The First Circuit’s recent decision in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund has provoked strong reactions among private equity professionals. The prospect of fund assets being exposed to portfolio company liabilities is disquieting. Piercing the corporate veil is a problem that calls for perspective: when concerns arise in this area, they arise from the magnitude side of the frequency versus magnitude risk equation. Limited owner liability is a concept that courts (and legislatures) rarely consider. When they do, however, the potential damages involved tend to be significant, and private equity funds represent a classic deep pocket. (The Sun Capital funds are in a sense fortunate that the size of the liabilities involved in this case, while not insignificant, are not far larger.) Moreover, the nature of the private equity business model and the structure of private equity funds both tend to increase the risk of alter ego and owner liability, at least at a conceptual level.
Set out below are, first, a brief overview of the Sun Capital case and, second, a few key observations, including some that have been lost in the general post-decision noise and chatter.
Sun Capital Partners III and IV are two related private equity funds which in 2007 purchased, through a holding company, 70% and 30%, respectively, of Scott Brass, Inc., a producer of brass and other metals. In November 2008, after a fall in copper prices, Scott Brass went bankrupt and stopped contributing to a Teamsters pension fund, effecting a “withdrawal” from the fund that triggered a requirement to pay Scott Brass’ portion of the pension fund’s unfunded liability. Litigation then ensued between the pension fund and the Sun Funds as to whether the Sun Funds were jointly and severally liable for this withdrawal liability of Scott Brass.
The basis for the pension fund’s claim was ERISA Section 1301(b), which provides that all “trades or businesses under common control” with the withdrawing entity are to be treated as a “single employer” with the withdrawing entity. It would be fair to read this single employer provision as statutory authorization for alter ego liability to the extent the conditions of the statute are satisfied.
In October 2012, a federal district court ruled in favor of Sun Capital on the basis that the Sun funds were not “trades or businesses” for purposes of Section 1301(b). On appeal, in July 2013, the First Circuit reversed and ruled that Sun Fund IV was a “trade or business” for this purpose. (The court also found that the Sun Funds did not purposely structure their investment to “evade and avoid” liability, a second claim brought by the pension fund, discussed below.) In arriving at this conclusion, the court found that Sun Capital was different from a mutual fund or other passive investor. In particular, Sun Fund IV
- was actively involved in the management of Scott Brass, including decisions such as hiring salespeople, upgrading IT systems and managing working capital;
- controlled the board of Scott Brass;
- caused Scott Brass to enter into management and advisory agreements with a related Sun Capital entity, which immersed itself in details of the management and operation of Scott Brass; and
- received an offset against fees owed to its general partner in an amount equal to 50% of the fees received by the related management company under the management and advisory agreements.
The “Common Control” Question is More Important than the “Trade or Business” Question
It would be understandable if a Sun Capital limited partner were disappointed with the Sun Capital decision, but properly understood, the “trade or business” question is really not the most important question for a fund limited partner. The question that matters the most is whether the private equity fund and its portfolio companies are members of a single “control group” for ERISA purposes. That is, even if the Sun Funds were not deemed trades or businesses themselves, their primary assets (aside from any remaining unfunded capital commitments) are ownership stakes in other portfolio companies, which themselves surely are trades or businesses. If these entities are all under common control for ERISA purposes, an unfunded pension liability could move up and then back down the ownership chain – even if the fund itself is not liable on the basis that it is not a trade or business, its portfolio companies, i.e., its investment assets, presumably are liable.
In this sense, the most important question is the one not addressed in the decision: whether the Sun Capital funds and their portfolio companies constitute a control group under ERISA Section 1301(b).
In general, ERISA provides that ownership of 80% of the voting power or value of a business gives rise to control. But as might be expected in this area, the devil is in the details. For instance, nonvoting preferred stock, which is often used in private equity capital structures, does not count for this analysis. On the other hand, management’s ownership stake, which one might assume could dilute a fund’s ownership level below the 80% threshold, may not count if it is subject to repurchase rights or similar restrictions of a type normally found in private company shareholder agreements.
Control group issues under ERISA can apply outside the relatively narrow area of unfunded pensions. For instance, the anti-discrimination rules for highly compensated employees that affect the tax qualification of 401(k) plans would, in the context of a private equity control group, require a portfolio-wide analysis across all the companies.
We look forward to seeing the lower court’s resolution of the control question on remand of the Sun Capital decision.
