The recent decision by the U.S. Court of Appeals for the First Circuit in the Sun Capital Partners case¹ may allay some of the concerns that private-equity and other investment funds that acquire or invest in portfolio companies with significant ERISA liabilities may have had in the wake of the most recent decision by the District Court in that case. The District Court had generally held that certain funds in the same fund family could be jointly and severally responsible for the ERISA liabilities of their jointly-owned portfolio companies, even where neither fund individually owns 80% of the applicable portfolio company. However, fund sponsors should be aware that the recent First Circuit decision does not reverse the First Circuit's earlier Sun Capital Partners decision,² under which a fund sponsor could be deemed to be engaging in a “trade or business” and therefore be potentially liable for certain ERISA liabilities of its portfolio companies under certain structures.

Background

Private equity and similar funds sometimes invest in portfolio companies that may have significant liabilities under the Employee Retirement Income Security Act of 1974 (“ERISA”) and the employee benefits provisions of the Internal Revenue Code of 1986 (the “Code”). For example, a company may have a substantially underfunded defined benefit pension plan, or significant potential withdrawal liability under a multiemployer pension plan.

A lurking question that has persisted is whether the fund and its portfolio companies are aggregated as a single employer for certain liability and other purposes under ERISA and the Code if the fund's ownership interest exceeds certain percentage thresholds. ERISA and the Code provide in general terms that the 80%-or-more affiliated group of a corporation or “trade or business,” commonly referred to as a “controlled group,” may effectively be aggregated and viewed as a single employer (i.e., under "common control") for these purposes.

The aggregation question can be a critical one, as liabilities under ERISA and the Code can in some cases be very significant. The effects of aggregation under ERISA and the Code could include, among other things:

• joint and several liability under ERISA provisions applicable to defined benefit pension plans governing funding and plan termination and the rules governing withdrawal liability to a multiemployer pension plan;

• imposition of certain excise taxes on all applicable affiliates jointly and severally;

• application of nondiscrimination and other rules applicable to employee benefit plans on a controlled-group basis; and

• responsibility for “COBRA” compliance on a controlled-group basis.

For many funds, the analysis under the ERISA controlled-group rules can turn in part on the critical threshold question of whether a particular investment fund is a “trade or business” for these purposes. If not, it may be the case that aggregation is not required, regardless of the extent of the fund's ownership of its portfolio companies.

The aggregation question for investment funds attracted increasing attention over recent years after the release of a September 26, 2007 letter (the “PBGC Letter”) from the Appeals Board of the Pension Benefit Guaranty Corporation (the “PBGC”). The PBGC has general administrative responsibility under the ERISA provisions applicable to the termination of defined benefit pension plans and withdrawal liability to multiemployer pension plans.

The specific aggregation provision that applies for purposes of the withdrawal liability rules is Section 4001(b)(1) of ERISA. Section 4001(b)(1) provides that, “under regulations prescribed by the [PBGC], all employees of trades or businesses (whether or not incorporated) which are under common control shall be treated as employed by a single employer and all such trades and businesses as a single employer.” Section 4001(b)(1) authorizes the PBGC to prescribe implementing regulations that “shall be consistent and coextensive with regulations prescribed for similar purposes by the Secretary of the Treasury under” Section 414(c) of the Code. Section 414(c) provides for the aggregation of trades or businesses for a number of tax purposes. The PBGC Letter states that the private equity fund there at issue was a “trade or business” under these rules, and that certain of its subsidiaries should be considered, together with such fund, to be a single employer under ERISA.

Sun Capital Partners v. N.E. Teamsters and Trucking Industry Pension Fund

The Initial Decision of the District Court

In October 2012, a Massachusetts federal District Court in the case of Sun Capital Partners III v. N.E. Teamsters and Trucking Industry Pension Fund,³ directly addressed the PBGC Letter. In Sun Capital Partners, a number of affiliated investment funds (the “Sun Funds”) had invested in a particular portfolio company (the “Portfolio Company”). One group of Sun Fund entities operating under the Sun Capital Partners III banner (“Sun Fund III”) owned 30% of the Portfolio Company. Another Sun Fund known as Sun Capital Partners IV (“Sun Fund IV”) owned the remaining 70% of the Portfolio Company.

