U.S. Insurer of Pensions Sees Flood of Red Ink

New York Times
May 20, 2009

The deficit at the federal agency that guarantees pensions for 44 million Americans tripled in the last six months to a record high, reaching $33.5 billion, largely as a result of surging bankruptcies among companies whose pensions it expects it will soon need to take over.

The agency, the Pension Benefit Guaranty Corporation, faced a shortfall of just $11 billion as of October. The combined effect of lower interest rates, losses on its investment portfolio and rising numbers of companies filing for bankruptcy produced the jump in its projected deficit, officials said Wednesday.

Because the agency has $56 billion in assets — most of which is invested in Treasury bonds — it is not facing any prospect of default in the short term, officials said.

“The P.B.G.C. has sufficient funds to meet its benefit obligations for many years because benefits are paid monthly over the lifetimes of beneficiaries, not as lump sums,” the agency’s acting director, Vince Snowbarger, testified Wednesday at a Senate hearing. “Nevertheless, over the long term, the deficit must be addressed.”

The financial troubles are just a small part of the challenges facing the pension agency, which was created by Congress in 1974 and today is responsible for pension programs covering 1.3 million people. It pays about 640,000 people actual benefits worth about $4.3 billion a year.

The P.B.G.C.’s former director, Charles E. F. Millard, was subpoenaed to testify at the hearing Wednesday. But he cited his constitutional right to avoid self-incrimination and declined to answer any questions.

Mr. Millard, who resigned in January, has been accused by the agency’s inspector general of having inappropriate contact with companies including BlackRock, JPMorgan Chase and Goldman Sachs, all of which competed for and won contracts to help manage $2.5 billion of the agency’s funds. Those contracts will now most likely be canceled.

Employers nationwide with so-called defined-benefit, or traditional, pension plans pay fees to the P.B.G.C. in return for a promise that it will take over their pension plan if a company fails.

On Tuesday, for example, the agency announced that it had assumed the pension plan once run by the Lenox Group, a bankrupt maker of tableware, giftware and collectibles based in Eden Prairie, Minn. Assuming control of pensions for this company’s 4,300 workers will cost the agency an estimated $128 million — the difference between what Lenox had in its pension fund and what the total estimated obligations are.

In the last six months, 93 companies whose pension plans are covered by the agency have filed for bankruptcy, including Chrysler, whose failure alone could cost the agency $2 billion. A bankruptcy by General Motors would make the situation worse. G.M. had 670,000 workers as of late last year in its pension system, whose collapse would cost the agency an estimated $6 billion.

Options to close the $33.5 billion deficit include a federal bailout by taxpayers, a change in insurance premiums it charges employers, or increasing its investment returns.

Last year, the agency’s board voted to allow it to shift its investment strategy to put more money into stocks, private equity and real estate, in an effort to reduce the deficit. If that shift had taken place, the losses would most likely have been larger. But only a relatively small amount of the funds have already been shifted to stocks, so the losses on the investment portfolio were responsible for just $3 billion of the jump in the deficit in the last six months.

Senator Herb Kohl, Democrat of Wisconsin and chairman of the Senate Special Committee on Aging, which held the hearing Wednesday, blamed poor supervision by the agency’s board and management, at least in part, for the troubles, adding that he intended to introduce legislation that would expand the board and require it to meet at least four times a year. The board has not met in person since February 2008.

“The role of P.B.G.C. is too crucial to allow its governance to slip through the cracks,” Mr. Kohl said.

How Firms Wooed a U.S. Agency With Billions to Invest

New York Times
July 28, 2009

As a New York money manager and investment banker at four Wall Street firms, Charles E. F. Millard never reached superstar status. But he was treated like one when he arrived in Washington in May 2007, to run the Pension Benefit Guaranty Corporation, the federal agency that oversees $50 billion in retirement funds.

BlackRock, one of the world’s largest money-management firms, assigned a high school classmate of Mr. Millard’s to stay in close contact with him, and it made sure to place him next to its legendary founder, Laurence D. Fink, at a charity dinner at Chelsea Piers. A top executive at Goldman Sachs frequently called and sent e-mail messages, inviting Mr. Millard out to the Mandarin Oriental and the Ritz-Carlton in Washington, even helping him hunt for his next Wall Street job.

Both firms were hoping to win contracts to manage a chunk of that $50 billion. The extensive wooing paid off when a selection committee of three, including Mr. Millard, picked BlackRock and Goldman from among 16 bidders to manage nearly $1.6 billion and to advise the agency, which Mr. Millard ran until January.

