On July 24, 2013, the First Circuit held in Sun Capital Partners III LP v. New England Teamsters & Trucking Indus. Pension Fund that a private equity fund can be jointly and severally liable in certain circumstances for pension liabilities incurred by its portfolio companies. This troubling decision, which reversed the district court but is in accord with an earlier district court decision and a ruling by the Pension Benefit Guaranty Corporation ("PBGC") Appeals Board, highlights the need for private equity funds to carefully structure their portfolio company investments.
Under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), if an employer "withdraws" from a multiemployer pension plan, it is liable for "withdrawal liability," which generally represents its proportionate share of the plan's unfunded vested benefits. For example, a complete withdrawal occurs if the employer permanently ceases to have an obligation to contribute to the plan.
In addition to the employer itself, all members of its "controlled group" are jointly and severally liable for the withdrawal liability. The controlled group of the employer generally includes (i) any corporations that are 80% or more related to the employer on a parent-subsidiary or brother-sister basis and (ii) any other entities that are both "trades or businesses" and are 80% or more related to the employer.
Similar rules apply to liabilities incurred when a single-employer pension plan is terminated by the employer in a "distress" termination or by the PBGC in an "involuntary" termination. Such terminations typically occur in connection with the bankruptcy of the employer. In the event of such a termination, the employer/plan sponsor and its controlled group members are jointly and severally liable to the PBGC for the plan underfunding, which is determined using very conservative PBGC-imposed actuarial assumptions.
Sun Capital Facts and Court Decisions
Sun Capital Fund III owned 30% and Sun Capital Fund IV 70% of the equity of Scott Brass, Inc. Pursuant to a collective bargaining agreement, Scott Brass contributed to the New England Teamsters and Trucking Industry Pension Fund. In connection with its bankruptcy, Scott Brass completely withdrew from this pension plan in 2008, and the plan assessed withdrawal liability in excess of $4.5 million.
Scott Brass had insufficient assets to satisfy its withdrawal liability. The pension plan then asserted that the two Sun Capital Funds were members of the Scott Brass controlled group and, as such, were jointly and severally liable for the withdrawal liability. In response, the Funds filed a declaratory judgment action arguing that, among other things, they were not "trades or businesses" and, thus, could not be part of the Scott Brass controlled group. The district court agreed, finding in favor of the Sun Capital Funds. The court held that the private equity funds were passive investors, and therefore were not trades or businesses for purposes of the controlled group rules.
In a case of first impression at the appellate court level, the First Circuit reversed the district court. It adopted what it described as an "investment plus" test for determining whether an entity is a trade or businesses. Under this test, merely making investments in portfolio companies for the principal purpose of making a profit would not be sufficient to cause a private equity fund to be treated as a trade or business. Rather, additional factors must be present that distinguish the fund from a mere passive investor. In finding that Sun Capital Fund IV was a trade or business, the court emphasized the following factors:
the Fund's partnership agreement and private placement memorandum contained statements to the effect that the Fund would be actively involved in the management and operation of the portfolio companies in which it invested;
the Fund's general partner was granted broad authority under the partnership agreement to participate in the management of the portfolio companies, including the authority to make decisions about hiring, terminating and compensating agents and employees of the portfolio companies;
the Fund's controlling stake in Scott Brass placed it and its affiliates in a position where it was able to participate in the management and operation of the company to a degree well beyond that of a passive investor; and
the Fund received a direct economic benefit from its involvement in the management of Scott Brass that a passive investor would not receive because management fees Scott Brass paid to the Fund's general partner offset the management fees the Fund was required to pay to the general partner.
The court remanded to the district court the determination of whether Sun Capital Fund III was a trade or business, because there were some distinguishing facts. In addition, it must be noted that the First Circuit only decided the "trade or business" issue. It did not address whether either Fund was 80%-affiliated with Scott Brass. Given that it was a 70/30 ownership split, it is unclear how either Fund could meet this threshold unless the Funds' interests are aggregated. As a general rule, the ERISA controlled group rules would not provide for such aggregation if the Funds have different investors, but the district court will need to make a determination based on the particular facts. A possible key fact will be if the Funds usually invest together; if so, the court will need to determine whether that makes them a single entity for controlled group purposes. However, we do not believe that ERISA's language would support that interpretation of the controlled group rules.
Historically, many practitioners and private equity funds have taken the position that private equity funds are not trades or businesses for tax and ERISA purposes. However, largely in response to their declining financial positions, multiemployer pension plans and the PBGC have become more aggressive in pursuing third parties in order to maximize their potential recoveries. They are likely to become even more aggressive as a result of the First Circuit's Sun Capital decision.
Private equity investors need to carefully structure their investments in portfolio companies and should consider structuring investments so that no individual fund owns 80% or more of any portfolio company with potential pension-related exposure. Investors should also consider limiting interactions with their portfolio companies as much as possible in order to be "passive" investors, although this will be more difficult for funds structured to qualify as "venture capital operating companies" and "real estate operating companies" to avoid ERISA plan asset status. In addition, investors must engage in careful diligence and be aware of pension-related exposures when making an investment, while managing portfolio companies, and in connection with any restructuring, reorganization or bankruptcy transaction.
In addition, the decision could have broad-ranging consequences if the court's reasoning were adopted in determining the income tax consequences of a private equity fund's activities. As one example, foreign investors could be treated as engaged in a U.S. trade or business, causing U.S. tax payment and filing obligations. We recommend that our clients consider steps to minimize the income tax risks associated with a broader interpretation of this case.
Gibson, Dunn & Crutcher's lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, or any of the following:
ERISA/Labor and Employment:
William J. Kilberg P.C. - Washington, D.C. (202-955-8573, firstname.lastname@example.org)
Scott A. Kruse - Los Angeles (213-229-7970, email@example.com)
Michael J. Collins - Washington, D.C. (202-887-3551, firstname.lastname@example.org)
Stephen W. Fackler - Palo Alto, CA (650-849-5385, email@example.com)
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Sean P. Griffiths - New York (212-351-3872, firstname.lastname@example.org)
Steven R. Shoemate - New York (212-351-3879, email@example.com)
Ari Lanin - Los Angeles (310-552-8581, firstname.lastname@example.org)
Business Restructuring and Reorganization:
Craig H. Millet - Orange County (949-451-3986, email@example.com)
Michael A. Rosenthal - New York (212-351-3969, firstname.lastname@example.org)
David M. Feldman - New York (212-351-2366, email@example.com)
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