Sun Capital case may tip private equity equation

A groundbreaking legal decision that could give pension funds and the Pension Benefit Guaranty Corp. more muscle in recovering pension liabilities has private equity firms suddenly paying a lot more attention to deals in which pension benefits are involved.

“This is clearly very new territory,” said attorney Michael Kreps, a principal with Groom Law Group in Washington. “From the pension fund side, they've got some pretty good precedent now. A lot of (pension) funds are now thinking, "we have more options than we had six months ago,'” he said.

“For the PBGC, it's a potential game changer,” Mr. Kreps said. The agency's multiemployer insurance program is expected to run out of money by 2025, and taking on one or more plans now headed for insolvency would hasten that crisis.

The case, brought by New England Teamsters & Trucking Industry Pension Fund, Burlington, Mass., against several Sun Capital Partners Inc. funds, is under appeal, but “there's exposure right now,” said private equity consultant David Fann, president and CEO of TorreyCove Capital Partners LLC in San Diego. “Anything that has a similar fact pattern will probably end in court. It opens the door for a lot of other lawsuits where private equity (companies) have withdrawn from pension plans.”

Jed Brickner, a New York partner in law firm Latham & Watkins LLP who advises private equity and other funds, agreed.

“If this ended up being the law of the land, it would significantly change the way that private equity investments are structured where the target has significant pension liability,” Mr. Brickner said. “Before the decision, the market thought transactions structured like Sun Capital were safe.”

Until now, private equity firms and their limited partner investors typically have not had to worry about being on the hook for pension liabilities under the Employee Retirement Income Security Act. The firms' individual funds are considered investors, rather than a controlling “trade or business” that would be responsible under ERISA, and their primary regulator is the Internal Revenue Service, where 80% ownership of a portfolio company is considered the threshold for company control. Many funds are structured to avoid that 80%, and few even calculate pension liabilities in their valuations, experts say.

On March 28, U.S. District Court Judge Douglas Woodlock for the District of Massachusetts in Boston saw it much differently, in a case involving pension withdrawal liability of a defunct portfolio company, Scott Brass Inc., owned by two Sun Capital Partners funds. While the two funds, Sun Capital Partners III and Sun Capital Partners IV, only owned 30% and 70%, respectively, “the substantial overlap” between the way the funds operated made them not only a trade or business, but “a partnership-in-fact,” Mr. Woodlock said in his decision. “It is the conduct of the funds that gives rise to a partnership.”

For the PBGC, which has been constrained by previous court interpretations that relied on specific statutes' definition of control, the pension fund's case is an innovative way to look at who is liable, said an agency lawyer, who asked not to be identified. “They have used common law arguments about partnership-in-fact to get around the 80/20 test,” the PBGC lawyer said.

The story began in 2007 when the Sun Capital funds invested in Scott Brass, which was a contributing employer in the $4.4 billion New England Teamsters & Trucking Industry Pension Fund. When Scott Brass went bankrupt in 2008, the pension fund sued the Sun Capital funds for $4.5 million in withdrawal liability. The pension fund's attorney, Catherine Campbell, of Feinberg, Campbell & Zack PC in Boston, said the trustees acted because they saw it as their fiduciary duty.

At the time, Sun Capital moved to stop the lawsuit, saying in court documents that “no reported case has ever upheld” the partnership theory, and that doing so “would fundamentally impair and interfere with the rights of private investment funds to voluntarily structure their legal relationships among and between one another.” The two investment funds had separate tax returns and financial statements, few overlapping limited partners, and statements in their co-investment agreements that they did not intend to form a partnership.

The District Court initially agreed with Sun Capital's argument that it was not a trade or business. But when the Teamsters pension fund appealed, the 1st U.S. Circuit Court of Appeals in Boston said that Sun Capital IV was a trade or business for withdrawal liability purposes, and ordered the District Court to reconsider Sun Capital III in that light. When the District Court took it up again this year, the answer was that not only was there common control, but also the relationship between the two funds was a partnership.

Unless Sun Capital wins this latest appeal, the Teamsters pension fund will get its $4.5 million, which already has been posted in a bond. The pension fund is also seeking $3 million in interest and damages, plus legal costs. The expense could be passed on to the funds' investors, many of whom are likely to be pension funds themselves.

PBGC officials are optimistic. While they have reached some settlements with single-employer pension plans in the past, they have had less success going after owners of bankrupt firms in multiemployer funds.

“This new argument has the potential to change that, all of a sudden,” said another PBGC lawyer who declined to be identified. “This could vastly expand liabilities. At this point, our options are wide open. We just have some internal decisions to make.”

Less enthusiastic are private equity firms and their lawyers, who caution their clients to take a look at existing fund structures and to be prepared to look at new ones differently. “It's going to modify the calculus as to how you view the company. Today you're going to place greater weight on the pension liabilities of a target than you would have before,” said Mr. Brickner.

If the ruling is allowed to stand, it also could change how future investing partnerships are formed. In cases where significant pension liabilities are involved, “it's going to make it more likely that funds are going to look for unrelated partners,” he said.

It also means more risk for investors. “When you value a company, you assume certain things are going to happen, e.g. pension liability. If that is wrong, it could affect cash flow, balance sheet exposure and investor returns,” said Mr. Fann of TorreyCove, who notes that private equity limited partners rarely ask for, or are given, transaction specifics down to the level of pension issues. “Until now, it was never part of economic scrutiny. They might (ask) now,” he said.

And if private equity partners don't have enough to worry about with the new definition of control, there could be more scrutiny, including for tax purposes. “There are lots of scenarios in which the IRS gets more active and the PBGC gets more active,” said Steven Rosenthal, a tax lawyer and visiting fellow at the Tax Policy Center in Washington. “In my view, any court that looks at these cases will find that private equity is a trade or business, so it's just a matter of time before cases bubble up.

“If the choice for a pension fund trustee is to cut benefits for the workers or to sue the private equity firm, I could imagine there would be more cases.” n