But on July 20, the agency permanently revoked the contracts with BlackRock, Goldman and JPMorgan Chase, the third winner, nullifying the process. The decision was based on questions surrounding Mr. Millard’s actions during the formal bidding process. His actions have also drawn the scrutiny of Congressional investigators and the agency’s inspector general.

An examination of thousands of pages of e-mail messages and other internal documents obtained by The New York Times shows the other side of the story: the two firms aggressively courted Mr. Millard, so extensively that they may have compromised federal contracting rules or at least violated the spirit of the law, contracting experts said. The records also illustrate the clash between Washington’s by-the-letter rules on contracting and the culture of Wall Street, where deals are often struck over expensive meals.

“Both sides should have known better,” said Steven L. Schooner, co-director of the Government Procurement Law Program at the George Washington University, who reviewed some of the material for The Times. “What happened here is wrong, stupid and probably illegal.”

BlackRock and Goldman, as well as Mr. Millard, all said that nothing improper happened either before the formal competition for the contract started last July, or while the competition, which concluded in October, was under way.

“Among the reasons that Mr. Millard was selected to head the P.B.G.C. is his understanding of the industry, his extensive background and the quality of his professional relationships,” said Stanley M. Brand, a lawyer for Mr. Millard. “He correctly separated his personal relationships from his official actions.”

A review of the documents shows that the third winner, JPMorgan Chase, had contacts with Mr. Millard before and during the competition, but did not display the same intensity as the other two.

Goldman and BlackRock saw Mr. Millard’s selection as a major business opportunity, the records show.

“This is a very big fish on the line,” one BlackRock executive wrote to another, discussing the government official.

Mr. Millard had at least seven meetings with Goldman executives in the year before the bidding started, and 163 phone contacts, the documents show. BlackRock had less frequent contact — 39 phone calls in that 12-month period. But one BlackRock executive told another that Mr. Millard had assured him in April, four months before the bidding, that he wanted to hire the company to help manage some of the money, company documents show.

“It sounds like we may have a tiger by the tail here,” one BlackRock executive wrote in an e-mail message.

The agency takes over pension programs when private companies go bankrupt. For years there was talk it might have to be bailed out by the government, and Mr. Millard, like many others, saw shifting from low-yield conservative investments like Treasury bonds to those with higher risks and higher potential returns as a way to solve the problem.

Before coming to Washington Mr. Millard had been a money manager for Prudential Securities and Lehman Brothers, a senior economic development official in New York City while Rudolph W. Giuliani was mayor, a member of the New York City Council and a Republican nominee for Congress.

Within weeks of his arrival at the agency, he told Goldman Sachs about his plans to shake up the agency’s portfolio.

“I just became head of the pension benefit guaranty corp in dc appointed by pres bush,” he wrote in a June 2007 e-mail message to John S. Weinberg, a vice chairman and a member of the family that has helped run Goldman since the 1930s. Mr. Millard told Mr. Weinberg, a longtime acquaintance, that he wanted to revamp the agency’s investment strategy.

“Is there a team at Goldman that does this and that would be interested in pursuing this business?”

“Yes, absolutely!” Mr. Weinberg wrote back.

Almost immediately, Goldman started to work informally for Mr. Millard by providing one of its top pension analysts at no charge to prepare at least six reports over the coming year, based on internal agency data, detailing possible investment strategies.

Goldman also coached Mr. Millard as he sought to sway skeptics in the Bush administration...

Implications for Private Equity Funds with Portfolio Company Pension Liability

By Jeffrey London, International Law Office
August 19, 2009

In September 2007 the Appeals Board of the Pension Benefit Guaranty Corporation (PBGC) held a private equity fund liable for the pension underfunding of one of the fund's bankrupt portfolio companies. Given the potentially severe economic implications of the decision for private equity funds, funds must remain focused on this issue and follow ongoing developments in this area.

Background

Under the Employee Retirement Income Security Act of 1974, when a pension plan sponsor terminates a plan, members of the sponsor's controlled group are jointly and severally liable for the corresponding unfunded liabilities, even though the members may have had no relationship to the pension plan. Entities are part of the same controlled group if they are (i) engaged in a 'trade or business', and (ii) under 'common control'.

In general, a parent-subsidiary group is under common control where the parent owns at least 80% of the stock of the subsidiary, based on either voting power or value, or, in the case of a partnership, at least 80% of the capital or profits interest. Accordingly, if a private equity fund engages in trade or business and owns at least an 80% interest in a portfolio company, it may be liable for certain pension and benefit liabilities of the portfolio company.

The controlled group liabilities would generally not extend further up the ownership chain to the fund's partners, unless any partner acquired an 80% or greater capital or profits interest in the fund. However, under general partnership law, the general partner of the fund would be responsible for any liabilities incurred by the fund, including the pension liabilities described herein.

