By Carol Buckmann
Is a private equity fund engaged in a trade or business? Prior to a 2007 PBGC decision asserting liability against an investment fund, it was generally assumed based on tax decisions that the answer was “no.” The answer is important because ERISA makes all trades or businesses that are part of a controlled group jointly and severally liable for withdrawal and plan termination liability. If private equity funds are engaged in a trade or business, they may be liable for withdrawal and plan termination liability of bankrupt or defaulting portfolio companies that have contributed to multiemployer or single employer pension plans. Their portfolio companies may also be liable for each others’ liabilities.
Sun Capital Partners.
In a landmark decision involving Sun Capital Partners, the First Circuit Court of Appeals upheld the PBGC’s reasoning and determined that private equity funds could be trades or businesses if they satisfied an “investment plus” test requiring that they engage in activities beyond those of a passive investor. Among the factors that the court considered important were a fund’s active involvement in the management and operations of portfolio companies and the receipt of indirect economic benefits, such as management fee offsets. Sun Capital partners appealed a lower court decision that aggregated two fund investments to reach the 80% ownership threshold required for controlled group membership on the ground that they had formed a “partnership in fact.” So far, it has been unsuccessful in requesting Supreme Court review.
The Sun Capital Partners decisions sent shock waves through the private equity industry. Many continue to believe that Sun Capital Partners was wrongly decided, and in response, funds considered changes to their way of investing, such as limiting investment to below the 80% ownership threshold that generally determines whether a trade or business is part of a controlled group and restricting their involvement with portfolio company operations, to avoid potential liability.
The Trilantic Litigation.
These issues have been raised again in disputes with a fund called Trilantic Capital Partners in courts where Sun Capital Partners is not binding authority. Trilantic’s lawsuits arose as a result of a portfolio company’s withdrawal from several multiemployer plans and potential PBGC liability for an underfunded portfolio company defined benefit plan. Trilantic made a preemptive strike by filing for a declaratory judgment in the southern district of New York that the named multiemployer plans and the PBGC could not collect Title IV liability from Trilantic or the special purpose vehicle through which it owned the portfolio company. Now one of the plans not named in the original declaratory judgment action has sued Trilantic and “any other trade or business under common control with [the portfolio company] that has not filed for bankruptcy” in Illinois to collect unpaid withdrawal liability from them. These are not final legal decisions, but they squarely put the Sun Capital Partners analysis under a microscope.
The New York Action.
Trilantic states that courts have rejected the notion that ordinary investors operate a trade or business, and that the Sun Capital Partners case is the sole exception and was wrongly decided. Covering all bases, the action also contends that Sun Capital Partners was based on “unique circumstances” that did not apply to Trilantic because Trilantic:
· Did not manage or direct day-to-day operations of the portfolio company
· Did not receive any compensation, income or fees from the portfolio company
· Had no management or monitoring agreement with the portfolio company
· Had no authority to hire or fire portfolio company employees
· Did not designate all Board members and, after a major creditor began to exert control over the portfolio company, had no representation on the Executive Committee formed to steer the company through bankruptcy
The complaint also alleges that following Sun Capital Partners would inhibit private equity investment and make it more likely that struggling companies would fail, ultimately adversely affecting the financial stability of multiemployer plans.
The Illinois Action.
The Local 731 Pension Trust alleges in federal district court that Trilantic and its special purpose investment vehicle (Clothesline Holdings) operate a trade or business for the following reasons:
· Trilantic works with portfolio company management to increase revenues, earnings and cash flow
· Trilantic exercises shareholder rights, including the right to elect directors
· Trilantic manages portfolio companies on an interim or emergency basis
· Trilantic and Clothesline contract for professional services and Trilantic contracts for management services
· Trilantic and Clothesline have federal EINs and claim business-related income tax deductions
These lawsuits raise the possibility of a split among the circuits on whether private equity funds operate trades or businesses that could ultimately be resolved by the Supreme Court. In the meantime, thorough due diligence about the pension liabilities of potential new investments and careful structuring of business operations will remain crucial for private equity funds.