Private Equity Fund

PBGC's Ruling that a Private Equity Fund was a Member of Controlled Group of Trades or Businesses Could Have Far-Reaching Consequences

By: Deborah L. Grace Sponsors of private equity funds have consistently taken the approach that the limited partnership which owns an interest in multiple portfolio companies is a passive investment fund and not a trade or business. Usually, a general partner has full control of the fund's operation, and will hire a management company to provide investment advisory and management services to the fund and to the portfolio companies owned by the fund. This view of the fund as a passive entity has been challenged by the Pension Benefit Guaranty Corporation ("PBGC"). Among other things, this could affect whether the fund or its other portfolio companies could be exposed to liability for funding defined benefit or multiemployer pension plans. In a September 2007 decision, the PBGC's Appeals Board held that a private equity fund (the "Fund") was liable for more than $3 million in unfunded pension liabilities arising from PBGC's termination of a pension plan sponsored by a portfolio company in which the Fund invested. To impose termination liability on the Fund, the Appeals Board stated that two tests must be met: the Fund must be under common control with the portfolio company and the Fund must be a trade or business. To determine whether common control existed, the PBGC looked at the regulations under Internal Revenue Code Section 414(c). These regulations provide that a parent-subsidiary group of trades or businesses under common control exists where one or more chains of organizations are connected through ownership of a controlling interest with a common parent organization. A private equity fund will have a controlling interest in a corporation if it owns stock possessing at least 80 percent of total combined voting power of all classes. With respect to a limited liability company or other such portfolio company, a private equity fund will have controlling interest if it owns at least 80 percent of the profits interest or capital interest of such company. The following example illustrates these rules. PEF, a private equity fund, owns stock possessing 80 percent of the total combined voting power of all classes of stock entitled to voting of S corporation. PEF is the common parent of a parent-subsidiary group of trades or businesses under common control consisting of the PEF and S Corporation. Assume further that S owns 80 percent of the profits interest in a limited liability company, LLC. PEF is the common parent of a parent-subsidiary group of trades or businesses under common control consisting of the PEF, S Corporation, and LLC. The result would be the same if PEF, rather than S, owned 80 percent of the profits interest in LLC. In the PBGC's Appeals Board decision, the Fund, which owned 96.3% of the stock of the corporation that was the 100% owner of the plan sponsor, did not dispute PBGC's determination that a parent-subsidiary relationship existed, but contended that it could not be a member of a controlled group because the Fund was not a trade or business. Specifically, the Fund argued that it was a passive investment vehicle that had no employees, no involvement in the day-to-day operations of its investments and no income other than passive investment income such as dividends, interest and capital gains. The Fund's partnership agreement delegated to its general partner full control over the business and affairs of the Fund. The Appeals Board pointed out that, as a matter of law, the general partner was an agent of the Fund. While the general partner hired a management company that was responsible for the day-to-day management of the Fund, such action did not relieve the general partner of its authority or fiduciary duties to the Fund and its partners. Relying heavily on the general partner's authority to manage the Fund, the fact that the general partner received compensation in exchange for its services, and the general partner's position as agent for the Fund, the Appeals Board found that the Fund was not merely a passive investor but was a trade or business for purposes of controlled group liability under ERISA. While the Appeals Board decision is only binding on the party that challenged the PBGC's ruling, and may be appealed by the Fund, it is an indication of how the PBGC might rule given similar facts. If the PBGC's decision is correct, then private equity funds that have 80% or more controlling interests in their portfolio companies may be exposed to a number of laws which such funds have previously viewed as not applicable. For example, the fund could be responsible for withdrawal liability if one of their portfolio companies fails to pay required contributions under a union multiemployer pension plan. This liability could also be assessed against any other portfolio company that is part of a fund's controlled group, since each member of the controlled group has joint and several liability for funding defined benefit pension plans. In addition, if one portfolio company terminated its employees' medical plan, the other members of the controlled group would be required to offer COBRA continuation to affected employees. Also, if the IRS were to follow the PBGC?s lead, then each 401(k) or other retirement plan sponsored by a portfolio company would have to comply with the Internal Revenue Code's non-discrimination and coverage tests on a controlled group basis. Given the potential liability associated with being part of a controlled group, a private equity fund should determine if it has a controlling interest in any of its portfolio companies. If such an interest exists then the fund should assess its potential liabilities if it were to be found to be a trade or business and therefore part of a controlled group.
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