LEGAL
In March 2016, the District Court for the District of Massachusetts held two private equity funds responsible for the pension withdrawal liabilities of a portfolio company, thus establishing a new kind of liability for private equity sponsors. Eleven private equity sponsors are also SEC reporting issuers. We hypothesize that changes in the law would affect the SEC disclosures of these issuers, and provide insight into how a new risk factor develops.
A pension plan is a trust fund established by an employer (known as the Plan Sponsor) and funded by contributions from the Plan Sponsor and its employees. Employees who contribute sufficient funds become vested members of the plan and, upon retiring, are entitled to payments from the trust. If, however, because of bankruptcy, a Plan Sponsor reduces or stops making contributions to its pension plan, the plan may be unable to deliver promised payments to vested members. The Employee Retirement Income Security Act of 1974 (29 USCA 1001 et seq, ERISA) provides private and administrative remedies to help pension plans remain viable in the event of underfunding or Plan Sponsor withdrawal.
The Pension Benefit Guaranty Corporation (PBGC), a self-financed government corporation created by subchapter III of ERISA, is responsible for ensuring that beneficiaries of underfunded pension plans continue to receive benefits. PBGC's primary tool is an insurance plan funded by Plan Sponsor premiums. But before PBGC dips into its insurance fund, it attempts to wring as much money as possible from the withdrawing Plan Sponsor and its affiliates. ERISA gives the PBGC power to satisfy outstanding pension liabilities by levying the assets of other "trades or businesses" under "common control" with the Plan Sponsor. ERISA regulations (29 CFR 4001.3) define "trade or business" and "common control" by reference to the Internal Revenue Code.
Private equity investing as a "trade or business"
Prior to 2007, the assets of investment entities affiliated with pension debtors were beyond the reach of ERISA because, under tax law, investing was not considered a trade or business. Between 2007 and 2016, a series of legal decisions – described variously by the nearly 100 law firm memos they spawned as controversial, troubling, and disturbing – crept from the PBGC to the Supreme Court and back, establishing the surprising rule that private equity funds may be held liable for the pension obligations of their portfolio companies. Perhaps more surprising was the notion that a U.S. Federal Circuit Court, interpreting tax law, found that a relatively common private equity investment structure transformed a private equity fund from an investor to a business.
The first notable development was a 2007 decision of the PBGC Appeals Board finding an unnamed private equity fund was a business for ERISA purposes and therefore liable for the pension obligations of its wholly owned portfolio company (2007 WL 8092481, (PBGC Decision)).
Also in 2007, Sun Capital Partners, Inc. (Sun), a Florida-based private equity sponsor, acquired Scott Brass, Inc. (Scott), a metals manufacturer based in Cranston, Rhode Island, for $7.8 million ($6.8 million of which was borrowed) via a complex structure typical of private equity buyouts. Scott's equity securities were purchased by a holding company jointly owned by two Sun funds: Sun Capital Partners III, LP and Sun Capital Partners IV, LP (III and IV, or Funds). III owned 30% of the holding company, and IV owned the remainder. The Funds were controlled by Sun Capital Advisors III, LP and Sun Capital Advisors IV, LP (Advisors), and Advisors, in turn, were controlled by Marc Leder and Rodger Krouse, the principals of Sun.
A year later, Scott was forced into bankruptcy. In its bankruptcy disclosure schedules, Scott listed creditors holding "Unsecured Nonpriority Claims" (Debtor's Schedules, In re Scott Brass Inc, No 1:08-BK-13702 (US Bankr Ct, Dist of RI)). At the top of the list was the New England Teamsters & Trucking Industry Pension Fund (Pension) which was owed an estimated $2.6 million "multi-employer early withdrawal penalty." As an unsecured, nonpriority debtor, Pension stood little chance of recovering anything from the wreckage of Scott.
Pension sought to recover the withdrawal penalty from the Funds, arguing that Scott and the Funds were businesses under the common control of Sun, and the Funds were, therefore, responsible for Scott's pension withdrawal payment. The Funds requested the intercession of the District Court for the District of Massachusetts. In granting summary judgment for the Funds, the District Court, without reaching the question of common control, held that "[i]t is ... well settled that merely holding passive investment interests is not sufficiently continuous or regular to constitute a 'trade or business'" (Sun Capital Partners III, LP v New England Teamsters & Trucking Indus Pension Fund, 903 F Supp 2d 107 (D Mass 2012), aff'd in part, vacated in part, rev'd in part, 724 F3d 129 (1st Cir 2013), Sun I). Pension appealed.
