Counting to 80

“Controlled group” liability under the US Employee Retirement Income Security Act (ERISA) – the risk that pension liabilities might spill out of one portfolio company of a private equity fund and be enforced against another portfolio company of that fund, or against the fund itself – is a risk that, until recently, presented uncertainty for private equity professionals due to the absence of any definitive authority on the point.

But because of the effect of disruptions on pension plan valuations and employer’s economic health, novel arguments have been made over the past five to six years in the bankruptcy and insolvency context to enforce ERISA claims against healthy sister portfolio companies of private equity funds and against the funds themselves on the basis of controlled group liability theories. These claims arise in two contexts – the first (and historically less frequent) is in the termination of single-employer pension plans by the Federal pensions regulator, and the second (and more frequent) is in claims made by union-sponsored “multiemployer” pension plans to enforce liabilities when a portfolio company stops contributing to (or “withdraws” from) the plan.

Some of these novel claims have been successful, and others have not, and there has been to date no appellate authority taking one side or the other. Consequently, we have moved from there being no case law on these important issues to there being both favorable and unfavorable law, which results in a different kind of uncertainly – the uncertainty of waiting to see which arguments take hold in the courts.  

The most recent development in this area of law, discussed here and elsewhere in detail at the time, was a decision out of the Federal district court in Massachusetts involving an investment by the Sun Capital private equity funds. This decision was favorable for private equity in two respects:  first, it refused to conclude that a private equity fund is a trade or business, which is necessary for the fund to be liable for these pension obligations; and second, the decision respected the division of the investment among different members of the fund family so as to break the 80 percent ownership requirement that is also necessary for controlled group liability (i.e., Sun Capital’s Fund III purchased 30 percent of the portfolio company’s equity, while Fund IV purchased 70 percent). The decision is now on appeal to the First Circuit.

How should private equity fund sponsors be dealing with this uncertainty in the law? We would offer the following observations:

Consider structuring at the outset. Private equity fund sponsors who are forming new funds should consider whether their investment activities and investor bases are appropriate for a multi-fund structure – for example by aggregating fund investors into onshore and offshore funds, taxable and non-taxable funds or based on other characteristics. Where a multi-fund structure is set up in advance and for purposes unrelated to potential pension liability, and each fund is managed by its own general partner, we believe that the risk of a subsequent claim of controlled group liability should be low.  

Consider special structuring for certain investments. In the case of a single-fund structure making an investment into a target where these pension liabilities are present, finding an unaffiliated co-investor to take a 20 percent or greater stake should be a silver bullet to any later controlled group arguments. In this context, the features of the different equity stakes (as well as management’s equity stake) and of governance should be a key area of focus. For example, if the co-investor acquires nonvoting stock or cedes its vote or other governance rights to the primary fund, the investment may open itself to controlled group arguments. If a co-investor cannot be found or is not feasible, breaking the investment up among different affiliated funds (as Sun Capital did) is the next best thing,  although this conclusion should be reviewed after the First Circuit issues its decision on appeal in the Sun Capital case.

Focus on trade or business fundamentals. On the issue of ensuring that the private equity fund is not a trade or business, not much new can be done at this stage. Sponsors should be sure to structure their funds so that they do not have employees, office space, or any of the other indicia of a trade or business – but it’s likely that nearly all funds already do this anyway. Because private equity funds market themselves based on their skill in improving assets through active management and control (and sometimes do not rigorously distinguish in their market materials among legal niceties (e.g., the legal distinctions between the fund and the manager and the entities for which the investment professionals are performing services), there is likely to remain an inherent tension between these “active” strategies and the “passive” trade or business concept that the PBGC and union pension plans will try to exploit. 

Be aware of other key unresolved issues. Even if Sun Capital is resolved favorably to private equity, other issues will remain. Key among these are: (1) if a fund is not a trade or business, does that fact break the controlled group chain for enforcing these liabilities against health sister companies? and (2) to what extent can a reshuffling of voting or governance rights undo what would otherwise be a strong case against controlled group liability? These questions are surely on the distant horizon, though have not yet presented themselves squarely in the litigation context.

Jonathan Lewis is a partner, Alicia McCarthy is counsel and Agatha Kluk is an associate in the New York office of Debevoise & Plimpton. They are members of the firm’s executive compensation & employee benefits practice. A non-edited version of this article originally appeared in the Winter 2013 issue of the Debevoise & Plimpton Private Equity Report.