On March 28, 2016, in a much-anticipated decision, the US District Court for the District of Massachusetts issued its ruling in Sun Capital Partners III, LP, et al. v. New England  Teamsters and Trucking Industry Pension Fund, No. 10-10921-DPW (D. Mass. March 28, 2016). In 2013, the First Circuit decided, in Sun Capital

Partners III, LP v. New England Teamsters and Trucking Industry Pension Fund, 724 F. 3rd 129 (1st Circuit 2013), finding that Sun Capital Fund IV (“Fund IV”) was a “trade or business,” and remanded the case to the district court to determine whether Sun Capital Fund III (“Fund III,” together with Fund IV, “the Funds”) was a trade or business and whether the Funds were under “common control” with Scott Brass, Inc. (“Scott Brass”), a Sun Capital portfolio company, for purposes of applying the multiemployer plan withdrawal liability rules. In a decision that could have far-reaching effects beyond the facts of the case, the district court held that Fund III is a trade or business and that the Funds formed a “partnership-in-fact” that was under common control with Scott Brass, thus making the Funds jointly and severally liable for the withdrawal liability, which was initially imposed on Scott Brass when it withdrew from the multiemployer pension plan.

Background

Under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and the Internal Revenue Code of 1986, as amended (the “Code”), all trades or businesses that are under common control (typically called a “controlled group”) are jointly and severally liable for certain pension and multiemployer plan liabilities (including withdrawal liability) of all of the trades or businesses in the controlled group. Generally, for both ERISA and Code purposes, whether trades or businesses are under common control is determined under Code rules, specifically Code Sections 414(b) (in the case of a group of corporations) and 414(c) (in the case of trades or businesses). In general, trades or businesses are under common control and are, therefore, in the same controlled group, if they are connected through a common ownership interest of at least 80 percent.

In 2007, the Funds made an investment in Scott Brass through a holding company (“Holdco”), which owned 100 percent of Scott Brass. Holdco, in turn, was 100 percent owned by a limited liability company (the “LLC”) in which Fund III owned a 30 percent interest, and Fund IV owned a 70 percent interest. Scott Brass contributed to  a multiemployer pension plan (the “Pension Plan”) that had a large unfunded liability. As noted in the First Circuit decision and repeated in the district court’s decision, the Funds’ respective ownership percentages of 30 percent and 70 percent were driven, in significant part, to avoid the possibility that the Funds would be aggregated with Scott Brass for purposes of withdrawal liability with respect to the  Pension Plan. 

In 2008, Scott Brass ceased making contributions to the Pension Plan and entered into bankruptcy proceedings. The Pension Plan notified Scott Brass of the amount of the withdrawal liability in December 2008. Scott Brass did not pay the liability, and the Pension Plan sought to collect the liability from the Funds on the theory that the Funds were in the same controlled group as Scott Brass and were, therefore, jointly and severally liable for the obligation.

First Circuit Decision

In July 2013, the First Circuit, on appeal from the initial district court decision, held that Fund IV was a trade or business. In reaching this conclusion, the First Circuit applied an “investment plus” test and found that a passive investment, coupled with additional activities and payments, can result in the conclusion that the investor is engaged in a trade or business. The court did not articulate a clear standard as to when the “investment plus” test would be met but rather adopted a very fact-specific approach. The court found that, given the benefits received by Fund IV and its degree of involvement in the affairs of Scott Brass, the “investment plus” test was satisfied and Fund IV constituted a trade or business. The court emphasized the fact that management fee offsets related to management services performed by Fund IV with respect to Scott Brass provided Fund IV with an economic benefit over and above what a true passive investor would receive. The court remanded the case to the district court on the issue of whether Fund III constituted a trade or business and whether the Funds were under common control with Scott Brass.

The Current Decision

TRADES OR BUSINESSES ANALYSIS OF FUND III

Upon remand, the district court found that, under the “investment plus” test, Fund III was a trade or business. The principal basis for the conclusion was that, like Fund IV, Fund III received benefits from waived management fees and fee offsets (including fee offset carryforwards) that a passive investor would not receive, and that Fund III was actively involved in the management of its portfolio companies, including Scott Brass. Further, the court found that the Funds effectively exercised control over the management and operations of Scott Brass. Based on the foregoing facts, the court concluded that Fund III satisfied the “investment plus” test and, therefore, was a trade or business.

The Funds raised the argument that the First Circuit’s conclusion that Fund IV was a trade or business was based on an erroneous determination of the facts, including the fact that, in practice, the partners in Fund IV did benefit from the fee offsets (because they were waived for other reasons). The district court noted that, although it was bound by the First Circuit’s decision as to the status of Fund IV, it felt obligated to evaluate the Funds’ argument. The district court concluded that there were several factors that supported the First Circuit’s conclusion and further indicated that the offset carryforwards enjoyed by each of the Funds as a result of their management activities were sufficient to satisfy the conclusion. The district court found that the mere potential of a benefit, even if it was not realized due to actions that were arbitrary or otherwise under the control of the managers or partners of the Funds, was sufficient.

COMMON CONTROL

The district court also held that Fund III and Fund IV were under common control with Scott Brass even though neither fund separately owned the requisite 80 percent ownership interest required under the controlled group rules. The court first noted that there was no dispute as to whether Holdco and the LLC were under common control with Scott Brass due to their direct and indirect ownership interest of 100 percent. The court then analyzed whether the respective ownership percentages of each of  the Funds in the LLC should be aggregated for purposes of meeting the required 80 percent ownership threshold required under the tax rules to bring the Funds under common control with Scott Brass, Holdco and the LLC. The court engaged in an interesting analysis regarding the forms of the various entities and how that factored into the determination of whether the entities were under common control.

