Private Equity Newsletter

October 07, 2015

This edition of Dechert’s Private Equity Newsletter reviews recent developments in private equity worldwide, including:

  • Buyer Beware – Court Lowers Hurdle to Make Claim for Withdrawal Liability Under the Successorship Doctrine
  • The Summer Budget – Changes to the UK Tax Treatment of Carried Interest
  • Evaluating Cybersecurity Risks and Preparedness in Target Companies
  • Proposed Partnership Treasury Regulations – Consider the Guaranteed Payment
  • Recent Developments in Acquisition Finance
  • Representation and Warranty Insurance: No Longer Optional


Buyer Beware – Court Lowers Hurdle to Make Claim for Withdrawal Liability Under the Successorship Doctrine

By Eric B. Rubin and Aryeh Zuber

In Tsareff v. ManWeb Services, Inc.,1 the U.S. Court of Appeals for the Seventh Circuit held that an asset purchaser’s pre-closing knowledge of a seller’s potential multiemployer plan withdrawal liability could be sufficient to obligate the purchaser for the seller’s withdrawal liability even where (a) the amount of the withdrawal liability was not determined until after the sale and (b) such liability was not assumed by the purchaser under the asset purchase agreement. The Tsareff decision likely will impact the way asset purchasers approach transactions involving companies that contribute or contributed to multiemployer plans, with an increased focus on protecting against these liabilities.

The Successorship Doctrine

The general common law rule of successor liability holds that, except in very limited situations, where one company sells its assets to another company, the buyer is not liable for the debts and liabilities of the seller, absent an express contractual assumption. However, the United States Supreme Court and several Circuit Courts of Appeal have imposed liability upon successors beyond the bounds of the common law rule in a number of different employment-related contexts when (1) the successor had notice of the claim before the acquisition; and (2) there was substantial continuity in the operation of the business before and after the sale.2 This doctrine, based in equity, is often referred to as the “successorship doctrine.”

The Seventh Circuit previously applied the successorship doctrine to delinquent pension fund contributions owed by a predecessor and to withdrawal liability owed by a Chapter 7 debtor.3 However, prior to Tsareff, the Seventh Circuit had not ruled on whether the notice element of the successorship doctrine can be satisfied if the withdrawal liability is only contingent (because no withdrawal had occurred) at the time of the acquisition.

Tsareff v. ManWeb Services

In Tsareff, Tiernan & Hoover (“Tiernan”), an electrical contractor and union employer, sold all of its assets to ManWeb Services, Inc. (“ManWeb”), a non-union employer. Prior to the sale, Tiernan was party to a collective bargaining agreement, in accordance with which it was required to make contributions to a multiemployer pension fund (the “Plan”) on behalf of its union employees. Following the sale, Tiernan ceased operations and no longer contributed to the Plan. ManWeb also did not make any contributions to the Plan.

Shortly after the sale, the Plan attempted to inform Tiernan that the sale had resulted in Tiernan’s complete withdrawal from the Plan, and assessed withdrawal liability against Tiernan in the amount of $661,978. Pursuant to a mail forwarding instruction, the notice of withdrawal liability was forwarded to ManWeb. Neither ManWeb nor Tiernan sought review of the withdrawal liability assessment, or requested arbitration to contest the imposition of withdrawal liability as required by law. When Tiernan failed to satisfy its withdrawal liability, the Plan filed an ERISA collection action against Tiernan, adding ManWeb as a defendant under a theory of successor liability.

On summary judgment, the district court ruled in favor of the Plan as against Tiernan. However, on the question of successor liability, the district court found that ManWeb was not liable because the notice requirement of the successorship doctrine was not satisfied. The court found that pre-acquisition notice of contingent liabilities was not sufficient to satisfy the notice requirement, and that because the Plan did not assess the amount of withdrawal liability until after the asset purchase—since, under ERISA, withdrawal liability is assessed only after withdrawal—ManWeb did not have sufficient notice. Thus, the successorship doctrine could not apply and ManWeb could not be liable.

The Court of Appeals reversed as to ManWeb, finding that the notice requirement can be satisfied even if the liabilities were only contingent at the time of the asset sale. Key to the Court’s conclusion was its analysis of the policy goals underlying the Multiemployer Pension Plan Amendments Act of 1980 (“MPPAA”)—the federal legislation establishing multiemployer pension fund withdrawal liability. The Court determined that in order to further the MPPAA’s goal of “ensuring that the responsibility for a withdrawing employer’s share of unfunded vested pension benefits is not shifted to remaining employers,” it would be equitable to apply the successorship doctrine even where the pre-acquisition notice of liability was for only contingent liabilities. The Court reasoned that if pre-transaction notice of contingent liabilities was insufficient to satisfy the notice requirement, a “liability loophole” would exist in the context of multiemployer plans. Multiemployer plans would be foreclosed from relief in some situations, such as where withdrawal liability was triggered after the sale, but not others, such as in the context of a bankruptcy, where withdrawal liability is triggered prior to the sale.

