Private equity investments are often structured through an onion skin of layers of entities, but a recent set of blockbuster U.S. court rulings suggests that, at least with respect to unfunded liability under U.S. pension law, all of that layering is likely for naught.
Two Sun Capital private-equity funds (designated III and IV) acquired a metal manufacturer, Scott Brass, Inc., with a known unfunded liability to its multi-employer pension plan. In part to avoid this poison pill, the two controlling partners of the Sun Capital family structured the acquisition via the two separate funds in a 70/30 split, avoiding the 80 percent ownership threshold in U.S. pension law that would trigger “common control” liability for Scot Brass’s pension deficit. Through a complex structure of general and limited partnerships and various subsidiaries, the two controlling Sun Capital partners arranged for one fund (III) to invest $900,000 for a 30 percent stake in a limited liability company that would ultimately acquire Scott Brass, while another fund (IV) invested $2.1 million for the remaining 70 percent stake in the LLC. The LLC in turn invested this money via yet another holding subsidiary to buy Scott Brass, leveraged by an additional $4 million in borrowed funds.
A downturn in the copper market ultimately undercut its business, and Scott Brass was dismantled in bankruptcy. Its $4.5 million unfunded pension liability remained, however, so the pension fund pursued the Sun Capital PE funds for Scott Brass’s pension deficit.
Ordinarily, limited liability shields investors from a company’s debts, but U.S. pension law specifically breaks down this shield with respect to pension liabilities. By federal statute,1 unfunded pension liabilities extend not only to the employer-company, but also to any parent company if two factors are met: (1) the parent company must be a “trade or business,” and (2) the business of the employer-company must be under “common control” with the parent; that is, the parent must own at least 80 percent of the employer-company.
In the first of two blockbuster rulings, the First Circuit Court of Appeals held in August 2013 that the Sun Capital funds satisfied the first of these tests; that is, they were engaged not simply in investment management, but an active “trade or business.” 2
It ultimately did not matter that active, paid management services were actually performed for portfolio companies by separate control-group members, the funds’ general partners and their subsidiary companies. The court aptly observed that these activities were undertaken on behalf of and for the benefit of the PE funds, so these activities were as a matter of agency law attributable to the funds as if the funds had done the managing themselves. In addition, the funds received financial benefits from these management services that would not be obtained by ordinary, even active investors; that is, offsets of partnership management fees that the funds would ordinarily have to pay to their general partners for coordinating their portfolio management activity.
Despite the widespread criticism levelled at this ruling by the PE industry, it was not surprising. On the contrary, it is somewhat surprising that U.S. pension and tax authorities have for so long refused to acknowledge the reality of the coordinated “trade or business” conducted within the large, interrelated families of PE funds. These funds’ business plans clearly envision active, remunerated management as part and parcel of their strategy, and their type of formal but not functional (or economic) separation of activities among control-group members is generally collapsed in contexts not involving PE funds.
But the second, “common control” requirement seemed an ironclad defense. The Sun Capital funds had deftly satisfied the objective, 80 percent rule by dividing ownership of the LLC 70/30, and the appeals court had overturned the district court’s attempt to ignore this synthetic structure.
At the end of March 2016, however, the district court found a way to aggregate the 70/30 split in a particularly troubling way. It found that, by agreeing to coordinate their investment strategy to acquire Scott Brass indirectly, the PE funds had actually formed an inadvertent partnership “to invest in and manage certain of their shared portfolio companies” via other entities, such as the LLC that acquired Scott Brass.3 The district court justified this sleight-of-hand by again noting the “economic realities” of the Sun Capital funds’ business model. The two funds (III and IV) did not each decide for its own reasons to invest in the LLC that ultimately acquired Scott Brass, the court reasoned. Rather, they were constant co-investors whose activities were coordinated from above, ordained by the Sun Capital controlling partners, always acting in lockstep, and never disagreeing. Indeed, the court posited, the very decision to split their investment 70/30 evidenced coordinated action by the funds to avoid pension withdrawal liability. This coordinated business activity constituted a partnership (or joint venture), a separate business entity.