The court first noted that the primary goal of ERISA, including the requirements relating to multiemployer plan withdrawal liability, is to protect the benefits of employees. The court also noted that the test for common control is a bright-line test based on ownership interests and that this is in tension with the purposes of  ERISA in the context involved in the case. The court then determined that, notwithstanding  that the Funds had tailored their ownership interests in the LLC to avoid the bright-line ownership test and established the LLC as the vehicle for their investment in Scott Brass, the purposes of ERISA and the facts surrounding the Funds’ investment justified looking past the ownership and investment structure established by the Funds to determine whether it was appropriate to aggregate the Funds’ interests  in the LLC for purposes of determining whether the Funds were under common control with Scott Brass.

The court reasoned that the responsibility for withdrawal liability is a matter of federal law and that the organizational form of an entity under state law is only one factor in determining the treatment under federal law. The court found that, in the case of the Funds, the LLC was merely an organizational arrangement between the Funds and “an attempt to avoid liability” rather than a truly independent entity. The court also noted that whether a partnership or joint venture exists is determined by federal partnership law and is based on several factors that courts have found relevant in determining whether a partnership exists. The court then applied the factors to the Funds’ investment in

the LLC and held that, although there was nothing to indicate that the Funds would be joined together as general rule, the factors relating to their co-investment in Scott Brass resulted in a partnership or joint venture or, in the court’s parlance, a “partnership-in-fact.” Factors that the court relied on for this conclusion included the Funds’ decision as to the split of their respective investment in the LLC (indicating an “identity of interest and unity of decision making”) and no meaningful evidence  of actual independence in their respective investments, even though they were organizationally separate. Accordingly, the court held that the Funds’ had established a “partnership-in-fact” that was sufficient to aggregate the Funds with the LLC and Holdco and determined that, as a result thereof, the Funds were under common control with Scott Brass for purposes of the withdrawal liability rules of ERISA.

TRADE OR BUSINESS ANALYSIS OF “PARTNERSHIP-IN-FACT”

After determining that the Funds were under common control with Scott Brass, the court engaged in a rather abbreviated analysis of whether that “partnership-in-fact” was a trade or business and held that it was clear that it was a trade or business under the “investment plus” test. The court relied on the fact that it was established to make a profit, that it was involved in the active management of Scott Brass and that because the Funds had placed employees of their related advisor companies in directorship positions at Scott Brass, there was an indication that the Funds engaged in a joint, rather than individual, effort to control Scott Brass.

Because the court concluded that Fund III was a trade or business, that the Funds were under common control with Scott Brass as a result of the formation of a “partnership-in-fact,” and that the “partnership-in-fact” was a trade or business that was under common control with Scott Brass, the Funds were jointly and severally liable to the Pension Plan for the withdrawal liability.

Practical Considerations

Although the case only addressed the effect of the Funds’ structure and ownership interests for purposes of applying the multiemployer plan withdrawal liability provisions of ERISA and only technically governs the First Circuit (as to the trade or business issue) and the District of Massachusetts (as to the common control issue), the case has the potential to have significant implications outside that limited scope. The  rules that were interpreted by the district court as to the common control issue are long- standing tax principles (even though the case was not a tax case) that apply to almost all aspects of employee benefit plans under both ERISA and the Code. Although it is difficult to know how far the decision will be taken or how it will be applied going forward, based on the holding in the case, funds may wish to consider the following in structuring their investments:

  • Funds should engage in extremely thorough due diligence when considering investment in a portfolio company, particularly those that may have pension or multiemployer plan liabilities.
  • Funds should consider the compensation and management structure of the fund and related funds to determine whether any changes could be made to make it less likely that the fund would be viewed as satisfying the “investment plus” test and thereby being treated as a trade or business.
  • Funds may want to consider revising investment practices, where appropriate, by bringing in unrelated funds or funds that would not be treated as a parallel fund of another investor so as to reduce the likelihood that the funds would be aggregated as a “partnership-in fact” under the court’s analysis. Of course, as a practical matter, this is rather difficult, since the court did not articulate with much clarity what factors drove its decision on this issue. In addition, under the “partnership-in-fact” analysis, it is possible that a court would find coordination between two or more completely unrelated investment funds.
  • Funds may want to analyze existing investments to determine the level of risk that is already present with those investments.
  • Funds should consider the effect of the decision on provisions of credit agreements and other legal documents that require representations or have other consequences in the event that a fund incurs liability for  benefit plans, particularly plans subject to Title IV of ERISA or multiemployer plans.

If taken to its logical (or illogical) conclusion, the decision could have the effect of aggregating funds with their portfolio companies as well as aggregating a fund’s portfolio companies with one another, thus expanding not only a fund’s liability with respect to its portfolio companies but also the portfolio companies’ responsibilities for the liabilities of other “sister” companies that are deemed to be in the same controlled group.  It will also be interesting to see if the Pension Benefit Guaranty Corporation (“PBGC”) tries to use the holding in the decision to attempt to collect delinquent contributions from, and impose other liabilities on, funds with respect to liabilities of the funds’ portfolio companies. The Internal Revenue Service also may attempt to incorporate the decision into its interpretation of tax rules applicable to employee benefit plans generally. If it does so, this could have broad implications for the discrimination testing of qualified retirement plans by portfolio companies, including coverage testing and ADP/ACP testing for 401(k) plans and even, perhaps, for purposes of meeting the group health coverage requirements under the Affordable Care Act, which includes substantial penalties for employers failing to meet the ACA’s coverage requirements. However, up to now the IRS has demonstrated less interest in that approach than other agencies, primarily the PBGC.