The Court of Appeals reversed as to ManWeb, finding that the notice requirement can be satisfied even if the liabilities were only contingent at the time of the asset sale. Key to the Court’s conclusion was its analysis of the policy goals underlying the Multiemployer Pension Plan Amendments Act of 1980 (“MPPAA”)—the federal legislation establishing multiemployer pension fund withdrawal liability. The Court determined that in order to further the MPPAA’s goal of “ensuring that the responsibility for a withdrawing employer’s share of unfunded vested pension benefits is not shifted to remaining employers,” it would be equitable to apply the successorship doctrine even where the pre-acquisition notice of liability was for only contingent liabilities. The Court reasoned that if pre-transaction notice of contingent liabilities was insufficient to satisfy the notice requirement, a “liability loophole” would exist in the context of multiemployer plans. Multiemployer plans would be foreclosed from relief in some situations, such as where withdrawal liability was triggered after the sale, but not others, such as in the context of a bankruptcy, where withdrawal liability is triggered prior to the sale.

The Court remanded the case to the district court to address whether ManWeb sufficiently continued the business of Tiernan to support a claim for successor liability.


Prior court decisions going back over 40 years have established that the successorship doctrine is applicable to employment-related liabilities. However, as Tsareff demonstrates, in the context of multiemployer plan liabilities, courts may be more willing to find successor liability in order to further the MPPAA’s policies of protecting remaining contributors to a multiemployer plan. This desire to further the MPAA’s policies has been cited by other circuits as well, as a recent decision by the U.S. Court of Appeals for the Ninth Circuit held that the successorship doctrine could be used to impose withdrawal liability on a newly formed business that continued some of the operations of a liquidated business owned by different individuals if there was a sufficient continuity between the customers of the new and liquidated businesses.4

Purchasers should take heed and carefully review a target’s potential multiemployer plan liabilities before undertaking a transaction, and ensure sufficient protection through purchase price reductions and indemnification, including the use of specific escrows.

Dechert’s Employee Benefits and Executive Compensation Group has extensive experience in these matters and can assist you in navigating through multiemployer plan issues. 


1) Tsareff v. ManWeb Services, Inc., Case No. 14-1618 (7th Cir. July 27, 2015).
2) Golden State Bottling Co., Inc., 414 U.S. 168 (1973); see also Einhorn v. M.L. Ruberton Constr. Co., 632 F.3d 89, 93-96 (3d Cir. 2011); Upholsterers’ Int’l Union Pension Fund v. Artistic Furniture of Pontiac, 920 F.2d 1323, 1326-28 (7th Cir. 1990); Haw. Carpenters Trust Funds v. Waiola Carpenter Shop, Inc., 823 F.2d 289, 294-95 (9th Cir. 1987); Stotter Div. of Graduate Plastics Co., Inc. v. Dist. 65, United Auto Workers, 991 F.2d 997, 998-99, 1002 (2d Cir. 1993). 
3) Upholsterers’ Int’l Union Pension Fund v. Artistic Furniture of Pontiac, 920 F.2d 1323 (7th Cir.1990); Chicago Truck Drivers, Helpers & Warehouse Workers Union (Indep.) Pension Fund v. Tasemkin, Inc., 59 F.3d 48 (7th Cir.1995).
4) Resilient Floor Covering Pension Trust Fund Board of Trustees v. Michael’s Floor Covering, Inc., Case No. 12-17675 (9th Cir., Sep. 11, 2015).


The Summer Budget – Changes to the UK Tax Treatment of Carried Interest

By Mark Stapleton

The Chancellor of the Exchequer’s recent Summer Budget and the related legislation introduced a series of unexpected tax changes along with the promise of further changes to come. Shortly after the Summer Budget was issued Dechert published an OnPoint describing some of the most important points in the Budget which affect the private equity and investment management industry. This article is an updated version of that OnPoint and includes information with respect to the draft legislation released after the Summer Budget. One of the most significant proposed changes would subject to UK taxation carried interest payments to non-UK domiciled executives working in the UK.

Carried Interest and Performance-Related Returns


The Chancellor’s Autumn Statement in December 2014 led to the introduction of wide-ranging anti-avoidance rules designed to counter “disguised investment management fees.” This was primarily aimed at circumstances where a return from a fund had been structured as a guaranteed profit share instead of a fee, but was drafted in much wider terms. Despite the far-reaching legislation, there was an exemption for “carried interest” and – after a high volume of representations to H.M. Revenue & Customs (HMRC) – carried interest for these purposes was defined broadly. Not only did the term include performance-related returns from traditional private equity-style carried interest, but also carried interest arrangements relating to alternative funds (including profits reflected by unrealised gains). In the Summer Budget, presented to Parliament on July 8, 2015, HMRC has now turned its attention to the taxation treatment of carried interest and performance-related returns.

