December 9, 2013
Interviewed by: David Snow
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What Does the Scott Brass Case Mean for PE?

A court case involving a private equity portfolio company might put GPs on the hook for pension liabilities as well as raise taxes on carried interest. Two tax and liability experts discuss the facts behind the case and the potential new risks that private equity investors face.

A court case involving a private equity portfolio company might put GPs on the hook for pension liabilities as well as raise taxes on carried interest. Two tax and liability experts discuss the facts behind the case and the potential new risks that private equity investors face.

What Does the Scott Brass Case Mean for PE?
Tax & Liabilities in Private Equity

David Snow, Privcap:
We are joined today by Michael O’Connor of Arsenal Capital Partners and Rick Bailine of RSM. Gentlemen, welcome to Privcap today, thanks for being here.

  We are talking all about tax and liability in private equity. Recently there is very high profile case that I would like to get your expert views on, regarding a private equity firm and one of its portfolio companies, and a court ruling that could have implications for private equity broadly. Maybe Rick, you can set the stage for that case and why all private equity firm sneed to be paying attention.

Rick Bailine, RSM:   
Sure, thank you David. The case is the Sun Capital case, came down I think it was in August really recently and what it involved, a private equity acquisition of a C corporation and this particular private equity group they specialized in acquiring troubled companies and in this particular instance it didn’t work out so well, and the troubled company did eventually go into bankruptcy. And when it went into bankruptcy, one of the questions came up well you have got some pension liabilities here, and who is going to be responsible for them. Is it simply the C corporation itself of the portfolio company? And the union that was involved who represented the workers, whose pensions were being threatened, they actually filed suit against the private equity groups owners. And the fundamental issue in the case was whether or not the private equity group who owned this now bankrupt C corporation portfolio company, could they be classified as being in a trader business under the pension laws.

Snow: And there is a quotation mark around “trade or business,” this is a term of art that is very important right?

Bailine: Yes, the words trade or business are used in various parts of the internal revenue code, the one that we are specifically talking about right now is ERISA, which is the pensions. Pension area of the internal revenue code. In order for the court to find that this private equity group had any liability for these pension liabilities,

one of the things they would have to conclude is that they were in a trader business. And typically the private equity does not see itself as being in a trader business although owning a portfolio company they are an investor in a portfolio company and they see themselves as more or less as a passive investor. In this case the court did hold that the private equity group, and the facts are fairly complicated, there was not just one partnership, one private equity firm involved, there were several private equity firms that both owned the stock of the company and others that provided financing and then some management services to the portfolio company, the court held the direct owners, even though they had no employees, were actually in a trader business and that was instrumental in the court ultimately holding that at least one of these companies, they sent an appeals decision, they sent it back to the lower court for further findings, at least one of these companies is going to be at least partially responsible for these pension liabilities so it came in the news in private equity that even a pure holding partnership with essentially no employees could be viewed as being in a trader business.

Michael O’Connor, Arsenal:
Right, exactly, at Arsenal we have a very heavy operating model in terms of our working with the management teams so this is something that really caught our attention and how do we look at each deal that we do, we talk to people like Rick to make sure we are okay upfront, what can we do in structuring, what can we do in our documentation and make sure we don’t run afoul of these regulations but certainly Arsenal is very active operator. We have probably more operating partners per deal than 90% of the PE firms out there so this is something that really hit home with us.

Bailine: And I think you just raised a very instrumental point, one of the things we learned in Sun Capital and we have seen this in other areas, particularly tax shelter litigation in the late 90’s, early 2000’s tax shelter, the court used the private equity groups own documentation against them. They specifically said we go out and buy troubled companies and work to turn them around and the judge was asking the question well if you are buying companies you know you have to work to turn around, how are you going to argue with me that you are not helping that company perform as trader business. Your entire purpose is to improve its business so they use your own documentation against you.

Snow: Let’s dwell briefly on the pension liability aspect of this. So if this decision gathers momentum and becomes replicated elsewhere, that would change the risk profile of doing a private equity deal,

right? You would have to look at the pension liability of a portfolio company differently or at least take greater care in doing acquisition. How would that change the way you think the majority of private equity firms deals.

