[co-author: Austin Stack]
In the latest decision in the Sun Capital series of cases, the U.S. District Court for the District of Massachusetts held that private equity investment funds can be liable for the withdrawal liability of a portfolio company.
The Sun Capital private equity funds were found to be engaged in a "trade or business" under the U.S. Court of Appeals for the First Circuit's 2013 "investment plus" test and were also under "common control" with the portfolio company, applying a new "partnership-in-fact" test.
The case has implications for traditional private equity funds that have more rights than a passive investor in regards to investments in portfolio companies with pension liabilities. It also may have implications for other employee benefit liabilities.
The latest decision in the series of Sun Capital cases was released on March 28, 2016, by the U.S. District Court for the District of Massachusetts. In Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund., No. 10-10921-DPW (D.Mass. 2016), the court ruled on questions remanded by the U.S. Court of Appeals for the First Circuit in 2013 in Sun Capital Partners III, LP v. New Eng. Teamsters & Trucking Indus. Pension Fund 724 F.3d 129 (1st Cir. 2013).
The First Circuit ruled in 2013 that the private equity fund, Sun Capital Partners IV LP (Sun IV), was engaged in a "trade or business." The District Court was asked to determine if the other private equity funds, Sun Capital Partners III LP and Sun Capital Partners QP LP (collectively, Sun III), were also engaged in a "trade or business" and whether Sun III and Sun IV were under common control with the portfolio company, Scott Brass Inc. (SBI). If they were, the funds could be held liable for the portfolio company's withdrawal liability under the Employee Retirement Income Security Act of 1974 (ERISA) and the Multiemployer Pension Plan Amendment Act of 1980 (MPPAA). The District Court ruled that Sun III was a "trade or business," and that Sun III and Sun IV were a "partnership-in-fact" under common control with SBI. Thus, the court held that the two private equity funds are jointly and severally liable for SBI's withdrawal liability of more than $4.5 million.
Background and the First Circuit Decision
Under ERISA, as amended by the MPPAA, an "employer" is liable to a multiemployer pension plan when it withdraws from the plan. To be considered an "employer" for purposes of withdrawal liability, an entity must 1) be a "trade or business" and 2) be under "common control" with the entity directly obligated for the withdrawal liability.
In 2007, Sun III and Sun IV acquired SBI, with Sun III owning 30 percent and Sun IV owning 70 percent. In 2008, SBI filed for bankruptcy, triggering withdrawal liability. The issue was whether the private equity funds were engaged in a "trade or business" and under "common control" with SBI, so as to make Sun III and Sun IV liable for SBI's withdrawal liability under ERISA.
The First Circuit ruled that Sun IV was engaged in a "trade or business" after applying an "investment plus" test, which essentially asked 1) whether the entity is engaged in an activity that is more than just passive investment with the primary purpose of income or profit and 2) whether the entity conducted that activity with continuity and regularity. The First Circuit noted that both funds were "actively involved" in the management of SBI, including having the ability to make hiring, termination and compensation decisions for SBI. Of particular importance to the court was that Sun IV received a financial benefit from its involvement with SBI in that SBI paid more than $186,000 to Sun IV's general partner, which reduced the amount of management fees that Sun IV had to pay. The First Circuit noted that this benefit was one that an "ordinary, passive investor would not derive." The First Circuit directed the District Court on remand to determine whether Sun III received a similar offset benefit.
Sun III Engaged in a "Trade or Business"
The District Court determined that SBI made payments to Sun IV's general partner that, under the joint ownership arrangement, would partially offset management fees that Sun III owed and provide an economic benefit to Sun III, albeit indirectly. Accordingly, the court ruled that the combination of the Sun III economic benefit and Sun III actively managing SBI meant that Sun III was engaged in a "trade or business."
The District Court noted that under the partnership agreements, the fees that SBI paid to the general partner generated a carryforward amount that could reduce future management fees owed. The carryforward amount satisfied the First Circuit's question regarding whether Sun III received "any benefit" from the fees that SBI paid. The court noted that this benefit was not available to a passive investor.
Sun III and Sun IV Are Under Common Control With SBI
Two or more "trades or businesses" are under "common control" if they are members of a "parent-subsidiary" group, a "brother-sister" group or a "combined group," according to Internal Revenue Code Section 414(c) and its regulations. To form a parent-subsidiary group – the relevant category in the Sun Capital cases – a common parent organization must own a "controlling interest" in at least one other organization (a controlling interest is defined as 80 percent ownership).
