Prof. Chris Sanchirico’s scholarship cited in groundbreaking federal court decision on pension obligation of private equity funds
A law review article written by Penn Law professor and tax policy expert Chris W. Sanchirico has helped persuade a U.S. Circuit Court to rule for the first time that a private equity fund should be held responsible for pension fund payments owed by a company it had purchased, which then went bankrupt.
The July 24 ruling by the First Circuit Court of Appeals in Sun Capital Partners v. New England Teamsters & Trucking Industry Pension Fund has important implications for the pension obligations of private equity funds. Moreover, the ruling may also affect the tax treatment of “carried interest,” the typical form of compensation for private equity fund managers, which has been much in the news over the last several years. The decision is expected to generate continued controversy.
Sanchirico, the Samuel A. Blank Professor of Law, Business, and Public Policy and Co-Director of the Center for Tax Law and Policy at Penn Law, spoke recently with the Law School’s Office of Communications about the decision and its significance.
Penn Law (PL): This is a complex case. What are the basic facts of the case, why does it matter, and what is at issue?
Chris Sanchirico (CS): The question in the Sun Capital case was whether the private equity funds that had purchased a metals manufacturer were required to step in and pay the manufacturer’s unfunded pension benefits when the manufacturer went bankrupt. The precise legal issue was whether the private equity funds were engaged in a “trade or business”—a necessary condition for liability in this circumstance. The court ruled that at least one of the funds was so engaged.
The phrase “trade or business” crops up in several areas of law, and many important consequences hang on its judicial interpretation. The important definitional boundary in Sun Capital was that separating a “mere investor” in a trade or business from someone who actually conducts the trade or business. This boundary is particularly important in tax law.
PL: How did your work come to be cited in the opinion?
CS: I wrote an article in the University of Chicago Law Review on the taxation of carried interest in 2008, when the issue was first surfacing. Private equity fund managers typically receive the right to a portion of fund profits—called a carried interest—in return for managing the fund. Controversially, this compensation is currently taxed as capital gain rather than ordinary income. The purpose of my article was to explore the implications of this tax treatment taking into account not only the direct effects on the fund manager, who receives the compensation, but also the offsetting effects on fund investors, who pay the compensation.
One of the important questions that arose in my article was whether private equity funds were engaged in a trade or business. (The specific issue was whether the private equity fund investors would have been able to deduct the fund manager’s compensation had the fund manager been paid by regular salary rather than by carried interest.)
The general view at the time was that private equity funds were not engaged in a trade or business. This was apparently based on the principle—annunciated in a famous early case—that mere investors were not engaged in a trade or business no matter how much time and trouble they took managing their investment portfolios.
In my 2008 article I argued that private equity firms didn’t fit the mere investor model, and that the often cited case was inapt. The modus operandi of a private equity firm, I pointed out, was to buy stagnant companies, turn them around, and then sell them at a profit. By their nature, and according to their own promotional materials, these funds became involved in the day to day operations of the businesses they invested in, firing managers, renegotiating contracts, restructuring the organizational chart, etc. “It is one thing to manage one’s investments in businesses,” I wrote. “It is another to manage the businesses in which one invests.”
So far as I know, the discussion in that article represents the first scholarly treatment of the question whether private equity funds are engaged in a trade or business. And at the time, the argument was skeptically received.
It was quite gratifying to see the court in Sun Capital conduct a similar analysis and reach a similar conclusion. Even more, the court included in its opinion the above quote from my article.
PL: You said that “trade or business” appears in several places in the law. Are there any other applications of the idea that private equity funds are not mere investors?
CS: Yes. Steve Rosenthal, my fellow Visiting Scholar at the Urban-Brookings Tax Policy Center this past academic year, applies the same kind of analysis in a more recent article. From the conclusion that private equity funds are engaged in a trade or business, Steve deduces that carried interest should be treated as ordinary income not capital gains.
So, perhaps the legal ground is shifting.