Public pension funds are going to get dinged when their private equity fund “partners” engage in the form of looting known as withdrawing from underfunded pension plans.
One thing that has always seemed astonishingly short-sighted is the way public pension funds have helped finance the elimination of private pension funds. Admittedly, there are not all that many defined benefit plans left standing, but the project has been underway for some time. Now that government employees are virtually the only people in the US who have defined benefit plans, the calls keep increasing to have them eliminated so as to put public workers on the same perilous footing as private sector workers. That of course ignores the fact that people in the private sector could have sought work in the public sector but didn’t and that the pensions of government workers are part of a total compensation package, as in their wages are lower by virtue of having retirement goodies.
In a ruling last month, Judge Douglas Woodlock ruled that two Sun Capital funds that had jointly purchased a company, Scott Brass, that went bankrupt, were subject to withdrawal liability of their pension fund. We’ve embedded a short memo by Wilkie Farr on the ruling as well as the decision itself at the end of the post.
The basis for the ruling. The short version is that if a “controlled group” that owns more than 80% of a company terminates an underfunded pension plan, it is responsible for withdrawal liability under ERISA. The Department of Labor did not want investors being able to close underfunded plans without incurring a serious cost; otherwise, it would be common for pension plans to be shut down any time they became underfunded, leaving beneficiaries in the lurch.
Sun Capital had sought to get around that by having two Sun Capital funds invest in a company that bought Scott Brass, with one owning 70% and the other 30% so as to fall below the 80% trigger. The Teamsters and Sun Capital sued each other, and the judge’s initial ruling in favor of Sun Capital was overruled in part and returned to Judge Woodlock to determine two issues key to deciding the case: whether the funds were engaged in a trade of business, and whether they were under “common control”.
The active nature of the investment as far as the general partners are concerned would seem to make them meet the “trade or business” test, but what about the passive limited partners?* Interestingly, they were hoist on the sharing of monitoring and transaction fees. The appeals court had already ruled that one of the two Sun funds, by virtue of the investors receiving management fee offsets, met the test. Woodlock was to determine whether the second fund, where no fee offsets had been paid but had been carried forward and were due and owing, was also in a trade or business. Woodlock concluded yes.
The second test was common control. Amusingly, Wilkie Farr sniffed that:
The District Court treated the private equity funds as if they were a “partnership-in-fact” for purposes of a specific investment, despite the fact that the funds had substantially different investors and portfolio companies, filed separate partnership tax returns, prepared separate financial statements and maintained separate bank accounts.
ERISA refers to a section of the tax code to define this issue, and former IRS resident scholar, now law professor at University of North Carolina Gregg Polsky advised the Teamsters on this case. And as you can see from this extract from the ruling, key precedents have taken a broader view of this question that formal niceties:
The agreement of the parties and their conduct in executing its terms; the contributions, if any, which each party has made to the venture; the parties’ control over income and capital and the right of each to make withdrawals; whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; whether business was conducted in the joint names of the parties; whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers; whether separate books of account were maintained for the venture; and whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.
Luna v. Commissioner, 42 T.C. 1067, 1077-78 (1964)
As the Judge Woodlock concluded:
The two Funds were organizationally separate – and this remains important under Culbertson and Luna – but the record shows no meaningful evidence of actual independence in their relevant co-investments.
The only case that addressed similar organizational issues was Bd. of Trs., Sheet Metal Workers’ Nat’l Pension Fund v. Palladium Equity Partners, LLC. Although the case was settled before fact-finding was completed. Here, three Palladium funds had together purchased over 80% of a group of industrial painting companies which went bankrupt and withdrew from a multi-employer pension plan. The judge noted:
The Palladium court was clear that as a matter of law, partnership-in-fact and common control can be found even across formally fully independent entities.
Implications. This ruling ought to wake up private equity investors, since the Sun Capital ruling will not only result in clawbacks to satisfy the withdrawal liability but presumably opens the door to other cases. The beneficiaries of pension plans terminated and were stiffed on withdrawal liability payments by Sun Capital-type structuring for controlling groups to keep the biggest individual owner’s share below 80% would have grounds to sue, or unions representing them might act on their behalf. Similarly, the Pension Benefit Guaranty Corp., which backstops private pension funds, it itself badly underfunded and should also lodge cases. I have yet to see any commentary on what the statute of limitations is in this area and therefore which plan terminations would be exposed, but you can expect that you’ll be hearing more about this issue.