Private equity fund deemed a “trade or business” under ERISA, exposing it to federal liabilities



On July 24, 2013, the U.S. Court of Appeals for the First Circuit held that a private equity fund constituted a “trade or business” under the Employee Retirement Income Security Act (ERISA) and therefore, as a member of its controlled group, was jointly and severally liable for the withdrawal liability of its portfolio company.1 The case is significant because until now private equity funds were treated as passive investors and not a trade or business.2 For the first time in an appellate court, the Sun Capital case makes it clear that joint and several liability for plan underfunding turns on the extent of the fund’s “investment plus” control over the subsidiary’s financial and management activities. To minimize the risk of exposure to withdrawal liability and in other contexts, private equity funds should structure their investments in a manner that reduces their control over the portfolio companies’ operations and financial affairs. Failure to do so may have far reaching results - beyond that of multiemployer liability. The aggregation of portfolio companies with private equity companies may unwittingly cause tax problems and compliance issues with respect to employee benefit plans that would also be required to be aggregated.

Background of the Case

Three private equity funds - Sun Capital Partners III LP, Sun Capital Partners III QP LP, and Sun Capital partners IV LP (“Sun Funds”) together acquired 100 percent of a portfolio company. None of the funds owned 80 percent or more on its own. Sun Funds’ general partner entered into a contract with, and actively participated in, the management of the portfolio company for a fee, with the services to be provided by a subsidiary of the general partner. When the portfolio company paid fees to the management company, Sun Funds would receive an offset to the fees Sun Funds owed to the general partner. The portfolio company was a contributing employer to a multiemployer plan. A couple of years after Sun Funds’ investment, the portfolio company withdrew from the multiemployer plan and filed for bankruptcy. The Teamsters demanded withdrawal liability payment in the amount of $4.5 million by Sun Funds and the portfolio company.

Commonly Controlled Trades or Business

Under ERISA, voluntary withdrawals from multiemployer plans are discouraged by imposing mandatory liability on all withdrawing employers for their proportionate shares of “unfunded vested benefits.”3 Not only the withdrawing employer can be held liable. Congress also provided that all “trades or businesses” under “common control” with the withdrawing employer are treated as a single entity for purposes of assessing and collecting withdrawal liability.4 Each trade or business found to be under common control is jointly and severally liable for any withdrawal liability of any other. The provision’s purpose is “to prevent businesses from shirking their ERISA obligations by fractionalizing operations into many separate entities.”5

Under Section 414(b) and (c) of the Internal Revenue Code (“Code”), a controlled group exists when a trade or business owns 80 percent or more of the equity in another trade or business. Neither “trade” nor “business” is defined in ERISA or the Code.

Overturning the district court, the First Circuit held that a private equity fund could, under certain circumstances, be considered a trade or business. Adopting the Seventh Circuit’s 6 “investment plus”-like test, requiring more activities than mere investment, the First Circuit placed great weight on the direct involvement of the fund and fund managers in the day–to-day management of the portfolio company and on their contractual rights to be so involved. The court distinguished the two Supreme Court cases 7that were, until now, relied upon to support the position that private equity funds are merely passive investors, on the basis that the private equity firms did not participate directly or indirectly in management activities.

While declining to provide general guidelines on what activities are required, the court set forth the following factors that, when taken together, supported a finding that Sun Funds was a trade or business:

  • Sun Funds’ partnership agreements and private placement memos explained that the Funds would be actively involved in the management and operation of the companies in which they invested;
  • Sun Funds’ partnership agreements gave the general partners authority to make decisions about hiring, terminating and compensating agents and employees of the portfolio companies;
  • The purpose of Sun Funds was to seek out potential companies in need of extensive intervention with respect to their management and operations;
  • Sun Funds’ controlling stake in the portfolio company was such that they were able to participate in the management and operation of the company beyond that of a passive investor;
  • A management team was built specifically for the purchased company, and restructuring and operating plans were developed for the company before it was acquired; and
  • Payments made to one of Sun Funds’ general partners for management services were offset against the management fees the Fund was required to pay to the general partner.

