In a landmark benefits decision, a Federal District Court in Massachusetts held that separate private equity funds sharing a general partner are jointly and severally liable under the Employee Retirement Income Security Act of 1974, as amended (ERISA) for the multiemployer pension withdrawal liability of a portfolio company in which both funds invested. Sun Capital Partners III LP v. New Eng. Teamsters & Trucking Indus. Pension Fund, 2016 BL 95418, (D. Mass., No. 1:10-CV-10921-DPW, Mar. 28, 2016). The decision, which fundamentally dismantles an archetypical structuring technique, will make it more difficult for private equity funds to structure around the potential exposure of multiemployer plan withdrawal liability.   

Background

Under the Multiemployer Pension Plan Amendments Act (MPPAA), all trades or businesses under common control with the contributing entity to a union pension fund are jointly and severally liable for the withdrawal liability of a contributing sponsor. Generally, common control requires a parent to have an 80% interest in the subsidiary. Therefore, private equity funds have generally endeavored to not own more than the requisite 80% of a company that would constitute “common control” under MPPAA. 

The current decision arises out of a remand of an earlier appellate court decision. As we noted in our prior alert here, the First Circuit Court of Appeals previously rattled the private equity industry in finding that a private equity fund, Sun Fund IV, qualified as a “trade or business” using an “investment plus” approach for purposes of the common control provisions of MPPAA. This finding put significant pressure on the other legal question remanded by the First Circuit to the District Court to determine (in addition to whether a separate fund, Sun Fund III, was also a “trade or business”), whether Sun Fund III and Sun Fund IV (the Funds) were in “common control” of Scott Brass Inc. (SBI), the company incurring the direct withdrawal liability. 

The Structuring Issue 

The investment in SBI was structured as follows: SBI was owned by Scott Brass Holding Corp., which was in turned owned by Sun Scott Brass LLC (the LLC). As the record indicated, the Funds’ investment in the portfolio company through the LLC was specifically structured so that neither Fund owned the requisite 80% of the company under MPPAA that would constitute “common control”.

After a factual analysis culminating in a finding that Sun Fund III was also engaged in a trade or business, the District Court addressed the critical “common control” issue. Notwithstanding, or rather in the court’s view because of, the conscious decision to use the LLC as an investment vehicle, the District Court found that the Funds were in common control with SBI as the result of formation of a general partnership-in-fact between the Funds. The court also imputed the “trade or business” status of the two funds to the partnership-in-fact. This general partnership was treated by the court as owning 100% of the LLC and therefore within the controlled group of SBI. As a result, the MPPAA liabilities would flow to the Funds as general partners.

As to the creation of a partnership-in-fact, which was the lynchpin for imposing withdrawal liability on the Funds, the District Court noted that the intent of ERISA’s common control provisions is to prevent organizations from forming separate organizations to avoid ERISA obligations. 

The District Court further noted that “the choice of organizational form under state law is not determinative of treatment under federal law.” Among other factors leading to the finding of a partnership-in-fact, the court stated the Funds were not passive investors in the portfolio company brought together by happenstance or coincidence. Rather, prior to making the investment, the Funds acted jointly in deciding to co-invest in the portfolio company. The Funds made a conscious decision to split their ownership in the portfolio company so that neither Fund owned the requite 80%, which evidenced an identity of interest and unity of decision making between the Funds. Further, the Funds appointed two of the three portfolio company’s board members, which resulted in the Funds ability to be intimately involved in the management and operations of the portfolio company. The court explained that the smooth coordination between the Funds of the management and operation of the portfolio company was indicative of a partnership-in-fact, resulting in the Funds’ common control of the portfolio company.

Conclusion

The overall takeaway from the Sun Capital case is that private equity funds, already susceptible to “trade or business” characterization for MPPAA purposes as a result of the First Circuit’s “investment plus” analysis, will now be under increased pressure to develop organizational substance as between non-parallel funds to thwart the establishment of a partnership-in-fact.   

It should be noted that this decision is, by its own terms, limited to the applicability of ERISA and MPPAA and does not purport to interpret the federal income tax provisions of the Internal Revenue Code. Thus, nothing in the District Court’s decision aggravates or mitigates the concerns raised in our earlier alert relating to “effectively connected income” (ECI) for a private equity fund’s non US investors or “unrelated business taxable income” (UBTI) for tax-exempt investors.