New Changes

With immediate effect, the so-called “base cost shift” – which enabled investment managers to take advantage of a share of the capital invested by external investors in calculating a gain on their carried interest – has been swept away. Going forward, only actual investment by an individual participating in the carried interest will be taken into account in calculating the capital gain on realisation of underlying investments. Essentially, the effective rate of tax on carried interest will be a minimum of 28%, rather than a considerably lower rate which had generally been available. Furthermore, this measure will also put an end to “cherry picking” of income and gains attributable to the carried interest.

HMRC has also introduced in this measure a very material change to the traditional “remittance basis” of taxation for non-domiciled individuals. Essentially, carried interest will be treated as sourced in the UK (and therefore taxable for a non-UK-domiciled person) to the extent it relates to investment management (or related) services performed in the UK. This will therefore change the expected tax-free status of carried interest for non-domiciled individuals performing investment management services in the UK in relation to an offshore fund.

It is very surprising that such an important measure should have been introduced without warning and with no mention at all from the Chancellor in his Budget speech.

The changes also include a provision to capture and tax as a capital gain carried interest which arises to an individual in circumstances where there has been no disposal of an asset for capital gains purposes. Due to the broad definition of carried interest, this could cover a wide variety of things – such as income, or capital returns which would otherwise have been untaxed due to “base cost shift” or where unrealised gains form part of the carried interest. A tax credit mechanism has been introduced to credit tax paid on actual gains ultimately arising, although there are various technical concerns with how this might operate in practice – in particular, that double taxation may arise in some scenarios.

In addition, concerns exist in relation to the U.S. tax position of U.S. citizens working in the UK in the private equity industry. As tax could arise at a later date in the UK with respect to the receipt of carried interest (as compared to when tax needs to be paid in the U.S.), there may be issues with obtaining credit for the UK tax against the U.S. tax liability of the individual entitled to carried interest. There is also some uncertainty over whether gains would be recognised as being the same item of income for U.S. tax purposes in the context of obtaining credit against U.S. tax liability.

HMRC Announces New Consultation Exercise

Separately, HMRC has issued a consultation document to clarify the circumstances in which performance-related returns can benefit from capital gains tax treatment. There are, however, some positive assurances for carried interest related to traditional private equity funds, and HMRC has said that such arrangements should continue to enjoy capital gains tax treatment (albeit now without the benefit of base cost shift). Unfortunately, the underlying impression from the consultation document appears to be less positive for alternative managers, and it seems likely that there will be little scope for the hedge fund sector to benefit from capital gains tax treatment on carried interest once the changes take effect in April 2016.

HMRC has recognised that whether or not capital gains tax treatment is available in relation to carried interest currently turns on whether a fund is carrying on a “trading” or “investing” activity in relation to its underlying assets. As the case law in this area is limited with respect to the activities of modern-day investment managers, there is a great deal of uncertainty as to the boundary between trading and investing. HMRC has further indicated that it believes that some funds have taken an overly aggressive view as to the distinction and have incorrectly taken the position that the fund is carrying on an investment activity. While HMRC believes this planning to be ineffective, it has also indicated a degree of reluctance to challenge these arrangements, as such a challenge would be time and resource intensive. However, those who have implemented such planning will likely find that it will cease to generate appropriate capital gains tax treatment post-April 2016.

The Consultation Document Proposals

HMRC has suggested two proposals to determine the circumstances in which capital gains tax treatment would be appropriate for performance-related returns.

Proposal 1: To focus on certain types of activities and classify only those activities as being capable of qualifying for capital gains tax treatment. A fund would need to be wholly or substantially carrying on such activities. HMRC has invited comments on the list of qualifying activities. However, the proposal seems rather restrictive and the examples given refer to the following:

  • Controlling equity stakes in trading companies intended to be held for a period of at least three years.
  • The holding of real property for rental income and capital growth where, at the point of acquisition, it is reasonable to assume that the property will be held for at least five years.
  • The purchase of debt instruments on a secondary market where, at the point of acquisition, it is reasonable to assume that the debt will be held for at least three years.
  • Equity and debt investments in venture capital companies, provided the investments are intended to be held for a specified period of time.

Proposal 2: To focus on the average holding periods of investments held by a fund and to allow capital gains treatment where this exceeds a certain period of time. A suggestion is that this might be on a graduated basis to avoid a “cliff edge” test which would otherwise represent “all or nothing” treatment. The example given in the consultation document is that relief could be granted on a graduated basis – allowing for a greater percentage of relief where assets are held (on average) for a lengthier period of time (e.g., 25% relief if assets are held for more than six months, 50% relief if held for more than one year, 75% relief if held for more than 18 months and full relief if held for more than two years).