The District Court determined that the funds formed a parent-subsidiary group with SBI because they formed a partnership-in-fact that owned 100 percent of SBI. The court acknowledged that the funds filed separate partnership tax returns, had separate financial statements and separate bank accounts, and explicitly disclaimed an intent to form a partnership or joint venture. However, the court rejected the argument that it should strictly adhere to organizational formalities and noted that the funds created a sub-entity to invest in SBI, invested similarly in five other transactions and more importantly, worked together to decide how to co-invest. The 70/30 ownership split was a decision made by the funds' controlling entities at the outset of the investment to jointly divide responsibilities and keep each entity's ownership under the 80 percent threshold to avoid either fund formally establishing a controlled group with SBI to thereby limit exposure to withdrawal liability. Finally, the court noted that the organizational choices of the funds show "unity of decision making between the Funds rather than independence and mere incidental contractual coordination." The District Court declared that such activity "was plainly intended to constitute a partnership-in-fact." Consequently, the funds were found to satisfy the "common control" requirement. The District Court also noted that under the analysis provided by the First Circuit, the partnership-in-fact was also a "trade or business," and so each fund was liable for SBI's withdrawal liability.
The decisions in the Sun Capital cases create considerable uncertainty for private equity funds regarding their portfolio companies' withdrawal liability. Both courts, eager to find a way to impose liability on the funds, refused to provide any clear guidance as to what exactly will satisfy the "investment plus" standard or what factors will be sufficient for a private equity fund to be considered a "trade or business." However, it is clear that an entity's degree of managerial involvement (even through subsidiary entities) and receipt of economic benefits not provided to an ordinary passive investor will be key factors. Additionally, the District Court's decision establishes that structural formalities and state law may be disregarded in determining whether a private equity fund is under common control with a portfolio company, and so careful structuring alone may not be sufficient. Thus, for example, welcoming independent third-party investors in portfolio companies may help to minimize the risk of a fund being under common control with a portfolio company.
The implications of the decisions coming from the Sun Capital cases should not be taken lightly for both future investments and the management of risks in current investments of private equity and other investment funds. Given the factors the District Court focused on, private equity funds may want to consider the following to avoid having two or more funds form a controlled group with a portfolio company through a partnership-in-fact: 1) avoid multiple co-investments with the same fund entities, 2) limit the investment administration and managerial rights granted to the fund entities, 3) avoid substantively identical governing documents for co-investing funds, 4) have the funds co-invest with different outside entities and 5) seek outside funds with independent ownership and management to become minority owners in a portfolio company. Also notable is that under the definition of "employer" for withdrawal liability purposes, it may be possible for one portfolio company to be jointly and severally liable for a peer portfolio company's withdrawal liability if the two form a "brother-sister" controlled group.
Most significantly, private equity funds will want to be especially aware of any unfunded pension liability that a potential portfolio company may have. The same reasoning and rationales in the Sun Capital decisions could easily apply to defined benefit plan funding liabilities. There is a premium in performing diligence on any kind of pension liability (under single or multiemployer plans) and understanding the calculation of pension funding and multiemployer plan withdrawal liability. Further, even though beyond the apparent scope of the decision that relates to ERISA controlled group rules and not tax rules, a court could also choose to apply the District Court's analysis in connection with other employee benefit plans in which controlled group determinations are relevant. Examples include nondiscrimination and coverage testing in pension plans, including traditional 401(k) plans, and the Patient Protection and Affordable Care Act "pay or play" penalties relating to offering and providing affordable healthcare coverage. Finally, although the District Court's ruling is currently not binding outside the District of Massachusetts, the funds will likely appeal, and the decision could be binding in the First Circuit if upheld. Courts in other circuits may find the reasoning persuasive and rule similarly despite not being bound by the decision.
Private equity funds provide an important resource for small and growing businesses needing funds, management support and opportunities for liquidity for small business owners. The potential for withdrawal and other underfunded pension liability may change the landscape for private equity funds. As the Sun Capital cases have demonstrated, controlled group liability issues for private equity funds are not likely to altogether disappear, and the analysis for investing in, managing and taking risks in portfolio companies with any potential pension liabilities will necessarily need to adapt as a result. Perhaps one of the most significant impacts of the Sun Capital cases will be the decreased willingness of free market investors to take risks on pension-heavy companies and the value any investor will be willing to pay for such companies.