Summary Judgment is American Lawyer senior writer Susan Beck's regular opinion column for the Litigation Daily.
The private equity industry enjoys a charmed life, with a business model that involves minimal risk and huge payoffs, and special tax breaks as icing on the cake. But is it possible that PE firms—which have thwarted efforts to rein in their special privileges—might not always get their way?
Maybe so, if a recent ruling by the U.S. Court of Appeals for the First Circuit stands. The court held that private equity firms might have to assume a bit more risk when they buy a company to "strip and flip." If the company goes belly up, they may have to make good on its unfunded pension obligations.
Last month, the First Circuit gave the private equity world a rude surprise when it ruled that two funds formed by Sun Capital Advisers Inc. could be held liable for $4.5 million owed by portfolio company Scott Brass Inc. to the New England Teamsters and Trucking Industry Pension Fund. Chief Judge Sandra Lynch rejected the argument by Sun Capital's lawyers at Kirkland & Ellis that the PE funds aren't liable for the pension obligation under ERISA because they're just passive investors. Instead, she found that Sun Capital's executives "exerted substantial operational and managerial control over Scott Brass," and that the two Sun Capital funds that owned Scott Brass could be required to pay that money to the Teamsters fund.
The court's unanimous ruling strikes me as reasonable and fair. Private equity firms attract investors by boasting about their crackerjack skill at turning around flagging companies. And there's no doubt that they do impose their will on their targets, usually by laying off workers and finding other ways to cut costs. So they shouldn't be able to evade pension obligations by crying that they're just passive investors.
For the Sun Capital funds, $4.5 million isn't a big hit. According to the court's ruling, the larger of the two funds made $70 million in investment income in 2009. (That's the most recent figure cited by the court.) But the decision, which overturned a lower court ruling, has alarmed the PE industry and prompted no fewer than eight law firms to dispatch client memos warning of its potential dire consequences, including Gibson, Dunn & Crutcher, Davis Polk & Wardwell, and Dechert. Last week, Sun Capital filed a petition for rehearing, stating that the First Circuit's ruling is "of exceptional importance to the private equity industry, because it potentially opens private equity funds to substantial unanticipated liability."
The Sun Capital case involved a typical private equity scenario. (Sun Capital, by the way, was formed by two former top executives at Lehman Brothers.) In February 2007 two Sun Capital funds bought Scott Brass, a small Rhode Island company that made brass jewelry, fasteners, and other products. One fund took 70 percent, and the other 30 percent. Internal Sun Capital emails showed that this split was designed to evade pension liability that could be triggered if one entity owned 80 percent. Sun Capital executives took two of the three seats on Scott Brass's board, and proceeded to implement their turnaround plan. Less than two years later Scott Brass was bankrupt.
When the company went bust, the Teamsters' pension plan asked the Sun Capital funds for $4.5 million owed to the plan. The Sun Capital funds responded by suing the Teamsters' plan, asking for a declaratory judgment that they didn't owe it any money. If Sun Capital didn't pay, the shortfall would have to be picked up by the Pension Benefit Guarantee Corporation, which is running a $5.2 billion deficit in its insurance fund for multi-employer plans.
ERISA law is complicated, technical stuff. But basically, the funds would owe the money if they were under common control with Scott Brass, and were a trade or business. U.S. District Judge Douglas Wooldlock in Boston agreed with Sun Capital that the larger fund wasn't engaged in a trade or business, and was merely a passive investor, and granted summary judgment to both funds. Reversing, the First Circuit held that the larger fund was a trade or business, noting that marketing materials to investors state that the fund is actively involved in the management and operation of its portfolio companies, and citing examples of specific management activity. And although the fund is a shell entity that doesn't have any employees, the employees of Sun Capital that were involved in Scott Brass's business were deemed agents of the fund. The court remanded the case to the district court to determine if the smaller fund was a trade or business and to examine the common control issue.
The Teamsters' appellate brief is here, and Sun Capital's brief is here. An amicus brief filed by the PBGC, which supported the Teamsters plan, is here. I reached out to lawyers at Boston's Feinberg, Campbell & Zack who represent the Teamsters fund, but did not hear back. Kirkland & Ellis partner Patrick Philbin, who represents Sun Capital, declined to comment.
Franklin Moss of Spivak Lipton represents several multi-employer plans in the entertainment industry, including the Motion Picture Industry Pension and Health Plan, and he told me that he thinks the First Circuit's ruling is very moderate. "Private equity firms are up in arms about it, but it's really a compromise ruling," he said. "I would argue for a more aggressive posture." For one thing, the First Circuit found that Sun Capital wasn't trying to evade its pension obligations by dividing the investment between the two funds, notwithstanding the emails showing that was precisely its intent.
As usual, the private equity industry wants to have it both ways. It wants the credit and the huge profits for masterminding the turnaround of a company. But if things don't go well, it wants to hide in the shadows.
This article originally appeared in The Am Law Litigation Daily.