On July 24, 2013, the U.S. Court of Appeals for the First Circuit, applying a "very fact specific approach," held that IV derived "a direct economic benefit ... that an ordinary, passive investor would not derive" from its involvement with Scott and was, therefore, a "trade or business," while III was not (Sun Capital Partners III, LP v New England Teamsters & Trucking Indus Pension Fund, 724 F3d 129 (1st Cir 2013), Sun II). The difference, as the Court saw it, between III and IV was that IV received management fees from Scott which could be offset against management fees IV owed to Advisors. The First Circuit remanded the case to the District Court "for further factual development … under the second part of the 'control group' test, that of 'common control.'"
On March 3, 2014, the Supreme Court declined to review Sun II (Sun Capital Partners III, LP v New England Teamsters & Trucking Indus. Pension Fund, 134 S Ct 1492, 188 L Ed 2d 388 (2014)).
On March 28, 2016, the District Court, on remand, held that the Funds and Scott were under Sun's common control. After correcting the First Circuit's misapprehension that only IV received a fee offset (the offsets were applied pro rata based on the Fund's ownership of the holding company that owned Scott), and declaring III a trade or business, the District Court addressed the question of common control. The Court looked past the 70/30 apportionment of ownership between III and IV and found a "partnership-in-fact," ultimately part of the "larger ecosystem of Sun Capital entities created and directed by Marc Leder and Rodger Krouse."
"Partnership-in-fact and common control" the Court declared, "can be found even across fully independent entities" (Sun Capital Partners III, LP v New England Teamsters & Trucking Indus Pension Fund, 172 F Supp 3d 447 (D Mass 2016), judgment entered sub nom Sun Capital Partners III, LP v New England Teamsters, No CV 10-10921-DPW, 2016 WL 1253529 (D Mass Mar 28, 2016), Sun III).
Evolution of a risk factor
SEC rules require certain public disclosure documents to itemize the most significant challenges to an issuer's business, operations, industry, or financial position. These "risk factors" are meant to provide a clear and concise statement of the risk of investing in the issuer's securities. Risk factors also act as "an insurance policy" against litigation based on failure to disclose known risks (Practice Note, Risk Factors: What Keeps You Up at Night). Thus, when drafting risk factors, public companies must strike a balance between overstating risks to forestall litigation and understating risks to encourage investment.
SEC rules mandate disclosure of "material" risks, but allow the issuer discretion to decide which risks investors might find material. Determining the materiality of inchoate risks is particularly challenging. In their 2004 paper, David Hillson and David Hulett described the assessment of potential risks as a process of balancing "how likely the uncertainty is to occur (probability), and what the effect would be if it happened (impact)," (David Hillson and David Hulett, Assessing Risk Probability: Alternative Approaches (2004)).
Prior to Sun II, only the filings of Icahn Enterprises, L.P. (Icahn) contained disclosure about risks associated with the underfunded pension obligations of portfolio companies. Icahn's risk factor, which refers to the PBGC Decision, ignores the "trade or business" prong of the ERISA test, stating simply: "[W]e and our subsidiaries are subject to the pension liabilities of all entities in which Mr. Icahn has a direct or indirect ownership interest of at least 80%." Icahn's risk factor also contains specifics about portfolio company pension liabilities. Icahn portfolio company ACF Industries LLC, for instance, is obligated to notify the PBGC of "certain 'reportable events,' such as if we cease to be a member of the ACF controlled group, or if we make certain extraordinary dividends or stock redemptions" (10-K, Icahn Enterprises L.P. (2008 WL 10085514)).
Following the ruling in Sun II, five of the publicly held private equity sponsors introduced pension liability risk factors. The 2013 10-Ks of KKR & Co. L.P. (KKR), The Carlyle Group L.P. (Carlyle), The Blackstone Group L.P. (Blackstone), and Apollo Global Management, LLC (Apollo), and the S-1 of Ares Management, L.P. (Ares), contained risk factors that described the two prongs of the ERISA liability test and mentioned that a recent case had found a private equity fund to be a "trade or business" under ERISA. Carlyle's risk factor, the most extensive, decried the broad ambit of ERISA liability as "one of the few situations in which one entity's liability can be imposed on another simply because the entities are united by common ownership" (10-K, Carlyle Group L.P. (2014 WL 6359869)). Blackstone and Carlyle emphasized the unsettled state of the law, observing that other cases had held that managing investments was not a trade or business. Ares, tacitly acknowledging Sun II to be limited to the First Circuit, warned that, "if [Sun II] is applied generally ... our funds could be exposed to liability ... that could be significant" (S-1, Ares Management LP (2014 WL 6305140)). With the exception of Icahn's, none of the risk factors contained specifics about pension obligations of portfolio companies, or mentioned the PBGC.
