On July 24, 2013, the U.S. Court of Appeals for the First Circuit became the first appellate court to address whether a private equity fund can become liable under ERISA for the pension plan underfunding (known as “Title IV liability”) of its portfolio companies. The decision in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund leaves several unresolved issues, but clearly states that where a private equity fund and its affiliated general partner or manager is significantly involved in the operation and management of a portfolio company, or realizes benefits beyond those of a passive investor through its relationship with a portfolio company, the private equity fund itself may become subject to the portfolio company’s Title IV liabilities.

As background, to impose Title IV liability under ERISA on a private equity fund, two conditions have to be met: (1) the private equity fund would have to constitute a trade or business, and (2) the private equity fund would have to be under common control with the portfolio company (this generally requires at least 80% ownership). If these conditions are satisfied, the private equity fund would be in the portfolio company’s “controlled group,” making it jointly and severally liable for the portfolio company’s Title IV liabilities.

In Sun Capital, two private equity funds sponsored by Sun Capital Advisors (“SCA”) purchased an interest in a company called Scott Brass. Scott Brass later went out of business and a multiemployer pension plan to which Scott Brass had contributed sought to assess Title IV liability on Sun Fund III (the 30% owner of Scott Brass) and Sun Fund IV (the 70% owner of Scott Brass). The pension plan alleged that the Sun Funds, as members of the Scott Brass controlled group liable for Scott Brass’s Title IV liabilities. The Sun Funds argued that they could not be members of the Scott Brass controlled group because they were not a trade or business. The district court agreed, finding that (1) based on long-established Supreme Court precedent in the federal income tax context, the Sun Funds, as mere investors, were not a trade or business, and (2) the activities of the funds’ agents (their general partners and managers) in managing the Scott Brass investment could not be imputed to the funds for purposes of the analysis.

On appeal, the First Circuit reversed the district court’s judgment which had been in favor of Sun Fund IV, and vacated and remanded the judgment which had been in favor of Sun Fund III. Notably, the court believed it was not bound by the relevant income tax guidance. Taking the position that there was no binding authority, the court interpreted the phrase “trade or business” in a manner particular to ERISA. The First Circuit adopted an “investment plus” approach to evaluating whether a fund is a trade or business for ERISA purposes, focusing on whether the fund is more than a mere passive investor. In articulating this “investment plus” approach, the court expressly declined to give guidelines as to what factors would constitute the “plus,” but suggested that relevent facts and circumstances should be considered.

In applying the “investment plus” standard here, the court did note that the private placement memoranda of the Sun Funds read as if the funds themselves were engaged in substantial operational activities common to a typical private equity fund. However, the court focused most strongly on Sun Fund IV’s management fee offset provision as indicating that it was more than a mere passive investor. Here, the relevant SCA management companies entered into a customary management agreement with Scott Brass providing for an annual management fee. Sun Fund IV’s organizing documents required that any management fee paid to its general partner or an affiliate by an underlying portfolio company be offset against the management fees payable by Sun Fund IV’s limited partners.1 The court viewed the offset as a way to “funnel management and consulting fees to Sun Fund IV’s general partner and its subsidiary,” and noted that this benefit is not of the sort normally received by passive investors. Finding the “investment plus” standard satisfied, the court held that Sun Fund IV was a “trade or business.” Sun Fund III did not contain an offset provision and the First Circuit remanded to the district court to determine whether it received any economic benefit from an offset of fees. Significantly, as part of its analysis, the First Circuit rejected the Sun Funds’ argument that the activities of the Sun Funds’ general partners and managers could not be imputed to the Sun Funds themselves.

As noted above, the court here dealt only with the first prong of the controlled group test (whether the fund is a trade or business), not the “common control” prong (whether there is 80% common ownership). On remand, the district court will determine whether the Sun Funds were under common control with Scott Brass. The acquisition was structured so that Sun Fund III and Sun Fund IV purposefully divided ownership 30%/70% to avoid either fund holding 80% ownership. The pension plan argued that this structuring should be disregarded based on a provision of ERISA that prevents transactions from being structured to “evade or avoid” Title IV liability. Both the district court and the First Circuit rejected the pension plan’s evade or avoid argument.

Given that neither Sun Fund alone owned 80% of Scott Brass, it would appear that neither should be under common control with Scott Brass. However, in the 2010 case of Board of Trustees, Sheet Metal Workers’ Local No. 292 Pension Fund v. Palladium Equity Partner, 772 F. Supp. 2d 854 (E.D. Mich. 2010) (decided on summary judgment), the Michigan district court left open the possibility that the ownership interests of multiple funds sponsored by the same private equity firm could be aggregated for purposes of the 80% test, depending on the facts and circumstances. The Palladium case was settled out of court.

Although not specifically addressed by the First Circuit, the logical extension of Sun Capital would be that, where a private equity fund is determined to be in a controlled group with a portfolio company, that portfolio company could ultimately be liable for the Title IV liability of other portfolio companies that are also in that private equity fund’s controlled group. This could have significant implications for private equity funds and their portfolio companies.

In light of this decision, private equity sponsors should be ever more diligent in considering investments in portfolio companies that sponsor significant defined benefit pension plans or contribute to multiemployer pension plans. Although the case leaves a number of open questions, there may be certain strategies for avoiding or reducing the likelihood of this result through proper fund and deal structuring.