1st Circuit Reverses Union Pension Liability Decision

As the appellate decision explains, ownership percentages are less important than organizations’ operating structures when determining withdrawal liability from a multiemployer union pension.

The 1st U.S. Circuit Court of Appeals has reversed a U.S. District Court ruling that two private equity funds are liable under the Multiemployer Pension Plan Amendments Act (MPPAA) for the pro rata share of unfunded vested benefits owed to a multiemployer pension fund by a bankrupt company, Scott Brass Inc., that is owned by the funds.

The District Court held that there was an implied partnership-in-fact which constituted a control group. The 1st Circuit reversed the decision because it concluded the multi-factored partnership test set forth in the case of Luna v. Commissioner had not been met, and it couldn’t conclude that Congress intended to impose liability in this scenario.

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Sun Capital Advisors Inc. (SCAI) is a private equity firm which pools investors’ capital in limited partnerships, assists these limited partnerships in finding and acquiring portfolio companies, and then provides management services to those portfolio companies. SCAI established at least eight funds. Two of them, Sun Fund III and Sun Fund IV, are the investors in Scott Brass Inc. (SBI).

As the lower court noted in its opinion, considered separately, one of the fund’s ownership stakes in Sun Scott Brass LLC is 70% and the other’s ownership stake is 30%, both of which separately fall below the necessary 80% threshold necessary to establish a “controlling interest.” However, the court found a limited partnership or joint venture existed. “The Sun Funds are not passive investors in Sun Scott Brass, LLC brought together by happenstance, or coincidence. Rather, the Funds created Sun Scott Brass, LLC in order to invest in Scott Brass, Inc.,” the opinion stated. “[I]t is clear beyond peradventure that a partnership-in-fact existed sufficient to aggregate the funds’ interests and place them under common control with Scott Brass, Inc.” So, combined, the funds’ ownership stake was 100%.

In its opinion, the 1st Circuit noted that an employer completely withdraws from a multiemployer plan when it permanently ceases to have an obligation to contribute under the plan, or permanently ceases all covered operations under the plan. On withdrawal, an employer must pay its proportionate share of the plan’s “unfunded vested benefits.” To prevent evasion of the payment of withdrawal liability, the MPPAA imposes joint and several withdrawal liability not only on the withdrawing employers but also on all entities (1) under “common control” with the obligated organization (2) that qualify as engaging in “trade or business.”

According to the opinion, the MPPAA regulations adopted in 1996 by the PBGC, include the Treasury Department’s regulations governing “common control.” The regulations state that entities are under common control if they are members of a “parent-subsidiary group of trades or businesses under common control.” The PBGC has not provided the courts or parties with any further formal guidance on how to determine common control specifically in the MPPAA context. Nor has PBGC updated its regulation on common control since that regulation’s adoption.

So, the Circuit Court looked to the partnership factors the Tax Court adopted in Luna. The factors are:

“The agreement of the parties and their conduct in executing its terms”;

“the contributions, if any, which each party has made to the venture”;

“the parties’ control over income and capital and the right of each to make withdrawals”;

“whether each party was a principal and co-proprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income”;

“whether business was conducted in the joint names of the parties”;

“whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers”;

“whether separate books of account were maintained for the venture”; and

“whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.”

While the 1st Circuit found there are some facts under the Luna factors that tend to support a conclusion that the Sun Funds formed a partnership-in-fact to assert common control over SBI, it said consideration of all of the factors leads to the opposite conclusion.

The Luna factors that counsel against recognizing a partnership-in-fact include the clear record evidence that the Funds did not “intend to join together in the present conduct of the enterprise,” at least beyond their coordination within SSB-LLC. The fact that the Funds expressly disclaimed any sort of partnership between the Funds counts against a partnership finding as to several of the Luna factors—specifically, factors one, five and six. The appellate court noted that most of the 230 entities or persons who were limited partners in Sun Fund IV were not limited partners in Sun Fund III. The Funds also filed separate tax returns, kept separate books, and maintained separate bank accounts—facts which tend to rebut partnership formation, and counting against factors six and seven.

The Sun Funds did not operate in parallel, that is, invest in the same companies at a fixed or even variable ratio, which also shows some independence in activity and structure, the appellate opinion states. The creation of an LLC by the Sun Funds through which to acquire SBI also shows an intent not to form a partnership. The formation of an LLC both prevented the Funds from conducting their business in their “joint names”—Luna factor five—and limited the manner in which they could “exercise mutual control over and assume mutual responsibilities for” managing SBI—Luna factor eight.

Using the Luna factors, the 1st Circuit concluded that most of them point away from common control. Moreover, the Circuit Court said it was reluctant to impose withdrawal liability on these private investors because it lacks a firm indication of Congressional intent to do so and any further formal guidance from the PBGC. “Two of [the Employee Retirement Income Security Act] and the MPPAA’s principal aims—to ensure the viability of existing pension funds and to encourage the private sector to invest in, or assume control of, struggling companies with pension plans—are in considerable tension here,” the court stated in its opinion.

The 1st Circuit reversed the entry of summary judgment for the New England Teamsters & Trucking Pension Fund and remanded the case to the lower court with directions to enter summary judgment for the Sun Funds.

Can Dual-Registered Firms Provide More Than One SEC Form CRS?

The SEC tackles this question and others in a new FAQ publication about the Regulation Best Interest rulemaking package, as does Morningstar in a new paper that examines the regulation’s impact on specific business models.

