At the end of March, the US District Court in Massachusetts issued an opinion that the three Sun Capital investment funds which had invested, through holding companies, in Scott Brass, Inc., a bankrupt company ("Scott Brass"), could be liable for pension withdrawal liability to a multiemployer pension plan to which Scott Brass had contributed. Is this a harbinger of rethinking private equity funds or will this decision be appealed and leave the questions open for years?
Through separate funds, one limited partnership owning 70% and the other parallel limited partnerships owning 30%, with other Sun Capital entities as the general partner of each fund, Sun Capital invested in Scott Brass. With each fund owning less than 80%, Sun Capital believed that the controlled group rules would not apply; the funds and Scott Brass would not be within a single controlled group. The union pension plan sued the Sun Capital funds when Scott Brass was bankrupt and unable to pay its withdrawal liability.
Under the Multiemployer Pension Plan Amendments Act ("MPPAA"), members of a bankrupt employer's controlled group can be jointly liable for withdrawal liability. In 2007, the Pension Benefit Guaranty Corporation (PBGC) announced its position that if a private equity fund ("PE fund") was not a passive investor but was in the trade or business through the management of investments, it could be considered as part of the controlled group with its portfolio companies.
The initial Sun Capital case was appealed to the U.S. Circuit Court for the First Circuit which confirmed the "investment plus" test should be used to determine if a PE fund should be considered to be a trade or business, and thus potentially within a controlled group. However, the First Circuit remanded to the District Court to determine if the Sun Capital funds met the "investment plus" test.
This test considers factors which could distinguish a PE fund from a passive investor. For Sun Capital, the factors to consider were:
- Written partnership agreements and statements that the PE fund would be actively involved in the management of the portfolio company
- Broad authority granted to general partners to participate in portfolio company management, including to hire or fire agents and employees of the portfolio company
- The extent that the PE fund's controlling stake in the portfolio company allowed for participation in management beyond that of a passive investor
- The PE fund received a economic benefit not available to an ordinary passive investor such as a management fee offset
District Court Conclusion - Liability
The District Court examined the limited partnership agreements of each Sun Capital fund, finding management fees the limited partners might owe the general partner were reduced by certain fees paid by the portfolio company and Sun Capital's waiver of fees would reduce future capital calls. When management fee offsets exceed management fees, "carry forwards" result which can be an economic benefit to the PE funds. The court concluded that each fund met the "trade or business" test.
Next, the court determined that the Sun Capital funds were under "common control" with Scott Brass, Inc. by disregarding the 70/30 ownership interests and noting that the MPPAA fostered "disregard of organizational formalism". Instead, the District Court found a "partnership-in-fact" among the Sun Capital funds. This partnership arose despite the separate legal entities and their agreements and the denial of partnership. Of key concern was that the Sun Capital funds and their general partners ultimately took direction from the co-CEOs of Sun Capital Advisors, Inc.
The District Court then connected the two concepts, finding that the Sun Capital funds were a partnership-in-fact that was in a trade or business and therefore in common control with Scott Brass, Inc. and jointly liable for pension withdrawal liability.
What does this mean?
The Sun Capital case raises many questions and not a lot of answers, particularly if an appeal from the District Court opinion is anticipated.
Some of the questions to ponder are:
- Should limited partnership agreements be reviewed and fees reconsidered?
- Should PE funds avoid an aggregate holding among all funds in a "family" in any portfolio company of 80% or more?
- How does this decision affect venture capital operating company (VCOC) status for PE funds?
- Does this open the portfolio company to consider its controlled group to include PE funds and other portfolio companies for purposes such as Affordable Health Care compliance and reporting or 401(k) plan coverage testing?
In any event, the Sun Capital case should be carefully watched in the future, while a blanket of caution is likely to cover PE funds and their portfolio companies.