As savvy private equity professionals know, under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), a private equity fund’s assets could be exposed to joint and several liability for unfunded pension benefit liabilities of any portfolio company of the fund if the fund is engaged in a “trade or business” and is under “common control” with the portfolio company. As these private equity professionals also know, however, private equity firms and their advisors have historically utilized a variety of structuring and other planning mechanics to reduce the risk that they would be viewed as engaged in a “trade or business” under ERISA.
Still, in recent years, the Pension Benefit Guaranty Corporation (the “PBGC”) has begun to assert that an investment fund sponsored by a private equity firm may be a “trade or business” that can be treated as under “common control” with one or more portfolio company investments for purposes of ERISA. For instance, in September, 2007, the PBGC Appeals Board issued a denial of an appeal of a PBGC finding of an investment fund being a “trade or business” under “common control” with a defunct portfolio company. While there has been no material judicial review of the PBGC’s views in the private equity investment funds area, several recent judicial decisions involving purportedly passive investment vehicles of individuals and families have held that such vehicles are engaged in a “trade or business” under ERISA. Although these cases can be distinguished from a typical private equity fund structure, they should be considered in fund raising, and in the worst case scenario, in defense against an assertion by the PBGC that a fund is engaged in a “trade or business.”
Background: ERISA Controlled Group Liability
ERISA, which is the federal law governing pension plans and how they are operated and funded, imposes joint and several liability on each member of a “controlled group” of business entities for certain pension obligations. For instance, in the context of a so-called “single employer” plan (i.e., one maintained by a company exclusively for its employees and those of its controlled subsidiaries), all “trades or businesses” that are part of the same controlled group can be jointly and severally liable for any deficiency in such plan’s funding that exits at the time at which the plan is terminated. Such a termination ordinarily will occur in the context of a bankruptcy proceeding. Similarly, if an employer withdraws from a multiemployer pension plan (i.e., a plan maintained pursuant to one or more collective bargaining agreements which is funded by contributions from more than one employer) that has unfunded benefits at the time of the withdrawal, such employer and each “trade or business” that is part of its ERISA “controlled group” are jointly and severally liable for its allocable share of the liabilities related to the multi-employer plan’s unfunded vested benefits (“Withdrawal Liabilities”).
Applicability to Private Equity Sponsors
In the context of the typical investment fund structure, an ERISA “controlled group” will exist if two or more corporations or partnerships are “trades or businesses” and are determined to be under common control, based essentially upon there being at least 80% common equity ownership. In the private equity context, this means that any two or more 80% or more common equity owned portfolio companies of a private equity investment fund face such potential joint and several liability.
But the private equity investment fund itself and its manager are often structured so that the fund is a passive investor in the portfolio companies, with all of the active management effected by the separately owned and operated manager. Many practitioners believe that, by isolating the fund from the normal operations of the manager and the portfolio companies, the fund would not be treated as a “trade or business” under ERISA. If the fund is not a “trade or business,” it cannot be part of the ERISA “controlled group” that includes any of the portfolio companies in which it is invested, which should insulate at least some of its assets from the pension liabilities of such companies.
The Hughes Decision
Although the Supreme Court has held that “investing is not a trade or business,” in Central States, Southeast and Southwest Areas Pension Fund v. Hughes, decided April 30, 2012, the Northern District of Illinois determined that the purportedly passive investment activities of a family estate planning vehicle was a “trade or business” for purposes of applying ERISA’s “controlled group” test. In Hughes, a multi-employer pension plan sought to impose Withdrawal Liability against three corporations, each of which was owned in significant part by members of one family and a related trust. The plan argued that the three corporations were jointly and severally liable for the Withdrawal Liability by reason of being “commonly controlled” “trades or businesses” for purposes of the relevant provisions of ERISA. One of these corporations was operated for estate planning purposes and for decades had held only securities, notes and one parcel of real estate. This corporation had constructed a small office on that property and leased space to tenants under “net leases” where the cost of certain expenses was factored into the rent due. The corporation argued that these limited activities did not make it a “trade or business” for purposes of ERISA’s “controlled group” test.
In similar contexts, several courts have used a two part test to determine whether an entity’s activities constitute “a trade or business,” asking whether such activities were intended for profit or income and continuous and regular in nature. The Hughes court stated that passive investing, including the holding of real estate, will generally satisfy the “for profit” prong, so long as income production is the primary purpose for holding the investment assets. In its “for profit” analysis, the court pointed to a variety of factors, including that the corporation made improvements to the land it owned, the property earned rental income and claimed business related income tax deductions, and the corporation possessed a federal employer identification number. The court found that the entity also engaged in “continuous and regular” activities because the corporation regularly paid an operating entity a fee to manage the property, contracted with third parties to clean and maintain the property, and paid costs in order to support and maintain the value of the property in the estate.
Hughes draws upon a Seventh Circuit decision that affirmed a district court’s surprising factual determination that an estate planning vehicle was a “trade or business.” That case, McDougall v. Pioneer Ranch Ltd. P’ship, 494 F.3d 571 (2007), involved a sizable Withdrawal Liability claim between the sole proprietor of a defunct business and a “family owned vacation property,” which was documented as a working farm for estate and tax planning purposes. The district court found that the partnership created to own the property was a trade or business, despite a long history of significant operating losses, because, among other factors, it: claimed business related tax losses on its federal income tax returns; sold some of the farm’s products; employed one full-time worker and one-part time worker and had a federal taxpayer identification number.
Happily, the appellate decision reflects some skepticism from the panel as to whether they would have reached the same factual conclusions as the district court. Moreover, the holding in McDougall could readily be distinguished from a properly operated private equity investment fund on the basis, among other factors, that the farm had reported itself as a trade or business to avail itself of federal tax benefits and was therefore estopped from denying that character when confronted with a material Withdrawal Liability claim. Hughes, however, disregards that element of McDougall to enable it to find a mechanism to construct a “trade or business” from relatively modest activities.
Impact of the Decision on Private Equity Funds
There are several bases upon which to distinguish Hughes and its predecessors from the typical private equity investment fund situation, including that each of these cases involved the ownership and operation of real property, which almost always necessitates more ongoing activity than pure securities holding. Furthermore, each case presents circumstances where the entity or its advisors were not careful or consistent in honoring the entity’s character as a passive investor.
Nonetheless, the Hughes decision is significant for private equity sponsors because of the low threshold it applied in determining a profit intent—a threshold an investment fund should assume it would readily transcend. But even more notable for sponsors are the factors Hughes cites in support of the conclusion that the entity’s activities were sufficiently continuous and regular to constitute a “trade or business,” including the retention and payment of a manager to act on the entity’s behalf and other relatively modest steps to maintain the real property that the entity owned. In light of its reliance on these factors, the Hughes court may have staked out a very narrow view of what activities a passive investor may undertake before becoming a functional “trade or business” under ERISA. Private equity sponsors will no doubt continue to take the position that the passive nature of their relationships to their portfolio companies precludes a determination that they are engaged in a “trade or business,” but Hughes is unlikely to make that argument easier to assert.