On July 24, 2013, the US Court of Appeals for the First Circuit determined that a private equity fund, which operated and managed the 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 of its portfolio company. (Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund, Case No. 12-2312, 2013 US App. LEXIS 15190 [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 Act 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 court adopted the investment-plus test that measures the degree of involvement in the management and operations of the portfolio company and the economic benefit over and above the pure investment. On this basis, the court disregarded the corporate entities and held the fund liable as employer for the pension shortfall. The ruling is a reminder that funds must be on the alert for this potential liability (and possibly other pension liabilities) in both structuring their investments and managing their portfolio companies.

The appellees in the case—private equity funds Sun Capital Partners III, L.P., Sun Capital Partners III QP, LP1 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 and its involvement in 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 holding company for Scott Brass for 100 percent of the membership interests, in which investment was split 70 percent/30 percent between the Sun Capital III and IV funds, respectively. The split between the funds was admittedly calculated to minimize the chances of incurring withdrawal liability by falling below the 80 percent parent-subsidiary common control threshold under ERISA and related US Treasury Department regulations. Each of the general partners of Sun Funds has both a committee that makes the investment decisions for the fund and, significantly, a management company. These management companies contracted with the holding company that owned the acquired company, Scott Brass, to provide management services for a fee, and contracted with Sun Capital Advisors Inc., an umbrella fund, to provide the employees and consultants to Scott Brass. When Scott Brass paid fees to the management company, the Sun Funds received an offset to the fees owed to the general partner. The question for the court was whether the Sun Funds qualified as a "trade or business" for purposes of control group liability given this structure and/or the way it operated in the Scott Brass acquisition.

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), which examines whether:

  1. The primary purpose of the activity is income or profit; and
  2. The activity is performed with regularity and continuity.

The purpose of the Sun Funds is 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 US 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 a passive investment.

The First Circuit noted that numerous individuals affiliated with the Sun Funds and their affiliates exerted substantial operational and managerial control over Scott Brass. Several factors satisfied the court's investment-plus test for what constitutes a business or trade, including the stated intent of the Sun Funds in the creation of the enterprise, the informational memos to potential investors that explained the Sun Funds' involvement in the management and operation of the companies in which they invested, the pre-acquisition restructuring and operation plans, the service agreements and fees, and the funds' involvement in management decisions and operations. Moreover, the Sun Funds' active involvement in management under the agreements provided a direct economic benefit to the Sun Funds that an ordinary, passive investor would not derive—an offset against the management fees it otherwise would have paid its general partner for managing the investment in Scott Brass.

Although the Sun Funds purposely structured their investment in Scott Brass to avoid possible withdrawal liability, the First Circuit did not impose liability on the Sun Funds on that theory because the Sun Funds did not meet the ownership test for control group liability. Therefore, for the moment, it would appear that structuring an investment so as to avoid 80 percent ownership of a portfolio company by any single entity will continue to afford sufficient protection from withdrawal liability on the grounds that the investment was structured to avoid it. However, the decision highlights that factors beyond percentage ownership will be considered in determining withdrawal liability. This calls for a fact-intensive inquiry in each case with respect to control and involvement in the affairs of a portfolio company to minimize the risk of incurring control group liability as an employer.2

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, demographic changes and increased employer withdrawals, 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.