Efficient capital markets rely upon the legal principle of limited liability, perhaps above all others. Investors must know that their entire wealth is not put at risk as a result of any single investment, and while they may be willing to lose the capital they have put into a company, they are very unlikely to be willing to lose more – especially if they don't have control over the activities of the company concerned. Private equity investment funds are set up on the same basis: the ultimate investors and fund sponsors are protected from liabilities below the fund, and each portfolio company is segregated from the others. It is fundamental to the business model.
Therefore, some recent court decisions which seem to undermine that principle are troubling. Much has been made in Europe of the European Commission's decision in the Goldman Sachs/Prysmian case, currently subject to an appeal, which held Goldman Sachs liable for the anti-competitive behaviour of one of its portfolio companies. Meanwhile, in the US, an ongoing dispute involving Sun Capital has also caused considerable concern, as it centres on when a fund will inherit liability for a portfolio company's unfunded pension liabilities. A recent determination in that case suggests that it is even more difficult than previously thought to avoid that outcome.
The facts are as follows: two of Sun Capital's funds, Fund III and Fund IV, owned 30% and 70% respectively of Scott Brass, Inc. Fund III consisted of two "parallel funds" - vehicles established within the same fund wrapper to accommodate certain investors, but which invariably invest alongside each other in the same deals – but Fund III and Fund IV were successor Sun Capital funds (with different investors), managed by the same fund manager. As neither Fund was above the 80% ownership threshold ordinarily needed for pensions liabilities to pass to a shareholder, and was in any event acting as a financial investor, they did not expect to be on the hook for the withdrawal liability incurred when Scott Brass became insolvent and stopped contributing to a pension fund. The court initially agreed with them in 2013, but the pension fund appealed.
The key question that the appeal court decided in 2013 was whether or not the funds were carrying out a "trade or business" and therefore liable if they met the 80% ownership threshold. Fund managers would argue that the fund is a financial investor in portfolio companies, and therefore not carrying out such a trade or business. However, the appeal court disagreed, and looked at a number of factors, such as: the fact that individuals from Sun Capital were involved in the management of Scott Brass (including directorships), the general partners of the funds received management fees and carried interest and had authority as the fund's agents to manage the business of Scott Brass, and, importantly, certain Sun Capital entities charged management and consulting fees directly to Scott Brass and passed on part of the benefit to the funds. The appeal court found that Fund IV was carrying on a trade or business, causing many private equity funds to evaluate their own potential liabilities. However, the case was then referred back to the District Court to decide if Fund III was also carrying on a trade or business, and, crucially, whether Fund III and Fund IV were in a "controlled group" and could therefore be aggregated to meet the 80% ownership test which would trigger liability.
The decision by the District Court, issued at the end of last month, is a landmark ruling in that, as well as concluding that Fund III was also carrying on a trade or business, it ruled that the two funds had created a "partnership-in-fact" which owned 100% of Scott Brass, and were therefore liable for the unfunded pension liability. It is important for fund managers to understand that structuring options used in the past to try to protect against such liabilities may not now be respected. As both funds in question were managed by Sun Capital, it is not clear whether the same analysis could be applied to a minority co-investing entity which was not managed by the "lead" manager.
It is to be hoped that unaffiliated investors would not be grouped together for these purposes, and that the "partnership-in-fact" finding in Sun Capital was specific to its facts. But uncertainty remains, because the decision does not give any clear guidance on how such a partnership is established. Sun Capital is appealing, so the process is not at an end, but in the meantime buyout funds investing in the US will be reminded of the need to tread very carefully when structuring investments, especially those with unfunded pension schemes.