Two key questions drive the court’s determination of whether a private equity fund will be saddled with the ERISA pension liability of a bankrupt portfolio company: (1) whether the fund is engaged in a “trade or business”; and (2) whether the fund is under “common control” with or has a “controlling interest” of at least 80% in the portfolio company.  

  1. “Trade or Business”

The First Circuit determined that Sun Capital Fund IV and the District Court held that Sun Capital Fund III, like many traditional private equity funds, were involved in a “trade or business” because the funds were not simply passive investors. Rather, the funds satisfied the First Circuit’s nebulous “investment-plus” standard based on the following facts:

  • The general partners of the two Sun Capital Funds are Sun Capital Advisors III and Sun Capital Advisors IV, and those general partners are each controlled by Sun Capital’s two senior managing principals.
  • Sun Capital’s senior managing principals are also the co-CEOs of Sun Capital Advisors, Inc., which advises Sun Capital Fund III and Sun Capital Fund IV, structures their deals, and provides management consulting and employees to the portfolio companies owned by the Sun Capital Funds.
  • The Sun Capital Funds’ limited partnership agreements and private placement memos explain that the Funds are actively involved in the management and operation of the companies in which they invest.
  • The Sun Capital Funds’ limited partnership agreements give the general partner of each Sun Capital Fund exclusive and wide-ranging management authority.
  • The Sun Capital Funds were able to place employees of Sun Capital Advisors in two of the three director positions at the bankrupt portfolio company, resulting in Sun Capital Advisors employees controlling the bankrupt portfolio company’s board and effectively controlling the management and operation of the portfolio company.
  • Under the Sun Capital Funds’ limited partnership agreements, the applicable general partner is required to make a capital commitment to the Fund, and the Fund is required to pay an annual management fee to the general partner based on a percentage of the Fund’s aggregate commitments or invested capital. The general partner may offset its capital commitment by the amount of any annual management fee that it otherwise agrees to waive.
  • The Sun Capital Funds’ limited partnership agreements also provide for a reduction to the annual management fee payable to the general partner – any fees earned by Sun Capital Advisors and its affiliates and principals from portfolio companies would offset the management fee.
  • When no management fees are owed or the amount of management fee offsets is greater than the management fees owed to the general partner for any period, such fee offset is “carried forward” and can be used to offset future management fees owed by the Sun Capital Funds to their general partners.
  • There was a direct economic benefit to the Sun Capital Funds that an ordinary, passive investor would not derive: an offset or carryforward against the management fees the Funds otherwise would have paid their general partners for managing the investment in the bankrupt portfolio company. In fact, the portfolio company made payments of more than $664,000 to SCP Management IV (an affiliate of the general partners), 30% of which was allocated to Sun Capital Fund III and 70% of which was allocated to Sun Capital Fund IV (based on their pro rata investment amounts). As a result, Sun Capital Fund III was able to obtain the benefit of a management fee offset and Sun Capital Fund IV was able to obtain the benefit of a management fee carryforward.
  1. Controlled By or Under Common Control at 80% Level

The District Court determined that Sun Capital Fund III and Sun Capital Fund IV acted like a “joint venture” whose collective stakes exceeded the 80% ERISA liability threshold2 sufficient to demonstrate a controlling interest of the bankrupt portfolio company because:

  • The Supreme Court previously determined for tax purposes that a “partnership” is not limited only to those entities that identify themselves formally as partnerships, but instead can include any persons that join together for the purpose of carrying on business and sharing in the profits.
  • Sun Capital Fund III (which consists of two parallel funds that invest together in the same proportion in each of their investments) and Sun Capital Fund IV, while formally independent entities whose investor groups do not completely overlap, ultimately made their investment and business decisions under the direction of Sun Capital Advisors’ senior managing principals.
  • While the Sun Capital Funds’ co-investment agreements disclaimed any intent to form a partnership or joint venture and contained no obligation for the Funds to act in concert, their limited partnership agreements are almost identical and the Funds are operated similarly.
  • While the Sun Capital Funds prepare and file separate partnership tax returns, maintain separate financial statements and bank accounts, provide separate reports to their partners and have largely non-overlapping sets of limited partners and largely non-overlapping portfolios of companies in which they have invested, the Funds engaged in joint activity to pursue the investment in the portfolio company and to create a limited liability holding company solely for the purpose of making the joint investment in the portfolio company.
  • During the few years before and after their joint investment in the portfolio company, the Sun Capital Partner Funds co-invested in five other portfolio companies, using the same organizational structure, but did not provide any evidence of making joint investments with other outside investors.
  • There was no evidence of disagreement between Sun Capital Fund III and Sun Capital Fund IV over how to operate the limited liability holding company, as might be expected from independent members actively managing a business.

Most telling, the court noted: “Notably, the Funds made a conscious decision to split their ownership stake 70/30 for reasons that demonstrate the existence of a partnership. The Funds assert three motivations for this split: [(1)]that Sun [Capital] Fund III was nearing the end of its investment cycle while Sun [Capital] Fund IV was earlier in its own cycle, [(2)] a preference for income diversification, and [(3)] a desire to keep each Fund below 80 percent ownership to avoid withdrawal liability. With the exception of income diversification, which two truly independent entities could also pursue in parallel but on their own, these goals are instinct with coordination and show joint action. . . [T]hese goals stem from top-down decisions to allocate responsibilities jointly. Entities set up with rolling and overlapping lifecycles and coordination during periods of transition offer advantages to the Sun [Capital] Funds group as a whole, not just to each Fund. And the choice to organize Sun Scott Brass, LLC, so as to permit each of the Sun [Capital] Funds coinvesting to remain under 80 percent ownership, is likewise a choice that shows an identity of interest and unity of decision-making between the Funds rather than independence and mere incidental contractual coordination. A separate entity which is perhaps best described as a partnership-in-fact chose to establish this ownership structure and did so to benefit the plaintiff Sun [Capital] Funds jointly.”