On July 24, 2013, the U.S. Court of Appeals for the First Circuit reversed a decision of the United States District Court for the District of Massachusetts and held that a private equity fund could be engaged in a "trade or business" and thus jointly and severally liable for the pension obligations of the portfolio companies within its "controlled group."1 For a discussion of the District Court opinion, see our Corporate Practice NewsWire of July 2013.

I. Background

The Sun Capital opinion addressed the issue of whether a private equity fund is engaged in a "trade or business" for purposes of the controlled group rules of the Employee Retirement Income Security Act of 1974 (ERISA). Generally, two or more trades or businesses under common control are jointly and severally liable for pension plan funding obligations and multiemployer plan withdrawal liability of plans within their controlled group of companies. Common control includes a parent-subsidiary relationship where the parent owns 80% or more of the subsidiary. Thus, a private equity fund that is found to be engaging in a trade or business and that owns at least 80% of a portfolio company would be liable for the pension funding liabilities of the portfolio company.

II. Facts

In Sun Capital, two private equity funds, Sun Capital Partners III, LP (Sun Fund III) and Sun Capital Partners IV, LP (Sun Fund IV), acquired (through holding companies) a 30% and 70% ownership interest, respectively, in a manufacturing company. A few years after the acquisition, the portfolio company withdrew from a multiemployer pension plan and filed for bankruptcy protection. The pension fund asserted a claim against the portfolio company for withdrawal liability in the amount of approximately $4.5 million and claimed that the two private equity funds were trades or businesses under common control with the bankrupt portfolio company and were thus jointly and severally liable for its withdrawal liability.

The private equity funds then sought a declaratory judgment that they could not be liable for the pension withdrawal liability as they were neither a "trade or business" nor under common control with the bankrupt portfolio company.

III. District Court Decision

The United States District Court for the District of Massachusetts granted summary judgment in favor of the funds.2The District Court noted that the Sun Funds did not engage in a trade or business as:

  • the Sun Funds did not have "any employees, own any office space, or make or sell any goods,"
  • the Sun Funds’ investments in the portfolio company occurred only once and were passive, and
  • although the Sun Funds did elect the directors of the portfolio company, this was solely in their capacity as shareholders.

The District Court refused to grant deference to an opinion of the Pension Benefit Guaranty Corporation (PBGC) imposing on a private equity fund the unfunded pension liability of its more than 80% owned portfolio company, as the PBGC determined that the investment activities of the private equity fund constituted a trade or business.3The PBGC concluded that the private equity fund was not a passive investor because its agent, the general partner of the private equity fund, was actively involved in the business activity of its portfolio company and exercised control over its management (referred to as "investment plus" in the First Circuit’s Sun Capital opinion).

The District Court also disagreed with the multiemployer pension plan’s argument that the Sun Funds should be responsible for the withdrawal liability because a principal purpose of splitting the ownership of the portfolio company by 70%/30% was to avoid the 80% controlled group rules and thus the withdrawal liability. ERISA requires that a transaction must be disregarded if its principal purpose is to evade or avoid withdrawal liability. Quoting its legislative history, the District Court found that this rule was designed to cover "essentially fraudulent maneuvers

lacking in economic substance by employee sellers, and not by outside investors." The District Court also reasoned that, at the time of their investment, the Sun Funds did not expect withdrawal liability and that there is no objection to structuring a transaction to mitigate potential exposure as opposed to avoiding a current ERISA liability.

IV. First Circuit Decision

The First Circuit:

  • reversed the District Court and held that Sun Fund IV was not merely a passive investor but a "trade or business" that was actively involved in managing the portfolio company’s activities,
  • remanded the case to the District Court to determine if Sun Fund III was a trade or business and whether both funds were under common control with the portfolio company for withdrawal liability purposes, and
  • affirmed the District Court decision by refusing to apply the "evade or avoid" provisions of ERISA, but for a different reason.

The First Circuit, in an opinion written by Chief Judge Sandra Lynch, applied an "investment plus" analysis similar to the PBGC opinion and as applied by the Seventh Circuit in a recent case.4The First Circuit considered a number of factors (none of which was conclusive on its own) in determining whether the Sun Funds were merely passive investors:

  • the Sun Funds’ limited partnership agreements and private placement memoranda explain that the two funds are actively involved in the management and operation of the companies in which they invest,
  • the Sun Funds’ private placement memoranda provide that their strategy is to identify potential portfolio companies that are in need of extensive intervention with respect to their management and operations, to provide such intervention, and then to sell the companies. The private placement memoranda also state that the Sun Funds’ principals "typically work to reduce costs, improve margins, accelerate sales growth through new products and market opportunities, implement or modify management information systems and improve reporting and control functions." Additionally, the First Circuit explained that the Sun Funds’ involvement can encompass even small details, includingsigning checks for their new portfolio companies and holding frequent meetings with senior staff to discuss operations, competition, new products and personnel,
  • through a series of appointments, the Sun Funds were able to place employees of their investment manager in two of the three director positions at the portfolio company, resulting in such employees controlling the portfolio company board, and
  • through various services agreements with the Sun Funds’ affiliates, the Sun Funds’ investment manager provided personnel to the portfolio company for management and consulting services (and such personnel were "immersed in details" involving the management and operation of the portfolio company).

The First Circuit found it important that Sun Fund IV received a direct economic benefit from its active management in the form of offsets against the fees it would otherwise have paid its general partner. This reflected a status of more than a mere passive investor in the opinion of the First Circuit. As it was not clear whether Sun Fund III also received an offset of management fees, the First Circuit directed the District Court on remand to determine the extent of the economic benefit it received.

The Sun Funds also claimed that the activities of their affiliates could not be attributed to them. As the Sun Funds were Delaware limited partnerships, the First Circuit analyzed Delaware law and concluded that the general partner of Sun Fund IV acted as its agent in providing management services to the portfolio company. Therefore, those activities could be attributed to Sun Fund IV.

Finally, the First Circuit affirmed the District Court decision not to apply the "evade or avoid" claim of the multiemployer plan, but for different reasons. ERISA provides that, if there is a transaction having a principal purpose of evading or avoiding withdrawal liability, the transaction must be disregarded. If the transaction dividing the Sun Funds’ 70%/30% ownership of the portfolio company is disregarded, however, the First Circuit would have needed to construe the hypothetical ownership of the portfolio company in order to provide the relief sought by the plan. The First Circuit refused to implement a fictitious restructuring with one of the Sun Funds owning 80% or more of the portfolio company as there was no way of knowing whether the Sun Funds would have made such an investment.

V. Implications of the First Circuit Decision

Private equity funds holding (individually or collectively with related funds) 80% or more of a portfolio company that they actively manage through their general partners and other affiliated entities may be jointly and severally liable for termination liability of the single-employer defined benefit pension plans, and multi-employer pension plan withdrawal liability, of their portfolio companies. Controlled group rules are also applicable for COBRA health care continuation issues and analysis under Section 409A of the Internal Revenue Code. In addition, nondiscrimination rules for tax qualified plans require nondiscrimination testing among controlled group members.