Private equity funds that did not look into the pension funding of their U.S. portfolio companies may now be facing a bill from the U.S. Pension Benefit Guaranty Corp. if companies fail, says a new report by Osler Hoskin & Harcourt LLP. Osler counsel Carol Buckmann adds that if companies are unionized, another bill might be coming from U.S. multi-employer pension plans if operations cease or are reduced. Both entities have been known to assert claims in Canadian proceedings as well as in the U.S. The risk emerges from a recent decision by the U.S. Court of Appeals that says private equity funds may be a “trade or business.”
Canadian (And U.S.) Investment Funds Face New Risk Of Pension Liability – What’s Keeping Fund Sponsors Up At Night
August 12 2013
By Carol Buckman, Osler, Hoskin & Harcourt LLP
Commonly controlled trades or businesses are jointly and severally liable for pension liabilities under the U.S. Employee Retirement Income Security Act (ERISA). This means that the entire liability may be assessed against any member of the group. In the view of the U.S. Pension Benefit Guaranty Corporation (PBGC) a private equity fund is a “trade or business” that could be liable for its bankrupt portfolio company’s unfunded pension liability under these rules. The PBGC’s position caused a shock wave in the investment community when it was issued in 2007.
Only a “trade or business” (regardless of whether incorporated) can be liable for the pension obligations of its ERISA-defined affiliates, but ERISA doesn’t define “trade or business”. As a result, a multi-employer union pension fund had to counterclaim in court to demand pension withdrawal liability from two private equity funds, citing the controversial PBGC position.
On July 24, 2013, the U.S. Court of Appeals for the First Circuit reversed a district court on an important “trade or business” issue in a decision whose reasoning should cause private equity funds to reevaluate their exposure for U.S. pension liability. This is so even though the appeals court did not consider the issue of whether the two funds pursued by the multi-employer plan were actually liable. This concern arises because the same definition of “trade or business” would apply for all purposes under Title IV of ERISA, and the PBGC will be able to rely on the new decision in pursuing investment funds who have controlling interests (generally, at least an 80% ownership interest) in portfolio companies with underfunded defined benefit plans. We’ve seen PBGC aggressively pursue claims against non-U.S. entities. We are aware of situations in which the PBGC has appeared in Canadian proceedings to assert these claims.
What Fund Activities and Structures Are Problematic?
The funds at issue, Sun Fund III and Sun Fund IV, owned 30% and 70%, respectively, of the portfolio company. Although the court declined to give deference to the PBGC opinion, it applied similar reasoning in determining that Sun Fund IV was more than a passive investor (a standard it called “investment plus”) because it engaged in profit seeking activity with continuity and regularity. Specifically, Sun Fund IV general partners were actively involved in managing and operating the portfolio company, including hiring, firing and determining compensation, and these activities were attributed to the fund. Further, Sun Fund IV received a direct economic benefit not available to passive investors – it was able to offset the management fees paid to the general partner for managing the portfolio company against the management fees it would otherwise have paid its general partner. The court decided that these activities were sufficient for the fund to be a “trade or business” rather than a passive investor.
The appeals court also decided that the 70%/30% ownership split, which had apparently been negotiated with ERISA’s 80% ownership threshold for controlled group liability in mind, would not be ignored to find 100% control of the portfolio company under a provision of ERISA that ignores transactions initiated to evade or avoid liability. The appeals court declined to take that position because that would create a fictitious transaction that might never have occurred.
What is Undecided
The appeals court declined to set a general test for determining when investment funds are “trades or businesses”, stating that it will be a facts and circumstances determination. While most venture capital operating companies (VCOCs) will be, by their nature, engaged in management activities similar to the Sun Funds’, other types of funds or business arrangements might not constitute “trades or businesses” even under the “investment plus” standard applied by the appeals court.
The appeals court did not determine whether Sun Fund III was also a trade or business, remanding to the district court for that determination. However, even if Sun Fund III is also a trade or business, the court would have to determine that there was a basis under the controlled group rules for aggregating funds established by the same or related investment firms to meet the 80% threshold. We don’t know whether that will happen.
Since the court declined to find that splitting ownership to stay below the 80% threshold was an attempt to evade or avoid liability, it may still be possible for multiple funds to negotiate for less than an 80% ownership interest in a portfolio company to limit Title IV exposure. It would appear to be permissible for a single fund to negotiate for a less than 80% interest to avoid pension liability where there are no related parallel investments. Stay tuned on these issues.
How Can Funds Protect Themselves?
While this decision is technically law only in the First Circuit, another district court in a since settled case involving Palladium Equity Partners had also found that investment funds could be trades or businesses. Other courts may adopt their reasoning. Accordingly, funds should consider the following:
Do thorough due diligence of potential pension liabilities of the portfolio company AND its affiliated companies before closing. It is important to understand that the portfolio company may have Title IV liability for plans other than those it directly sponsors or makes contributions to, such as plans of subsidiaries and brother-sister entities, in addition to plans covering its own employees.
Consider contractual provisions such as comprehensive ERISA representations and indemnification from former owners, and keeping ownership below 80%. (though there are some situations in which less than an 80% interest could still result in liability, as the controlled group rules are complicated.) Also consider how potential liability will affect representations, covenants and default provisions in loan agreements.
Consider whether to restrict ownership or involvement with portfolio companies under the fund’s governing documents and operating rules.
If there are defined benefit pension plans in the controlled group, continue to monitor their funded status and potential liabilities after the investment. Multi-employer plan liability is assessed on withdrawal, And even if the single employer plans are not terminated voluntarily, the PBGC has the right to involuntarily terminate plans. This could occur even before bankruptcy if PBGC feels
that its liability exposure will be increased if the plan continues. Sometimes, making additional contributions or changing investment strategy will improve the plan’s funded status and allay PBGC’s concerns.
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