Developments: The Scott Brass Decision

Posted on August 17, 2013

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Scott Brass Website Picture

The Scott Brass decision by the U.S. First Circuit Court of Appeals is unlikely to have the significant impact on private equity funds that many are foreseeing.  The decision does, however, create yet another level of uncertainty to the deployment of capital to companies where it is most needed.

Five years after the US financial crisis, small and medium enterprises and companies that do not have the highest credit ratings, or who get into a bit of financial trouble, but who employ a significant portion of the workforce, still have difficulty finding the financing they need from traditional sources such as banks to remain an engine of growth for the US economy.

Background

The United States Court of Appeals for the First Circuit recently ruled in Scott Brass.   In the short time since the decision was handed down on July 24, 2013, some are already building a wall of worry.  Other than pitting organized labor (Teamsters) against organized capital (Sun Capital Partners), the case would have been a more or less uninteresting review of existing precedent related to the liabilities of a passive pool of capital (in the form of a limited partnership managed by Sun Capital) invested in an insolvent portfolio company.  I am not addressing in this post the question, by the way, of the merits of the decision, only of some of its implications.

The court found it convenient to reach for arguments that supported a finding that at least one fund managed by Sun Capital was “actively” involved in the business of Scott Brass for pension plan (ERISA) purposes though Sun Capital engaged in no more activity than what PE general partners often do: it became involved in certain decisions by Scott Brass (to the extent negotiated in the contracts with the company one presumes).

What is more novel here is the reach by the court to find liability for the pension plan at the level of the passive investors whose money Sun Capital manages in one of its funds. Essentially, the court attributed the manager’s activities to the fund for ERISA purposes.  It also placed great reliance on the fact that fees received by Sun Capital from Scott Brass were used by Sun Capital to offset the 2% management fees otherwise owed by the fund’s investors to Sun Capital.

Thoughts

The Scott Brass decision adds further uncertainty for those wishing to invest capital into worthwhile pursuits that benefit the economy and ultimately create jobs.  By itself the decision does not have far-reaching consequences for the future, yet in individual situations can have quite painful results.  Some investments will not be made because of the additional layer of risk.  Some investments will be made, but at higher cost to compensate for the additional risk.  Also larger funds groups have the ability to adjust better under the ERISA rules while smaller funds will face more difficult investment choices further pressuring capital flowing to smaller and midsize companies.

The other aspect of this case of course is that fund structures for funds that invest into distressed companies will need to be reviewed to determine whether appropriate fund structuring could provide ways to mitigate exposure to these risks.

One last note, this decision doesn’t resolve the Scott Brass case, only an aspect of it and it can be appealed further.  The underlying case bears watching.