Following a remand by the First Circuit Court of Appeals, a federal district court recently found that two affiliated private equity funds were jointly and severally liable for the withdrawal liability of a jointly owned portfolio company that previously participated in a multiemployer pension plan.
Terms to Know:
- Multiemployer pension plans are qualified retirement plans in which more than one employer participates pursuant to a collective bargaining agreement (such plans must meet requirements of ERISA, the Internal Revenue Code and the Labor Relations Management Act). Multiemployer pension plans often cover employers in the same industry whose employees are part of a unionized workforce.
- Withdrawal liability arises when a participating employer is no longer obligated to participate in a multiemployer pension plan, it ceases operations covered by the plan, or is deemed to have partially withdrawn from the plan (for example, if there is a 70% decline in its contributions). Upon withdrawal, the withdrawing employer must pay its portion of unfunded vested benefits under the multiemployer pension plan.
The Sun Capital Partners Case:
The case, Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, 2016 WL 1239918 (D. Mass. Mar. 28, 2016), involved two affiliated private equity funds, Sun Fund III and Sun Fund IV (the “Sun Funds”), that invested in Scott Brass, Inc. (“Scott Brass”). The Sun Funds created an LLC in which they were 30% and 70% owners, respectively. That LLC wholly owned a holding corporation, which in turn wholly owned Scott Brass (see Appendix A to the opinion, below, showing the ownership and management structure). Scott Brass participated in a multiemployer pension plan and in connection with its bankruptcy withdrew as a participating employer in the multiemployer pension plan. The cessation of Scott Brass’s obligation to contribute to the plan triggered the assessment of withdrawal liability under such plan.
Under ERISA, if a corporation or unincorporated trade or business is a member of a controlled group and a member of the controlled group incurs withdrawal liability, the other members of the controlled group are jointly and severally liable. An unincorporated entity must be considered engaged in a trade or business, as opposed to a passive investor, for it to be considered a member of the controlled group and, thus, liable for withdrawal liability. The issues in the case involved whether the Sun Funds, which were limited partnerships, were 1) engaged in a trade or business, and 2) members of a controlled group with Scott Brass.
The appellate court in the case determined based on a fact-specific inquiry that the Sun Funds could be engaged in a trade or business. The court cited the limited partnership agreements of the Sun Funds which provided that “a ‘principal purpose’ of the partnership is the management and supervision of its investments” and that the general partners of the Sun Funds have “exclusive and wide-ranging management authority” over the Sun Funds, effectively allowing the private equity fund to control the Scott Brass board. Further, the Sun Funds’ “active involvement in management” gave them a “direct economic benefit” different from that of a passive investor.
The district court then analyzed whether the Sun Funds were part of a controlled group with Scott Brass. Under applicable law, corporations and trades or businesses are under common control if they have a parent-subsidiary or brother-sister relationship or are otherwise part of a combined group of trades or businesses. A parent-subsidiary relationship involves a chain of organizations where a common parent has a controlling interest (i.e., 80% or more) in subsidiary organizations. The Sun Funds argued that because neither of them owed 80% or more of the LLC holding company, neither satisfied the 80% or more ownership requirement necessary to find a controlled group. The court determined that the analysis was not limited to the structure formed by the Sun Funds, which is a common private equity structure. Rather, the Sun Funds had formed an unwritten partnership-in-fact before forming the LLC holding company and this partnership-in-fact, which was a general partnership, was the 100% owner of the LLC holding company. The court also concluded that this partnership-in-fact was a trade or business for the same reasons that the Sun Funds were trades and businesses and, thus, the partnership-in-fact was a member of the Scott Brass controlled group. And, because the Sun Funds were general partners of this partnership-in-fact, they were liable for the obligations of the partnership-in-fact, including Scott Brass’ withdrawal liability.
In finding a partnership-in-fact between the Sun Funds that was the sole owner of the LLC holding company, the court emphasized that the Sun Funds were closely affiliated entities and were managed by the same two individuals, that the Sun Funds formed an LLC to co-invest in Scott Brass and had in a few other instances co-invested in other portfolio companies using the same LLC structure, but with varying ownership interests below 80%. Although the formation documents entered into by the Sun Funds with respect to the Scott Brass transaction had expressly disclaimed any intent to form a partnership, decisions were made by the same two individuals who served on the investment committees of each of the Sun Funds’ general partners. Ultimately, even though each Sun Funds’ general partners decided to invest at certain ownership percentages (70% and 30%) for certain reasons, including the avoidance of withdrawal liability as part of a controlled group, that decision was part of the pre-formation activities that led the court to find there was a general partnership-in-fact between the Sun Funds.
As a result of Sun Capital Partners, by investing in portfolio companies that participate in multiemployer pension plans, private equity funds may themselves become subject to withdrawal liability. Even if a fund does not own an 80% interest in the portfolio company and specifically acts to avoid being considered part of a controlled group with the portfolio company, pre-formation planning with an affiliated fund or funds could cause a court to conclude that such entities formed a general partnership that owns the portfolio company.
Further, if this novel partnership-in-fact reasoning is upheld, it is highly likely the Pension Benefit Guaranty Corporation will extend the analysis in Sun Capital Partners to private equity funds that co-invest in portfolio companies that maintain single-employer defined benefit pension plans in asserting liability for underfunded plans.
It is also possible that the IRS will extend this analysis to other employee benefit plans maintained by portfolio companies. For example, portfolio companies that treat their group health plans as not being subject to the requirements of the Affordable Care Act on account of being a small employer may be subject to the employer-mandate excise tax and other excise taxes as a result of such plans not complying with the market reforms applicable to large employer plans. Additionally, qualified defined contribution plans and other welfare and fringe benefit plans and arrangements subject to nondiscrimination testing under the Internal Revenue Code may fail such tests if the portfolio companies must be aggregated for testing purposes as a single employer.
This court’s holdings may be particularly troublesome to private equity firms who have credit facilities, as to which the representations, notice obligations and events of default are based on the common understanding that the private equity fund is not in a trade or business and thus neither it nor the portfolio companies are liable for the pension obligations of another portfolio company, much less the portfolio companies of its affiliated private equity funds with which it has a minority interest as a co-investor.
Accordingly, private equity funds that make investments in portfolio companies that participate in or sponsor pension plans should review and reassess their risk of being a trade or business, a part of a controlled group, or being in a partnership-in-fact arrangement. Contact one of our private equity or employee benefits attorneys to set up a consultation if you have questions.