Following Remand by the First Circuit, District Court Rules That Two Affiliated Private Equity Funds Formed a “Partnership-in-Fact” and Had Controlled Group Liability for the Pension Liabilities of Their Portfolio Company
In the latest development in the Sun Capital litigation, on March 28, 2016, following remand from the First Circuit, the District Court for the District of Massachusetts held that Sun Capital funds with substantially different investor bases and investment portfolios formed a deemed “partnership-in-fact” with respect to a bankrupt portfolio company in which each fund was a co-investor and, as a consequence, the funds had controlled group liability under ERISA for the defined benefit pension liabilities of the portfolio company, even though neither fund, standing alone, was an 80-percent owner of the company.
As discussed in more detail below, this decision may have broad impact within the private equity industry. If the reasoning adopted by the courts in the Sun Capital cases is broadly applied in other circuits, private equity funds could become directly liable for the pension liabilities of certain of their portfolio companies. In addition, it is possible that the District Court’s decision could be applied to cause portfolio companies in which affiliated funds have co-invested to become liable for the pension liabilities of other such portfolio companies (although the scope of the opinion is not entirely clear in this regard).
ERISA Controlled Group Liability
Under ERISA, members of a group of trades or businesses under common control are jointly and severally liable for the tax-qualified defined benefit pension liabilities (such as underfunding and withdrawal liabilities) of any member of the group. For this purpose, a controlled group generally includes all parent-subsidiary affiliated groups of “trades or businesses” connected through at least 80-percent common ownership by vote or value (in the case of corporations) or capital or profits (in the case of partnerships). Prior to the First Circuit’s decision discussed below, the activities of a typical private equity fund were generally not thought to constitute a “trade or business” for this purpose.
Sun Capital Facts
In Sun Capital, two private equity funds, “Sun Fund IV” and “Sun Fund III”,1 indirectly—through a special purpose limited liability company—owned 70% and 30%, respectively, of Scott Brass Holding Corp. (“Scott Brass”), a bankrupt portfolio company with unpaid pension withdrawal liability of roughly $4.5 million to the New England Teamsters and Trucking Industry Pension Fund (the “Teamsters Pension Fund”). The Sun Capital funds themselves had no employees, offices or activities other than holding shares in portfolio companies, paying management fees and receiving investment returns. Each Sun Capital fund was managed by a general partner controlled by principals of the Sun Capital group. The fund documents stated that the purpose of each fund was “the management and supervision” of its investments. Under the fund documents, each general partner was given broad discretion to manage the affairs of the funds and its portfolio companies (such as decisions about hiring employees of the funds and portfolio companies). The fund offering memorandum stated that the principals work to “reduce costs, improve margins, accelerate sales growth” and so forth. The general partners of the Sun Capital funds used the funds’ controlling interest to elect Scott Brass board members. The general partners were entitled to an annual management fee from the Sun Capital funds (the “Management Fee”). This Management Fee, however, was offset by fees Scott Brass paid to an affiliate of the general partners for various services the affiliate provided to Scott Brass (the “Management Fee Offsets”). Sun Fund III and Sun Fund IV had different investors and their portfolio investments were different, except for a limited number of overlapping investments (including Scott Brass).
2013 First Circuit Sun Capital Decision
In 2013, the U.S. Court of Appeals for the First Circuit held that Sun Fund IV should be treated as engaged in a “trade or business” for purposes of ERISA controlled group liability, since the sum of its passive investment in Scott Brass, “plus” Sun Fund IV’s other activities amounted to a greater role than would be undertaken by an ordinary passive investor (the “investment plus” test).2 The other activities considered relevant by the First Circuit were (1) the fund’s stated intent in its offering documents to actively manage and supervise its portfolio investments, (2) the broad powers given the general partner of the fund to accomplish that purpose, (3) the close involvement of the fund in the management and operation of Scott Brass through appointing members of the board, and (4) the management and consulting services provided by Sun Capital affiliates. The First Circuit also considered the Management Fee Offsets to be a ‘plus’ factor because such offsets represented a “direct” economic benefit that an ordinary, passive investor would not have obtained. 3 The case was then remanded to the District Court for a determination of (1) whether Sun Fund III also received a similar economic benefit which, when combined with its other activities, would be sufficient to cause it to be a “trade or business” and (2) whether the two funds together were part of an ERISA controlled group with Scott Brass.
This week, on remand, the District Court applied the First Circuit’s “investment plus” test, holding that both Sun Fund III and Sun Fund IV were engaged in a “trade or business”, in large part because the Management Fee Offsets received by or credited to the Sun Capital fund provided a valuable economic benefit that would not be available to an ordinary investor.4
Going further, the District Court went on to find that Sun Fund III and Sun Fund IV formed a deemed “partnership-in-fact” with respect to their investment in Scott Brass and other portfolio companies, and that this deemed partnership-in-fact owned 100% of Scott Brass. The District Court appears to have based its holding on the facts that:
- Sun Fund III and Sun Fund IV had co-invested in five other companies together;
- no evidence had been given that either fund co-invested with unaffiliated parties; and
- no evidence had been given that the two funds ever disagreed over how to manage the portfolio investments. Although not entirely clear from the decision, the deemed partnership-in-fact apparently “sits above” the limited liability company the funds formed to hold their investment in Scott Brass, and encompasses the five other overlapping portfolio investments of Sun Fund III and Sun Fund IV. The District Court did not, however, address the question of whether the six overlapping portfolio investments could thus be construed as comprising a single ERISA controlled group, with the deemed partnership-in-fact as the parent and with each portfolio company liable for the Scott Brass pension liabilities. Rather, the District Court merely held that “it is clear beyond peradventure that a partnership-in-fact existed sufficient to aggregate the Funds' interests and place them under common control with Scott Brass, Inc.”5
The full impact of the Sun Capital decisions likely will not be known for some time. It can reasonably be anticipated that similar cases may be brought in other circuits. While the outcome cannot be predicted, the following observations can be made:
- A private equity fund can be treated as a trade or business for purposes of ERISA controlled group liability and, thus, become liable for the pension liabilities of portfolio companies at least 80 percent owned by the fund.
- Even where no single fund owns at least 80 percent of a portfolio company, a commonly controlled group of funds nevertheless could be construed as forming a deemed partnership that could expose the funds to the pension liabilities of its portfolio companies.
- It is not clear from the decision whether such a deemed partnership-in-fact could be used to impose ERISA controlled liability on the brother-sister portfolio companies jointly owned by an affiliated group of funds.
- Although the Sun Capital cases are focused only on the ERISA controlled group rules, since the decision relies on generally applicable federal income tax authorities, it is not clear how the decision will impact similar areas of tax law, such as (1) the qualified plan rules which also apply on a controlled group basis (e.g., the non-discrimination and participation rules a pension and 401(k) plan must satisfy to achieve tax-free status) and (2) the rules for determining whether investment activities constitute a trade or business in other contexts (e.g., for the purpose of determining whether investors in a private equity fund are engaged in a U.S. trade or business).