Appeals Court Ruling Raises Pension Liability Issues for Private Equity Funds

February 5, 2014, 11:32 AM

After years of threats from Congress and tax-reform advocates, private equity fund sponsors have been dealt a potential setback from an unlikely source: The federal 1st Circuit Court of Appeals. The courts recent decision in Sun Capital Partners III, L.P. v. New England Teamsters could make private equity funds liable for their portfolio companies underfunded pension obligations, a potentially massive liability in some transactions that will require careful pre-closing structuring to sidestep. The ruling has also rekindled the debate over the tax treatment of fund sponsors profits, which relies on investor status to achieve favorable capital gains rates on their earnings.

ERISA historically protected private equity funds from their portfolio companies underfunded pensions. Under ERISA, which governs liability in this context, any trade or business under common control with a pension plan sponsor is jointly liable for the sponsors pension obligations. That includes underfunding liabilities.

A trade or business generally is limited to an active, continuous operation that exists to make a profit or income. Common control exists where one entity owns at least 80% of another entity, usually seen with parent companies that own at least 80% of a subsidiary company. Crucially, though, common control can flow up to a parent company and back down to other subsidiaries.

In contrast to operating companies, private equity funds historically have been considered passive investors rather than active trades or businesses under ERISA. As a result, they have avoided pension liabilities of their portfolio companies, even where the fund owned 100% of the portfolio companys stock. This view has prevailed almost universally until recently, when both the PBGC and a federal district court opined that private equity funds could be trades or businesses under the so-called investment plus approach (though neither of those pronouncements created binding law).

Earlier this year, the 1st Circuit followed this tack: After reviewing the Sun Capital funds active management of its portfolio companyin circumstances very typical for private equity investmentsit concluded that the fund was so involved in running the portfolio company that it became an active trade or business, eliminating the primary justification for shielding private equity funds from pension liabilities in distressed portfolio companies. The court followed the PBGCs investment plus approachbut declined to explain what any particular plus might bein holding that the Sun Capital funds were not merely passive investors without ERISA liability. (The court did, however, highlight as one important factor the fact that the fund received an offset of fees charged by the management company for fees paid by the funds portfolio companies.) Unlike the PBGCs and district courts non-binding positions, the 1st Circuits rationale is now mandatory in all district courts within the 1st Circuit, which covers Maine, Massachusetts, New Hampshire, Rhode Island, and Puerto Rico. And as the first court at this level to apply this approach, the ruling sets an example for future appeals courts across the country.

One important question was left unansweredwhether divided ownership of the portfolio company between two of Sun Capitals private equity funds (70% in one fund; 30% in another) could be aggregated for purposes of common control under ERISA. Allowing aggregation would result in common control even where no single entity owns 80% of the portfolio company. Regardless of this outcome, the trade or business prong is the only safeguard preventing pension liability where a fund owns at least 80% of a portfolio company and is therefore categorically under common control. And while the Sun Capital case involved the companys withdrawal from a multiemployer pension plan, the same ERISA rules govern single-employer pension plans like the earlier example.

Interestingly, though, the Sun Capital decision did hold that prospectively structuring the purchase 70%/30% between two funds was not enough to impose evade or avoid liability on the funds, which may result if one fund owns at least 80% of the company and attempts to later restructure its ownership to avoid ERISA liability.

In the wake of the Sun Capital case, fund sponsors should closely review any existing pension funding problems in their portfolio companies. Going forward, fund sponsors should diligently address a targets pension planand the targets ability to continue meeting its funding obligationsbefore closing on a transaction. If any problems exist, fund sponsors should either address them with the sellers or attempt to structure the deal to circumvent the common control provisions now that the trade or business safeguard no longer provides protection with any certainty. If pension underfunding issues cannot be fully resolved before closing, funds may consider buying less than 80% of the outstanding equity or being prepared to assume any pension liabilities. Sponsors must also remember that common control can flow up to the fund and back down to its other portfolio companies, putting the entire range of the funds investments at risk, so they should fully consider the wide-reaching effects of this scenario before acquiring a company with serious pension troubles.

Kaufman & Canoles prides itself on resolving the most daunting challengesor avoiding them altogether. Whether youre new to the game or a seasoned professional, our attorneys draw from diverse backgrounds in employee benefits, mergers and acquisitions, private equity fund formation, and corporate law to distill your most complicated legal situations down to sound business advice. So when youre ready to go to the next level, we can take you there. And we will. - Robert Q. Johnson