Looking at the first proposal, aside from the lengthy holding periods envisaged, there is no mention of portfolio equity holdings outside of venture capital companies, nor holdings in derivatives or loan origination no matter what the holding period might be following acquisition. As to the second proposal, the focus is on actual holding periods rather than focusing on the intention of the taxpayer at the point of acquiring assets, which is a key feature of the current case law test of whether a person is trading. Such an intention test appears to have been rejected by HMRC on the basis that it would not produce a “robust and principled basis for tax and performance linked returns.” Accordingly, notwithstanding that a fund might have been established with the intention to hold assets for the medium to long-term, it may not give rise to capital gains treatment on a carried interest arrangement if in fact there is a short-term sale of a significant proportion of the assets (possibly due to a favourable offer emerging unexpectedly).

The closing date for the consultation was September 30, 2015. Dechert has been making representations in relation to the above proposals through its involvement with the Alternative Investment Management Association (AIMA). Our view is that proposal 2 would be preferable in terms of certainty of treatment of carried interest.

Non-Domiciled Individuals

Aside from the very significant changes affecting non-domiciled individuals with respect to carried interest referred to above, new restrictions have been introduced for those who are UK-tax resident but not UK-domiciled:

  • It will no longer be possible for persons to be treated as non-UK-domiciled for UK tax purposes if they have been resident in the UK for more than 15 of the past 20 years.
  • Those who were UK-domiciled at birth but who have since acquired a domicile elsewhere will automatically become UK-domiciled for tax purposes if they return to the UK and become UK-resident again.

These changes will come into effect from April 2017. Non-UK-domiciled individuals who are affected by the changes will want to consider appropriate planning before such date, which might include advance realisation of unrealised offshore profits.

UK Companies and Their Shareholders

Despite the fact that the UK has one of the lowest corporation tax rates in Europe, the government has announced that corporation tax will reduce further to 19% in 2017, and then again to 18% in 2020. While lower rates of corporation tax have encouraged investment managers to reconsider the use of companies rather than LLPs as the vehicle of choice – particularly following the tax changes to LLPs implemented in 2014 – the Summer Budget has also introduced further adverse changes to the taxation of dividends. While the tax credit system for dividends will be abolished from April 2016, the relevant tax rate on dividends for higher-rate taxpayers will rise to 32.5% and for additional rate taxpayers to 38.1% (compared to equivalent effective rates of 25% and approximately 30.6%, respectively, under current law). In addition, basic rate taxpayers will no longer receive dividends without further tax (save the first £5,000, which will be exempt in addition to the personal allowance), but will incur tax at a new 7.5% rate. These changes will affect shareholders in companies and will now need to be factored into assessing the tax efficiency of the limited company structure.

The tax landscape for private equity and investment management has shifted considerably over the last few years and, as noted above, the Summer Budget continues this trend and provides significant food for thought in relation to the existing and future structuring.


Evaluating Cybersecurity Risks and Preparedness in Target Companies

By Timothy C. Blank and Hilary Bonaccorsi

Before committing resources to a potential investment, private equity firms should aggressively evaluate a target company’s cyber risks and cyber preparedness. Some target companies are naturally more exposed to cyber risk than others because they collect and store information that criminals are interested in stealing—information such as customers’ names, Social Security numbers, tax information, credit card information or financial account information. However, regardless of business type, virtually any company that caters to individuals is exposed to cyber risks if it has not adopted policies to protect customer information, or if it only has policies on paper and does not implement them in practice. This article will help private equity firms assess a target company’s actual cyber risks by guiding them through the diligence process. Issues include:

  • what to look for to make sure a company has a comprehensive information security program in place;
  • how to make certain that the components of that program are actually being implemented; and
  • how to ensure that the company’s designated information security officer is effectively monitoring the ongoing information security threats the company faces.

Does the target company have a comprehensive information security/privacy program?

A comprehensive information security/privacy program consists of several important components that work together. As part of the diligence process, private equity firms should be sure to review the following policies and enlist an expert to evaluate them for completeness:

  • Written Information Security Program (“WISP”): A WISP should address how the company protects the customer information it collects and retains and explain the technical, administrative and physical safeguards the company has in place to make sure the information is not accessed by criminals, or inadvertently exposed by an employee.

  • Incident Response Plan: This action plan explains what the company will do if there is a data breach or cyber-attack. It lays out how the company will determine whether a given incident constitutes a reportable event, how incidents will be escalated within the organization, names and contact information for internal decision-makers, as well as internal and external counsel, and guidelines for how to investigate the incident.

  • Online Privacy Policy: Every company that has a website should also have an online privacy policy that addresses how the company engages with website users and customers. The policy should explain how the company collects information from users, what type of information it gathers, how it shares that information and whether users can limit that sharing. 

