The U.S. District Court for Massachusetts recently held that a private equity fund was not a “trade or business” for purposes of the controlled group liability rules under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). This opinion, which is currently being appealed, rejects the controversial position of the Pension Benefit Guaranty Corporation (the “PBGC”) that a private equity fund can be held jointly and severally liable for the pension obligations of its portfolio companies. While the final outcome of the appeal and the applicability of the decision in other jurisdictions remain unclear, the opinion should provide some comfort to funds that hold portfolio companies that sponsor or contribute to underfunded pension plans that are subject to Tile IV of ERISA. The decision also serves as a friendly reminder of the potential risks and liabilities associated with portfolio company pension plans.

The issue in Sun Capital Partners III, LP v. New England Teamsters, Civil Action No. 10-10921-DPW (D. Mass. Oct. 18, 2012), was whether a pair of parallel private equity funds (the “Sun Funds”) that indirectly owned 70% and 30% of a portfolio company should be jointly and severally liable for withdrawal liability incurred when the portfolio company withdrew from a multiemployer pension plan. Under ERISA, members of the same “controlled group” are jointly and severally liable for certain pension liabilities of the other members of the controlled group, including withdrawal liability in respect of multiemployer plans. An entity’s controlled group generally includes all “trades or business” under “common control” with the entity (i.e., having at least 80% common ownership).

Many practitioners have long believed that a properly structured investment fund should not be deemed a “trade or business” for purposes of the controlled group rules based on well-established tax principles that investment activities do not in and of themselves constitute engaging in a “trade or business.” However, in 2007, the PBGC Appeals Board, to the consternation of many fund managers, issued an opinion holding that a private equity fund was a “trade or business” due to its active involvement, through its general partner and management company, in the management of the portfolio company, and accordingly held that the fund was jointly and severally liable for the portfolio company’s pension liabilities.

The Sun Capital holding rejects the PBGC Appeals Board’s ruling and sets out the following principles.  

The court held that the Sun Funds were not “trades or businesses” because they were merely passive investment pools that existed only to receive investment income, which for federal tax purposes, does not constitute engaging in a trade or business. In coming to this conclusion, the court posited that (i) the management and consulting activities of the funds’ management company were not attributable to the Sun Funds themselves, but rather were the works of an agent and (ii) the Sun Funds’ appointment of directors to the portfolio company’s board did not cause them to be engaged in a trade or business, but was rather an action taken in each fund’s role as shareholder of the company.

The court also held that the Sun Funds’ decision to split their investment in the portfolio company so they would have 70% and 30% ownership, respectively, did not constitute a transaction with a principal purpose of evading or avoiding liability under ERISA. This was the case even though the funds acknowledged that one purpose of dividing their ownership in this manner was to minimize exposure to potential future withdrawal liability by keeping their individual ownership under 80%. The court found that (i) because the Sun Funds listed other legitimate business purposes for the split, avoiding ERISA liability was not the primary purpose and (ii) the evade and avoid rule is intended to prevent employer sponsors from splitting up their businesses in order to avoid ERISA liabilities, not to prevent outside investors from structuring their investments to minimize risk of a future pension liability—particularly if that liability has not yet materialized at the time of the investment.

Though the Sun Fund ruling is helpful in moving the pendulum back from the PBGC’s 2007 opinion, private equity funds should continue to use caution in structuring investments in portfolio companies with underfunded pension liabilities. In particular, private equity funds should continue to carefully consider the risks of purchasing an 80% or more ownership interest in a portfolio company. Even if the ruling that a private equity fund is not a trade or business is upheld, there would still be uncertainty around whether a fund’s other 80%-held portfolio companies would be deemed to be in the same controlled group as one another. In addition, when splitting an investment among different funds, funds should take care to document the non-ERISA business purposes for the structure. Finally, when documenting the governance structure for a fund’s investment in a portfolio company, it would be helpful to clearly identify a separate entity, like a management company, that will conduct any management activities for the fund.