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, if a fund's ownership interest exceeds certain percentage thresholds, the fund and its portfolio companies are aggregated as a single employer for certain liability and other purposes under ERISA and the Code. 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.

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) of the Code provides for the aggregation of trades or businesses for a number of tax purposes. The PBGC Letter holds 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

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, Civ. Action No. 10-10921-DPW (D. Mass. Oct. 18, 2012), 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 of the Sun Funds, Sun Capital Partners III, LP (which was considered by the district together with a second, parallel entity, Sun Capital Partners III QP, LP¹) (“Sun Fund III”) owned 30% of the Portfolio Company. Another Sun Fund, Sun Capital Partners IV, L.P. (“Sun Fund IV” and, together with Sun Fund III, the “Sun Funds”) 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 judgement 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 the PBGC Letter’s 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.'”

In Sun Capital Partners, the Pension Fund also asserted that the Sun Funds were liable under Section 4212(c) of ERISA, which provides that, “[I]f a principal purpose of any transaction is to evade or avoid liability under [the provisions of ERISA governing withdrawal liability], [the withdrawal-liability rules] shall be applied (and liability shall be determined and collected) without regard to such transaction." The district court rejected that assertion.

We reported on the decision by the district court in a previous OnPoint, 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."² We further stated: "While the final word on the matter may well not yet have been written, Sun Capital Partners could at a minimum increase the extent to which the PBGC Letter may be viewed by the market with a jaundiced eye."

The district court opinion in Sun Capital Partners was indeed not the final word on the aggregation issue, and the U.S. Court of Appeals for the First Circuit has now issued its opinion in the case. In a decision that is 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 set out the questions before it as follows: “To impose withdrawal liability on an organization other than the one obligated to the [Pension] Fund, two conditions must be satisfied: 1) the organization must be under 'common control' with the obligated organization, and 2) the organization must be a trade or business."³ It is the “trade or business” issue that was at the focus of the PBGC Letter, and that issue will be considered first, below.

There are several levels of analysis at issue regarding the consideration of the “trade or business” point. Regarding the threshold question of whether the tax analysis of what constitutes a "trade or business" should control for purposes of ERISA, the First Circuit said:

As to the first argument, we reject the proposition that, apart from the provisions covered by [Section 414(c) of the Code], interpretations of other provisions of the . . . Code are determinative of the issue of whether an entity is a "trade or business" under [Section 4001](b)(1). . . . We are particularly convinced this is the case because the Supreme Court has been hesitant to express a uniform definition even within the Code itself. . . . Moreover, [Section 4001](b)(1)'s statement that it must be construed consistently with only certain uses of the phrase in the Code undercuts the Sun Funds' assertion that the phrase must be uniformly interpreted.⁴

In some ways, this approach may be unsatisfying, because it arguably skirts the question of whether the result under Section 414(c) of the Code, whatever that result ultimately is, controls for purposes of Section 4001(b)(1) of ERISA. In contrast, the district court faced this question squarely and had concluded that the approach for purposes of Section 4001(b)(1) of ERISA needs to be consistent with the analysis under Section 414(c) of the Code.

With respect to the substantive “trade or business” question as applied to Sun Fund IV, the First Circuit described Sun Fund IV, in light of the “layers of fund-related entities,” as not a mere passive investor, but rather as a fund that was “sufficiently operated, managed, and was advantaged by its relationship with” the Portfolio Company. In this regard, in the Sun Capital Partners case, the PBGC had looked to a number of characteristics relating to the Sun Funds to bolster its “trade or business” determination, including (i) profit motive, (ii) the fund’s continuity and regularity, (iii) the provision by the Sun Funds’ agent of management and advisory services, and the related receipt of fees, and (iv) the Sun Funds’ position, consistent with its stated purpose, to exercise control through the general partner by virtue of their controlling stake in the portfolio company. This approach of the PBGC was referred to by the First Circuit as an "investment plus" standard.

