The Case

In Sun Capital Partners v. New England Teamsters & Trucking Industry Pension Fund, No. 12-2312, 2013 WL 3814984 (1st Cir. July 24, 2013), the First Circuit Court of Appeals in reversing, at least in part, a Federal District Court decision, recently held that a private equity fund may be liable for a portfolio company’s ERISA pension obligations.  In doing so, the Court of Appeals essentially agreed with the conclusion in a 2007 PBGC proceeding where the PBGC found a private equity fund to be a “trade or business”.

In the Sun Capital case, two investment funds managed by Sun Capital-related entities invested in a portfolio company which had withdrawal liability obligations from a multiemployer plan.  Under ERISA, as applicable to the case, withdrawal liability is imposed on a joint and several basis on the withdrawing employer and on all “trades or businesses” in a “controlled group” with the withdrawing employer (the same rule applies to liability for terminations of certain underfunded pensions).  The multiemployer plan in which the portfolio company participated asserted that the Sun investment funds were both “trades or businesses” and in an ERISA controlled group which included the portfolio company.  Therefore, the plan asserted, the Sun investment funds could be held responsible for the portfolio company’s withdrawal liability.

Notably, in general, entities must be 80% commonly owned (by vote or value) in order to be in a controlled group.  The two investment funds, Sun Capital III and Sun Capital IV owned 30% and 70%, respectively, of the portfolio company.  The Court of Appeals did not resolve whether either of the investment funds was under “common control” for ERISA purposes with the portfolio company, but rather remanded the issue back to the District Court.  However the Court of Appeals did conclude that a private equity fund could be a trade or business for ERISA purposes, at least in certain circumstances, thus satisfying at least one prong of the test to impose liability.

The Court of Appeals thought it important that entities related to the Sun funds’ general partners were closely involved in the business and operations of the portfolio company, which it viewed as significantly different to mere passive management of the investment itself.  The funds had argued that pursuant to U.S. Supreme Court precedent, an investor managing its own investments is not engaged in a trade or business.  In this regard, it was noted that among other things the funds own documents stated that the principal purpose of the funds was the management and supervision of its investments and that the general partners would have exclusive and wide-ranging management authority to make decisions about hiring, terminating and compensating employees of its portfolio companies.  Also, the management services to the fund, and to the portfolio company, were provided by a subsidiary owned by the general partners using personnel employed by affiliates of the general partner.

The Court also found it very significant that a Sun management entity was paid management fees by the portfolio company, but, as is a common practice in the private equity business, those fees were subject to offset against amounts paid by each investment fund to its manager (another Sun-related entity), implying that the fee earned by the funds was connected to the management of the portfolio company.  It is not clear what the conclusion would be if no offset was involved.

As mentioned above, neither of the funds had 80% ownership, so it is reasonable to conclude, as the funds argued, that control could not be established in this case. However, the multiemployer plan argued that the Sun funds were effectively partners in a joint venture, which itself was the 100% parent of  the portfolio company, thereby creating a controlled group.  The Court of Appeals remanded this issue back to the District Court for further development and a ruling.

The Court also found no liability because the investment funds structured their investment so that the funds should not be liable for the portfolio company pension liability merely because they had structured their acquisition (30%/70%) of the portfolio company in part to avoid creating a controlled group.

What is the Effect?

The District Court’s earlier ruling had been welcomed by the private equity community, as it effectively insulated funds from ERISA’s controlled group liability, even if a fund owned more than 80% of a portfolio company.  That conclusion is now in doubt following the Court of Appeals’ recent ruling.  The Court of Appeals’ ruling is also in line with the PBGC’s reasoning in its 2007 holding.

The Court of Appeals decided that the definition of “trade or business” for purposes of the Tax Code is not dispositive for other purposes, such as ERISA.  So, in considering its own definition, it is clear that a private equity fund could be held to be in a trade or business where the fund or its affiliate is heavily involved in the business of the target company, which is generally a hallmark of private equity investing.  Clearly, according to the Court of Appeals, a private equity fund could be in a controlled group where it has a more than 80% ownership.  It is not clear whether the side by side investment of two funds operated by the same management group could be aggregated so that a controlled group is created even if neither such fund itself owns 80% of an entity. We will have to wait for that conclusion by the District Court.

The Court of Appeals made the specific point that its conclusion as to trade or business status for ERISA purposes is not necessarily conclusive for other purposes not relating to pension liability, such as under the Tax Code generally.  Characterization under the Tax Code as a trade or business could have a number of unintended effects on the fund and its investors.  For example, effectively connected income issues could arise for the fund’s non-US investors and “unrelated business taxable income” concerns for the fund’s tax-exempt investors.