* Pension liabilities become new risk factor
* Sponsors may avoid struggling companies
* Impacts debate on carried interest taxation
By Gregory Roth
NEW YORK, Aug 7 (Reuters-BUYOUTS) - In a court case that
could add a new risk factor to some private equity deals, the
First Circuit Court of Appeals last month ruled in favor of the
New England Teamsters and Trucking Industry Pension Fund, which
argued that two investment funds managed by Sun Capital Partners
were liable for $4.5 million in pension liabilities for Scott
Brass Inc. The Sun Capital portfolio company went bankrupt in
The ruling dials up the potential risks for sponsors
contemplating buying companies with employee pension
obligations. Experts said the ruling could lower the price of
some deals, and lead some firms to steer clear of troubled
companies that have pension obligations, even if they are the
only potential suitors willing to try and rescue them.
Scott Brass is a Rhode Island-based maker of brass and
copper products that was purchased by two Sun Capital funds, Sun
Capital Partners III LP and Sun Capital Partners IV LP, in 2006.
Things quickly went south after the price of copper fell
sharply; the company declared bankruptcy two years later.
Soon after Scott Brass went bankrupt, the Teamsters pension
fund that provided benefits for some of Scott Brass's unionized
workers presented Sun Capital with a bill for $4.5 million in
"pension withdrawal liabilities." Such withdrawal liabilities
are the cost to a firm for stopping regular contributions to a
pension plan that covers workers at multiple companies.
Sun Capital claimed in court that its funds were passive
investment vehicles that didn't meet the criteria under the
Employee Retirement Income Security Act, or ERISA, that would
require the funds to assume these liabilities (an argument that
a corporate acquirer would be unable to make).
But the First Circuit Court, which covers much of New
England, ruled otherwise, saying that Sun Capital was engaged in
a "trade or business" through its management and operational
control of Scott Brass, and wasn't just a "passive investor."
The ruling not only prevented Sun Capital from avoiding these
pension obligations. It also affirmed that Sun Capital was a
"business," whose primary purpose was "to seek out potential
portfolio companies that are in need of extensive intervention
with respect to their management and operations, to provide such
intervention, and then to sell the companies."
This active relationship was explicit, according to the
court, since Scott Brass paid Sun Capital for the management
services it provided to the portfolio company. These fees
offered "a direct economic benefit" to Sun Capital in exchange
for its business services, countering Sun Capital's claims that
its only benefit was passive investment income from dividends
and capital gains. Moreover, said the court, these fees for
management services would not flow to a fund's other investors,
its limited partners.
"This was the right decision," said Catherine Campbell, a
pension attorney at Feinberg Campbell and Zack, which
represented the New England Teamsters in the case. She said
"private equity firms pitch to investors by saying that they
apply their capital, people and expertise to turn companies
around and then sell them at a profit. How can you do that and
be a passive investor, as they were claiming in court?"
But Steve Judge, the chief executive of the Private Equity
Growth Capital Council, the industry's main trade group, said
that argument was too simple since there were many different
types of private equity firms, many of which don't do
turnarounds or don't seek full control of companies in their
Sun Capital executives declined to comment to Buyouts
Magazine, as did Patrick Philbin, a partner with Kirkland &
Ellis, the firm representing Sun Capital in the case. Sun
Capital is led by co-chief executives Marc Leder and Rodger
Krouse. It is not clear whether Sun Capital will try and get
this ruling overturned.
The Private Equity Growth Capital Council's Judge worried
that if this ruling were to be applied widely, "it would upend
longstanding case law on which PE firms, investors and portfolio
companies have long relied."
Indeed one law firm, Choate Hall & Stewart, said in a
research note that if a private equity fund could be
characterized as a "trade or business" under ERISA, it was
possible that each portfolio company in a fund could be held
liable for the pension liabilities of other companies in the
fund, "if portfolio companies can be connected via a chain of
ownership passing through the fund."
Meanwhile, some commentators, such as Rosenthal of the Tax
Policy Center and New York Times tax columnist Victor Fleischer,
said that the First Circuit's decision could provide ammunition
to those seeking to end the capital-gains tax treatment of
The capital gains tax treatment of carried interest is based
in part on the idea that such investments are passive-and not
the primary business of a private equity firm. Even though the
First Circuit ruling is limited to pension law, wrote Fleisher
in The Times, "it is not a big leap to argue that the (Sun
Capital) fund was engaged in a trade or business for tax
But Private Equity Growth Capital Council's Judge disagreed,
saying that "speculation that this ruling has implications for
tax law is just that-speculation. The court here did not opine
on tax issues at all," he said. Moreover, "this case only
applies in the context of ERISA and only in the First Circuit."