Capital Infusion: Private Equity Funds: Potential Liability for Portfolio Company Pension Obligations

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In Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, 2013 U.S. App. LEXIS 15190, No. 12-2312,  ___ F.3d ___ (1st Cir. 2013), the United States Court of Appeals recently ruled on a matter of first impression concerning the liability of private equity funds (PEFs), under the Employee Retirement Income Security Act (ERISA), for the pension obligations of their portfolio companies. The court’s decision makes it clear that PEFs are not immune from liability for these obligations.

Case Background

The case presented to the Court of Appeals concerned two PEFs managed by Sun Capital Advisors, Inc. (Sun Capital) and their investments in a company called Scott Brass, Inc. (SBI). The PEFs invested $3 million in SBI through a limited liability company (the “LLC”) owned by the PEFs. The invested funds were transferred to a wholly-owned subsidiary (the “Subsidiary”) of the LLC, which used the funds and additional borrowed money to purchase all of SBI’s capital stock. The Subsidiary then hired one of the PEF’s general partners (the “General Partner”) to provide management services to SBI. The General Partner then contracted with Sun Capital to provide advisory services. It was claimed, that through this structure, individuals associated with Sun Capital and its affiliated entities exerted operational and managerial control over SBI, including providing it employees and consultants.

Prior to and for more than one-year after the PEFs made the above-described investment, SBI made contributions on behalf of its employees to a multiemployer pension fund (the “Pension Fund”). However, SBI eventually stopped making contributions and, consequently, incurred withdrawal liability under ERISA for its pro rata share of the Pension Fund’s unfunded vested benefits. In response to SBI’s default on its contribution payments, the Pension Fund demanded that the PEFs pay SBI’s withdrawal liability of approximately $4.5 million, arguing that they had entered into a partnership or joint venture in common control with SBI. The PEFs responded by filing suit against the Pension Fund in federal district court seeking a declaratory judgment that they were not liable for SBI’s withdrawal liability. The Pension Fund counterclaimed for the full amount due.

The Applicable ERISA Test

SBI participated in the New England Teamsters and Trucking Industry Pension Fund (TPR), a multiemployer pension plan subject to ERISA, as amended by the Multiemployer Pension Plan Amendment Act (MPPAA). The MPPAA was enacted to protect the viability of defined pension benefit plans, to create a disincentive for employers to withdraw from multiemployer plans, and also to provide a means of recouping a fund’s unfunded liabilities. The MPPAA provides that all employees of trades or businesses that are under common control shall be treated as employed by a single employer and all such trades and businesses as their single employer. The MPPAA’s definition of employer extends beyond the business entity withdrawing from the pension fund, thus imposing liability on related entities and effectively piercing the corporate veil and disregarding formal business structures. Whether an organization is liable for another organization’s withdrawal liability depends upon whether (i) the organization is under “common control” with the obligated organization, and (ii) the organization is a “trade or business” (the “ERISA Test”).

Court Rulings

The District Court Ruled in Favor of the PEFs

The lower court held that the PEFs are not “trades or businesses” because they (i) were not engaged in the management of SBI, (ii) do not have offices or employees, (iii) do not make or sell goods, and (iv) reported only investment income on their tax return. As a result of these findings, the lower court did not need to address the “common control” prong of the ERISA Test.

The Court of Appeals Reversed the District Court’s Ruling

On appeal, the Court of Appeals reversed the district court’s decision. Specifically, the court held that one of the PEFs is a “trade or business,” but remanded to the trial court the issues of (i) whether the other PEF is a “trade or business,” and (ii) whether one or both of the PEFs are under “common control” with SBI. In its decision, the court refused to set out general guidelines for determining what is required for a PEF to constitute a “trade or business” under the ERISA Test. Rather, the court described the analysis as a “very fact-specific approach,” and after cautioning that no factor is dispositive, set forth the following factors that contributed to its decision that one of the PEFs is a “trade or business”:

  • The PEFs’ limited partnership agreements and private placement memorandums (i) explain that they are actively involved in the management and operation of the companies in which they invest, including stating that a “principal purpose” of the partnership is the “management and supervision” of its investments, and (ii) grant each PEFs’ general partner exclusive and wide-ranging management authority.
  • The general partners’ own partnership agreements permit them to make decisions about hiring, terminating, and compensating agents and employees of the PEFs and their portfolio companies.
  • The general partners receive a percentage of total commitments to the PEFs and a percentage of profits as compensation.
  • The PEFs’ purpose is to seek portfolio companies that need intervention in their management and operations, to provide such intervention, and then to sell the companies at a profit.
  • The private placement memos explain that restructuring and operating plans are developed for a target company in need of intervention before it is acquired, and a management team is built solely to make significant changes to the company.
  • The PEFs’ controlling stake in SBI made them and their affiliated entities intimately involved in SBI’s management and operation.
  • Through a series of appointments, the PEFs were able to place employees of Sun Capital in two of the three director positions at SBI, thus controlling SBI’s board.
  • Through a series of service agreements, Sun Capital provided personnel to SBI for management and consulting services and, thereafter, individuals from those entities were immersed in details involving SBI’s management and operations.
  • The PEFs’ active involvement in management under the agreements provided a direct economic benefit to at least one of the PEFs that an ordinary passive investor would not derive; an offset against the management fees the PEF otherwise would have paid its general partner for managing the investment in SBI.

In making its decision, the court arguably relied most heavily on the last factor in the above laundry list. Indeed, while the court held that the PEF that received the direct economic benefit is a “trade or business,” it remanded to the trial court the issue of whether the other PEF is a “trade or business” because it could not tell from the record before the court whether the other PEF received an economic benefit that an ordinary passive investor would not derive.

Current Status of Case

The appellate court issued its decision on July 24, 2013, remanding certain issues to the district court. As of the date of this article, no party has taken any further action in the district court. The PEFs have until October 21, 2013 to petition the United States Supreme Court for review of the Court of Appeal’s decision.

Conclusion/Potential Ramifications

This decision provides precedent for courts to find that a PEF is a “trade or business” for purposes of imposing liability for pension obligations of its portfolio company. A finding that a PEF is a “trade or business” appears to depend upon the control a PEF can and does exert over its portfolio company’s management and operations and the direct economic benefit a PEF receives from its portfolio company that an ordinary passive investor would not derive.