Sun Capital Partners involves the payment of multiemployer plan withdrawal liability stemming from the bankruptcy of the Portfolio Company. The Portfolio Company incurred multiemployer plan withdrawal liability by virtue of a withdrawal from the New England Teamsters and Trucking Industry Pension Fund (the “Pension Fund”), and the Pension Fund sought to collect the liability not only from the Portfolio Company, but, under the ERISA aggregation rules noted above, also from the Sun Funds.

The Sun Funds sought a declaratory judgment to the effect that they were not liable under ERISA to the Pension Fund, contending that they were not properly aggregated with the Portfolio Company under ERISA. One of the bases for this contention was that the Sun Funds were not “trades or businesses” for these purposes, and therefore were not subject to the aggregation rules. The District Court in Sun Capital Partners declined to rely on the PBGC Letter and squarely rejected its approach to the “trade or business” question. The District Court stated: “Even taken in the light most favorable to the Pension Fund, the record establishes that the Sun Funds are not a ‘trade or business.’”

We reported on the decision by the District Court in a previous OnPoint,⁴ characterizing the court’s decision as being “carefully reasoned” and serving as “a welcome addition to the authority regarding the question of whether investment funds may be aggregated with their portfolio companies for purposes of the controlled-group rules.”⁵

The Initial Decision of the First Circuit

The District Court opinion in Sun Capital Partners was not the final word on these issues, and in 2013 the U.S. Court of Appeals for the First Circuit issued its first opinion in the case. In a decision that was, as we noted at the time, “potentially troubling for funds with characteristics similar to those of the funds at issue in the Sun Capital Partners case,” the First Circuit reversed the decision of the District Court.

The First Circuit focused on whether the Sun Funds were a “trade or business” and concluded that “on the undisputed facts of this case, Sun Fund IV is a ‘trade or business’ for purposes of [ERISA],” based, in part, on the theory that Sun Fund IV’s “active involvement in management” provided it with a “direct economic benefit.” Having concluded that Sun Fund IV is a "trade or business," the First Circuit remanded the case to the District Court on the factual issue of whether Sun Fund IV was under “common control” with the Portfolio Company.

We reported on the decision by the First Circuit in a previous OnPoint,⁶ noting at the time that the First Circuit’s “trade or business” holding was “troubling, both for purposes of withdrawal liability and other ERISA liability, and for other purposes where aggregation principles may be relevant under ERISA or the Code.”

The Second Decision of the District Court

On remand, the District Court determined that, although each Sun Fund’s respective ownership stake in the Portfolio Company was under 80%, both Sun Funds were liable for the Portfolio Company’s withdrawal liability. The District Court reached this conclusion by determining that the two Sun Funds had together created a partnership-in-fact to invest in the Portfolio Company. In this regard, the District Court found that a partnership-in-fact between the Sun Funds existed largely on the basis that they engaged in “joint activity” prior to deciding to co-invest in the Portfolio Company through a limited liability company that was formed in connection with the acquisition (the “LLC”). The District Court viewed the 70%/30% split between the two Sun Funds as a choice showing “an identity of interest and unity of decision-making between the [Sun] Funds rather than independence and mere incidental contractual coordination,” and as an investment structure stemming from “top-down decisions to allocate responsibilities jointly . . . and offer advantages to the Sun Funds group as a whole.” The Court observed that there was “no meaningful evidence of actual independence” between the Sun Funds in their co-investments.

The District Court proceeded to determine that the partnership-in-fact was itself a “trade or business” for ERISA purposes. Having held that the deemed partnership with respect to the Sun Funds was a trade or business, which owned 100% of the Portfolio Company, the District Court then held that the deemed partnership was aggregated with the Portfolio Company for ERISA purposes, thereby causing the deemed partnership to be jointly and severally responsible for the LLC’s ERISA liability, and, in turn, for the Portfolio Company’s withdrawal liability. Having now gotten the withdrawal liability up to the deemed partnership, the District Court then pushed the liability further up to Sun Fund III and Sun Fund IV under general partnership principles, as they were viewed as being partners in the deemed partnership that the District Court had discovered.

