Private equity funds face increased risk of being on the hook for their portfolio companies' pension liabilities following a federal appeals court ruling that is also raising broader questions about tax exposure for private equity partners and their investors.
The 1st U.S. Circuit Court of Appeals in Boston ruled July 24 that a private equity fund could have joint and several liability for its portfolio companies' pension obligations if the fund holds a sufficient stake in the companies. While the appeals court did not define the size of a stake, legal experts say 80% is considered typical.
The ruling in Sun Capital Partners III LP vs. New England Teamsters & Trucking Industry Pension Fund is considered precedent-setting because it is the first such decision at the appeals court level. It overturns a 2012 district court ruling stating private equity firms did not operate as “trades or businesses,” but rather were passive investors and therefore did not have liability for portfolio companies' pension liabilities.
The U.S. District Court for the District of Massachusetts now will have to address the issue of ownership control in this specific case, and Sun Capital has requested a circuit court rehearing on the “trade or business” issue.
“This is an important precedent for defined benefit plans and scary for private equity funds and their investors,” said David Fann, CEO of TorreyCove Capital Partners LLC, San Diego, a private equity investment consultant.
In addition to the legal uncertainty that could complicate future buyouts of companies with pension plans covered by the Employee Retirement Income Security Act, “one major consequence,” said Mr. Fann, “is that private equity investment returns could be lowered materially if pension liabilities of underperforming companies are borne by private equity funds.”
That prospect has also occurred to private equity investors, who are waiting for further legal clarification “This area of the law is new and still developing. We are working with counsel to determine the impact to our private equity program,” said Jeanne Chenault, spokeswoman for the $59.1 billion Virginia Retirement System, Richmond, which has a 9% private equity allocation. “It is on our radar.”
The Sun Capital Partners case rose to the circuit court level in a challenge by pension fund officials seeking $4.5 million in withdrawal liability for Rhode Island metal fabricator Scott Brass Inc. The company, which declared bankruptcy in 2008, was a portfolio company of two Sun Capital funds, which in 2006 invested $3 million in cash and borrowed another $4.8 million that resulted in one fund owning 70% of Scott Brass and the other owning 30%. According to court documents, Sun funds lost their entire investment in Scott Brass as a result of the involuntary bankruptcy.