Reversing the most important holding in a closely watched district court decision, the First Circuit held last week that a private equity fund is a “trade or business” and may be financially responsible for the withdrawal liability that one of its portfolio companies incurred when it ceased contributing to a multiemployer pension plan. Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund, 2013 U.S. App. LEXIS 15190 (1st Cir., July 24, 2013). The court endorsed the position of the Pension Benefit Guaranty Corporation, embodied in a 2007 administrative decision, that a “trade or business” (a term used frequently in the Internal Revenue Code but nowhere defined) can arise from an investment for profit plus some additional factors indicating that the investment is not merely passive. The court saw “no need to set forth general guidelines for what the ‘plus’ is”; taking “a very fact-specific approach”, it concluded – by what might be called a “we know it when we see it” test – that one of the funds involved in the litigation was a “trade or business”, while the record was insufficient to decide about the other.

If characterized as a “trade or business”, a private equity fund is jointly and severally liable for the withdrawal liability of any portfolio company in which it has an 80% or greater ownership interest. The district court had held that the Sun Capital funds were not “trades or businesses”, so it did not consider whether they met the ownership test. At least on the surface, it seems unlikely that they did, since the withdrawn employer was owned by two funds that split ownership 70/30, but the plan has not yet had the opportunity to present its argument in full. The issue will be resolved on remand.

Ironically, the expanded definition of “trade or business” is unlikely to have much more than a nugatory impact on private equity funds, which can readily structure their acquisitions to avoid forming controlled groups with their portfolio companies. There could, however, be consequences for the owners of closely held corporations. Much of the First Circuit’s analysis, if carried just a bit further, could lead to the conclusion that working for and drawing a salary from a company that one owns meets the “investment-plus” threshold. Earlier cases, some of them relied on by the First Circuit, have already undermined the wall between personal and corporate assets in the multiemployer plan context. Sun Capital Partners continues that trend.

The case was a sequel to a private equity failure. In early 2007, two Sun Capital private equity funds, Sun Capital Partners III and Sun Capital Partners IV, bought all of the stock of Scott Brass, Inc., the former taking 30% of the stock, the latter 70%. The venture was not a success. By the end of 2008, Scott Brass was in bankruptcy proceedings, and the New England Teamsters plan, to which it had been a contributing employer, was looking for some solvent pocket from which to extract withdrawal liability. It sent demands for payment to the Sun Capital funds, which reacted by bringing a declaratory judgment action to establish that they had no liability for this Scott Brass obligation.

The district court, in concluding that the funds were not trades or businesses and therefore could not be members of a controlled group, attached considerable weight to their structure and their precise relationship to other Sun Capital entities. Sun Capital Partners III and IV are organized as limited partnerships, each with one general partner. Sun Capital Advisors, Inc. finds investors and potential deals for the funds but has no ownership interest in them. The two entrepreneurs who own Sun Capital Advisors have about a 60% profits interest in the funds’ general partners, along with full management control of the funds. Finally, each general partner owns a subsidiary that provides management services to portfolio companies.

The district court saw the funds as no more than investors. They had no employees and did nothing except buy stock, vote it for directors favored by their general partners, collect dividends and look forward to capital gains after the company was turned around and sold for a profit (an unrealized hope in this instance). Those were all activities of an investor rather than a manager. It was true that subsidiaries of the general partners had management contracts with Scott Brass, but the court declined to attribute those activities to the funds.

The First Circuit focused on a different set of facts. In bare outline, it regarded the following as indicative of a trade or business, without explicitly assigning decisive weight to any one factor:

  1. “The Sun Funds’ limited partnership agreements and private placement memos explain that the Funds are actively involved in the management and operation of the companies in which
  2. “[T]he general partners [of the Sun Funds] are empowered through their own partnership agreements to make decisions about hiring, terminating, and compensating agents and employees of the Sun Funds and their portfolio companies.”
  3. “It is the purpose of the Sun Funds to seek out 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. . . . Involvement can encompass even small details, including signing of all checks for its new portfolio companies and the holding of frequent meetings with senior staff to discuss operations, competition, new products and personnel.”
  4. “[T]he Sun Funds' controlling stake in [Scott Brass] placed them and their affiliated entities in a position where they were intimately involved in the management and operation of the company. . . . Through a series of appointments, the Sun Funds were able to place [Sun Capital Advisors] employees in two of the three director positions at [Scott Brass], resulting in [Sun Capital Advisors]I employees controlling the [Scott Brass] board.”
  5. “Through a series of service agreements [with the funds’ general partners] . . . , [Sun Capital Advisors] provided personnel to [Scott Brass] for management and consulting services. Thereafter, individuals from those entities were immersed in details involving the management and operation of [Scott Brass].”
  6. “Moreover, the Sun Funds’ active involvement in management under the agreements provided a direct economic benefit to at least Sun Fund IV that an ordinary, passive investor would not derive: an offset against the management fees it otherwise would have paid its general partner” (because management fees paid by Scott Brass to the general partner’s management subsidiary were credited toward the general partner’s compensation from the fund).