We reported on the decision by the District Court in a previous OnPoint.⁷ We noted at the time that “by inserting a partnership-in-fact in the investment structure specifically designed to avoid the 80% threshold, the District Court created the possibility that any number of affiliated funds could be deemed to have created a partnership and effectively be subject to the ERISA liabilities of their portfolio companies.” However, we further noted that the decision was “merely one at the District Court level, and indeed, is being appealed and may be reversed,” and observed that “it should not by any means be assumed that the novel rationale put forth by the District Court in Sun Capital Partners will ultimately carry the day.”

The Second Decision of the First Circuit

On November 22, 2019, the First Circuit reversed the District Court, concluding that an implied partnership-in-fact had not been formed between the Sun Funds. In reaching its conclusion, the First Circuit looked to federal tax law regarding the recognition of a partnership. Specifically, the Court analyzed the relationship under the partnership factors set forth in Luna v. Commissioner,⁸ which considers:

• the parties’ agreement and conduct;

• the parties’ contributions to the venture;

• the parties’ control over income and capital and the right to make withdrawals;

• whether each party was a principal and coproprietor, or whether one party was the agent or employee of the other;

• whether business was conducted in the joint names of the parties;

• whether the parties filed federal partnership returns or otherwise represented that they were joint venturers;

• whether separate books of account were maintained for the venture; and

• whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.

The First Circuit noted that certain details of the relationship between the two funds suggested that they had in fact operated a partnership-in-fact. In particular, the court pointed to the facts that (i) the Sun Funds had acted together to seek out potential portfolio companies; (ii) the funds, together, had developed restructuring and operating plans for the target companies; (iii) the funds were run by the same two individuals who were in control of both funds’ general partners; and (iv) the funds pooled resources, personnel and expertise through their jointly owned management company, which they used to identify, acquire and manage portfolio companies, structure deals, and provide management consulting and employees to portfolio companies.

However, despite the foregoing, the First Circuit ultimately determined that those factors were not controlling to the outcome. The Court noted that: (i) the funds had not “intend[ed] to join together in the present conduct of the enterprise,” as evidenced by the funds’ express disclaimer of any sort of partnership in its operating documents; (ii) most of the persons who were limited partners in Fund IV were not limited partners in Fund III; (iii) the funds filed separate tax returns, kept separate books and maintained separate bank accounts; (iv) the funds did not operate in parallel; (v) the funds had formed an acquisition vehicle through which to acquire the portfolio company, which prevented them from conducting their business in their joint names and limited the manner in which they could exercise mutual control over and assume mutual responsibility for managing the portfolio company; (vi) the funds formally organized themselves as limited-liability organizations; and (vii) the instant case involved investments in different businesses rather than fractionalizing already-existing businesses.

Conclusion

The First Circuit’s reversal of the latest District Court opinion in Sun Capital Partners is a welcome decision that overturns the District Court's arguably overbroad application of the aggregation and liability rules as applied in the ERISA context. The most recent Sun Capital Partners decision also provides some potentially significant guidance on when funds within the same fund family might indeed effectively be aggregated notwithstanding that neither fund individually owns 80% or more of the underlying company. However, fund sponsors should keep in mind that the First Circuit’s initial “trade or business” decision remains in effect. Thus, fund sponsors may wish to continue to review issues raised by the Sun Capital Partners litigation as they structure their investments and consider risks surrounding potential ERISA liability.

As we noted in our prior OnPoints on this issue, even the First Circuit’s initial Sun Capital Partners decision that holds that Sun Fund IV was a “trade or business” and therefore potentially subject to ERISA’s aggregation rules is not necessarily the last word on the matter. Courts in other circuits that have not yet considered these issues may well be presented in the future with the opportunity to analyze the issues for themselves, and otherwise to give the matter their own careful and critical review.

Footnotes