  • Privacy Notices: Companies that come within the Federal Trade Commission’s (“FTC”) or the Securities and Exchange Commission’s broad definitions of “financial institution” must, under certain circumstances, tell people what types of information they collect from them, how they collect it and whether they share that information with other organizations. Under certain circumstances, they also need to provide people with the opportunity to keep that information private and to opt out of having it shared.

  • Cyber-Insurance Policy: When a company’s technical or physical safeguards fail, comprehensive cyber coverage can cover the costs associated with forensic examinations, notification costs, legal fees, potential business losses and public relations expenses.

Is the information security/privacy program actually being implemented?

A comprehensive information security/privacy program cannot simply exist on paper—the company must also actually implement and monitor the policies it has adopted. Implementing the policies increases the chance customer information will be protected in accordance with industry standards, which thereby decreases the risk of a cyber-incident. Implementing and monitoring the policies will also be important should the company become the target of an FTC enforcement action, as the FTC has taken the position that when a company’s privacy policy tells its customers that it safeguards their information, but fails to actually do so, it has engaged in deceptive trade practices.1

Private equity firms should look carefully at the following areas to determine whether a target company’s information security/privacy program is actually being implemented:

  • Technical safeguards: Companies should have user authentication protocols in place, require secure passwords that must be changed frequently, and block information after several failed attempts to access it. Companies should also encrypt personal information, monitor systems for unauthorized use, and maintain up-to-date firewall and malware protection.

  • Physical safeguards: Hardcopy records containing personal information should be stored in locked facilities and transported in a way that minimizes the risk of disclosure.

  • Administrative safeguards: Companies should ensure that access to customers’ personal information is limited to authorized personnel, train employees on safeguarding procedures and ensure that terminated employees no longer have access to sensitive records.

  • Contracts with third party providers: Personal information often needs to be shared with third-party service providers in order to provide customers with the services and products they have requested. Companies should select service providers who will protect the personal information in the same way the company does and contractually require them to do so. Careful review of these third party contracts should be part of the diligence process.

  • Limits on what information is collected and shared: All companies should limit the amount of personal information they collect and retain. Financial institutions should make sure they share information only in the ways in which they tell people they do.

Is a designated information security expert effectively monitoring threats to the company?

Every target company should have a Chief Information Security Officer (“CISO”), or other executive-level employee who is focused on and can speak fluently about the company’s approach to cybersecurity and data privacy. The CISO should, at a minimum, be able to explain:

  • What the company sees as the major cyber risks it faces and how it has prioritized the protection of the associated data. This should involve an in-depth understanding of the company’s data storage architecture, as well as the company’s incident response plan, including how it fits the company’s particular business model.
  • How often each component of the company’s information security/privacy program is evaluated, tested and updated.
  • The company’s responses to any past cyber-attacks or data breach incidents, which should include copies of data breach notification letters, records of how the incident was investigated, and an explanation of how the company worked proactively with law enforcement and its applicable regulator, if the incident rose to that level.


In the current environment, private equity firms should expect that a target company that collects personal or sensitive information from its customers or users will be the victim of a data breach or cyber-attack. Appropriate diligence by a private equity firm will, however, enable the firm to adequately assess the risks in making the investment in the target company. 


1) See generally Fed. Trade Comm’n v. Wyndham Worldwide Corp., No. 14-3514, 2015 WL 4998121, at *1 -*2 (3d Cir. August 24, 2015). 


Proposed Partnership Treasury Regulations – Consider the Guaranteed Payment

By Joshua Milgrim

Proposed regulations were issued under Section 707(a)(2)(A) of the Internal Revenue Code of 1986, as amended (the “Code”), that address circumstances when certain arrangements between partnerships and their partners will be re-characterized as disguised payments for services (the “Proposed Regulations”).1 The Proposed Regulations, issued on July 22, 2015, contain “conforming modifications” to the current regulations issued under Section 707(c) of the Code, relating to guaranteed payments. Importantly, as a result of the Proposed Regulations, certain preferred equity investments in entities treated as partnerships may result in “guaranteed payments,” which could have an adverse effect on the taxation of the income from such investment for certain investors. The Proposed Regulations technically do not take effect until published in final form, but the preamble to the Proposed Regulations (the “Preamble”) states that Treasury and the IRS view the Proposed Regulations as generally reflecting Congressional intent as to when arrangements are appropriately treated as disguised payments for services.

Guaranteed payments are payments made to a partner that are considered as made to one who is not a member of the partnership only for purposes of the gross income rules under Section 61 of the Code and for the deductibility of business expenses under Section 162(a) of the Code. The Code and the Treasury Regulation describe guaranteed payments as payments for services or for the use of capital to the extent the payments are determined without regard to the income of the partnership.

