Just before Thanksgiving, the First Circuit Court of Appeals handed a “win” to Sun Capital’s private equity funds which had been battling against multiemployer pension withdrawal liability since the 2008 bankruptcy of the portfolio company, Scott Brass.  The decision in Sun Capital Partners III, LP, et al v. New England Teamsters & Trucking Industry Pension Fund, et al is narrow and focused on the particular facts and so leaves open other private equity funds to be liable for pension withdrawal liability and other liabilities.  The Sun Capital line of cases continues the erosion of the notion that a private equity fund could be merely an investor in a portfolio or target operating company.

How can a private equity fund investor be tagged with pension withdrawal liability?

When a portfolio company of a private equity fund(s) has a pension plan and triggers withdrawal liability under the Multiemployer Pension Plan Amendments Act (“MPPAA”), the other members of its “control group” are jointly and severally liable to the multiemployer plan for the withdrawal liability.  Generally the control group is based on 80% ownership by an entity that is in a trade or business.  Sun Capital had 3 private equity funds none of which owned 80% of Scott Brass.  But, the cases have treated two of the funds as a single “entity” due to common investments and management.  Even so, neither the remaining fund nor the combined fund owned 80% of Scott Brass.  Only if all 3 funds are combined would there be 80% or more ownership. The saga of the Sun Capital cases weaves an analysis that avoids 80% ownership as a control group; the recent decision did not find a “partnership-in-fact” among the funds and Scott Brass.  But, not all private equity funds can fit into the facts of the Sun Capital cases.

In the District Court decision three years ago, the Sun Capital funds were considered to be in a “trade or business” because they benefited from compensation arrangements such as fee waivers and carryforwards.  This conclusion was not questioned by the First Circuit in the recent decision.  Thus, private equity funds must still consider whether the terms of their partnership agreements and ownership agreements move them from investors to being in a trade or business.

The District Court decision found that the Sun Capital funds had formed a “partnership-in-fact” despite one fund (combined) holding 30% and the other fund holding 70% of Scott Brass.  On appeal, the First Circuit reversed, holding that there was no partnership-in-fact or implied partnership among the Sun Capital funds.

How did the Court determine there was no partnership?

The Court, noting that the Pension Benefit Guaranty Corporation (PBGC) and MPPAA refer to Internal Revenue Code provisions for determining “control groups”, referred to federal partnership law and a 1964 Tax Court decision to review 8 factors in determining whether a partnership-in-fact existed among the Sun Capital funds notwithstanding the formal ownership structures.  If such a partnership existed, it would hold more than 80% of Scott Brass and be jointly and severally liable for the pension withdrawal liability. 

Factors favoring a partnership were examined:

• The Sun Capital funds developed plans for target companies before acquisition and planned to exercise mutual control and responsibilities over the target companies.
• Ultimately, all Sun Capital funds are wholly controlled by 2 individuals. 
• There were no disagreements evidenced between the alleged partners in managing Scott Brass. 

Factors against partnership included:

• There is evidence of no intent to join in a partnership, expressly disclaiming it.
• There was little overlap in the limited partners or in investments between the Sun Capital funds.
• The funds kept separate tax returns, books and bank accounts.
• The funds did not invest in parallel -- not investing in the same companies or proportions.
• Investing in Scott Brass through an LLC in which each Sun Capital fund invested was some evidence of lack of intent to form a partnership.

Finally, the Court expressed concern that there is a lack of congressional intent to impose withdrawal liability on private investors.

How are private equity investors still at risk of withdrawal liability?

If a private equity fund owns 80% of a target company or otherwise meets the “control group” test, the Sun Capital partnership analysis does not apply.

If a private equity fund meets the “control group” test, then the “trade or business” analysis in the Sun Capital District Court decision must still be considered.  The management fee waivers and carry forwards afforded the funds through the limited partnership agreements were indicative of meeting the “trade or business” test in the lower court case.

If a private equity fund invests in parallel or in tandem with another fund, the partnership analysis could reach a different conclusion on “control group” status.

Other questions?

There are still questions to be answered after this Sun Capital decision. 

How does a private equity fund relying on the venture capital operating company (VCOC) exception to the plan asset rules deal with the partnership factor of control over the business when the fund holds less than 80% of the target or portfolio company?

Should there be additional representations or protections in a purchase agreement for a target company?

If a private equity fund has “control group” status for the purpose of pension withdrawal liability, does it have that status for other purposes such as Affordable Care Act reporting or 401(k) plan coverage testing?