In 2014, Oaktree Capital Group, LLC (Oaktree) introduced a pension obligation risk factor, raising the number of private equity sponsors with such risk factors to seven. Where Carlyle's risk factor was peevish, Oaktree's feigns surprise, as if investors might not believe the ambit of ERISA liability: "[The] sponsoring employer and all members of its 'controlled group' will be jointly and severally liable for 100% of the plan's unfunded benefit liabilities whether or not the controlled group members have ever maintained or participated in the plan" (10-K, Oaktree Capital Group, LLC (2015 WL 828769)). Oaktree's risk factor is twice as long as the other six, and contains the most complete and detailed statement of the law. After noting decisions to the contrary, it adds, "in 2007 the PBGC Appeals Board ruled that a private equity fund was a 'trade or business' for ERISA controlled group liability purposes and at least one Federal Circuit Court has similarly concluded that a private equity fund could be a trade or business for these purposes."
Sun III was decided in March 2016, just weeks after our 11 issuers filed their 10-Ks for 2015. Therefore, risk factors responding to Sun III did not appear until early 2017. Blackstone, KKR, Carlyle, and Apollo made significant changes to their pension liability risk factors. All replaced a single sentence summarizing Sun II with a paragraph describing factors that could lead to a finding that an investment fund was a "trade or business" and part of the same "controlled group" as a portfolio company, for ERISA purposes. The new paragraphs also speculated on other potential risks posed by the holding in Sun III, including Blackstone's observation that "a court might hold ... one of the fund's portfolio companies ... jointly and severally liable for another portfolio company's unfunded pension liabilities (10-K, Blackstone Group L.P. (2017 WL 00724661))," and KKR's concern that "if the rationale of [Sun III] were expanded to apply also for U.S. federal income tax purposes, then certain of our investors could be subject to increased U.S. income tax liability." Apollo, on the other hand, sought to reassure investors that Sun III's holding "may not necessarily" use the same "test that would be used for U.S. federal income tax purposes (10-K, Apollo Global Management LLC (2017 WL 00561446))."
Oaktree, Ares, and Icahn, by contrast, made no significant changes to their risk factors in response to Sun III. This is likely because all three appear to have anticipated Sun III in their 2015 disclosures. Oaktree's 2015 10-K, for example, states that a private equity fund found to be a trade or business may be liable for portfolio company pension liabilities resulting in a "need for additional capital ... and/or a lien by the PBGC (10-K, Oaktree Capital Group, LLC (2016 WL 00749525))." Ares' 2015 10-K treats Sun III as a foregone conclusion, warning "if this decision [Sun II] is applied generally to private equity investing, our funds could be exposed to liability ... that could be significant (10-K, Ares Management LP (2016 WL 00761460))."
Conclusion
Drafting risk factors is a complex task. Material risks must be described in a manner that satisfies regulators, informs investors, and guards against future liability. But before drafting considerations come into play, an issuer must identify all applicable risks and separate out those deemed material.
The differences we observed in the development of this risk factor reflect the highly individualized nature of risk factor drafting. Despite superficial similarities (and despite the seven issuers being represented by only three law firms), each issuer's risk factor is different. All seven risk factors changed as the law developed, but each issuer's path appears to have been set by internal concerns rather than what was disclosed by peers – thus following Practical Law's dictum that while issuers should "not ignore" competitor disclosure, the guiding light of risk factor drafting should be each "company's unique circumstances" (Practice Note, Risk Factors: What Keeps You Up at Night?). In the end, five of the seven issuers used similar language to describe the holding in Sun III, but there remain significant differences between the risk factors. The language surrounding the description of Sun III was used, in the case of KKR's warning about tax law consequences, to amplify the threat posed by Sun III, and in Apollo's, to mollify investor anxiety. These differences may reflect a difference in approach, but may also signal differences in the situation, or structure of the issuers.
The only significant divergence we noted was the decision (by all issuers other than Icahn) to refrain from classifying the PBGC Decision as a material risk prior to Sun II. While it could be argued this was due to inattention, it seems more likely that the decision was a judgment regarding the risk's materiality. Before Sun II, there was no caselaw supporting the PBGC's interpretation of ERISA.
Craig Eastland is a product operations specialist for Thomson Reuters. He spent 12 years working as a law librarian at a number of firms including Sullivan & Cromwell, McCarthy Tetrault, and Fried Frank Harris Shriver & Jacobson, where he was head of reference. In 2008, he founded the securities law blog "The Speculative Debauch." He has also worked as a research consultant for the Committee on Capital Markets Regulation. Craig studied illustration at the Rhode Island School of Design and law at New York Law School. Craig is currently a member of the Business Law Center Experts On-Call team, dedicated to providing support for those conducting in-depth business law research.
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