Potential Impact of the Case

Taking the Sun Capital case to its logical conclusion, any private equity fund (or funds combined) that owns 80 percent or more of a portfolio company and actively participates (directly, through its general partner, or through other affiliated entities) in the management of the portfolio company and receives a fee for such activity, is at risk of being considered a member of the portfolio company’s controlled group.

Although the First Circuit stated that it was interpreting trade or business solely for purposes of ERISA’s multiemployer withdrawal liability rules, it is conceivable that the ruling will be applied more broadly to other areas of taxation and benefits that are affected by controlled group status:

  • Single-employer plan termination liability rules. A private equity fund (and each portfolio company under common control of the fund) would be jointly and severally liable to the PBGC for any unfunded benefit obligations upon termination of a portfolio company’s pension plan. ERISA imposes joint and several liability on all members of a pension plan sponsor’s controlled group (“ERISA Affiliates”) upon termination of the pension plan.
  • Coverage and discrimination rules applicable to tax-qualified retirement plans
  • COBRA obligations
  • Shared responsibility taxes under the health care reform law
  • Federal income tax for foreign investors from income derived from the fund
  • Unrelated business taxable income (UBTI) for tax-exempt investors
  • Deductibility under Code Section 162 of investors’ management fees

Due Diligence

The Sun Capital decision highlights the need to consider potential ERISA Affiliate liability before acquiring a private equity company or investing in portfolio companies, and reassess the possible ERISA Affiliate liability that may already exist with private equity companies as a result of prior transactions or agreements. The PBGC’s current funding deficit makes it likely that the PBGC will pursue any organization that is jointly and severally liable for any underfunded benefit obligations upon the termination of a pension plan in the event that the sponsor is unable to fulfill its obligations. Furthermore, it is unclear how far the ruling in this case will extend. In light of the significant potential liability involved, it would be imprudent to ignore these potential risks. Private equity funds and others (for example, lenders) concerned about ERISA obligations relating to subsidiary or controlled companies should begin with a risk assessment that takes into account any employee benefit plans that may be aggregated within the fund’s current organizational structure, with consideration given of the “investment plus” factors in the Sun Capital case.

  1. Sun Capital Partners III v. New England Teamsters & Trucking Industry Pension Fund, 2013 WL 3814984 (1st Cir. 2013).
  2. Cf. an earlier unpublished opinion letter by the Pension Benefit Guaranty Corporation in 2007 (the PBGC applied the test in Comm'r v. Groetzinger, 480 U.S. 23 (1987)) and a 2010 decision by the U.S. District Court for the Eastern District of Michigan in Board of Trustees, Sheet Metal Workers v. Palladium Equity Partners, 722 F.Supp. 2d 854 (E.D. Mich. 2010) that treated a private equity firm as a trade or business. In the Palladium case, the Court denied summary judgment on the issue of whether the investment fund must share the portfolio company's withdrawal liability under ERISA. The case was ultimately settled.
  3. 29 U.S.C. § 1381.
  4. 29 U.S.C. § 1301(b)(1).
  5. Central States, Southeast and Southwest Areas Pension Fund v. White, 258 F.3d 636, 644 (7th Cir. 2001), quoting Board of Trustees of the Western Conference of Teamsters Pension Trust Fund v. H.F. Johnson, Inc., 830 F.2d 1009, 1013 (9th Cir. 1987).
  6. Central States, Southeast & Southwest Areas Pension Fund v. Messina Products, LLC, 706 F.3d 874 (7th Cir. 2013). Sun Capital quotes Messina for the proposition that when an employer participates in a multiemployer pension plan and then withdraws from the plan with unpaid liabilities, federal law can pierce corporate veils and impose liability on owners and related businesses; formal business structures are disregarded. Similar principles apply to private equity investors.
  7. Whipple v. Commissioner, 373 U.S. 193 (1963) and Higgins v. Commissioner, 312 U.S. 212 (1941).

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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