THE GROUP YOU BELONG TO MAKES ALL THE DIFFERENCE:
WILL PRIVATE EQUITY FUNDS HAVE TO CHANGE THEIR PRACTICES?
By Carol I. Buckmann
What happens when private equity funds invest in financially distressed businesses with pension obligations? Does it matter if they own at least an 80% interest in their portfolio companies?
Under Title IV of ERISA, trades or businesses in the same controlled group or under common control are jointly and severally liable for multi-employer plan withdrawal liability and for underfunding when a single employer plan terminates. This means that all of the liability may be assessed against any group member. Private equity finds have traditionally taken the position that they were not trades or businesses for purposes of Title IV of ERISA. This was true even if the funds made parallel investments, and it meant that in the past they structured their investments in target companies without worrying much about exposure for Title IV liabilities.
All of this has been changing, beginning with a PBGC appeals board decision that found a private equity fund to be a trade or business responsible for single employer plan underfunding. That led some funds to become concerned about keeping their investments in portfolio companies at under 80%. Even that may not be enough if the reasoning in a recent district court decision in the Sun Capital Partners case is followed. The district court in Sun Capital Partners applied a new theory to aggregate fund investments of less than 80% on the basis that they formed a co-investment partnership.
One fund owned 30% and the other 70% of a portfolio company called Scott Brass, so neither had the required 80% interest usually needed to be deemed a controlled group member. The funds were not required to invest in the same entities and had different investors.
Although there are ERISA provisions that permit transactions entered into with the intent to evade liability to be ignored, they are rarely invoked and were not applied by the Sun Capital Partners court when it decided to aggregate the ownership interests of the two partnerships. (However, in a recent suit of note filed against Renco, and subsequently settled on the basis that Renco would take the plan back, the PBGC contended that sale of ownership interests to get below the 80% threshold was an attempt to evade or avoid liability under Section 4069 of ERISA that could make the seller liable post-sale for plan underfunding.)
What were the factors that led the district court to combine investments?
To reach its conclusion that the Funds were engaged in a trade or business, the District Court as directed by the First Circuit Court of Appeals, looked to whether the facts and circumstances surrounding the Funds’ investment in Scott Brass, and their other investment activities, were more than would be undertaken by a “passive investor who does not engage in management activities” — an “investment plus” standard. Applying this standard, the District Court focused on the following factors in concluding that the Funds were engaged in a trade or business:
• The Funds’ activities in making investments in portfolio companies with the principal purpose of making a profit.
• The Funds’ activities in relation to Scott Brass’ property, including active involvement in management and operations (e.g., the Funds’ ability to place employees of Sun Capital Advisors in the majority of the director positions at Scott Brass), and the Funds’ similar activities with respect to their investments in other portfolio companies.
• The direct economic benefits accruing to the Funds by reason of the investment that would not be available to an ordinary passive investor, specifically, offsets against, and “carryforwards” with respect to, management fees related to Scott Brass that the Funds would have paid to their respective general partners for managing the investment in Scott Brass.
Should Funds Be Worried?
Of course, this is only one decision in one circuit, and it may or may not be followed elsewhere. However, two factors make it more likely that it will be followed: 1. it appears to be the first court decision aggregating funds with less than 80% ownership of a portfolio company, and a case of first impression is more likely to be followed by other courts; and 2. the decision is consistent with the views in the PBGC opinion and strengthens its hand in pursuing deep pockets for single employer plan termination underfunding. We can expect both the PBGC and multiemployer plans pursuing withdrawal liability to cite this decision favorably in their briefs.
What About Other Portfolio Company Investments?
It is long-settled law that for purposes of the Internal Revenue Code, control can be traced through a common parent, even if the parent is not a U.S. company. That means, for example, that if a common parent directly owns at least 80% of subsidiaries A and B, both A and B are in a controlled group and can be liable for each other’s funding obligations. If the reasoning in Sun Capital Partners is extended in a similar manner, each of the portfolio companies of the aggregated funds could be liable for each other’s Title IV liability.
How Can Funds Protect Themselves?
What might funds start to do differently now that the law may be changing? They could begin with better due diligence, to avoid situations where liability assessments are likely. Avoid the kinds of fee arrangements that were at issue in the Sun Capital Partners case, and involvement in management and control of the Board. They might limit their total investments to percentages that don’t add up to 80%. They could bring in unrelated investors in their different funds, and seek contract protections where possible, such as indemnifications. But these would fundamentally change the way private equity funds such as venture capital funds have operated, and it should be noted that a fund seeking to be a “venture capital operating company” as defined by the Department of Labor is required to obtain and exercise management rights on a regular basis to avoid being deemed to hold ERISA plan assets. It remains to be seen whether Sun Capital Partners is really a game changer that will require all of these actions.