The treatment of a distributive share is clear (it provides for a share of the income, loss, gains and losses of the partnership). When a non-U.S. partner is allocated its share of a partnership’s capital gain (such as when a partnership has sold a portfolio company that is a corporation), the partner is generally not subject to U.S. income tax. The treatment of a guaranteed payment for the use of capital (i.e., to a financial partner) is less clear. A common concern is that a guaranteed payment made to a non-U.S. financial partner should be treated as interest, which would not qualify as “portfolio interest,” or other forms of U.S. source payments that would be subject to a 30% withholding tax. Accordingly, for a financial partner, the characterization of their share of income as a “distributive share” of income rather than a guaranteed payment is a critical determination, and certainty (or at least a perception of a reasonably low level of risk) that a partnership interest will not result in a guaranteed payment can be a very important deal point to a foreign investor providing capital to a partnership.

Proposed Regulation 1.707-2 is a proposal of a full regulation dealing with disguised payments for services, but the proposals for Treasury Regulation 1.707-1 (dealing generally with transactions between partners and partnerships) are not substantial in length. One of these changes is to example 2 of Treasury Regulation 1.707-1(c). In the example, a partner in a partnership is entitled to the greater of (a) 30 percent of partnership income or (b) US$10,000. The example, without these modifications, concludes that the partner has a guaranteed payment only to the extent that US$10,000 exceeds 30% of the partnership income. The modification to the example in the Proposed Regulations, however, concludes that the partner has a US$10,000 guaranteed payment in all events (regardless of the amount of the partnership’s income). An interesting question is whether the Proposed Regulations, and specifically this example 2, applies to a payment to a partner in a partnership that is not a service provider, such as the holder of a “preferred” interest that is entitled to a minimum payment with respect to its economic investment in the partnership.

The Preamble and the Proposed Regulations both generally refer only to the treatment of payments to partners for services, and refer to the proposed changes in Treasury Regulation 1.707-1 as “conforming.” While there is no explicit discussion in the Preamble of how or whether the Proposed Regulations apply to payments for the use of capital, Section 707(c) of the Code and Treasury Regulation 1.707-1(c) apply both to payments to a partner for services as well as payments for the use of capital. Examples 1, 3 and 4 of Treasury Regulation 1.707-1(c) (which are not changed by the Proposed Regulation) refer specifically to payments to partners for services; but example 2 does not explain the reason for the payment to the partner. (Interestingly, when example 2 was in proposed form in 1955, it was drafted to refer to a payment for services, and we have not found any explanation for the changes to this example).

Even without the Proposed Regulations, there has been some lack of certainty around the proper treatment of a partnership interest that provides a partner with a “greater of” return that is not measured in some way by the net income of the partnership. Under current law and regulations, many advisors have reasoned that a partnership interest could have certain features resembling example 2 and still have “distributive share” treatment, or at the very least that while a preferred return is accruing and is not paid, one could “wait and see” how the partnership performs before concluding whether or not there would be a “guaranteed payment.” The change to example 2 further clouds this issue, and may lead an investor to structure a preferred investment in a manner that does not include a specific minimum payment amount. Although it is not clear when the Proposed Regulations will become effective, or whether the IRS may assert the principles of the Proposed Regulation even before effectiveness, careful consideration should be given to the potential effects of the Proposed Regulations when designing a preferred equity investment in a partnership, especially for a non-U.S. investor.


1) The portion of the proposed regulations addressing management fee waivers received a significant amount of attention, and was discussed in A Sea Change for Waive-rs? - Proposed Regulations Address Tax Treatment of Management Fee Waivers. The Proposed Regulations are similar in many respects to the U.K. disguised investment management fee measures discussed in The UK's Summer Budget  - Private Equity and Investment Management.


Recent Developments in Acquisition Finance

By Jeffrey M. Katz and Scott M. Zimmerman

When a portfolio company underperforms, a sponsor may consider various options to address the perceived performance issues, including changes to a portfolio company’s management team, cost structure, capital structure or other parameters, depending on the nature of the issue(s) at hand. When changes in capital structure may be desirable, often in the context of excessive debt and related liquidity issues, a sponsor’s choices may include a consensual workout outside of bankruptcy, or a court-supervised restructuring under Chapter 11 of the U.S. Bankruptcy Code that can restructure and discharge debt over the objections of certain dissenting creditors. The range of options available to a sponsor in such situations has potentially been narrowed by a recent court decision.

Newfound Negotiating Leverage of Minority Bondholders

In Marblegate Asset Management, LLC v. Education Management Corporation,1 the Federal District Court for the Southern District of New York held that the U.S. Trust Indenture Act2 (TIA) protects minority bondholders by invalidating provisions in a bond indenture that would have the practical effect of eliminating a bondholder’s right to receive payment on its bonds without its consent.