Aggregating the two funds’ investment into one partnership thus formed an unbroken line of 100 percent “common control” ownership between the partnership and Scott Brass. Because partners are jointly and severally liable for the debts of a general partnership, the Sun Capital funds were 100 percent liable for their partnership’s liability for its “common control” subsidiary’s, Scott Brass’s, pension deficit.
While the court identified a phantom partnership “sitting atop the LLC,” it blithely held without deciding that the partnership – rather than the “partner” Sun Capital funds – owned the LLC and ultimately Scott Brass. But the $3 million investment was advanced to the LLC, and doubtless reflected in the LLC’s organizational documents, by the funds (III and IV), not by the theoretical “partnership-in-fact.” The court’s skipping over these sorts of fine details reveals how intent it was to aggregate these entities and their larger than 80 percent ownership of the LLC at all costs.
This holding is disturbing for many reasons. It neatly aggregates formally separate entities and brushes aside limited liability simply by observing that the Sun Capital funds acted on a coordinated investment strategy. But of what formal business entity is this not true? Is not coordinating action to reap investment reward and avoid ordinary partnership liability the very raison d’être of investors’ forming juridical entities like LLCs? And the court does not account for the myriad complications implicated by this ruling. What of the division of capital and therefore profits and losses? If an inadvertent partnership is, in fact, the owner of the LLC, then the profits and losses of that LLC should by law be divided between the “partner” funds equally, rather than 70/30 as they obviously intended. And what of the many obligations attaching to partners that are decidedly not present between investors in limited liabilities entities? Are the heightened fiduciary duties of Meinhard v. Salomon to be applied to all PE funds who coordinate their investment strategy? The questions on the LLC side are equally vexing.
There is hope that this obnoxious ruling will be overturned on appeal. In its earlier ruling, the First Circuit had rejected the pension fund’s theory that the court should “create a transaction that never occurred” as no court had “created a fictitious transaction in order to impose [common control] liability.” Nonetheless, the district court’s theory for just such a “fictitious transaction” is clever if novel, and it may well be upheld on appeal. The courts are understandably eager to find any solution to the growing pension crisis in the U.S., which threatens not only companies, but cities and states, as well. What better way to do this than to offload underfunding liabilities onto politically unpopular PE funds operating through phantom “partnerships”?
This would be a very pernicious precedent. PE funds cannot scale back their management activities without undermining their investment-and-management strategy. And if coordinated investment will result in an inadvertent phantom partnership “sitting atop” the entity chains that connect the funds via “common control” to their portfolio companies, exposure to unfunded pension liabilities of portfolio companies is all but inevitable. Due diligence will now be even more important to discover such landmines, and front-end adjustment of the offer price for such companies seems to be the only reliable, however unsatisfactory, way to avoid throwing good money after bad.
Luckily, relatively few U.S. companies have defined-benefit pensions. Most have transitioned to defined-contribution retirement savings accounts, which are not subject to the deficit liability rules at issue here. This latest Sun Capital ruling may make companies with defined-benefit pensions inappropriate investment targets for PE funds. This would be yet another ironic nail in the coffin of defined-benefit pension funds and their union supporters in the U.S.
- See 29 USC § 1301(b)(1).
- See Sun Capital Partners III, LP et al. v. New England Teamsters & Trucking Industry Pension Fund, No. 12-2312 (1st Cir., July 24, 2013), http://media.ca1.uscourts.gov/pdf.opinions/12-2312P-01A.pdf.
- See Sun Capital Partners III, LP et al. v. New England Teamsters & Trucking Industry Pension Fund, No. 10-10921-DPW (D. Mass. Mar. 28, 2016), https://www.gpo.gov/fdsys/pkg/USCOURTS-mad-1_10-cv-10921/pdf/USCOURTS-mad-1_10-cv-10921-1.pdf.