On July 24, 2013, in a case the court said was one of “first impression,” the First Circuit held that, due to the nature of its involvement in the management of its portfolio company’s operations, a private equity firm was potentially liable for the portfolio company’s pension obligations. The decision has significant implications for the way private equity funds structure their relationship with the portfolio companies. The decision may have important insurance implications as well. A copy of the First Circuit’s opinion can be found here.
In 2007, two Sun Capital Investments funds invested in Scott Brass, Inc., which went bankrupt in 2008. The New England Teamsters and Tracking Industry Pension Fund asserted that the funds were liable for the unfunded vested benefits in the bankrupt company’s pension fund. The union argued that the funds acted as a part of controlled group and therefore were jointly and severally liable for the pension liability. The funds argued that because they were merely investors in the bankrupt company, they were not participating in a “trade or business” that could be a “controlled group” or under “common control” with Scott Brass sufficient to make them liable under ERISA for the pension fund. The district court agreed with the funds and the union appealed.
In a July 24, 2013 opinion written by Chief Judge Sandra Lynch for a unanimous three-judge panel, the First Circuit held that the funds were sufficiently involved in the management and operation of the portfolio company for their activities to qualify as being involved in a “trade or business” but remanded the case to the district court for further proceedings to determine if the funds and Scott Brass were under common control.
As noted in an August 14 2013 memo about the decision (here), the Sherman & Sterling law firm notes that private equity funds have traditionally taken the view that, as passive investors, the funds are not a “trade or business.” The Court applied an “investment plus” test to determine whether the private equity firm’s activities met the legal standard.
In concluding that the test had been met, the Court cited such factors as the fact that the funds’ limited partnership agreements and private placement memoranda explicitly described the funds as actively involved in their portfolio companies’ management; and that the partnership agreement also gave the general partner the authority to make decisions about hiring, firing and compensation agents and employees of portfolio companies. The funds’ controlling stake gave the funds the right to place two of their employees on the portfolio company’s board, giving the funds effective control of the board.
As the law firm memo notes, the First Circuit’s decision “creates potential ERISA liability risk for private equity funds that engage in active management.” If the fund is involved in the management and operation of its portfolio companies – as many funds are – “there is potential for the fund to be held responsible for the portfolio company’s ERISA liabilities.” The memo notes the potential liabilities include the “joint and several liability for withdrawal from a multiemployer pension fund” (which is what was at issue in the First Circuit case) and “joint and several liability for missed contributions to and underfunding upon the termination of a pension plan.”
As many commentators have noted, this decision has important implications for the way private equity funds structure there relationships with their portfolio companies. It also has implications for the way fund documents describe the private equity firm’s role. The Sherman & Sterling memo that many of these same implications could also extend to venture capital firms as well, where venture capital firms taking an active role in management could also risk incurring ERISA liability for the portfolio companies.
This case also has interesting insurance implications. Many organizations carry fiduciary liability coverage to protect the firm and its officials from liability under ERISA. However, these policies typically apply to loss from claims alleging wrongful acts in connection with the operation of Sponsored Plans. The Sponsored Plans to which the policy coverage applies typically are those operated by the insured organization itself (or jointly by the insured organization and a labor organization). The liability protection under the policy typically would not extend to liability arising from the operation of a third party organization’s plans, such as, for example, those of a private equity firm’s portfolio company.
To be sure, even if there otherwise were coverage under the policy for this type of liability, the policy would likely exclude coverage for “benefits due” (such as pension benefits that were due but not paid into the plan fund). Many of the potential ERISA liabilities described in the law firm memo might well be excluded from coverage, even if a portfolio company’s pension plan were otherwise within the scope of the private equity firm’s fiduciary liability coverage, by operation of the “benefits due” exclusion
It may be that there is in fact no liability here that would not run afoul of the benefits due exclusion. However, if there is liability for which the exclusion would not otherwise preclude coverage, there appears a substantial likelihood that the liability would be uninsured.
These issues are at (or perhaps beyond) the very outer edges of my knowledge about the scope and reach of fiduciary liability insurance. Just the same, I think the First Circuit’s recognition of the potential for private equity firm’s to incur ERISA liability for the portfolio companies’ pension funds, and the seeming likelihood that that liability would be uninsured, raises interesting questions.
I know that many of readers know a great deal more about the intricacies of the scope of coverage under fiduciary liability insurance policies. I strongly encourage those who have greater insight into these issues and that have view on this topic to add their comments to this post using the blog’s comment feature [links to D&O Diary comments section].
Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.
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