National Round-up

DetroitExtra Pension Payouts?Who knew that Detroit had for years been taking money out of its pension fund when investment returns exceeded actuarial assumptions and paying it out to thousands of city employees and pensioners whose “base” pensions were deemed to be too small?   Detroit had also used some of the excess funds to reduce its own annual pension fund contributions, but, two years ago, discontinued all such extra payments in a vain effort to stave off bankruptcy.

Numerous other cities and states across the country have also been issuing “13th checks” to their retirees for many years.  In fact, San Diego underwent a similar pension scandal in 2001 and barely avoided bankruptcy itself.

Detroit’s “bump-ups,” however, have now come home to roost.  Not only did they deprive the city’s pension plan of billions of dollars that could be earning income today, the suspended payments must now be made to retirees retroactively and continue to be honored through Detroit’s bankruptcy according to a recent ruling from a Michigan state judge (who likened his order to “a ticket refund on the Titanic”).

While the Michigan constitution protects municipal pensions, Detroit has filed for federal bankruptcy protection which could trump state law and invalidate the pension add-ons.  Other cities and states with severely underfunded pensions are therefore watching the Detroit case closely to see whether a federal bankruptcy filing could actually free them from otherwise unpayable pension liabilities.

Carried Interest Double Trouble for Private Equity:  Right after Mitt Romney bared his embarrassingly low (14%) effective tax rate during the 2012 presidential campaign and Warren Buffett then called for a flat 30% tax on millionaires, it really looked as if the preferential tax treatment of carried interest on private equity investments would not survive Obama’s second term.

Almost a year has gone by since then without a word about carried interest, but its tax treatment recently resurfaced thanks to a seemingly unrelated pension fund decision against Sun Capital Partners, a PE fund that, in 2007, acquired an electronics component manufacturer, Scott Brass, Inc., which went bankrupt the following year.

Sun Capital brought the suit against Scott and its underfunded pension fund in order to avoid liability for the underfunding, claiming that it was a mere passive investor in the company.  The First Circuit Court of Appeals, however, found that Sun Capital was actively involved in Scott’s operations, controlled its board and management team and was paid a fee by Scott for its management services, all of which led to its ruling that Sun Capital was actually engaged in a “trade or business” involving Scott and was therefore responsible for the company’s pension obligations under US labor law (ERISA).

Since PE funds typically acquire controlling positions in their portfolio companies and oversee their management and operations, the adverse holding in Sun Capital now also calls into question PE’s principal argument for the preferential treatment of carried interest.

Under the US tax code, a carried interest in a portfolio company qualifies for capital gains treatment only if the PE fund owning that interest does not actively operate the portfolio company as a “trade or business.”  If it does, as was found in Sun Capital, its carried interest would be deemed to be compensation for management services, and any profit earned by the fund on the sale of the portfolio company would be characterized as a return on labor rather than capital, in which case the carried interest would be treated for tax purposes as ordinary income.

Now let’s see if the Obama administration uses Sun Capital to renew its legislative assault on PE’s sacred cow.