The appellate court was unimpressed by what the district court had regarded as crucial: that all of the management activities were carried out by Sun Capital Advisors pursuant to agreements between Scott Brass and subsidiaries of the funds’ general partners. All of those activities could, in the First Circuit’s view, be attributed to the funds on the theory that the general partners were acting as the funds’ agents. In essence, the court ignored the formal boundaries of the Sun Capital entities and treated them as a single enterprise.

The court was likewise unswayed by the argument, suggested by Supreme Court decisions (particularly Higgins v. Commissioner, 312 U.S. 212 (1941) and Whipple v. Commissioner, 373 U.S. 193 (1963)), that activities aimed at generating dividends and capital gains are “distinctive to the process of investing and [are] generated by the successful operation of the corporation’s business as distinguished from the trade or business of the taxpayer himself”. Whipple at 202. The First Circuit responded,

The Sun Funds say that, because they earned no income other than dividends and capital gains, they are not “trades or businesses.” But the Sun Funds did not simply devote time and energy to SBI, “without more.” Rather, they were able to funnel management and consulting fees to Sun Fund IV’s general partner and its subsidiary. Most significantly, Sun Fund IV received a direct economic benefit in the form of offsets against the fees it would otherwise have paid its general partner.

It should be noted, though, that the “economic benefit” is questionable. The payment of management fees by Scott Brass reduced pro tanto the value of the fund’s investment in the company, thus negating the smaller fee owed to the general partner. Nonetheless, the court regarded this putative benefit as extraordinarily significant. In fact, it remanded, rather than reversed, the decision concerning Sun Capital Partners III, because the record didn’t show whether that fund had the same fee offset arrangement as its sibling.

The other aspect of the case was more straightforward. In putting together the Scott Brass acquisition, the Sun Capital funds knew that they were buying a troubled company that could wind up with a large liability to the New England Teamsters plan. That was the admitted reason why one fund purchased 30% of the stock and the other 70%. Thus neither met the 80% threshold for forming a controlled group with Scott Brass.

The plan apparently has theories – not yet well enough developed to comment on – under which the funds would be treated as a single 100% owner. Before getting to those, it offered one that was rejected by both the district and the appellate courts. ERISA, §4212(c) provides:

Transactions to Evade or Avoid Liability. – If a principal purpose of any transaction is to evade or avoid liability under this part, this part shall be applied (and liability shall be determined and collected) without regard to such transaction.

The plan argued (and the funds did not seriously deny) that a principal purpose of the 70/30 ownership split was to avoid potential future withdrawal liability. The way to apply the withdrawal liability rules “without regard to such transaction” was, the plan continued, to pretend that one of the funds had been the sole purchaser. The district court rejected that idea, because it did not believe that a stock purchase was a transaction that could, by its nature, evade or avoid withdrawal liability. The appellate court took a different path to the same conclusion: If the actual transaction were disregarded, the court would have no authority to replace it “with a transaction that never occurred”.

The language of [section 4212(c)] instructs courts to apply withdrawal liability “without regard” to any transaction the principal purpose of which is to evade or avoid such liability. . . . The instruction requires courts to put the parties in the same situation as if the offending transaction never occurred; that is, to erase that transaction. It does not, by contrast, instruct or permit a court to take the affirmative step of writing in new terms to a transaction or to create a transaction that never existed. In order for the [plan] to succeed, we would have to (improperly) do the latter because simply doing the former would not give the [plan] any relief, but would only sever any ties between the Sun Funds and [Scott Brass].

What is worrisome about the court’s analysis is the ease with which, with a little imagination, it could be applied to an individual who owns one or several companies, participates actively in their management, and draws a salary for his services. Could he not be characterized as being in the same “trade or business” as Sun Capital? In many ways, his situation is simpler: He controls elections to the board of directors, is “intimately involved in the management and operation of the company” and receives economic benefits, in the form of salary, in addition to the prospect of dividends and capital gains. Is the fact that private equity funds are big and proclaim to the world that their objective is to improve the management of acquired companies a sufficient distinction to protect the personal assets of thousands of small businessmen from withdrawal liability claims?

Sun Capital Partners is one of several recent cases making it easier for multiemployer plans to expand the list of parties responsible for paying withdrawal liability. The First Circuit took particular note of two Seventh Circuit decisions holding that individuals who owned rental properties were engaged in a trade or business: Central States Southeast and Southwest Areas Pension Fund v. Messina Products, LLC, 706 F.3d 874 (7th Cir., Feb. 8, 2013) and Central States Southeast and Southwest Areas Pension Fund v. SCOFBP, LLC, 668 F.3d 873 (7th Cir., 2011), cert. denied, 132 S. Ct. 2688 (2012). Since the rental “businesses” were unincorporated, their owners faced unlimited personal liability to the plans from which their wholly owned corporations had withdrawn.

The movement away from keeping owners’ investment portfolios safe from withdrawal liability is bound to be troubling to small businessmen. It also may not redound strongly to the benefit of multiemployer plans. Certainly, there can be few stronger deterrents to signing up for a plan, or incentives to withdraw at time when it is relatively well funded, than the risk that everything one owns could someday be seized to cover the plan’s unfunded benefits.