A Warning Shot for Private Equity Funds: First Circuit Court of Appeals Holds Fund Engaged in a "Trade or Business" for Purposes of Allocating ERISA Pension Withdrawal Liability


Under Title IV of the Employee Retirement Income Security Act (ERISA), withdrawal liability upon cessation of participation in a multiemployer pension plan and termination liability upon the involuntary or distressed termination of a single-employer pension plan may be assessed jointly and severally among members of the employer's controlled group. Section 4001(b) of ERISA indicates that two or more entities will be considered to be a single employer where: (1) the entities are under common control[1] and (2) the entities are each engaged in a "trade or business." Private equity funds have historically taken the position that they are not engaged in a "trade or business" under ERISA and, as a result, should not be jointly and severally liable for any pension liability incurred by a portfolio company in which the fund invests, regardless of the level of ownership. However, a recent ruling by the First Circuit Court of Appeals highlights that multiemployer pension funds and the Pension Benefit Guaranty Corporation may be successful in challenging this position, particularly if a private equity fund utilizes a "turnaround" strategy or other investment strategy which necessitates the private equity fund's active participation (directly or through its affiliated entities) in the management of its portfolio companies.

In Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, No. 12-2312 (1st Cir. July 24, 2013), the First Circuit Court of Appeals considered an appeal from the U.S. District Court for the District of Massachusetts, which had previously ruled that, for ERISA purposes, two affiliated private equity funds, Sun Capital Partners III, LP (Sun Fund III) and Sun Capital Partners IV, LP (Sun Fund IV), were not "trades or businesses" responsible for withdrawal liability owed by a jointly owned bankrupt portfolio company, Scott Brass, Inc., to the New England Teamsters and Trucking Industry Pension Fund upon its withdrawal from the Pension Fund.

In reversing the lower court's decision with respect to Sun Fund IV, the Court of Appeals found that the private equity fund was not a mere passive investor in Scott Brass, but rather was actively involved in the management and operations of Scott Brass through the actions of the Sun Fund IV's managing general partner and that general partner's wholly owned subsidiary management company. Moreover, the court found that Sun Fund IV had benefited from those management activities in ways distinguishable from a passive investor: while Sun Fund IV's general partner and its subsidiary management company had separately contracted with Scott Brass for the provision of management and consulting services and were separately compensated by Scott Brass, the benefit of these fees under those separate contracts accrued to Sun Fund IV through a fee offset arrangement between Sun Fund IV and its general partner.

In determining that these activities constituted a "trade or business" for ERISA purposes, the court applied an "investment plus" standard previously utilized in a Sixth Circuit decision (Bd. of Trs., Sheet Metal Workers Nat'l Pension Fund v. Palladium Equity Partners, 722 F. Supp. 2d 854 (E.D. Mich. 2010)) and derived from a 2007 PBGC Appeals Board ruling.[2] The court held that Sun Fund IV was indeed a "trade or business" as it was "able to funnel management and consulting fees to Sun Fund IV's general partner and its subsidiary" for management services provided by the general partner. The court noted that Sun Fund IV's investment strategy called for "active management through an agent" for the benefit of the fund and that the Sun Funds' private placement memoranda "explain that the Funds are actively involved in the management and operations of the companies in which they invest." Illustrative of this fact was that the authority to make determinations about hiring, terminating and compensating agents and employees of the Sun Funds and their portfolio companies (including Scott Brass) was given to the Sun Fund IV's general partner's limited partner committee.

As noted above, Section 4001(b)(1) of ERISA provides for shared responsibility for pension withdrawal and termination liability among trades or businesses which are under common control. While the Court of Appeals determined that Sun Fund IV constituted a trade or business, it remanded the case back to the District Court to determine whether either Sun Fund III or Sun Fund IV was under common control with Scott Brass.[3] The purchase of Scott Brass by Sun Fund III and Sun Fund IV appears to have been structured to limit each of the Fund's ownership interest in Scott Brass so as to avoid the 80 percent parent-subsidiary common control threshold of Section 4001(b)(1) of ERISA. Key issues before the District Court on remand may include whether Sun Fund III or Sun Fund IV had voting power over Scott Brass in excess of its equity interest or whether the Funds could be viewed as a single entity under an "alter ego" doctrine.

The Sun Capital Partners case is the latest example of the intensified efforts by multiemployer pension funds and the PBGC to recoup pension withdrawal and termination liability. Where the pension plan sponsor or contributing employer has sought bankruptcy protection, multiemployer plans and the PBGC will have added incentive to seek to creatively expand the scope of the "employer" under Section 4001(b)(1) of ERISA. While this decision may be cited as controlling precedent only within the First Circuit, Sun Capital Partners joins Palladium Equity Partners in suggesting that private equity funds may no longer be automatically viewed as passive investors when multiemployer plan withdrawal liability is incurred by a portfolio company. Furthermore, although both the Sun Capital Partners and the Palladium Equity Partners cases involved multiemployer pension plan withdrawal liability under Section 4201 of ERISA, there is nothing in those decisions that would suggest that the "investor plus" analysis utilized therein could not be equally applicable for allocating PBGC liability under Section 4062 of ERISA to a private equity investor in connection with the distressed or involuntary termination of a single employer pension plan. Indeed, the September 26, 2007, PBGC Appeals Board decision cited by the court in Sun Equity Partners involved the allocation of PBGC liability under Section 4062 of ERISA to a private equity fund resulting from an involuntary PBGC-initiated termination of a single-employer pension plan sponsored by one of the private equity fund's portfolio companies.

The Sun Capital Partners case highlights the importance of careful structuring of equity investments by private equity firms, particularly with regard to potential portfolio companies that sponsor defined benefit pension plans or that participate in multiemployer pension plans under the terms of one or more collective bargaining agreements and which may face substantial termination or withdrawal liability to avoid controlled group status. For private equity funds that are part of a controlled group with their portfolio companies (e.g., 80 percent or greater shareholders), those funds need to be aware of the risks involved, at least within the First Circuit (the states of Maine, Massachusetts, New Hampshire and Rhode Island, as well as the commonwealth of Puerto Rico) absent a reconsideration of the issue by the court.[4]

[1] Separate entities are generally consider to be under "common control" if the entities are part of a parent-subsidiary controlled group (i.e., the parent entity directly or indirectly owns at least 80 percent of the stock or voting power of the subsidiary) or a brother-sister controlled group (i.e., five or fewer individuals, estates or trusts own more than 50 percent of the stock or voting power of each of the entities). See, ERISA § 4001(b)(1) (29 U.S.C. § 1301(b)) and PGGC Regulation § 4001.3.
[2] A copy of the September 26, 2007 PBGC Appeals Board decision.
[3] In addition, the court did not make a determination as to whether the activities of Sun Fund III were sufficient for it to constitute a 'trade or business" for purposes of ERISA. Finding that insufficient facts had been provided for it to make such a determination, the court also remanded this issue back to the District Court for further proceeding.
[4] On August 7, 2013, Sun Fund III and Sun Fund IV filed a petition for a panel rehearing or a hearing en banc by the Court of Appeals.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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