A federal appeals court recently ruled that a private equity fund might be responsible for the unfunded pension liabilities of its bankrupt portfolio company. This ruling could have broader repercussions for private investment funds and the companies they own. If the companies are considered to be related employers under the rules that govern employee benefits, they might acquire other unexpected obligations, such as the obligation to provide health care to their employees.
We have written before about the risk that private investment funds and their portfolio companies will be aggregated for purposes of applying employee benefits requirements. In general, the employee benefits rules treat all members of a “controlled group” of companies as a single employer. A “controlled group” is a group of trades or businesses that are connected through 80% or more common ownership or control in a parent-subsidiary or brother-sister relationship. For example, if a private investment fund owns at least 80% of two portfolio companies, all three entities might be members of a “controlled group,” with the result that they would be responsible for the unfunded pension liabilities of the other members of the group and might be aggregated for purposes of applying other employee benefits requirements.
Trade or Business
Private investment funds have traditionally taken the position that they are not engaged in a “trade or business,” but instead are merely investors in their portfolio companies. Accordingly, the funds have maintained that they and their portfolio companies do not meet the first part of the controlled group test: they are not “trades or businesses” under common control.
The Appeals Board of the federal Pension Benefit Guaranty Corporation (“PBGC”) rejected this position in a 2007 letter ruling. The PBGC concluded that a private equity fund was more than a passive investor in its portfolio company: the fund and its affiliates provided management and advisory services to the company for a fee, and the fund exercised control over the company. Applying this analysis (which later court decisions have labeled “investment plus”), the PBGC concluded that a private equity fund was a trade or business that could be aggregated with its portfolio companies under the controlled group rules.
Our earlier post described a 2012 decision by a federal district court in Massachusetts that had declined to adopt the PBGC’s “investment plus” standard; but a recent ruling by a federal court of appeals has overturned the lower court’s decision. In Sun Capital Partners III L.P. v. New England Teamsters & Trucking Industry Pension Fund, the Court of Appeals for the First Circuit used the “investment plus” approach to determine whether a private investment fund was engaged in a trade or business. The First Circuit held that the fund was not merely a passive investor in the portfolio company, but instead was actively involved in the portfolio company’s management and operation.
The First Circuit rejected the fund’s argument that the management activities of the fund’s general partner and the general partner’s affiliated management company should not be attributed to the fund itself. The court held that the general partner acted as an agent of the fund when the general partner and its affiliate provided management services to the portfolio company. The court noted that the fund received an economic benefit from these activities, since the management fees paid by the portfolio company to the general partner offset compensation that the fund might otherwise have owed to the general partner. The court concluded that these management activities were sufficient to demonstrate that the fund was engaged in a “trade or business.”
In an effort to avoid controlled group liability, Sun Capital Advisers, Inc. had structured the funds’ acquisition of the portfolio company so that no single fund would own 80% of the company. Instead, one Sun Capital fund owned a 70% interest in the portfolio company and another Sun Capital fund owned a 30% interest in the company.
The First Circuit applied the “investment plus” analysis to conclude that the fund with a 70% interest in the portfolio company was engaged in a trade or business. The First Circuit remanded the case to the district court to determine whether the fund that owned a minority interest also was engaged in a trade or business, and (if so) whether the two funds should be considered to be entities under common control that together owned 100% of the portfolio company.
The Sun Capital decision leaves several significant questions unanswered for private investment funds and their advisers.
The First Circuit declined to provide guidelines that would help investors determine what activities constitute the “plus” in an “investment plus” analysis (although the court criticized the PBGC for failing to provide adequate guidance on this issue). Instead, the First Circuit adopted what it described as a very “fact-specific” analysis, and it cautioned that no single factor was dispositive. Under this approach, it is very difficult for private investment funds and their advisers to determine how to structure their relationships with portfolio companies so as to avoid being characterized as trades or businesses.
The First Circuit also did not decide whether separate funds formed by the same private equity firm should be aggregated and treated as being under common control. Accordingly, it is not clear whether related funds can avoid controlled group liability as long as each fund holds an interest less than 80% in its portfolio companies, as the Sun Capital funds did. This important question should be answered at a later stage of the Sun Capital litigation if the litigation continues.
Finally, if a private investment fund and its portfolio companies are considered to be trades or businesses under common control, it is not clear whether they will be treated as members of the same “controlled group” only for purposes of sharing liability for unfunded pension benefits, or whether they will also be aggregated for purposes of applying other employee benefits requirements. Although the statute at issue in the Sun Capital litigation is limited to unfunded pension benefits, it incorporates the “controlled group” definition from section 414(c) of the Internal Revenue Code, which has very broad application to other employee benefit provisions. As a result, there is a significant risk that the controlled group concept, if applicable to a private investment fund, could extend to areas unrelated to pension funding.
Possible Repercussions for Private Investment Funds
If private investment funds and their portfolio companies are members of a controlled group, the most immediate consequence will be to make the investment funds responsible for the unfunded pension obligations of their portfolio companies. In addition, one portfolio company might be responsible for the unfunded pension obligations of another portfolio company, since all members of a controlled group generally are liable for one another’s unfunded pension benefits.
If controlled group status extends beyond the rules governing pension liabilities, the fund and its portfolio companies will be treated as a single employer for purposes of applying a variety of employee benefits requirements. For example, a company that maintains a section 401(k) plan for its employees must demonstrate that the plan covers a nondiscriminatory cross-section of the employer’s work force. If the portfolio company is a member of a controlled group that includes a private investment fund and the fund’s other portfolio companies, the section 401(k) plan sponsor will have to take into account the work force of the entire controlled group when it applied this nondiscriminatory coverage test. At a minimum, complying with the nondiscrimination rules will require extensive sharing of information among portfolio companies that currently have little reason to communicate with one another.
Some retirement savings arrangements are designed exclusively for small employers. A company’s status as an eligible small employer is determined on a controlled group basis. Accordingly, a portfolio company that is able to sponsor a simple retirement account or a simplified employee pension for its employees on a stand-alone basis might be ineligible to sponsor these arrangements if it is deemed to be part of a larger controlled group.
The Sun Capital decision also has significant potential repercussions under the health care rules. The “employer mandate,” which was recently postponed until 2015, requires every large employer either to offer affordable, minimum value group health coverage to its employees or to pay a substantial excise tax. An employer with at least 50 full-time employees is a “large employer” that is subject to the employer mandate; and the 50-employee threshold applies on a controlled group basis. Accordingly, for example, three portfolio companies with 25, 15, and 10 employees respectively will not be subject to the employer health care mandate if they are considered separately; but if they are deemed to be members of a single controlled group because they are owned by the same family of private investment funds, they will be subject to the employer mandate and will be taxed if they fail to provide adequate employee health care.
Sun Capital has filed a petition asking the First Circuit to rehear its case, and suggesting that the rehearing be conducted “en banc” (that is, before the court’s entire complement of judges). The First Circuit’s decision was written by the chief judge of the circuit, and it received the unanimous support of the other two First Circuit judges who participated in the case. In these circumstances, rehearing is unlikely. Private investment funds and their advisers will wish to follow this case closely to determine how it will ultimately affect their employee benefits liability.