A new frequently asked questions (FAQ) document published by the U.S. Securities and Exchange Commission (SEC) presents some important information about the Regulation Best Interest rulemaking package and the related Customer Relationship Summary Form (Form CRS).

The SEC warns that the FAQ responses simply represent the views of the staff of the Division of Investment Management and the Division of Trading and Markets, noting that the FAQ is “not a rule, regulation, or statement of the Commission.” Still, the document may be helpful as firms work to meet the requirements of Reg BI ahead of its important 2020 deadlines.

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The first question asks whether a firm that provides multiple tiers of service to retail investors can prepare and deliver three different Forms CRS—one for each type of service that it offers. The SEC’s response here is a direct “No.”

“Each broker/dealer or investment adviser must only prepare one relationship summary summarizing all of the principal relationships and services it offers to retail investors,” the FAQ document states. “For example, if an investment adviser offers a wrap fee program, advice to participants in a 401(k) plan, and discretionary asset management for high net worth clients, the investment adviser would be required to prepare a single relationship summary describing all of the firm’s different services.”

Similarly, the SEC says, if a broker/dealer offers a range of brokerage services to retail investors—such as self-directed, full-service, and employer-sponsored retirement plan options—the broker/dealer would be required to prepare a single relationship summary describing all of the firm’s different services.

The same is true for dual-registered firms, which also must prepare a single relationship summary addressing both brokerage and investment advisory services.

According to the FAQ, in the staff’s view, a firm may deliver the relationship summary separately, in a bulk delivery to clients, or as part of the delivery of information that the firm already provides, such as the annual Form ADV update, account statements or other periodic reports.

“A firm must initially deliver its relationship summary to each of its existing clients and customers who are retail investors within 30 days after the date by which it is first required to electronically file its relationship summary with the SEC,” the document notes. “If the relationship summary is delivered in paper format as part of a package of documents, a firm must ensure that the relationship summary is the first among any documents that are delivered at that time. If the relationship summary is delivered electronically, it must be presented prominently in the electronic medium, for example, as a direct link or in the body of an email or message, and must be easily accessible for retail investors.”

Another FAQ question is more technical, asking how firms can create machine readable headings to comply with General Instruction 7.A.(i) to Form CRS. As a general matter, the document advises firms to consult with the specifications and instructions provided by the software provider of the application being used to create the PDF of the firm’s relationship summary. The FAQ specifically includes guidance for users of Microsoft Word and Adobe.

Reg BI’s Impact on Different Business Models

After hearing many similar questions from its clients and in the financial media, Morningstar has also published a new detailed analysis of Regulation Best Interest, “Regulation Best Interest Meets Opaque Practices,” focused on the question of how Reg BI may or may not impact the use of revenue sharing among advisers and brokers.

“Not all revenue-sharing payments create conflicts, and we built a taxonomy of revenue-sharing payments from the least to most likely to create conflicts of interest: educational expenses, platform fees; data fees; select lists; and payments based on sales, assets, or accounts,” the paper suggests. “Critically, the degree to which any revenue-sharing arrangement creates a conflict depends on the magnitude of the payments and the degree to which the payments are directly tied to sales.”

Morningstar’s analysis posits that, despite “historically low levels of scrutiny,” recent regulatory developments may force changes in revenue sharing as brokers work to mitigate conflicts of interest in order to comply with Regulation Best Interest.

“Brokers now have an obligation to mitigate and disclose the kinds of conflicts that revenue sharing can create, and we expect certain kinds of arrangements to get increasing scrutiny as the regulation goes into force,” Morningstar warns. “We recommend that market participants and policymakers use our taxonomy when evaluating revenue-sharing arrangements for the level of conflict they create. We also recommend that the SEC collect data on revenue sharing in a structured, standardized format to facilitate further research in this area.”

The analysis argues that conflicts “embedded in popular share classes” are often opaque and harder to evaluate than other conflicts of interest.

“Load sharing creates conflicts of interest when brokers have incentives to recommend one fund over another,” Morningstar finds. “The degree to which revenue sharing creates conflicts of interest depends on the magnitude of the payments and the degree to which they are tied to sales. Regulation Best Interest may force changes in revenue-sharing practices as brokers mitigate conflicts of interest. Brokers traditionally followed a suitability standard, which did not impose much scrutiny on revenue sharing. Regulation Best Interest strengthened the standard of conduct for brokers and is likely to affect revenue-sharing practices.”

As Morningstar recounts, prior to Regulation Best Interest, brokers were not expected to put their clients’ interests ahead of their own.

“Consequently, as long as a recommendation was suitable, it did not have to be in the client’s best interest. A broker could have had access to investments that were better suited to the client’s needs and not recommended them because of a conflict of interest, for example, financial incentives tied to one product over another—and that would not interfere with their fiduciary duty,” the paper explains. “Regulation Best Interest, which the SEC finalized in June of this year, altered the landscape for standards of conduct. Brokers now have to act in their clients’ best interest, a higher standard than the previous suitability requirement. They must also eliminate or disclose and mitigate material conflicts of interest.”

Also notable, according to the paper, is that brokers are explicitly required to consider cost as a factor under Regulation Best Interest, while such a requirement was not as explicit under the suitability rules.

“Regulation Best Interest’s standard, however, is still not as rigorous as the fiduciary standard under ERISA, which is what would have applied to brokers if the DOL fiduciary rule had remained in effect,” the paper concludes.

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