Think twice before you bet against the widows and orphans.
Last week, the United States Court of Appeals for the First Circuit issued a ruling that will make it harder for private equity funds to walk away from the unfunded pension liabilities of companies they have bought if the company goes bankrupt.
Specifically, the court ruled that one of Sun Capital’s private equity funds was “not merely a ‘passive’ investor†but actively involved in the operations of Scott Brass Inc., a portfolio company that went bankrupt in 2008. The case was brought by the New England Teamsters and Trucking Industry Pension Fund.
The case is undoubtedly important for private equity deals. Firms must consider the greater risk of unfunded pension liability when valuing targets. Portfolio companies may be grouped together to take advantage of certain pension qualifications. But the implications of the case potentially go beyond pension law.
The taxation of private equity funds is built on the premise that the funds are merely investors in portfolio companies and are not engaged in a “trade or business†for tax purposes - in other words, they are not actively involved in the business. But the court found in the Sun Capital case that a private equity fund was engaged in a trade or business for purposes of the Employee Retirement Income and Security Act, also known as Erisa. It is not a big leap to argue that the fund was engaged in a trade or business for tax purposes. And then it gets really interesting.
This raises the issue of whether foreign investors in a private equity fund could be taxed as effectively connected with a United States trade or business. (Under current law, those foreign investors are usually untaxed and need not file tax returns in the United States.) Similarly, tax-exempt investors like pension funds and university endowments could face tax liability for unrelated business taxable income on their investments. And if, as Steven M. Rosenthal of the Tax Policy Center has argued, the fund is in the trade or business of developing portfolio companies for sale to customers, the profit share paid to the fund’s managers, which is often taxed at lower long-term capital gains rates under current law, may instead be taxed as ordinary income.
The Sun Capital decision is important because it collapses a legal structure aimed at keeping the activities of the fund manager legally separate from the fund’s investors. Typically, a private equity fund is managed by a general partner; a management company that is affiliated with the general partner usually helps to manage the fund’s portfolio companies. The general partner puts in a small amount of capital but shares 20 percent of the profits, or carried interest. The limited partner investors, who contribute most of the capital, are usually institutional investors, including many tax-exempt and foreign investors. The limited partners are mostly passive and not engaged in the active management of the fund’s portfolio companies. Given the passive nature of the fund’s investors, most practitioners agree that the fund itself is not a trade or business.
No one disputes that the general partner (or its affiliated management company) often gets highly involved with the fund’s portfolio companies. In Sun Capital, for example, the management company weighed in on the portfolio company’s personnel decisions, capital spending and possible acquisitions. The critical question is whether the general partner’s activities can be attributed “downward†to the fund - that is, from the partner to the partnership.
In Sun Capital, the appeals court held that the activities of the management company should be attributed to the fund and its investors for Erisa purposes, and thus that the fund, and not just the general partner, was engaged in a trade or business. In a crucial passage, the court noted that Scott Brass Inc. paid fees to the general partner of the fund for the management services it provided. Those fees were then used to offset part of the 2 percent annual management fees that the limited partners normally pay to the general partner. The court explained that these fees thus “provided a direct economic benefit†that “an ordinary, passive investor would not derive: an offset against the management fees it otherwise would have paid its general partner.†Such management fee offsets are common but not universal, and some practitioners have noted the increased risk that these fee offsets may result in limited partners being treated as effectively connected with a trade or business.
Of course, the entire private equity business model is premised on the fund’s managers creating value through active management of portfolio companies, which then presumably leads to an increase in the portfolio company’s value. The increase in value is then realized through a dividend or sale of the company. This value creation did not happen in the case of the bankrupt Scott Brass, and so the court used the management fee offset to identify an economic benefit to the limited partners. But even without a management fee offset, limited partners generally derive an economic benefit from the activities of the general partner. What else would justify the fees? By looking through the legal fiction separating the fund’s managers and investors, the court’s reasoning could easily apply in the tax context.
For now, nothing in the Sun Capital decision changes the definition of trade or business for tax purposes. The court’s holding is an interpretation of Erisa, not tax law, and unless the Internal Revenue Service decides to make the argument in the tax context, nothing has changed. There are also some other code sections, like the “stock or securities†exception in section 864, that may further protect foreign investors from being treated as effectively connected with a United States trade or business.
Finally, there were human aspects to the case that, while not discussed by the court, might have made a difference. Sun Capital was co-founded by Marc Leder, a flashy investor who has gotten attention for using the bankruptcy process to shed legacy pension liabilities. (Mr. Leder is also known for being the host of the private fund-raiser where the Republican presidential candidate Mitt Romney dismissed 47 percent of Americans as victims who depend on the government to take care of them.) Here, Sun Capital bought a Rhode Island brass and copper manufacturer with obligations to a Teamsters pension fund. Sun Capital was trying to walk away from its pension liabilities.
The case evokes the 1991 movie “Other People’s Monday,†where Danny DeVito - as Lawrence Garfield (known to his critics as “Larry the Liquidatorâ€) â€" seeks to take over the struggling company New England Wire and Cable. I’m not surprised that the court wanted to write a Hollywood ending for the pensioners of Scott Brass Inc.
Victor Fleischer is a professor of law at the University of San Diego, where he teaches classes on corporate tax, tax policy, and venture capital and serves as the director of research for the Graduate Tax Program. His research focuses on how tax affects the structuring of venture capital, private equity, and corporate transactions. Twitter: @vicfleischer
