Friday, October 14, 2016

Employment Agreements (Including Severance, Parachute, Clawback, Noncompete and §409A Issues)

See "Employment Agreements (Including Severance, Parachute, Clawback, Noncompete and §409A Issues)" by Charles C. Shulman, at Tax Management Compensation Planning Journal 9-2-2016
Employment agreements, which are very common for executives and senior management, raise a number of issues relating to terms of employment, severance on termination, change in control, excess parachute tax under Internal Revenue Code §280G, noncompete provisions, clawback provisions, SEC disclosure requirements, and restrictions on nonqualified deferred compensation under §409A.
The terms of employment agreements and severance arrangements are of particular relevance in corporate transactions. Executives may be terminated as a result of a transaction, and the general severance provisions in the employment agreements may be triggered.
Severance provisions are often triggered on termination of employment only if there is also a change in control of the employer, or the amount of severance may be more generous if the termination occurs after a change in control. Some agreements may allow an employee to quit for any reason and still receive severance, if the quitting is in connection with a change in control. Employment and change in control agreements often provide that options will vest on a change in control typically even without a termination of employment.
http://www.ebeclaw.com/memos/Employment_Agreements_TMCPJ_9.2.16.pdf 

Wednesday, May 4, 2016

Whether Private Equity Funds are a Trade or Business - Sun Capital Partners III v. N. E. Teamsters Truck. Industry Pension Fund

Whether Private Equity Funds are a Trade or Business -
Sun Capital Partners III v. N. E. Teamsters Truck. Industry Pension Fund


1.  Background on Controlled Group Liability

a. Controlled Group Liability.  Controlled group status as a single employer as set forth in IRC §414(b) and (c) apply for termination liability, multiemployer withdrawal liability, PBGC premiums, minimum funding obligations, COBRA continuation coverage, etc.

b. Parent-subsidiary test. A parent-subsidiary controlled group will exist if there is a chain of entities conducting trades or businesses that are connected through a controlling interest with a common parent, with controlling interest being defined: (i) in the case of corporation as at least 80% of the total combined voting power of all classes entitled to vote or at least 80% of the total value of all shares; (ii) in the case of a trust or estate an 80% actuarial interest; (iii) in the case of a partnership (or entity taxed as a partnership) an 80% interest in profits or capital; and (iv) in the case of a sole proprietorship 100% ownership. IRC §1563(a)(1); Treas. Reg. §1.414(c)-2(b)(2).

c. Brother-sister test. A brother-sister controlled group exists where there are two or more trades or businesses which meet two tests: (i) the same five or fewer persons who are individuals, estates or trusts own together 80% or more of “control” as defined above in each of the entities; and (ii) such five individuals own together 50% or more of the entities where ownership is taken into account only to the extent it is identical with respect to each such trade or business.  IRC §1563(a)(2); Treas. Reg. §1.414(c)-2(c). That is, if corporations X, Y and Z are partially owned by individual A with a 20%, 30% and 40% interest, respectively, the identical ownership interest that is counted for individual A is only 20%.

d. Trade or business.  A trade or business is generally interpreted to mean regular and continuous activities that are designed to produce income.  Neither ERISA nor the Treasury Regulations define “trade or business.” Courts have generally adopted the standard articulated in C.I.R. v. Groetzinger, 480 U.S. 23, 35, 107 S. Ct. 980, 987, 94 L. Ed. 2d 25 (1987), where the Supreme Court held that in the context of IRC §162: “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer's primary purpose for engaging in the activity must be for income or profit. Sporadic activity, a hobby, or an amusement diversion does not qualify.”

e. Liability of sole proprietor engaging in trade or business. Although individual shareholders of corporations are not liable for the corporation's Title IV liabilities under the controlled group rules, a controlled group includes a trade or business, and thus any unincorporated trade or business that an individual operates, e.g., a sole proprietorship or a partnership, would indirectly cause him or her to be individually liable for the plan termination.  Many courts have found shareholders liable by reason of some activity they engaged in as a sole proprietor.

2.  Whether Private Equity Funds are a Trade or Business

a. Trade or Business. Only “trades or business” under common control are treated as part of an ERISA controlled group. Neither ERISA nor the Treasury regulations define “trade or business.” As stated above, courts have generally adopted the standard articulated in C.I.R. v. Groetzinger, where the Supreme Court held that a trade or business is an activity with continuity and regularity and for the primary purpose for income or profit (while sporadic activity, a hobby, or an amusement diversion does not qualify).

b. 2007 PBGC Appeals Board Opinion – Private Equity Investors are Not Passive Investors.  With regard to private equity funds many practitioners had taken the view that since they are generally passive investment vehicles with no employees and minimal involvement in day-to-day operations, they are not trades or businesses, and therefore separate portfolio companies owned by a private equity fund or funds would not be in the same ERISA controlled group. However, the PBGC ruled in a 2007 PBGC Appeals Board Opinion that a private equity fund was a trade or business, because it was engaged in an activity with the primary purpose of income or profit and conducted business through an agent (the general partner) who managed fund investments on a regular basis.

c. 80%-owned portfolio companies of a private equity fund. According to this PBGC ruling, 80%-owned portfolio companies of a private equity fund would generally be in the same ERISA controlled group (except in a rare case where the fund's activity does not meet the Groetzinger standard).

