On July 24, 2013, in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund, the First Circuit Court of Appeals ruled that under ERISA a private equity fund can be jointly and severally liable for certain unfunded pension liabilities of its insolvent portfolio company. The court held that a private equity fund could be deemed to be a “trade or business” under circumstances where the fund’s active involvement in the management of its portfolio company went beyond the monetary contributions of a mere passive investor.
Under ERISA, an employer that withdraws from a multiemployer pension plan is subject to “withdrawal liability” for its proportionate share of the plan’s unfunded vested benefits. Withdrawal liability can be imposed not only on the employer itself, but also on any other entity in the employer’s “controlled group” if the employer fails to continue its pension fund contributions.
In order for such joint and several withdrawal liability to be imposed on a partnership, such as a private equity fund, the partnership must be (i) a “trade or business” and (ii) under common control with the obligated employer. Common control generally requires 80% or more common ownership (direct or indirect) among the entities. The statute does not define what constitutes a “trade or business,” but private equity funds have historically taken the position that they are not engaged in a “trade or business” because they are simply passive investment vehicles.
Sun Capital Decision
In Sun Capital, the Court was called to determine whether two private equity funds (Sun Capital Partners III, LP and Sun Capital Partners IV, LP) which invested in and collectively owned all of the equity in a portfolio company (Scott Brass Inc.) could be subject to withdrawal liability as a result of the portfolio company’s bankruptcy and ceased contributions to New England Teamsters and Trucking Industry Pension Fund. In November 2012, the District Court for the District of Massachusetts granted Sun Capital’s summary judgment motion asserting that the two private equity funds were not engaged in a “trade or business” and therefore could not be subject to withdrawal liability.
The District Court was persuaded that the activities undertaken by the private equity funds were akin to those of passive investors. The Court was not convinced that actions such as appointing individuals to serve on the portfolio company’s board of directors rose to the level of active management. Additionally, the District Court separated the actions of the private equity funds from the active management activities of the management company providing services to the portfolio company.
On appeal, the First Circuit in Sun Capital applied a multi-factor test no one of which was dispositive. The specific factors that the First Circuit considered were:
- whether the funds invested in the portfolio company for the principal purpose of making a profit;
- whether the general partners of the funds took an active role in the day to day management and operations of the portfolio company;
- whether the funds’ controlling stake in the portfolio company place them in a position where they were intimately involved in the management and operation of the portfolio company; and
- whether the funds received a direct economic benefit from their active management of the portfolio company that an ordinary, passive investor would not receive.
Finding that the first of these factors was clearly applicable, the First Circuit focused on the funds’ management activities regarding Scott Brass. With respect to the second factor, the Court noted that the general partner of one of the funds (Sun Fund IV) contracted with the fund to provide extensive management and consulting services to the portfolio company.
The Court rejected Sun Capital’s argument that management activities engaged in by the funds’ general partner should not be taken into account, and asserted that the employment and management decisions made by the general partner, including hiring, terminating, and compensating employees or independent contractors, clearly went beyond mere passive investment.
Regarding the third factor, the First Circuit was persuaded by the plain language of the documents governing the relationship between the parties. Specifically, the partnership agreements and private placement memoranda emphasized that the funds would take an active role in management and operation of the portfolio company.
With respect to the fourth factor, the First Circuit highlighted the fact that Sun Fund IV received a direct economic benefit because management fees the fund was required to pay to the fund’s general partner for managing the portfolio company were partially offset by management fees that Scott Brass paid to the general partner.
Having found all of the factors to be present, the First Circuit reversed the District Court’s and held that Sun Fund IV was engaged in a “trade or business.” The First Circuit remanded to the District Court the determination as to whether Sun Fund III was engaged in a “trade or business,” primarily because it was unclear from the record whether Sun Fund III received the offset of management fees.
The First Circuit also remanded to the District Court the determination as to whether the funds were under common control with the portfolio company. Since the ownership split between Sun Fund IV and Sun Fund III was 70/30, it bears watching to see whether the District Court will aggregate the funds’ ownership in order to reach the 80% threshold.
Financial sponsors must be extremely careful in performing due diligence on the contingent benefits and liabilities of their prospective portfolio companies. Funds should pay special attention to any potential multiemployer plan withdrawal liability, and consider addressing any potential exposure through appropriate indemnities and/or purchase price adjustments.
Although not specifically addressed in the Sun Capital decision, funds will also want to consider single employer defined benefit plan termination liability and other related forms of liability, because the same test for central group liability would apply.
In addition, private equity firms need to be aware that they will be held accountable for the language in their partnership agreements and private placement memoranda. Drafters of these documents should understand that highlighting strong and active management oversight in these agreements can support a court’s finding the fund to be a trade or business. Finally, private equity funds should focus on structuring ownership of portfolio companies with potential withdrawal liabilities in such a way to avoid the common control ownership threshold.