Ruling throws doubt on pension liability risk

A ground breaking US appeals court decision related to Sun Capital has raised questions over when a GP could be on the hook for a bankrupt portfolio company's pension plan.

Private equity firms could more easily be on the hook for a bankrupt portfolio company’s unfunded pension plan under Employee Retirement Income Security Act (ERISA) rules following a US federal appeals court decision issued Wednesday.

The court decision, in the case between New England Teamsters & Trucking Industry Pension Fund and private equity firm Sun Capital Partners, hinged on whether or not a private equity fund can be considered a “trade or business” or whether it is merely a passive investment vehicle. 

Reversing a previous court decision, the appeals court ruled that Sun Capital's investment in metals manufacturer Scott Brass can be considered a trade or business due to its involvement in the portfolio company's operations, noting Sun Capital's right to hire and fire portfolio company personnel as evidence. 

Mike Crumbock, employee benefits attorney at Pepper Hamilton, called the case “discomforting for private equity”. He said private equity firms previously had comfort that their funds could avoid being characterized as a trade or business, but now the issue has become unsettled.

“Going forward I don’t think private equity can avoid pension liabilities by relying on not being a trade or business under common control with its portfolio companies anymore. Funds are going to have to be very careful about what control they exercise over their portfolio companies and how they structure their investments in companies in the future.”

The court was also asked to consider if Sun Capital funds collectively controlled the portfolio company for ERISA purposes. Sun Capital split its investments across funds to stay under a 80 percent “controlled group” liability test. The court ruled one Sun Capital fund with 70 percent stakes in Scott Brass was a trade or business, but left it to the lower court to decide if a sister Sun Capital fund with a 30 percent ownership stake was also a trade or business, and represented a “joint venture”, which if taken with the first fund would push Sun Capital past the 80 percent controlled group benchmark. 

Multiple industry sources expressed disappointment at the outcome of the appeal, describing it at odds with income tax precedent. If labelled a trade or business, private equity funds would lose their pass-through tax status. Potentially aware of the implications, the appeals court said its trade or business definition was limited to ERISA purposes, in effect removing the possibility the decision would result in non-US investors becoming subject to US tax on income and gains from private equity funds.

Pepper Hamilton tax partner Steve Bortnick said a fund treated as engaged in a trade or business also raised the question of whether carried interest should then be taxed under ordinary income, as opposed to the more favorable capital gains rate. He added however that nothing in the Sun Capital decision should be read to result in this outcome.