Until the PBGC's decision, many practitioners had taken the position that private equity funds were not trades or businesses and, therefore, were shielded from the pension liabilities of their portfolio companies. However, the decision revealed that the PBGC disagrees.

Decision

The private equity fund involved in the decision was a Delaware limited partnership. The fund owned a 96% interest in a Delaware corporation which had sponsored a pension plan that was terminated when the corporation filed for bankruptcy.

The PBGC asserted that the fund, as a member of the corporation's controlled group, was liable for the corporation's unfunded pension liabilities of over $3 million arising from the plan's termination.

The fund disputed any liability, arguing that it could not be in the corporation's controlled group because the fund was not engaged in a trade or business. The fund argued that it was merely a "passive investment vehicle that has no employees, no involvement in the day-to-day operations of its investments and no income other than passive investment income".

The PBGC rejected the fund's argument and held the fund liable for its portfolio company's termination liability. The PBGC distinguished its decision from cases where individuals with passive investment activities were found not to have been conducting a trade or business. It explained that the fund, unlike the taxpayers in those cases, was actively involved in its investments, as evidenced by the general partners' investment and management services and compensation for such services. The fund was formed as a business entity "to select, acquire, dispose of, and manage investments... through its agent", unlike individual taxpayers, who invest their own money for their own gain.

Implications

Aside from the obvious effect that private equity funds (and members of their controlled group) may be liable for the pension plan termination liability of their portfolio companies, the decision has implications for numerous other situations in which liability can be imposed on funds.

If the PBGC's interpretation of engaging in 'trade or business' is followed by arbitrators or courts, a private equity fund that owns 80% of its portfolio company may be liable for the withdrawal liability incurred by a portfolio company when it withdraws from a multi-employer pension plan. In addition, portfolio companies may be barred from terminating underfunded pension plans unless all members of the controlled group are in bankruptcy or liquidation. Further, for failing to meet minimum funding standards the fund may be liable for:

• certain payments under the Consolidated Budget Reconciliation Act of 1985;
• PBGC premiums; and
• excise taxes.

Credit agreements may also be affected by the decision. Credit agreements often contain clauses that prohibit the underfunding of any pension plans in the debtor's controlled group, as well as requiring certain financial covenants to be maintained. An underfunded pension plan sponsored by a portfolio company could cause a different portfolio company owned by the fund, or the fund itself, to violation of its covenants under ERISA or financial covenants.

Since the issuance of the PBGC decision, interested parties have awaited further interpretative guidance, but to date there has been no guidance from the federal courts on whether they will apply the PBGC's position. However, because the structure of the fund in the PBGC decision was similar to that of many private equity funds, it is reasonable to expect that in future the PBGC will pursue other funds. Given the potentially large liabilities, prudent private equity funds should use careful planning before acquiring portfolio companies and when determining the ownership levels of such companies.

Recommendations

One way to avoid the issue, or to minimize its impact, is to perform thorough due diligence on target companies and their ERISA-controlled groups. Due diligence should enable private equity funds to determine whether a target's pension plan is underfunded and potential multi-employer pension plan withdrawal liability exists. If so, the private equity fund may consider reflecting these potential liabilities in the purchase price. Due diligence should also be used to determine whether the target is a member of a controlled group with plan sponsors whose plans are or may become underfunded. The due diligence should be continued after the deal closes because plan underfunding fluctuates according to changes in, among other things, the equity markets, the debt markets and the plan sponsor's workforce.

Another possible way to avoid liability is to structure the acquisition such that even if the private equity fund is engaged in a trade or business, the fund is not under common control with the target. This can be achieved in several ways. For example, the fund may keep its ownership level, by vote and value, to less than the 80% threshold. Alternatively, the private equity firm might split the interest in the target among two or more of its funds, if possible, or employ an alternative investment vehicle, either of which can dilute the fund's interest in the target to under 80%. Even in the event of such a bifurcation, there remains a risk that the PBGC could posit that the investment is, in effect, maintained by a single entity, in which case the PBGC decision could be applied.

Since this area of law continues to evolve, funds should remain updated on developments, both administrative and judicial. While these potential control group liabilities have been largely ignored in the past, the risk of having liabilities assessed against a fund or among portfolio companies has substantially increased based upon the PBGC's position and the current lack of judicial authority to the contrary.

For further information on this topic please contact Jeffrey London at Kaye Scholer LLP by telephone (+1 312 583 2300), fax (+1 312 583 2360) or email (jlondon@kayescholer.com).

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