Pension Debt Ruling Has Implications for Private Equity

Late last month, a federal judge ruled that private equity funds are liable for the pension debt of their portfolio companies.

Observers say the ruling could shake up the private equity industry.

The legal nuts and bolts are outlined in this Lexology article; but a New York Times piece provides a more down-to-earth explanation of what this means for private equity:

Late last month, Judge Douglas P. Woodlock of the United States District Court in Massachusetts found that two private equity funds were jointly liable for the pension fund debt of one of the companies they acquired.

“The private equity world is all over this,” said Paul Secunda, a labor law and employee benefits expert at Marquette University Law School. “For everybody else, it’s like, what’s the big deal?”

To answer that, it helps to go back to the beginning of the story.

It started with a Rhode Island company, Scott Brass, which makes brass and copper for all sorts of industries. In 2007, an affiliate of the private equity firm Sun Capital Partners bought Scott Brass, splitting the ownership between two separate Sun Capital funds.

A year later, Scott Brass went bankrupt and stopped contributing to its pension fund, run by the New England Teamsters and Trucking Industry Pension Fund.

Federal law imposes pension liability on any “trade or business” that is under “common control” with Scott Brass. The pension fund argued that Sun Capital’s funds met that definition — and should be liable for the $4.5 million pension fund debt.

In 2013, the United States Court of Appeals for the First Circuit found that one of Sun’s funds did constitute a “trade or business” — the first time a private equity fund was classified as such. The appeals court sent the case back to a lower court to decide whether Sun’s other fund was “a trade or business” as well.

On March 28, Judge Woodlock found not only that the other fund’s activities met the test of being “a trade or business,” he also found that the two funds served as a “partnership in fact” — one that was under common control with Scott Brass. That made the funds liable for the pension debt.

And what does the ruling mean, if it’s upheld? From the New York Times:

Two years ago, the appeals court’s opinion drew a flurry of attention over whether the Sun Capital case would challenge the foundation of the private equity business model by changing how it is taxed. That’s because the appeals court relied on federal income tax principles to conclude that Sun’s private equity fund was a “trade or business” for the purposes of employee benefits law.

In theory, if the I.R.S. were to adopt the same reasoning in a tax context, it could kill the goose that lays the golden eggs of the private equity industry: its huge tax breaks. It could do it in a way that would turn the investing world upside down.

And that’s why it probably will not happen, said Gregg D. Polsky, a tax law professor at the University of North Carolina School of Law who has written critically about the industry’s practices.

“It could create all sorts of potential headaches and uncertainties for investors,” Professor Polsky said, including foreign investors and tax-exempt investors like university endowments. “I don’t think the I.R.S. is interested in doing that.”

Until now, private equity firms have looked at companies with underfunded pension plans as undervalued targets, because the private equity firms were not responsible for funding those plans once they took over the company. Now they know they might be if Judge Woodlock’s ruling is upheld on appeal, and if other courts adopt it.