The First Circuit’s “Evade or Avoid” Analysis Seems Superficial
The second element of the Sun Capital decision involved the pension fund’s claim that the Sun Funds purposely structured their investment in Scott Brass so as to avoid ERISA’s 80% ownership threshold. (Under ERISA Section 1392(c), transactions undertaken to “evade or avoid liability” under Section 1301(b) are to be disregarded.) Specifically, the pension fund claimed that the Sun Funds divided their ownership into 70%/30% shares specifically to avoid the 80% test and on this basis, liability should be imposed upon the Sun Funds.
The lower court opinion explained that Sun Capital proffered three reasons for the investment split: (i) Sun III was nearing the end of its investment period, (ii) diversification of the investment risk between two funds, and (iii) legal advice to keep ownership below 80% to minimize potential withdrawal liability exposure. The court admitted that based on deposition testimony and an internal e-mail (“did this due to unfunded pension liability”) a jury could find the principal purpose of the split was to avoid withdrawal liability.
Nonetheless, the First Circuit, in a somewhat abstruse analysis, concluded that Section 1392(c) was not triggered on the basis that if the 70/30 split were set aside, the transaction likely would never have occurred. (“There is no way of knowing that the acquisition would have happened anyway if Sun Fund IV were to be a 100% owner…) The court’s analysis seems to be based on statements in the legislative history of Representative Frank Thompson that the intent of Section 1392(c) was to prevent employers from going out of business and then resuming business under a new name, a situation the First Circuit found to be lacking on these facts.
Resolution of the “evade or avoid” liability question is of central importance to private equity professionals. We would feel better about advising clients to use a Sun Capital investment split between sister funds with affiliated general partners to avoid liability if the court’s analysis had a more coherent logical flow. However, it does appear that, at least in the First Circuit, this kind of pre-planning will stand up.
The “Trade or Business” Holding May Have Tax Implications
The First Circuit’s conclusion that Sun Fund IV was conducting a “trade or business” for purposes of ERISA Section 1301(b) may have implications in other tax-related contexts where whether a private equity fund is conducting a trade or business is relevant.
The Sun Funds argued to the court that the “trade or business” conclusion was inconsistent with two storied Supreme Court tax decisions on the topic – the first (Higgins) which held that the mere management of one’s own investments is not a “trade or business” so that expenses incurred in connection therewith are not deductible as “trade or business” expenses, and the second (Whipple) which held that a loan by an individual to a corporation of which he was the 80% shareholder and CEO should not be considered a loan made by the individual in the course of a trade or business, so that a loss on the worthlessness of the loan should be a capital loss on a non-business bad debt, rather than an ordinary loss.
The First Circuit rejected the Sun Funds’ argument. First, the court said that the meaning of a phrase for purposes of one statutory provision need not be the same for purposes of another statutory provision. Second, the court said it viewed its holding that Sun Fund IV was conducting a “trade or business” as being consistent with those Supreme Court decisions in any event – that the level of business activity conducted by Sun Fund IV with respect to Scott Brass was sufficient to constitute a “trade or business” under the Higgins-Whipple test. It is this latter portion of the First Circuit’s analysis that has potential tax implications for private equity funds in other contexts.
One potentially helpful tax application of the First Circuit’s approach is with respect to the deductibility by individual investors of expenses incurred at the private equity fund level. It is often not entirely clear whether those expenses should be fully deductible for the private equity fund investors as “trade or business” expenses or only deductible as investment expenses, which are miscellaneous itemized deductions that are deductible only to the extent they exceed 2% of an individual’s adjusted gross income and that are not deductible at all for alternative minimum tax purposes. The Sun Capital decision provides support for the more favorable approach.
By contrast, there are potentially unhelpful implications for private equity fund investors who do not want the fund to be deemed to be conducting a trade or business. This is particularly true of foreign investors. They uniformly rely on the position that gains on sales of portfolio companies structured as corporations are nontaxable in the U.S. because they are not “effectively connected” with a U.S. trade or business. If the Sun Capital decision were to be viewed as casting serious doubt on this position, that could have major implications for such foreign investors. (By contrast, tax-exempt investors should be indifferent to the decision, because the statutory definition of “unrelated business taxable income” excludes dividends and gains from the sale of property, aside from inventory property, and thus does not depend on whether a private equity fund is deemed to be conducting a trade or business.)