In Marblegate, Education Management Corporation (EDMC), an operator of for-profit colleges, had sought to restructure debt issued under an indenture by one of its subsidiaries by forcing the bondholders to choose, pursuant to an exchange offer, between either (i) a partial recovery for all bondholders through receipt of an equity interest in the issuer’s parent that had guaranteed the bonds, if all bondholders would consent to the proposed exchange, or (ii) no recovery for non-consenting bondholders and a partial recovery for consenting bondholders, if one or more bondholders failed to consent to the proposed exchange. The no-recovery outcome for non-consenting bondholders would be achieved by eliminating the parent’s guaranty of the bonds and leaving them with a claim only against a shell entity without assets.

The court analyzed Section 316(b) of the TIA, which states that a bondholder’s right to receive principal and interest payments under an indenture or to institute suit for the enforcement of any such payment shall not be “impaired or affected” without the bondholder’s consent.

The court summed up the situation concisely: “In effect, Marblegate bought a US$14 million bond that the majority now attempts to turn into US$5 million of stock, with consent procured only by threat of total deprivation, without resort to the reorganization machinery provided by law.” The “reorganization machinery” of a federal a bankruptcy case was not a feasible option for EDMC, because much of its funding came from federal grants which would no longer be available after a bankruptcy filing.

The court considered the legislative history of the relevant TIA provisions and took an expansive approach as to the rights they guaranteed to bondholders, finding that Congress intended that a bondholder must have not only the right to sue on its bonds but also the separate right to receive payment, unless such bondholder otherwise consents.

The court held that, despite the terms of the indenture, which as a technical matter permitted each of the various actions taken pursuant to the exchange offer, the exchange offer as structured violated the TIA because it effectively would leave non-consenting bondholders with no ability to receive payment on their bonds, and therefore the related indenture provisions were invalid.

The decision is currently under appeal to the U.S. Court of Appeals for the Second Circuit.

What a Sponsor Can Do

If upheld on appeal, the Marblegate decision could restrict a sponsor’s ability to achieve an out-of-court restructuring with a portfolio company’s bondholders under an indenture subject to the TIA, absent unanimous bondholder consent. This could entice minority bondholders to become “holdouts” in an effort to either disproportionately influence the outcome of a negotiation or demand to be bought out at a premium to market. (A sponsor could still, as an alternative, condition an exchange offer on its being accepted by a designated super-majority of bondholders, such that any remaining de minimis hold-out class would be stripped of covenants but not of economic rights. However, this in turn may incentivize bondholders to try to become part of the small hold-out class whose payment rights would not be affected and, in addition, still may prevent a sponsor from exploiting existing flexibility under an indenture, as in Marblegate.) There are, however, options a sponsor could consider going forward in order to mitigate the potential effects of such an outcome in an out-of-court restructuring.

Some bond indentures, such as those issued in private placements for resale only to qualified institutional buyers under Rule 144A3 and without registration rights, are not subject to and do not provide bondholders with the protections afforded by the TIA, and thus the TIA issues on which the Marblegate court based its decision would not be relevant, assuming the relevant indenture did not contain similar language tracking the TIA provisions at issue. Thus, if a sponsor were planning (market conditions permitting) to finance or refinance via the capital markets its portfolio company’s acquisition or other debt, it could consider doing so via such a Rule 144A offering. As noted, the sponsor would also need to ensure that the indenture in question would not track the particular language at issue from the TIA, which under current market practice is carried over in many Rule 144A indentures.

Sponsors could take care to negotiate the relevant indenture language in such a case so as to avoid inclusion of the provisions that were pivotal in the Marblegate decision. While there would be no guarantee that the bond market would embrace such an approach, it would appear to be in the best interests of many bondholders as well, particularly those who invest for the longer term and who may from time to time find themselves hampered in their efforts in a workout to reach an acceptable consensual resolution, by virtue of smaller holdout positions. It would also benefit distressed buyers seeking to facilitate such a transaction.

We expect to see developments in this area if the Marblegate decision is upheld on appeal.

Bankruptcy Court Signals that Agreements Among Lenders Will be Enforced

In our last newsletter, we discussed the implications of the increased use of unitranche facilities to finance leveraged acquisitions, as alternative financiers (with whom the unitranche structure originated) have assumed a more prominent role as arrangers and underwriters of such financings. Unitranche facilities effectively combine a first-lien loan and second-lien loan into a single facility with a single set of operating covenants for the target business and a single set of closing conditions. We had noted the advisability of sponsors continuing the trend of insisting to see the agreement among lenders, both as it is being negotiated and as it is finalized, although the borrower is neither a party to the agreement nor bound by it. It is advisable due to the potential strategic significance to the portfolio company and its sponsor of many of the provisions commonly included within agreements among lenders, particularly with respect to amendments, waivers, covenant resets, default remedies and the like. The allocation of rights under an agreement among lenders becomes increasingly pivotal upon a deterioration in the performance of the portfolio company or other looming workout or restructuring scenario with respect to its outstanding indebtedness.

