Last week, reversing a decision of a federal district court in Massachusetts, the First Circuit held, in Sun Capital Partners III, LP et al. v New England Teamsters & Trucking Industry Pension Fund et al., that a private equity fund qualified as a “trade or business” and may be included in a “controlled group” with its portfolio companies for purposes of determining whether the private equity fund can be held jointly liable for the portfolio company’s multiemployer pension plan withdrawal liabilities. In order for multiple entities to be jointly and severally liable for ERISA multiemployer pension liabilities, the entities must be “trades or businesses” under “common control”. The First Circuit engaged in a fact-intensive analysis to conclude that, through the management and operation of a portfolio company, a private equity fund could transition from a passive investor to an active trade or business with responsibility for the portfolio company’s withdrawal liability.
The decision removes recent comfort afforded last November to private equity funds by the lower court’s holding that a private equity fund was not a trade or business. The specific facts of the case are set forth in our alert dated November 6, 2012 (which can be found here).
There are several important takeaways from the First Circuit’s decision:
First, as a result of the First Circuit’s holding, private equity funds must be prepared to be treated as a “trade or business” for ERISA purposes. As a consequence, funds must be aware of “control group” liabilities under ERISA that could arise when a private equity fund owns 80% or more of the vote or value of one or more portfolio companies. These liabilities generally include funding obligations to single-employer qualified defined benefit pension plans and withdrawal liability from union sponsored multiemployer plans. Similar “control group” issues are implicated in qualified plan and welfare plan discrimination testing and responsibility for COBRA obligations.
Second, the Sun Capital decision makes clear that planning possibilities remain for private equity funds in respect of ERISA control group liabilities, for example by splitting an investment in a particular portfolio between separate funds so that no single fund owns an 80% controlling interest (assuming no substantial overlap in the identity of the separate funds’ investors).
Third, there were particular facts in this case that led the First Circuit to reach the conclusion that one of the funds was a “trade or business”. Important to the court was the level of management activities conducted by members of the fund’s general partner. The court noted the fund’s partnership agreement and private placement memos stated that the principal purpose of the partnership was the management and supervision of its investments and that these agreements gave the general partner “exclusive and wide-ranging management authority” to make decisions about hiring, terminating and compensating employees of its portfolio companies. Further, the court stated that the fund’s controlling interest in the portfolio company allowed it to place employees of the management company on the portfolio company’s board of directors and placed the fund in a position where “they were intimately involved in the management and operation of the company.” Finally, the court stated that the fund’s active involvement in management under these agreements provided a direct economic benefit “that an ordinary passive investor would not derive”, namely a direct fee paid by the portfolio company to the general partner with a corresponding reduction in the fee otherwise payable by the fund to the general partner. It is unclear how the contractual “management rights” required by a private equity fund to qualify as a “venture capital operating company” (VCOC) would fare under the First Circuit’s “trade or business” analysis.
Finally, the holding raises the concern as to whether it can be applied beyond the ERISA context. The treatment of a private equity fund as being in a “trade or business” could raise “effectively connected income” (ECI) issues for the fund’s non-US investors and “unrelated business taxable income” (UBTI) issues for the fund’s tax-exempt investors. Further, such treatment could cause some of the general partner’s income from the fund that is treated as capital gain to be taxed as ordinary income.
The Sun Capital case has been remanded to the district court to resolve other issues, including whether the private equity fund is under “common control” with its portfolio companies.