds are not engaged in a trade or business. Further, if the PE fund cannot be held liable, then the chain of ownership between portfolio companies held by the same private equity fund is also broken. This decision also provides significant leverage to negotiate with the PBGC or a multi-employer pension fund should a PE fund be defending itself against the PBGC or multi-employer pension fund for pension liability claims.
In order to avail themselves of the benefits of this decision, PE funds should evaluate their operations and contractual relationships to determine if such operations and relationships are comparable to those outlined by the court in the Sun Capital Partners case. In addition, PE funds may wish, when possible, to structure future investments across multiple funds with each fund owning less than 80 percent of the portfolio company in order to minimize risk of pension liability.
On November 2, 2012, the multi-employer pension fund appealed the decision in the Sun Capital Partners case to the U.S. Court of Appeals for the First Circuit.