O’Connor: Well the pension tax expert is one more individual on our due diligence team. That 5-­‐10 years ago wasn’t there. It has increased our due diligence, it has increased the number of outside experts we bring in, it has increased the complexity of transaction.

Snow: So you have a specific consultant who only does tax liability?

O’Connor: We hire people like Rick’s firm. Make sure they have a good sound. We had about a year ago that had a pension situation in it and we went outside, hired some very good pension people, made sure we very thoroughly analyzed that situation. So it is, again, how does it affect us, it is longer due diligence, it is more expensive due diligence, it is more risk awareness in this situation.

Bailine: It is one more thing you have to factor in to what does the balance sheet look like, is there contingent liability that three or four years ago we wouldn’t have thought about how does that affect the value of what I am buying.

Snow: I guess there is almost a philosophical question at play which is trade or business, a private equity firm that invests in a widget company, are they actually a business themselves that produces widgets or are they merely an investor that provides some support and strategic guidance to a widget business and what you are saying is the line has traditionally been no, that they are not in that business.

Bailine: Correct. Typically the owners of the business are the owners of a business. They are the investors who provide the capital for the business. Particularly here if you are looking at a corporation, sometimes the lines come blurred between a partnership and its partners for either tax or legal purposes. But typically if you are looking at a corporation, a corporation in all, under all 50 states is an entity separate and apart from its owners. Owners are not generally liable for the liabilities of the corporation, that is one reason people choose to do business in the corporate form rather than a partnership form, typically partners are liable for liabilities of a partnership but owners are not liable for liabilities of the corporation. Here, because of the way the pension laws were written, there is the potential for what is called pierce the corporate veil and make the owners liable for the corporate liability but one of the touchstones was they had to find they were in a trader business. Which as you said that line needs to be pretty clear, it is now blurrier than it used to be.

O’Connor: Right, now we are spending more time, we do not put our people into the companies. It is strategic support, it is peak project type assistant, it is things of that nature so it just requires us to spend more time in documenting it. We are not officers of the company, we are not inside on a daily basis, we are outsiders, we are investors, we will provide you with strategic support where you need so the ability now to draw that line and document that line is much more increased than it has been in the past.

Bailine: And I think the other thing you have to be very careful of is you want to make sure that the owners, the partnerships, the investment funds which are the direct owners of the stock, that they are not benefiting. Either directly or indirectly from any management fees that get paid to the companies that do that. And you are right, even at Sun Capital, they didn’t put employees directly into the bankrupt company but they are providing the management services and the court found there was a nexus between the fees that were paid, you got to be extremely careful now, with how you structure the fees.

Snow: Is it one unfortunate trend here that actually the private equity in general has been emphasizing its operations capabilities and its operating muscle with regard to its portfolio companies, which tends to further blur the line between the passive investor and an actual roll up your sleeves operator.

O’Connor: The conundrum is we have very good technical experts, strategic experts and certain niches that we operate in. So for us to be able to add value we put those people advising these companies so it is almost a double edge sword. We have the strategic people who are very good backgrounds in these types of business, especially industrials, there is a sector we operate in. A lot of chemical companies. We have great chemical people on the team so how do we not add value and not add, walk afoul of this rule is a big issue now. We create value by strategically positioning these companies with experts inside our PE firm. But that in and of itself almost creates a problem from a documentation IRS issue in this area.

Snow: Well here is a multi billion dollar if not trillion dollar question which is the trade or business classification could have implications for the carried interest tax treatment, correct? And can you draw the line and explain how that is the case?

Bailine: The answer to your question is yes, a dialogue has started because of the Sun Capital case, because it held, because Sun Capital held that private equity group was in the trader business, I want to be very clear about this, the court was very specific about two things, the holding in that case was very factual based on the facts of that case, the court was not making necessarily a broad holding. Number two, it was based on ERISA the pension rules. And as we said at the outset the words trader business are used in various parts of the internal revenue code, and the court made it clear that the supreme court, the law of the land, has been very reluctant to say that the words trader business mean the same thing everywhere in the code so it is entirely possible that this decision could, you could put a fence around it and say it only works in the pension area but there are people who don’t like private equity quite frankly and they are now making the new argument people have questioned whether carried interest should be taxed as capital gain or ordinary income for a number of years. I don’t think this is going to be the impetus that turns  carried interest into ordinary income but it is just another argument people are making.

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