Recent proceedings in the RadioShack bankruptcy case in Delaware4 have been the first significant indication that a bankruptcy court will recognize and enforce the terms of agreements among lenders, thus reinforcing the importance to sponsors of knowing the terms contained in such agreements

A question long surrounding the agreement among lenders has been whether, given that the borrower is not a party to it and not bound by it, it should be recognized and given effect by bankruptcy courts. On the one hand, creditors have resort to state courts to enforce rights under agreements that are strictly between them, and perhaps should not have standing in a federal bankruptcy court to assert rights arising from agreements that do not involve the bankrupt borrower as a party. On the other hand, the agreement among lenders will often address many matters of seeming direct relevance to a bankruptcy case, such as who has the right to offer DIP financing and on what terms, and thus, although the bankrupt borrower is not a party, perhaps the bankruptcy court should indeed recognize and enforce it.

The agreement among lenders at issue in the relevant RadioShack proceedings prohibited the “last-out” lenders from receiving any recovery until the “first-out” lenders were paid in full. Claims had been made in the case by the unsecured creditors committee under various theories of liability against both the first-out and last-out lenders, in respect of which contractual indemnification from the debtor was available in favor of the respective lenders to the extent of any liability. The court was conducting a hearing on a proposal made by the last-out lenders to acquire certain RadioShack assets pursuant to a sale under Section 363(b) of the Bankruptcy Code, via a credit bid of their debt and a cash payment to the first-out lenders in an amount equal to all principal and interest owed to them, in a transaction that would release the last-out lenders (but not the first-out lenders) from the claims of the unsecured creditors committee and would not set aside any reserve for potential liability of the debtor to the first-out lenders pursuant to the contractual indemnity in their favor in respect of such unreleased claims. The first-out lenders objected to the proposed sale on the ground (among others) that it would violate the provision in the agreement among lenders prohibiting the last-out lenders from receiving any recovery until the first-out lenders were completely paid off (and which specifically included a reference to amounts due under indemnities), since the first-out lenders would be subject to additional exposure on such account under the transaction as proposed.

The parties wound up resolving their dispute consensually (by agreeing to set aside a limited reserve for the benefit of the first-out lenders for their potential exposure) and the court therefore did not need to issue a formal ruling on the issue. The bankruptcy judge stated orally at the hearing, however, when referencing the rights of the first-out lenders and the provision in the agreement among lenders noted above, that if the dispute were not resolved consensually, “[The first-out lenders have] rights that must be respected under the documents and rights that must be respected under the [Bankruptcy] Code…. At a minimum, I would regard the indemnification rights as part of the collateral package and part of the rights that the first out lenders have and that I am obliged to treat and respect them . . . .”5

What a Sponsor Should Do

The RadioShack judge’s signal that the terms of the agreement among lenders would have been recognized and enforced by the bankruptcy court underscores the importance to a sponsor of being kept informed of the terms of the agreement among lenders under a portfolio company’s unitranche facility. Sponsors now should have additional negotiating leverage to see and review the agreement among lenders as it is being negotiated in the course of a unitranche financing transaction. Sponsors should seek acceptable assurances from its unitranche lenders that the agreement among lenders documentation provided to the sponsor is accurate and complete, not subject to undisclosed side letters, and not subject to future amendment without notice to the sponsor or, in respect of certain key terms, sponsor consent. In that way a sponsor can remain alert to important terms that could impact future events at its portfolio company, particularly in case of its underperformance.

We look forward to updating you on additional developments in the next issue. 


1) No. 14 Civ. 8584, 2015 WL 3867643 (S.D.N.Y. June. 23, 2015).
2) 15 U.S.C. Sec. 77ppp(b).
3) Rule 144A under the Securities Act of 1933, as amended.
4) In re RadioShack Corp., Case No. 15-10197 (Bankr. D. Del. filed Feb. 5, 2015).
5) Hearing transcript at 19-20, In re RadioShack Corp. (Mar. 30, 2015) (afternoon session).


Representation and Warranty Insurance: No Longer Optional 

Dechert and Marsh Joint Study

Representation and warranty insurance is no longer optional in the M&A landscape. Private equity and strategic buyers that don’t understand the product, and its strategic uses and pitfalls, risk being left behind. In this joint study, Dechert LLP and Marsh explore significant deal terms and trends in the use of R&WI, including: R&WI policies can offer terms that are superior to those found in traditional indemnification packages; positive claims experience with most major underwriters; and premiums are substantially lower than in the late ‘90s/early ‘00s. 

Read the study »

Subscribe to Dechert Updates