In a potentially landmark decision related to the Employee Retirement Income Security Act (“ERISA”), the U.S. District Court for the District of Massachusetts ruled that two Sun Capital private equity funds that owned 70% and 30%, respectively, of a portfolio company are effectively in the same controlled group as the portfolio company and consequently liable for withdrawal liability owed by the portfolio company to a multiemployer pension plan (“MEP”).

The ruling could negatively impact a common mechanism utilized by private equity funds to prevent controlled group liability for obligations of their portfolio companies. These funds might now be held responsible for the ERISA obligations of their portfolio companies going forward.

The funds at issue were part of a larger family of funds advised by Sun Capital Advisors Inc. The funds invested in Scott Brass Inc. (“SBI”), structuring the investment on a 70/30 basis for several reasons, including the desire to remain below the 80% threshold necessary for controlled group liability. Generally, a controlled group under both ERISA and the Internal Revenue Code consists of trades or businesses under common control, meaning that there is an unbroken chain of at least 80% ownership tracing back to a common parent or five or fewer individuals.

SBI had been a participating employer in the MEP but subsequently ceased contributions to the MEP, triggering withdrawal liability, and then filed for bankruptcy. The MEP assessed withdrawal liability against SBI and demanded payment from the funds as well, asserting that they were under common control with SBI, notwithstanding the 70/30 ownership structure.

The funds obtained a declaratory judgment from the district court that they were not trades or businesses, a prerequisite for controlled group liability.

The First Circuit reversed the District Court decision on the trade or business issue, holding that the fund that owned 70% of SBI was a trade or business, applying an “investment plus” test to determine whether the funds were mere passive investors in SBI or if they had a more active role in the management of the company. Central to the court’s “investment plus” analysis was that the fund indirectly benefited from the management fees paid by SBI to the fund adviser, because the fund’s own fee obligations to the adviser were proportionately reduced by the fees paid by SBI. The First Circuit remanded the case for a determination of whether the second fund was a trade or business and whether the ownership portion of the controlled group test was met.

On remand, the District Court applied the First Circuit’s “investment plus” test to determine that both funds were conducting a trade or business.

More significantly, the District Court held that the funds’ joint ownership of 100% of SBI caused them to be in the same controlled group and, therefore, liable for SBI’s outstanding pension obligations.

Although neither fund owned 80% of SBI, the District Court determined that the funds had formed a de facto partnership for the purpose of investing in SBI, and this partnership owned 100% of SBI. The District Court looked to the significant coordination between the two funds with respect to the investment, holding that there was “unity of decision-making between the Funds rather than independence and mere incidental contractual coordination.” This coordinated, joint activity was evidence of the de facto partnership. The court further held that the de facto partnership was itself a trade or business and thus in the same controlled group as SBI. The individual funds, as partners of this de facto partnership, were liable for the partnership’s obligations, effectively causing the funds to be liable for SBI’s withdrawal liability.

It has yet to be seen whether this decision will be upheld by the First Circuit on appeal, but to the extent that it stands, the decision can have significant ramifications for private equity funds. The acquisition of an 80% or greater stake in a portfolio company, even where the investment is divided between two or more funds, could expose the investing funds to liability for the portfolio company’s underfunded pension or withdrawal liability obligations. Although the liability could be avoided if the investment were purely passive, that may be a difficult bar to meet under the “investment plus” test.

The ruling could also be significant from a tax perspective. Private equity funds are generally viewed for tax purposes to be investors in portfolio companies rather than engaged in a trade or business. If the court’s holding that the Sun Capital funds were engaged in a trade or business under ERISA (the First Circuit analysis employed tax principals and authorities) were expanded into the tax realm, it could potentially negatively affect the tax treatment of fund managers (with respect to the character of the carried interest), tax-exempt investors (with respect to unrelated business taxable income) and foreign investors (with respect to effectively connected income).

Fund managers should review their current structures and potential ERISA obligations in light of the District Court ruling.