d. Palladium Equity Partners 2010 Case Affirming PBGC Opinion and Investment Plus.  A 2010 Eastern District of Michigan case found the 2007 PBGC Appeals Board Opinion to be persuasive and “investment plus” is a trade or business. Board of Trustees, Sheet Metal Workers National Pension Fund v. Palladium Equity Partners, 722 F. Supp. 2d 854 (E.D. Mich. 2010) (genuine issue of material fact existed as to whether three Palladium limited partnerships, as well as Palladium Equity Partners, LLC which served as advisor, were an ERISA controlled group parent liable for ERISA multiemployer withdrawal liability of the Haden group of companies; the court found the 2007 PBGC Appeals Board Opinion to be persuasive that although investment alone is not a trade or business, where there is “investment plus,” e.g., investment advisory and management services by the fund for the benefit of its partners and compensation for the investment advisory and management services, this  would constitute a trade or business; court found there was a genuine issue of material fact as to whether the Palladium funds had a business purpose other than merely investment; the Palladium funds joined their investments to exert power over financial and managerial activities of the portfolio companies, selected five of the seven board members and set up several committees to control the internal operations of the portfolio companies; there was also general issue of material fact regarding alter-ego liability).

e. Sun Capital Partners III, LP 2013 First Circuit Case.  A 2013 First Circuit case, Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund, overturned a district court case and it also found the PBGC Appeals Board Opinion to be persuasive.  724 F.3d 129 (1st Cir. 2013), cert. denied, 134 S. Ct. 1492 (2014):
  • two private equity funds managed by Sun Capital owned 70% and 30% of Scott Brass, Inc. which withdrew from a multiemployer pension plan prior to filing for bankruptcy; Scott Brass was indirectly wholly owned by Sun Fund III (30%) and Sun Fund IV (70%);
  • the district court at 903 F.Supp.2d 107 (D. Mass. 2012), had granted the Sun Capital Partners equity funds’ motion to dismiss holding that the private equity funds were passive investors and not a trade or business and the 2007 PBGC Appeals Board Opinion was found by the district court to be unpersuasive because activity of the general partner should not have been attributed to the investment fund and continuity and regularity of an activity should not be found merely based on the size of the investment and profitability;
  • however, the First Circuit overturned the district court ruling regarding the funds being a “trade or business” and held that at least the larger of the two Sun funds (Fund IV) was engaged in a trade or business under aninvestment plusanalysis since there was more than mere passive investment, noting that

o   the funds sought out potential portfolio companies that were in need of extensive management intervention,
o   the general partners of the funds had wide range management authority,
o   the funds had the power to appoint a majority of board members,
o   the general partners of the funds could make decisions regarding hiring, termination and compensation of employees in the portfolio companies, and
o   at least with respect to Sun Fund IV (the 70% owners) the active investment in management provided a direct economic benefit that an ordinary passive investor would not derive, i.e., management fees the fund otherwise would have needed to pay its general partner of the fund was offset by fees the underlying company was paying to the general partner.
  • both the district court and the First Circuit found in regard to Sun Capital funds that the purchase of Scott Brass, Inc. in a 70%-30% split was not done with a principal purpose to evade or avoid liability under ERISA §4212(c), according to the district court because there were legitimate business reasons for the investment ownership in order to decrease investment risk for each fund and according to the First Circuit because disregarding a 70%-30% split would leave zero ownership;
  • the First Circuit remanded the case to the district court to determine if there was a trade or balance in Sun Fund III (the 30% owners) and to determine if there was common control by the 70%-30% ownership (for example if the joint venture is seen as common ownership). 


f. Sun Capital Partners III, LP, 2016 D.C. Mass. Decision on Remand.

On remand of Sun Capital Partners from the First Circuit, the District Court in Massachusetts ruled that: (i) both funds (the Sun Fund IV with a 70% investment and Sun Fund III with a 30% investment) were trades or businesses, and (ii) that there was common control under ERISA by reason of Fund III and IV being a "partnership in fact."  Sun Capital Partners III, LP v. New England Teamsters and Trading Industry Pension Fund, _ F. Supp. 3d _, 2016 WL 1239918 (D. Mass. March 28, 2016).

The District Court of Mass. in 2016 held that:

  • under the "investment plus" analysis not only was Sun Fund IV a trade or business, but Sun Fund III was also a trade or business because it too had a direct economic benefit that a passive investor would not have, i.e., an offset of fees otherwise owed by Sun Fund III to its general partner for managing the investments that were indirectly paid by the underlying portfolio company; and

  • with regard to controlled group common ownership, Sun Fund IV and Sun Fund III of Scott Brass, Inc. (with 70% and 30% ownership), while not specifically meeting the requirements for an ERISA controlled group because there was no 80% controlling interest, nevertheless Sun Fund III and Sun Fund IV are a jointly controlled entity where there was a partnership-in-fact since the two funds often co-invest together, and despite the lack of permanently fixed co-investing, these Sun Funds should be considered as joining together as a "partnership-in-fact" to invest in Scott Brass.

  • The district court noted that the fund split in ownership was done because the fund was nearing the end of its investment cycle, a preference for income diversification and a desire to keep ownership below 80% to avoid ERISA withdrawal liability (though avoiding controlled group liability was not the principal purpose of the transaction for purposes of ERISA § 4212(c)).
Sun Capital Partners appealed the District Court decision to the First Circuit on April 8, 2016.

g. Criticism of 2016 District Court Sun Capital Partners Case.  The latter holding of the Sun Capital district court case that there was an ERISA controlled group with regard to the funds because of a partnership-in-fact (resulting in aggregation of the ownership interests despite the lack of partnership formalities) is a puzzling holding for the following reasons:
  • partnership-in-fact is tax law concept that should not be automatically applied to ERISA controlled group liability situations;
  • finding an ERISA controlled group could have consequences beyond withdrawal liability, such as single employer plan termination liability, non-discrimination testing, being a single entity for COBRA and IRC § 409A purposes and defaults in credit agreements; and
  • the bright line ERISA controlled group test was being expanded in a way not contemplated by the statute or regulations.