Federal Appeals Court Ruling Casts a Cloud Over Private Equity Controlled Group Assumptions

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1 Federal Appeals Court Ruling Casts a Cloud Over Private Equity Controlled Group Assumptions August 2013 Lockton Companies A recent federal appeals court case has sent shudders through private equity funds, holding that a private equity (PE) fund is engaged in a trade or business for purposes of controlled group determinations under ERISA. The decision kicks wide open the door to potential determinations that PE funds and their portfolio companies are members of the same controlled group for purposes of ERISA, and perhaps the federal Tax Code as well. Edward C. Fensholt, j.d. Senior Vice President Co-Director of Compliance Services Lockton Benefit Group efensholt@lockton.com Mark Holloway, J.D. Senior Vice President Co-Director of Compliance Services Lockton Benefit Group mholloway@lockton.com From an employee benefits angle, such determinations could draw PE funds and their portfolio companies into the danger zone for purposes of retirement and health plan discrimination testing, and even some health reform obligations. L O C K T O N C O M P A N I E S

2 Background Controlled groups of trades or businesses typically exist where they are under common control, generally defined as at least 80 percent common ownership (i.e., stock ownership, in the case of for-profit companies, profits interest in the case of partnerships and similar entities). In the employee benefits world, controlled group status is very important because benefit plans subject to nondiscrimination rules generally must be tested on a controlled group basis (there are narrow exceptions). This means all employees in the entire controlled group need to be considered. Under health reform, whether an employer is subject to the employer mandate depends on its size, and that size is determined on a controlled group basis. Union-affiliated pension funds can seek withdrawal liability from a delinquent employer s controlled group, and the Pension Benefit Guaranty Corporation (PBGC) may troll for money from the controlled group brethren of a bankrupt sponsor of an underfunded defined benefit pension fund whose liabilities the PBGC has taken on. Traditionally, PE funds have assumed they and their portfolio companies were not part of a controlled group merely by virtue of the funds ownership of or investment in those companies (some funds hedge their bets a bit, splitting ownership of portfolio companies between related funds, so no fund holds at least 80 percent of a portfolio company). Controlled groups of trades or businesses typically exist where they are under common control, generally defined as at least 80 percent common ownership. The theory has been that, for a controlled group to exist under ERISA, there must be two things: (1) trades or businesses that (2) are under common control. PE funds have argued that a PE fund is merely an investment vehicle, not a trade or business itself, and therefore the first prong of the controlled group test can never be met. The Supreme Court had essentially concluded the same, in a case considering a PE fund s controlled group status for tax purposes. 2

3 The Sun Capital Case The recent case in question involved ERISA, not tax issues, and centered on a company owned by two related Sun Capital PE funds. The company went bankrupt, leaving a union-affiliated pension fund with millions of dollars in unpaid withdrawal liability under Title IV of ERISA (Title IV contains special rules related to defined benefit pension plans; withdrawal liability is imposed upon an employer that withdraws from a union-affiliated pension fund at a time when the fund is underfunded). The pension fund went hunting for targets of opportunity, and set its sights upon the Sun Capital PE funds. One of the Sun Capital funds owned 70 percent of the defunct company, the other owned 30 percent. In 2007 the PBGC considering controlled group issues under Title IV of ERISA had issued an administrative opinion finding a PE fund liable for the defined benefit pension liabilities of one of its portfolio companies. The case aroused the interest of, but not much concern by, PE funds, which saw the administrative opinion as poorly reasoned and wrongly decided. Several months ago the federal trial court hearing the Sun Capital case concluded likewise, dismissing the PBGC opinion as incorrect and shielding the Sun Capital funds from the withdrawal liability sought by the union-affiliated pension fund. But the First Circuit Court of Appeals, with jurisdiction over Rhode Island, Massachusetts, New Hampshire and Maine, recently reversed the trial court. The appeals court concluded that at least one of the Sun Capital funds was engaged in a trade or business, and sent the case back to the trial court to decide two things: whether the other fund is also a trade or business, and whether the funds owned sufficient interests in the bankrupt company that the company could be considered under common control, for ERISA purposes, with one or both of the funds, thus establishing a controlled group. The First Circuit s trade or business conclusion is important, and highly fact-specific. The court thought the PE funds were too actively engaged in the portfolio company to be considered merely a passive investor. The court noted that the funds had solicited investors by representing that they (the funds) intended to actively manage and supervise their portfolio companies, the funds managing partners had considerable power to do just that, the funds had the right to control their portfolio companies by appointing directors, and Sun Capital had caused the bankrupt company to hire affiliates of Sun Capital to provide management and other services. Also significantly, the court found that at least one of the Sun Capital funds received a direct economic benefit something an ordinary, passive investor would not receive when the fund was permitted to offset, against the fees it otherwise owed the fund s managing partners, fees paid by the bankrupt portfolio company to those partners. 3

4 What It Means The case is interesting for many reasons. The case centered on a trade or business assessment under ERISA s controlled group rules, and not the Tax Code s controlled group rules. But the former expressly pattern themselves on the latter, meaning the court s analysis could easily bleed over into employee benefit issues that arise under the Tax Code, such as retirement plan discrimination testing, applicability of the employer mandate under health reform, and nondiscrimination rules for self-insured health plans. Although the First Circuit s decision on the trade or business issue is binding law only in the First Circuit, other federal courts might begin to adopt the First Circuit s reasoning More interesting, the manner in which the Sun Capital funds dealt with the portfolio company is not uncommon. If the funds activities mean the funds are trades or businesses for purposes of a controlled group analysis, then many PE funds are exposed to the possibility of similar conclusions. So the case now returns to the trial court, which must consider the two funds respective interests in the bankrupt portfolio company (one owned 70 percent, the other 30 percent), and decide whether one or both of the funds had a sufficient ownership interest that the company and the fund (or funds) were under common control. Where Do PE Funds Go From Here? Many PE funds are huddling with legal counsel to consider the impact of the Sun Capital case. It is entirely appropriate that they do so. Although the First Circuit s decision on the trade or business issue is binding law only in the First Circuit, other federal courts might begin to adopt the First Circuit s reasoning. Certainly, the decision will embolden pension funds, and others, to launch controlled group claim against PE funds. Without doubt, the PE world will closely watch what the trial court does with its controlled group analysis, now that the appeals court has concluded the Sun Capital funds were engaged in a trade or business. If the trial court declines to aggregate the interests of the two funds, then it seems likely it will conclude the funds and the company were not under common control. But some PE funds own at least 80 percent of the stock of their portfolio companies. These funds seem to be at the greatest risk of controlled group determinations, certainly in the First Circuit, and perhaps elsewhere if the court s recent opinion gains traction in the other circuits. 4

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