Private Equity Funds Found Responsible for Withdrawal Liability of Bankrupt Portfolio Company

by McGuireWoods LLP
Contact

As we previously reported here and here, two private equity funds (the Sun Funds) managed by Sun Capital Advisors, Inc. (SCAI) have for years battled with the New England Teamsters & Trucking Industry Pension Fund (TPF) over whether the Sun Funds are responsible for some $4.5 million of ERISA Title IV withdrawal liability to the TPF incurred by Scott Brass, Inc. (SBI). The Sun Funds are Sun Capital Partners III, LP (Fund III), and Sun Capital Partners IV, LP (Fund IV). SBI is a portfolio company of the Sun Funds, which indirectly own all of SBI’s stock.

In a recent decision of the U.S. District Court for the District of Massachusetts, Fund III and Fund IV were found jointly and severally liable for SBI’s withdrawal liability. Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund, No. 10-10921-DPW, 2016 U.S. Dist. LEXIS 40254 (D. Mass. March 28, 2016). The decision demonstrates a judicial willingness to find private equity funds can be “trades or businesses” under “common control” with their portfolio companies so as to trigger exposure to such liability. Moreover, the decision indicates that multiple-fund parallel investment structures are not immune from withdrawal liability to multiemployer plans that have been aggressively seeking recourse to satisfy their often woefully underfunded obligations to retirees. The decision also has implications for private equity funds beyond withdrawal liability and for lenders to portfolio companies of such funds.

Background

If an employer stops contributing to a multiemployer pension plan having unfunded vested benefits, the plan will assess withdrawal liability under Title IV against the employer for its proportionate share of the value of such benefits.

Under ERISA Section 4001(b)(1), under regulations to be issued by the Pension Benefit Guaranty Corporation (PBGC), all employees of trades or businesses (whether or not incorporated) that are under common control must be treated as employed by a single employer and all such trades and businesses as a single employer. Accordingly, a multiemployer plan can also impose withdrawal liability on an entity other than the contributing employer, if such entity is (i) a trade or business and (ii) under common control with the contributing employer. McDougall v. Pioneer Ranch Ltd. P’ship, 494 F.3d 571, 577 (7th Cir. 2007).

The PBGC’s regulations as to the meaning of “common control” provide that it will make this determination based on regulations issued under Section 414(c) of the Internal Revenue Code (Code). Under the latter regulations, for example, if “A” owns at least 80 percent of the stock of “B,” then “A” and “B” are under common control.

The PBGC has not adopted regulations defining or explaining the meaning of “trade or business.” The phrase “trade or business” as used in Section 4001(b)(1) is not defined in Treasury regulations and has not been given a definitive definition by the Supreme Court for purposes of that section.

Earlier Litigation

SBI stopped contributing to the TPF less than two years after being acquired by the Sun Funds. Not long thereafter, an involuntary bankruptcy proceeding was begun against SBI. The TPF assessed withdrawal liability against SBI and also against the Sun Funds, claiming that the Sun Funds were a partnership or joint venture under common control with SBI and therefore jointly and severally liable with SBI under Section 4001(b)(1). The Sun Funds then filed suit against the TPF seeking a declaratory judgment that they were not responsible for SBI’s withdrawal liability. The district court initially held that the Sun Funds were not trades or businesses and the TPF appealed.

On appeal, the First Circuit held that the trade-or-business requirement was satisfied as to Fund IV and remanded the case to the district court to determine whether Fund III was a trade or business and to decide the issue of common control. Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund, 724 F.3d 129 (1st Cir. 2013).

To determine whether the Sun Funds were trades or businesses, the First Circuit used an “investment plus” test, meaning something more than passive investment by these funds was required. The court considered whether the investor received an economic benefit over and above that which would have been received by a strictly passive investor. It found that the management services agreement between SBI and the management company responsible for directing and overseeing Fund IV’s investments resulted in management fee offsets and/or carryforwards that would benefit Fund IV. As a result of these benefits, the First Circuit found that Fund IV was a trade or business.

The District Court’s Decision on Remand

On remand, the district court reached the following conclusions:

