March 31, 2016
On March 28, 2016, in a much-anticipated ruling in the Sun Capital case, the U.S. District Court for the District of Massachusetts held on remand that two private equity funds had formed a “partnership-in-fact” and were engaged in a “trade or business” and, accordingly, were jointly and severally liable for multiemployer pension plan “withdrawal liability” obligations of one of their portfolio companies. The court apparently reached this result by treating two private equity funds as if they were a single “partnership” even though the two funds had separate investors and separate lifecycles and did not always invest in the same portfolio companies.
As discussed in more detail in our prior Client Alert, the Sun Capital case was remanded from the First Circuit to the district court in July, 2013. The First Circuit held that a private equity fund (“Fund IV”) was engaged in a trade or business for purposes of the controlled group liability provisions of the Employee Retirement Income Security Act of 1974 (“ERISA”) and, as such, would be jointly and severally liable for the unfunded pension obligations of one of its portfolio companies, Scott Brass, Inc. (“SBI”), if it were found to be part of the same “controlled group” as SBI under the relevant ERISA provisions. Under ERISA, entities that are engaged in a “trade or business” are part of the same controlled group if they are under common control. Common control generally exists where the entities are at least 80%-related by ownership.
Although the case was an ERISA case (and was specifically limited to ERISA by the First Circuit), it caught the attention of the tax community because of its analysis of whether a private equity fund was engaged in a trade or business – even though only for ERISA purposes. In holding that Fund IV was engaged in a trade or business under ERISA, the First Circuit adopted an “investment plus” standard and emphasized (i) the active involvement by Fund IV and/or its affiliates in the management and operation of its portfolio companies and (ii) the receipt by Fund IV of an “economic benefit” beyond that which an ordinary, passive investor would receive due to the fact that management fees owed by Fund IV to its general partner were to be reduced by management fees paid by SBI to the general partner.
Ultimately, the First Circuit remanded the case to the district court to determine: (i) whether another private equity fund managed by Sun Capital (“Fund III,” and together with Fund IV, the “Funds”) was engaged in a “trade or business” for purposes of the ERISA controlled group liability provisions (given that the First Circuit was unable to determine whether Fund III had received an economic benefit in the form of an offset of management fees otherwise owed to its general partner) and (ii) whether the Funds and SBI were part of the same “controlled group” for purposes of the ERISA controlled group liability provisions.
Trade or Business. The district court found that Fund III received a reduction in management fees as a result of management fees paid by SBI to Fund III’s general partner, and, therefore, consistent with the First Circuit Court’s “investment plus” standard, the district court found that Fund III was engaged in a trade or business for purposes of the controlled group liability provisions of ERISA.
Common Control. In general terms, because each of the Funds was found to be engaged in a “trade or business,” either Fund would be a member of the same controlled group as SBI if it was 80%-affiliated with SBI.
Since Fund III owned 30%, and Fund IV owned 70%, of a limited liability company (the “LLC”) that indirectly owned 100% of SBI, neither fund was 80%-affiliated with SBI. Thus, according to the district court, “absent some mechanism by which the ownership interests of [the Funds] would be aggregated,” the unfunded pension obligations of SBI would not extend to the Funds. The district court found, however, that such a mechanism existed. Although not altogether clear, it appears that the district court relied on general federal income tax principles to find that Fund III and Fund IV formed a “partnership-in-fact sitting atop the LLC.” Factors the district court relied on to reach such a finding included, among others, (i) the Funds being closely affiliated entities and part of a “larger ecosystem” of Sun Capital entities created and directed by two individuals (who each retained substantial control over both Funds), (ii) the Funds having co-invested in five other companies using the same organizational structure (and the joint activity that took place in order for the two funds to decide to co-invest), and (iii) certain other factors illustrating that the Funds had an “identity of interest and unity of decision making.” In its analysis, the district court acknowledged that the two funds filed separate partnership tax returns, had separate financial statements and bank accounts, were not parallel funds and had largely non-overlapping sets of limited partners and portfolio companies in which they had invested, and had expressly disclaimed an intent to form a partnership or joint venture in the operating agreement of the LLC. Moreover, the district court did not explain how treating the Funds as having formed a partnership-in-fact supported its conclusion. That is, the Funds actually had formed the LLC, and it is not apparent how treating a partnership-in-fact as owning all of the interests in the LLC would support the district court’s ultimate holding.
Irrespective of its precise reasoning, the district court held that the Funds were jointly and severally liable for SBI’s unfunded pension obligations. We expect this holding to be appealed to the First Circuit for review.
