Private equity funds that engage in active management of portfolio companies are troubled by the decision in a lawsuit involving Sun Capital Partners.

The decision is troubling on two levels.

First, two private equity funds were held liable for shortfalls in pension plan contributions by a portfolio company that the two funds owned.

Second, the portfolio company was a corporation and the two funds were shareholders, but the courts treated the funds as if they were engaged directly in the “trade or business” of the portfolio company based on the logic in a US Supreme Court decision in an income tax case.  This could have tax implications.

Look Through

Two investment funds managed by Sun Capital Advisors bought a company, Scott Brass, Inc., that made high-quality brass, copper and other metals.  The funds purchased the company in 2007 for $7.8 million.

Sun Capital describes the business of the funds it manages as buying underperforming but market-leading companies at below intrinsic value with the aim of turning them around and then selling them for a profit. 

Scott Brass made contributions to a Teamsters pension fund under a collective bargaining agreement.  Sun Capital employees were heavily involved in the business after the acquisition.  However, falling copper prices in the fall 2008 reduced the value of the Scott Brass inventory, and the company was forced into bankruptcy in November 2008.  Scott Brass had stopped making contributions to the pension fund shortly before the bankruptcy.  There had been some underfunding of pension benefits even before the Sun funds bought the company.

After the bankruptcy, the Teamsters pension fund sent a demand for $4.5 million in withdrawal liability to Scott Brass and Sun Capital.

It claimed that the two Sun Capital investment funds and Scott Brass were under common control and, therefore, were jointly and severally liable for the withdrawal liability for the underfunding.

The Multiemployer Pension Plan Amendments Act of 1980 allows the US government to recoup unfunded pension liabilities in union, multi-employer plans.  Any employer withdrawing from a plan must pay its proportionate share of the plan’s vested but unfunded benefits.  The Act treats all trades or businesses under common control as a single employer of workers who work in any of the businesses.  However, two conditions must be satisfied to impose liability on an entity for underfunding in a pension plan.  The entity must be under common control with the company employing the union workers, meaning at least 80% common ownership, and the entity must be a “trade or business.”

US taxpayers would have had to pick up the underfunding through the US Pension Benefit Guaranty Corporation if the Sun funds were found not liable.         

The Sun funds owned 100% of the shares in Scott Brass.  One fund held 70% and the other fund held 30%.

A US appeals court found the fund with the 70% interest liable for its share of the underfunding in 2013, but sent the case back to a federal district court to assess whether the fund with the 30% interest should also be held liable.  (For earlier coverage, see the October 2013 NewsWire article, Investment Fund.)  The district court said yes in late March.

The case is Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund.

Investment Plus

The two funds had different sets of investors, although there was some overlap.  Sun Capital admitted that an important consideration in splitting ownership of Scott Brass in a 70-30 ratio between the two funds was to try to avoid having either fund reach the 80% threshold that would have made Scott Brass under common control with the fund holding the 80% interest.  PBGC regulations say common control is 80%.

The district court said the economic reality is there was common control.  Many private equity funds use parallel fund structures in which an onshore fund for taxable investors and an offshore fund for US tax-exempt and foreign investors invest alongside one another.  The court said it would treat parallel funds as under common control and, although the funds in this case were not parallel funds since they had only some investments in common, the two funds had effectively formed a partnership to invest in Scott Brass.  They were not two separate funds choosing the level of ownership interest each wanted to hold independently and making independent decisions about the Scott Brass business.  They were under common management, and the management company supplied two of the three Scott Brass directors.

The court said the partnership of the two funds was engaged directly in the Scott Brass trade or business because of its active management of that company.

The earlier decision in the case by the US appeals court in 2013 led to considerable hand wringing among tax lawyers about the possible broader tax implications.

Among the potential implications are the possibility that income earned by fund managers from portfolio companies they actively manage will be treated as ordinary income rather than investment returns.  Foreign investors who set up US entities treated as corporations to hold inbound US investments that they actively manage could be considered engaged in US trades or businesses and forced to file US tax returns, causing them to lose protections under US tax treaties that reduce or eliminate US withholding taxes on dividends and interest the foreign investors receive from US sources.  Tax-exempt investors could have to pay taxes on corporate dividends received through funds as “unrelated business taxable income.”

However, there has been less public comment after the latest decision.  It may be that the decisions, while a warning, will end up holding no larger lesson than that private equity funds should think twice about investing in portfolio companies that have underfunded union pension plans.