On July 24, 2013, the First Circuit Court of Appeals determined that a private equity fund that was actively engaged in the management and operations of its portfolio company, and was compensated for its services, was a trade or business that could be held jointly and severally liable for US$4.5 million in pension withdrawal liability incurred by the portfolio company. Sun Capital Partners III, LP v. New Eng. Teamsters & Trucking Indus. Pension Fund, Case No. 12-2312, 1st Cir. July 24, 2013. The decision rests on the basic principle that, for purposes of determining liability for pension underfunding under the Multiemployer Pension Plan Amendments Act of 1980 (MPPAA), the definition of “employer” is extremely broad and “extends beyond the business entity withdrawing from the pension fund, thus imposing liability on related entities within the definition, which in effect, pierces the corporate veil and disregards formal business structures.” (Id.) The ruling is a reminder that funds must be on the alert in both structuring their investments and managing their portfolio companies for this potential liability.
The appellees in the case, private equity funds Sun Capital Partners III, L.P., Sun Capital Partners III QP, LP, and Sun Capital Partners IV, LP, (collectively, the Sun Funds) sought a declaratory judgment in the District Court of Massachusetts that they were not liable as an employer to the New England Teamsters and Trucking Industry Pension Fund for the payment of pension withdrawal liability arising from the withdrawal from the multiemployer pension plan and subsequent bankruptcy of Scott Brass, Inc., one of the companies in which the Sun Funds were invested. The district court ruled in favor of the Sun Funds.Sun Capital Partners III, L.P. v. New Eng. Teamsters & Trucking Indus. Pension Fund, 903 F. Supp 2d 107 (D. Mass 2012).
The issues on appeal to the First Circuit were whether the Sun Funds were “trades or businesses” under the Employee Retirement Income Security Act of 1974 (ERISA) and whether the investment transaction was structured with the primary purpose of evading or avoiding withdrawal liability. The First Circuit ruled against one of the Sun Funds on the first issue and remanded the case to the district court to determine the “trade or business” issue with respect to the other fund.
The facts of the case with respect to the Sun Funds’ control of the portfolio company management were determinative. The Sun Funds are limited partnerships to which individuals and institutional investors contribute capital for investment purposes. The stated purpose of the funds is to invest in underperforming but market-leading companies at a discount, with the goal of turning them around and selling them for profit. Accordingly, the Sun Funds’ controlling stakes in the portfolio companies are typically used to implement restructuring strategies.
The Sun Funds created a Delaware limited liability company to act as the investment vehicle for Scott Brass and invested US$3 million in the LLC for 100 percent of the membership interests; this investment was split 70/30 between the Sun Capital III and IV funds. The split between the funds was admittedly calculated to minimize the chances of incurring withdrawal liability. The LLC invested the US$3 million in a holding company in exchange for US$1 million of the holding company stock and US$2 million of debt. In 2006, the holding company then purchased the stock of Scott Brass for US$3 million in cash and an additional US$4.8 million of borrowed funds. Each of the Sun Funds’ general partners has both a committee that makes the investment decisions for the fund and, significantly, a management company that is designed to provide managerial and consulting services to the holding company or the acquired company for which it would be paid management fees. In fact, the holding company signed an agreement with the GP of Sun Capital IV to provide management services to the holding company and its subsidiary, Scott Brass.
Under the MPPAA, members of a commonly controlled group of trades or businesses are jointly and severally liable for withdrawal liability. In determining whether the Sun Funds constituted a “trade or business” within the meaning of the statute, the court turned first to the two-prong test of the Supreme Court in Commissioner v. Groetzinger, 480 US 23 (1987):
- the primary purpose of the activity must be income or profit, and
- the activity must be performed with regularity and continuity. The purpose of the Sun Funds was undeniably profit. For the second prong of the Groetzinger test, the First Circuit relied on its own version of the “investment plus” test derived from a Pension Benefit Guaranty Corporation (PBGC) Appeals Board ruling. The PBGC’s ruling looked to the fund’s activities with respect to the portfolio company that were over and above its passive investment. The First Circuit noted that numerous individuals with affiliations to Sun Capital exerted substantial operational and managerial control over the debtor. The stated intent of the Sun Funds in the creation of the enterprise, the Sun Funds’ information memoranda to potential investors that explained the funds’ involvement in management and operation of the companies in which they invest, pre-acquisition restructuring and operation plans, the service agreements and fees, and the funds’ involvement in management decisions and operations were all factors which satisfied the court’s “investment plus” test for what constitutes a business or trade.
The Sun Funds purposely divided their investment in Scott Brass to fall below the 80 percent parent-subsidiary common control threshold under ERISA and related Treasury Department regulations to avoid incurring withdrawal liability. The First Circuit remanded the case back to the district court to determine whether the Sun Capital Funds satisfied the second prong of control group liability standard, the “ownership test.” A trade or business is not liable under ERISA for the withdrawal liability of another entity unless the ownership test is satisfied. In general, a parent-subsidiary relationship will trigger controlled group status under the ownership test if one trade or business owns, directly or indirectly, 80 percent or more of the equity of the other trade or business. Thus, unless the district court determines that Sun Capital Fund III and Sun Capital Fund IV should be aggregated and treated as a single entity under some form of alter ego theory or through constructive ownership rules, it appears that the Sun Capital Funds may still avoid withdrawal liability through the use of a multiple funds investment strategy designed to keep any single fund from owning 80 percent or more of the equity of Scott Brass. However, the Sun Capital decision highlights that private equity funds cannot continue to rely solely on passive ownership of portfolio companies to avoid withdrawal liability. The inquiry into a fund’s controlled group status calls for a fact-intensive inquiry in each case with respect to the degree of a private equity fund’s control and involvement in the affairs of a portfolio company to minimize the risk of incurring control group liability as a trade or business.
The issues raised by the case are likely to be revisited in many other situations. According to a recent study of the US Government Accountability Office, multiemployer pension plans cover more than 10 million employees and retirees. As a result of investment declines, increased employer withdrawals from the plan and demographic changes, many multiemployer plans have had large funding shortfalls. Private equity investors may well become targets of the pension funds and others as they seek to make up the underfunding of pension plans.