From an ERISA perspective, this case is extremely troubling for private equity funds. Before the First Circuit’s 2013 Sun Capital decision, most funds were comfortable that they were not engaged in a “trade or business,” so that the first prong of the controlled group test would not be satisfied. The 2013 Sun Capital decision, as well as a few additional cases decided since 2013, have made that position more difficult to support.
In Sun Capital, however, Fund III and Fund IV had different investors, and neither Fund owned 80% of SBI. For these reasons, the consensus has been that Sun Capital should prevail under the common control prong of the controlled group test. If the First Circuit upholds the district court’s decision, multiemployer pension funds may well be emboldened to seek to collect withdrawal liability from private equity funds, particularly where the private equity funds are managed by the same sponsor and those funds own in the aggregate 80% or more of the applicable portfolio company. The controlled group rules applicable to multiemployer plan withdrawal liability also apply to single employer plan terminations with the Pension Benefit Guaranty Corporation (the “PBGC”), so that risk also will apply to liability to the PBGC. Going forward, private equity sponsors that acquire portfolio companies with multiemployer pension plan obligations or that sponsor single-employer defined benefit pension plans need to take this risk into account and may want to seek outside investors so that the aggregate investments by the sponsor’s funds fall below the 80% threshold.
From an income tax standpoint, our prior Client Alert on Sun Capital noted that the court’s trade or business analysis presented potentially troubling issues, including, for example, a possible impact on the determination of whether a foreign person is engaged in a U.S. trade or business. The recent district court decision does nothing to assuage that concern. We continue to believe that the “investment plus” analysis ought not to apply to generally treat private equity funds as engaged in a trade or business.
The district court’s use of federal income tax principles to reach its conclusion regarding the “partnership-in-fact” conclusion is equally, if not more, troubling. The IRS or a state taxing authority may view the district court’s decision as an opportunity to treat two or more separate partnerships as a single partnership. Although tax practitioners have recognized the possibility that parallel funds and alternative investment vehicles could be treated as forming a “partnership-in-fact” with the main fund (or be “collapsed” into the main fund) and often have taken steps to mitigate this risk, such as those taken by Sun Capital, the risk of “partnership-in-fact” has been viewed as modest. The sweeping language and somewhat opaque reasoning of the Sun Capital decision – if imported into the tax law – could have far reaching implications for investment funds that form parallel funds or alternative investment vehicles to address a range of business and tax sensitivities (including sensitivity to certain types of income, such as effectively connected income and unrelated business taxable income). Notwithstanding this potential, we do not believe such a result is likely. While we will continue to watch the Sun Capital cases, we do not believe that they have application outside of ERISA. Our private equity and other clients should feel free to reach out to the members of our tax department to discuss any concerns they have regarding the implications of this decision.
 Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, No. 10-10921-DPW (D. Mass. Mar. 28, 2016).
 Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, 724 F.3d 129 (1st Cir. 2013), cert. denied, 134 S. Ct. 1492 (2014).
 There actually were two funds in the Fund III family that invested in parallel. Both Sun Capital and the New England Teamsters and Trucking Industry Pension Fund (the “Pension Fund”) treated them as if they were a single fund, and we do the same here.
 Notably, the district court also found that the “partnership-in-fact” (discussed under the heading “Common Control”) was also engaged in a trade or business despite the fact that it received no similar “direct economic benefit.”
 29 C.F.R. § 4001.3(a); Treas. Reg. § 1.414(c)-2(b).
 The district court, similar to the First Circuit Court, specifically noted that it considered the two parallel funds compromising Fund III as one fund for purposes of the opinion and therefore appears to have implicitly aggregated the two vehicles for purposes of the controlled group analysis.
 Multiemployer plans may then try to expand the “partnership-in-fact” analysis of Sun Capital to cover this scenario as well, but we believe that would stretch even the district court’s expansive analysis beyond the breaking point. There are some other arguments that multiemployer plans could make under ERISA (e.g., under ERISA’s “evade or avoid” rule applicable to withdrawal liability), but those should be unavailing when bona fide outside investors are involved.
 The district court’s decision appears to be results-oriented and fails to address a number of factors in favor of not finding a “partnership-in-fact.”
The following Gibson Dunn lawyers assisted in preparing this client alert: Michael Collins, Sean Feller, Eric Sloan, Benjamin Rippeon, Paul Issler, David Rosenauer, Jeffrey Trinklein, Romina Weiss, Lorna Wilson and Mary Kwon.
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For further information or to discuss any concerns you may have regarding the implications of this decision, please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the lawyers listed below:
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