A recent court decision provides some food for thought as to the calculus of investing in a portfolio company with multiemployer pension plan exposure. The decision is not the last word on this topic, but it is a worrying precedent.
Yesterday, the U.S. Court of Appeals for the First Circuit ruled that two private equity funds that held a combined 100% stake in a portfolio company that withdrew from a multiemployer pension plan can be held liable for the company’s withdrawal liability. (Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, 1st Cir., No. 12-2312, 7/24/13.)
The First Circuit panel found that at least one of the private equity funds qualified as a “trade or business” under ERISA for purposes of assessing withdrawal liability. The decision focused on the profit-seeking motives of the private equity funds, the degree of control they exercised over the withdrawing employer, and the extent to which they received economic benefits greater than that which could be expected from a passive investment. The First Circuit panel also afforded limited deference to a 2007 opinion letter promulgated by the Pension Benefit Guaranty (PBGC) Corporation and presented by the PBGC in an amicus brief filed with the court.
This decision reverses much of the U.S. District Court’s decision in the case (Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, 903 F. Supp. 2d 107, D. Mass. 2012) that did not find the private equity funds to be “trades or businesses.”
Why is this decision a big deal?
Under ERISA, a “trade or business” under common control with a withdrawing employer is jointly and severally liable for that employer’s withdrawal liability to a multiemployer pension plan. An employer’s withdrawal liability may be substantial; in recent years, many employers’ contingent withdrawal liability has increased exponentially due to adverse interest rates, pension fund demographics, and poor pension fund investment performance. Prior to the Sun Capital decision, the commonly held view was that a private equity fund was merely a passive investor in a portfolio company and could not be a “trade or business.”
“Investment Plus” Test Used by the First Circuit
In Sun Capital, the private equity funds took the commonly held view and argued that they merely had a passive investment in the portfolio company, and, thus, were not a “trade or business” with regard to that investment. The First Circuit found that some form of an investment “plus” approach is appropriate when evaluating whether a private equity fund or similar investor is a trade or business requirement.
Taking a fact-specific approach to the trade or business analysis, the First Circuit said that the private equity funds invested in the portfolio company with the principal purpose of making a profit. The First Circuit also found that the private equity funds undertook activities as to the portfolio company and became actively involved in the management and operation of the company. The general partners of the funds had authority to make decisions about hiring, terminating, and compensating the portfolio company’s agents and employees. Looking at the private equity funds’ internal operating documents, the First Circuit noted that the funds’ stated purpose was 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. As a result, the funds became intimately involved in managing their portfolio companies, the First Circuit found. The active involvement in the portfolio company’s management provided “a direct economic benefit…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 [the portfolio company].” Taken together, these factors met the “plus” requirement as to one of the private equity funds.
The First Circuit remanded the case to the District Court for further analysis as the status of one of the two private equity funds as a “trade or business” and whether the funds were in common control with the portfolio company.
Attention to Acquisition and Fund Structuring Required
In light of the Sun Capital decision, increased attention to potential investments in companies with multiemployer pension plan obligations (and thus, potential withdrawal liability exposure) is necessary – both as to the ownership interest (a less than 80% ownership stake may suffice to insulate a private equity fund from withdrawal liability exposure) and as to the structuring of the private equity fund (internal fund documents, private placement memoranda, agreements with affiliated limited and general partner entities, etc.