August 5, 2013

Court Ruling Creates Potential Liability for Investment Funds and May Have Broader Implications

The First Circuit recently held that a private equity fund was a “trade or business” in determining whether the fund itself might be liable for the pension plan withdrawal liability of one of its portfolio companies. The court focused heavily on the fund's various management rights and the structure of the typical management fee offset. This may have broad implications in how private investment funds structure their investments, and funds should consider possible ways to mitigate this exposure.

The First Circuit Court of Appeals in Boston recently held that a private equity fund qualified as a trade or business under the Multiemployer Pension Plan Amendment Act (“MPPAA”) for purposes of assessing multiemployer pension plan withdrawal liability under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) with respect to one of its portfolio companies.

The case, Sun Capital Partners III LP v. New England Teamsters & Trucking Indus. Pension Fund (1st Cir., No. 12-2312, July 24, 2013), involved two private equity funds organized by the same sponsor (Funds III and IV). Together the funds held 100% of the interests in a portfolio company.

The equity interests in the portfolio company were indirectly held 30% by Fund III and 70% by Fund IV. (Fund III was actually structured as two parallel funds. The court took the view that the parallel funds could be viewed as one fund for this purpose since they generally made the same investments in the same proportions and had the same general partner.)

Each Fund obtained certain management rights in the portfolio company, both directly and indirectly through its general partner. Each general partner also received a management fee from the portfolio company, which offset the management fee owed to it by the Fund. The court held that the management rights (including those held by each of the general partners) were for the economic benefit of the Funds and that due to the management fee offset, Fund IV received the economic benefit of the portfolio company’s management fee (see below for a discussion of the court’s findings with respect to Fund III).

The portfolio company contributed as an employer to a union-sponsored, multiemployer pension plan but ceased contributions and went bankrupt. Under MPPAA’s multiemployer withdrawal liability rules, when an employer ceases to contribute to a multiemployer plan, it is liable for a portion of the plan’s underfunding. This so-called withdrawal liability may also be assessed against any entity that is a trade or business under common control with the employer — in this context, any entity that is a “trade or business” and owns an 80% or more interest in the employer.

The multiemployer plan asserted that Fund III and Fund IV had entered into a partnership or joint venture that were trades or businesses in common control with the employer — and therefore were jointly and severally liable for the withdrawal liability of the employer/portfolio company to the pension plan under MPPAA. The Funds filed suit against the plan in Federal district court in Massachusetts seeking a declaration that they were not subject to that withdrawal liability.

In 2012, the District Court rejected the plan’s arguments and held that neither Fund III nor Fund IV constituted a “trade or business” for purposes of withdrawal liability under MPPAA and ERISA. The plan (supported by the Pension Benefit Guaranty Corporation (“PBGC”) as amicus) appealed to the First Circuit Court of Appeals in Boson.

The First Circuit reversed the District Court and held that Fund IV was a “trade or business” for purposes of withdrawal liability, emphasizing that Fund IV’s investment in the portfolio company was a so-called “investment plus” because the Fund was actively involved in the management of the portfolio company, both directly and indirectly through its general partner.

The Court’s Analysis – A Cause for Concern

The court focused on the Funds’ principal purpose (as stated in their offering materials) of managing and supervising its investments, and the desire to seek potential investments that need extensive intervention with respect to their management and operations, with the ultimate goal of selling the investments for a profit.

The court also noted that for ERISA purposes, the Funds portrayed themselves as “venture capital operating companies” (or “VCOCs”) with direct contractual rights to substantially participate in or substantially influence the management of certain of their portfolio companies. The court further highlighted that the economic benefit received by Fund IV in the form of a management fee offset is a benefit that a passive investor would not typically derive.

The court remanded to the District Court for a determination whether Fund III was also a “trade or business” since it was not clear whether Fund III received any benefit from a management fee offset with respect to fees paid by the portfolio company. The court also remanded on the question of whether the two Funds were acting as a joint venture and might be aggregated for purposes of the common control test.

Although the court holding is technically limited to withdrawal liability to a union-sponsored multiemployer pension plan under MPPAA and ERISA (and the court went out of its way to stress this point), the holding almost certainly would be extended to liability for underfunded single-employer defined benefit pension plans.

There is some concern that the court’s holding or analysis may be extended to other situations in other employee benefits contexts, including retirement plan non-discrimination testing across portfolio companies under common control and COBRA liability.

In addition, the court’s holding arguably supports the view that the economic benefit to a private investment fund of fees paid by third parties to a sponsor of such fund and realized by the fund through a typical management fee offset provision creates a risk that such fee income could be trade or business income of the fund for federal income tax purposes with the result that tax exempt investors in the fund could have unrelated business taxable income and/or foreign investors in the fund could have income which is effectively connected with a U.S. trade or business.

Practical Considerations

In light of this ruling, private investment funds (including private equity, venture capital, real estate and hedge funds) should understand that in connection with an investment in a portfolio company or other entity where:

  • One or more funds of the same fund complex own 80% or more of the portfolio company or other entity, either by profits or capital, and
  • The portfolio company or other entity participates in a union-sponsored multiemployer plan or sponsors a defined benefit pension plan, and
  • The portfolio company or other entity becomes insolvent or files for bankruptcy, or otherwise stops contributing to the plan, then

there is the possibility (especially in the First Circuit) that any withdrawal liability or other underfunded pension liability could become an obligation of the investing fund(s) regardless of the structure or limited liability nature of the portfolio company or other entity and the intervening entities between the portfolio company or other entity and the fund.

Funds should consider the potential impact of this decision in structuring their investments and related management rights, fees and fee offsets as it may be possible to address, or at least mitigate, this exposure depending on the facts of the particular investment.