In a decision with significant implications for private equity funds and their investors, the First Circuit Court of Appeals held in Sun Capital1 that a Sun Capital Advisors private equity fund was a “trade or business” for purposes of ERISA’s Title IV controlled group rules. Under the court’s rationale, private equity funds would be exposed to joint and several liability for unpaid pension liabilities under Title IV of ERISA that apply on a controlled group basis where a sufficient ownership link exists between the fund and the portfolio company. Moreover, the rationale would expose one portfolio company to another portfolio company’s controlled group liabilities where sufficient common ownership is present.
ERISA Controlled Group Liability
Under Title IV of ERISA, all members of a controlled group are jointly and severally liable for ERISA Title IV liabilities that are imposed on a controlled group basis, including defined benefit plan termination liability, multiemployer plan withdrawal liability, and PBGC premiums. In order for an entity that is a partnership, such as a private equity fund, to be a member of a controlled group, the partnership must (i) be a “trade or business,” and (ii) be under “common control” with one or more other entities. In general, “common control” is present if there is an 80% or more ownership link (direct or indirect) between entities. Although in many cases private equity funds are under common control with some or all of their portfolio companies, they have historically taken the position that they are not “trades or businesses” based on case law developed under the Internal Revenue Code with respect to what constitutes a “trade or business.”
The Sun Capital Decision
In Sun Capital, a multiemployer pension plan sought to collect from two Sun Capital private equity funds withdrawal liability incurred by a bankrupt portfolio company that was 70%-owned by one of the funds and 30%-owned by the other. Relying principally on case law establishing what constitutes a “trade or business” for Internal Revenue Code purposes, the district court in Sun Capital ruled that neither of the funds were trades or businesses and therefore were not liable for the portfolio company’s withdrawal liability. The First Circuit reversed the district court, applying a facts and circumstances analysis to find that the activities of one of the funds were sufficient to give rise to a trade or business. In reaching its conclusion, the court pointed to a number of factors, including the following:
- The fund invested “in portfolio companies with the principal purposes of making a profit.”
- Statements in the fund’s private placement memorandum and partnership agreement to the effect that the fund would be “actively involved in the management and operation” of its portfolio companies.
- The power of the fund’s general partner to “make decisions about hiring, terminating, and compensating agents and employees of the Sun Funds and their portfolio companies.”
- The appointment by the Sun Capital funds of two out of the three members of the bankrupt portfolio company’s board of directors.
- The provision of management and consulting services to the bankrupt portfolio company by an affiliate of Sun Capital.
- The offsetting of fees payable by the fund to its general partner by fees paid directly to the fund’s general partner by the bankrupt portfolio company.
Significantly, the First Circuit rejected the fund’s argument that management activities engaged in by the fund’s separate management entity should not be taken into account. Rather, the First Circuit concluded that the management entity was acting as the fund’s agent such that its activities should be attributed to the fund.
Although the First Circuit ruled on the trade or business status of one of the funds, it remanded the case to the district court to determine whether the second fund was a trade or business and whether either of the funds were under “common control” with the bankrupt portfolio company. For the private equity fund industry, whether the 70%-30% ownership split between the two funds prevents either of the funds from being treated as being under “common control” with the portfolio company is a key issue to watch on remand.
The Sun Capital decision highlights the importance of taking potential ERISA controlled group liabilities into account in evaluating portfolio company investments and developing ownership structures. Allocating investments among a sponsor’s funds so that no fund owns more than 80% of the portfolio company may ultimately be sufficient to address the risk, but the issue remains unresolved under the First Circuit’s decision. Bringing in unrelated minority investors is currently a more reliable means of addressing controlled group liability exposure and may be attractive in some situations. Where either approach is used, careful attention should be paid to the complex rules that apply for purposes of determining whether the 80% threshold for “common control” is met (under which attribution rules and rules that exclude certain ownership interests for purposes of the calculation can effectively reduce the threshold below 80%). Also, although unclear, it appears likely that the First Circuit’s rationale would extend to other benefit plan obligations that are imposed on a controlled group basis under Title I of ERISA and/or the Internal Revenue Code, including COBRA obligations, pension plan minimum funding obligations, retirement and welfare plan nondiscrimination testing, and large employer status under the Affordable Care Act.