  • Fund III and Fund IV were each a trade or business under the investment plus test. The court found that Fund III also benefited from management fee offsets and/or carryforwards and was therefore a trade or business.
  • As trades or businesses, the Sun Funds would be under common control with SBI if the requisite ownership test were satisfied.
  • Under federal tax law for determining when there is a partnership, the Sun Funds formed a “partnership-in-fact” based on their coordinated investment activities. The court noted that the Sun Funds were organized as separate legal entities that distinctly disclaimed any partnership with any other entity. Measured separately, neither of the Sun Funds would have satisfied the requisite ownership requirement to establish a group of companies under common control, as Fund III indirectly owned 30 percent of SBI and Fund IV owned the remaining 70 percent. However, the court reviewed the Sun Funds’ activities under federal tax law and determined that they were partners based on various factors, including the following:
    • Investment and other business decisions were made pursuant to the advice and direction of SCAI.
    • The two funds operated in a similar fashion and their organizational documents were nearly identical.
    • There was a pattern of co-investment by the Sun Funds in other portfolio companies without any evidence of investments with non-affiliated investors.
    • There were no disagreements between the Sun Funds over the management and operation of SBI.
    • The Sun Funds partnership-in-fact, like the individual Sun Funds, was a trade or business “for precisely the same reasons as the Sun Funds are trades or businesses,” i.e., the partnership was involved in the active management of SBI.
  • The ownership of 100 percent of SBI by the partnership-in-fact was sufficient to consider all three entities as being under common control.

Observations

The district court’s decision on remand marks the first time a court has found that a private equity fund and its portfolio companies are trades or businesses under common control. We would expect the Sun Funds to appeal, and if the district court’s decision is upheld, it will have significant implications for both the private equity and lending industries, including the following:

  • Common use of management fee offset arrangements
  • It may be very difficult for private equity funds to avoid being considered trades or businesses for ERISA purposes under the investment plus test adopted by the First Circuit and applied by the district court, with its focus on the management fee offset structure. Such or similar fee arrangements are relatively pervasive throughout the private equity industry. Many limited partners pushed for these types of arrangements, but may want to reconsider in light of this decision.
  • Affiliated funds; parallel investing
  • A manager of a private equity fund may establish affiliated funds, such as an offshore fund, in order to attract investors with special tax concerns. The affiliated funds invest in the same portfolio companies as the principal fund. These funds may be aggregated for purposes of determining whether their total ownership in a portfolio company meets the 80-percent threshold in order for there to be a group of trades or businesses under common control.
  • Responsibility of other portfolio companies for withdrawal liability or single-employer pension plan funding deficiencies
  • Responsibility for multiemployer plan withdrawal liability of a private equity fund’s portfolio company may extend not only to the private equity fund, but also to other portfolio companies owned by such fund that are under common control with the company that withdrew. Similarly, if a portfolio company sponsors a single-employer defined benefit pension plan, the responsibility for funding deficiencies as to such plan may extend to the private equity fund or to other portfolio companies owned by that fund that are under common control with the company that is the plan sponsor.
  • Minimum coverage testing of qualified plans sponsored by portfolio companies
  • If a private equity fund has two or more portfolio companies, one or more of those companies may sponsor 401(k) or other qualified retirement plans. If the fund and the companies were not considered trades or businesses under common control, each company’s plans would be tested for purposes of meeting the qualified plan minimum coverage requirements of Code Section 410(b) without regard to the employees of any other company. Conversely, if the fund and the companies were considered trades or businesses under common control, the plans would be tested as if they had all been sponsored by a single employer, which could make passing the coverage requirements problematic.
  • Venture capital operating companies
  • Many multiemployer plans today have enormous funding deficiencies. (The TPF has been in “critical status” for several years and therefore has adopted a rehabilitation plan under the Pension Protection Act of 2006.) Consequently, one can expect that if an employer stops contributing to a multiemployer plan with severe funding problems, that plan will aggressively pursue withdrawal liability against any entity, in addition to the employer, as to which it has a colorable claim that the entity is a trade or business under common control with the employer.
  • In Sun Capital Partners, the investment plus test was considered satisfied on account of the management fee offset structure. When a private equity fund is a “venture capital operating company” (VCOC), a multiemployer plan may claim that such status satisfies the investment plus test.
  • Private equity funds that desire to attract benefit plan investors may structure themselves as VCOCs in order to meet an exception under the Department of Labor’s “plan asset” regulation, 29 C.F.R. Section 2510.3-101. In order to be a VCOC, a fund must actually exercise management rights as to one or more of the operating companies in which it invests. “Management rights” are defined in that regulation as contractual rights directly between the fund and an operating company to enable the fund to substantially participate in, or substantially influence the conduct of, the management of the operating company. The First Circuit’s opinion in Sun Capital Partners states that the Sun Funds were VCOCs. The TPF had argued that any investment fund classified as a VCOC was necessarily a trade or business, but the court of appeals declined to adopt this argument. However, some other court could well find the argument persuasive, depending on the facts and circumstances.
  • Lenders to portfolio companies
  • Lenders should consider common-control liabilities when entering into financing arrangements with portfolio companies of private equity funds. Legal and financial due diligence regarding these potential liabilities is crucial and loan documentation must be carefully reviewed to provide lenders with adequate notice and event-of-default protections.

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.

© McGuireWoods LLP | Attorney Advertising

Written by:

McGuireWoods LLP
Contact
more
less

McGuireWoods LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.