The First Circuit also referred to the status of the Sun Funds as “venture capital operating companies” under the ERISA regulations (“VCOCs”), which regulations would, among other things, effectively have required the Sun Funds to have direct contractual rights to substantially participate in or substantially influence the management of at least one of the operating companies in which they invested. The First Circuit said: “These private equity funds engaged in a particular type of investment approach, to be distinguished from mere stock holding or mutual fund investments.” It may be of particular concern to private-equity and other funds intended to be VCOCs that the First Circuit viewed the type of owner-level activities contemplated by the VCOC rules as potentially sufficient to give rise to “trade or business” status. Thus, funds structured as VCOCs, as well as other funds with similar characteristics, may be among those that could be affected by the First Circuit's reasoning.

Having reviewed the details surrounding the Sun Funds, and applying the “investment plus” standard to Sun Capital IV, the First Circuit concluded as follows:

Where the issue [under ERISA’s multiemployer plan withdrawal rules] is one of whether there is mere passive investment to defeat pension withdrawal liability, we are persuaded that some form of an "investment plus" approach is appropriate when evaluating the "trade or business" prong of [Section 4001](b)(1), depending on what the "plus" is. Further, even if we were to ignore the PBGC's interpretation, we . . . would reach the same result through independent analysis. . . . We see no need to set forth general guidelines for what the "plus" is, nor has the PBGC provided guidance on this. We go no further than to say that on the undisputed facts of this case, Sun Fund IV is a "trade or business" for purposes of [Section 4001](b)(1).

While the First Circuit felt empowered to make a “trade or business” determination as to Sun Fund IV, it acknowledged the difficulty of doing so in an undeveloped area of the law, stating:

We express our dismay that the PBGC has not given more and earlier guidance on this "trade or business" "investment plus" theory to the many parties affected. The PBGC has not engaged in notice and comment rulemaking or even issued guidance of any kind which was subject to prior public notice and comment. . . . Moreover, its appeals letter that provides for the "investment plus" test leaves open many questions about exactly where the line should be drawn between a mere passive investor and one engaged in a "trade or business."

In crafting and applying a “trade or business” analysis under ERISA without the benefit of more developed PBGC authority, the First Circuit seemed to conclude, as noted above, that it might not be bound to follow existing tax precedent. Nevertheless, the First Circuit proceeded to review its analysis in light of Supreme Court precedent under the Code,⁵ and concluded that “[t]he ‘investment plus’ test as we have construed it in this opinion is . . . consistent with” that precedent.⁶ While arguably one might reasonably ask whether the First Circuit’s tax analysis would have been the same were the IRS to have weighed in on the subject, the First Circuit’s analysis could give substantial pause to private equity and other funds that are concerned about aggregation under both ERISA and the Code.⁷

Before turning to other aspects of the Sun Capital Partners case, we note that, over the course of its discussion, the First Circuit made it clear that its “trade or business” analysis is extremely fact-specific. Indeed, as to Sun Fund III, the First Circuit remanded the “trade or business” question back to the district court for additional factual development. It is noted that certain types of funds (e.g., buyout funds) could be more likely than others to have facts similar to the facts surrounding the Sun Funds.⁸

Importantly, there were other issues addressed by the First Circuit in Sun Capital Partners, and the news was not all bad for the Sun Funds. Indeed, the First Circuit made very clear that, with respect to Sun Fund IV, it was only holding that Sun Fund IV was a trade or business. Notably, the First Circuit did not hold that Sun Fund IV was under common control with the Portfolio Company.

To the contrary, the First Circuit specifically remanded the case to the district court on the “common control” question. Unlike the “trade or business” analysis, the “common control” analysis is somewhat straightforward, and the applicable tests are fairly well defined. Generally, for these purposes, the “common control” inquiry will implicate an 80%-or-more level of ownership. In particular, in Sun Capital Partners, Sun Fund III owned 30% of the Portfolio Company and Sun Fund IV owned 70% thereof. Thus, in the absence of further facts or analysis, ERISA aggregation might ultimately not apply to the Sun Funds and the Portfolio Company, if the 80% level of ownership is not viewed as having been reached.

As indicated above, however, the Pension Fund also claimed under Section 4212(c) of ERISA that the Sun Funds had engaged in a transaction to evade or avoid withdrawal liability, and that, therefore, the 70%/30% split should be ignored. In effect, the Pension Fund’s claim was that, with deemed 100% ownership by a single Sun Funds entity, ERISA aggregation should apply.

The Pension Fund was unsuccessful in prevailing on this claim. The First Circuit “beg[an] (and ultimately end[ed]) [its] analysis by reviewing the plain language of [Section 4212(c)],”stating:

The language of [Section 4212(c)] instructs courts to apply withdrawal liability "without regard" to any transaction the principal purpose of which is to evade or avoid such liability. . . . The instruction requires courts to put the parties in the same situation as if the offending transaction never occurred; that is, to erase that transaction. It does not, by contrast, instruct or permit a court to take the affirmative step of writing in new terms to a transaction or to create a transaction that never existed.

. . . .

This is simply not a case about an entity with a controlling stake of 80% or more under the MPPAA seeking to shed its controlling status to avoid withdrawal liability. As such, disregarding the agreement to divide ownership of [the vehicle used for the acquisition of the Portfolio Company] would not leave us with Sun Fund IV holding a controlling 80% stake in [the Portfolio Company]. The Sun Funds are not subject to liability pursuant to [Section 4212(c) of ERISA] and the district court's conclusion that they are not is affirmed.

As a result, the Pension Fund’s victory on the “trade or business” point may well turn out to have been a Pyrrhic. If no Sun Fund is considered to have owned 80% or more of the Portfolio Company, then, even if one or more of the Sun Funds is a “trade or business,” there may well be no aggregation under the “common control” precondition to ERISA aggregation.

Conclusion

So where does all of this leave us? While the First Circuit’s “trade or business” analysis seem clearly antithetical to the interests of affected investment funds, that seems to be only the first part of the story.

On the plus side of the ledger for investment funds, the First Circuit validated the approach that, if any particular entity within a fund structure owns less than 80% of a portfolio company, then aggregation might not be necessary (absent a transaction to evade or avoid ERISA liability), notwithstanding a "trade or business" characterization of the entity. This aspect of the case may provide some solace in a number of situations in which multiple (albeit related) entities are investing in a portfolio company with ERISA liabilities and other potential aggregation issues.

Thus, if the Pension Fund won the “trade or business” battle but will lose the aggregation war as a result of a lack of “common control,” the Pension Fund in Sun may have succeeded in Sun Capital Partners in making troublesome law, but without anything to show for it from the Sun Funds. For those concerned about the reach of the First Circuit’s decision, the “common control” point, together with the favorable holding by the First Circuit under the “evade or avoid” provisions of Section 4212(c), could be daunting to those seeking aggregation, and largely moot the “trade or business” issue in a wide range of cases. Investment funds may want fully to explore legitimate structuring opportunities, such as the ones that were viewed favorably in Sun Capital Partners, to reduce the risk of adverse consequences under ERISA (and the Code).

But the First Circuit’s “trade or business” holding is nevertheless 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.⁹ Not all ownership will avoid the 80% level, and not all ownership will be structured in advance with an awareness of aggregation concerns - so the issue will need to be watched.

In addition, as indicated above, the First Circuit’s approach in Sun Capital Partners is highly focused on the particular facts and circumstances present in that case. Consequently, even for those investment funds that are potentially concerned by the First Circuit’s decision in Sun Capital Partners, investment funds may wish to begin by reviewing their own particular facts and circumstances to see whether a Sun Capital Partners analysis would indicate that aggregation may apply.

In any event, there may continue to be room to view the PBGC Letter with a jaundiced eye, and the First Circuit's decision in Sun Capital Partners, like the district court's decision in the case, may not be the last word on the “trade or business” question as relevant to employee benefits. 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.