On March 28, 2016, the United States District Court for the District of Massachusetts (the “District Court”) held that two private equity funds were jointly and severally liable for multi-employer pension plan withdrawal liability incurred by one of their jointly-owned portfolio companies despite the fact that neither fund owned more than 80 per cent of the portfolio company.
Sun Capital Partners III, LP v. New Eng. Teamsters & Trucking Indus. Pension Fund, 2016 WL 1239918 (D.Mass. 2016) (Sun Capital II) The District Court ruled that the two private equity funds were engaged in a trade or business and had formed a “partnership-in-fact” that was a trade or business under common control with the portfolio company. As such, the two funds, as partners of the partnership, are jointly and severally liable for such liability.
Under the Employee Retirement Income Security Act of 1974, as amended (ERISA), withdrawal liability can be imposed on the withdrawing employer and all of the “trades or businesses” that are under “common control” with the withdrawing employer. In general, ERISA provides that a parent is under common control with its subsidiary if the parent owns at least 80 per cent of the subsidiary.
Scott Brass, Inc. (SBI), the portfolio company in the instant case, incurred $4.5 million in withdrawal liability when it went bankrupt and ceased contributions to the New England Teamsters and Trucking Industry Pension Fund (the Pension Fund). At such time, SBI was owned by Scott Brass Holding Corp., which was owned by Sun Scott Brass, LLC (the LLC). Sun Capital Partners III, LP (Fund III) owned 30 per cent of the LLC, and Sun Capital Partners IV, LP (Fund IV, and together with Fund III, the Funds) owned the other 70 per cent of the LLC. The Pension Fund asserted that Fund III and Fund IV were jointly and severally liable for the withdrawal liability because they were engaged in a trade or business under common control with SBI.
In 2013, the U.S. Court of Appeals for the First Circuit held that Fund IV was engaged in a trade or business, but remanded to the District Court the determination of whether Fund III was also engaged in a trade or business, and whether the 70 per cent ownership of Fund IV and the 30 per cent ownership of Fund III could be aggregated to meet the 80 per cent controlled group test. Sun Capital Partners III, LP v. New Eng. Teamsters & Trucking Indus. Pension Fund, 724 F.3d 129 (1st Cir. 2013) (Sun Capital I).
Sun Capital II
Trade or Business
The District Court first held that both Fund III and Fund IV were engaged in a trade or business under the First Circuit’s “investment plus” standard from Sun Capital I, which provides that a private equity fund can be considered to be engaged in a trade or business if, when combined with an otherwise passive investment in a portfolio company, it engages in certain other activities with respect to such portfolio company, focusing in particular on both funds’ receipt of benefits related to their active management of SBI. Among other things, to support its finding that Fund III had received such economic benefits, the District Court found that the management fee payable by Fund III was reduced as a result of fees paid by SBI to the general partner of Fund III (through a management fee offset mechanism). The Court of Appeals had previously found that Fund IV was engaged in a trade or business based on a similar management fee offset resulting from the payment of fees by SBI to the general partner of Fund IV.
While neither Fund III nor Fund IV owned more than 80 per cent of SBI, and despite the fact that both funds were organizationally separate and had different limited partners, the District Court found that Fund III and Fund IV had formed a “partnership-in-fact” under federal law. The District Court found that the following details indicated the existence of a partnership:
- the Funds created the LLC in order to invest in SBI;
- the Funds also co-invested in five other companies, using the same organizational structure;
- the Funds split their ownership in the LLC 70/30 for reasons related to the Funds’ investment cycles, a preference for income diversification and a desire to keep each fund below 80 per cent ownership to avoid withdrawal liability, of which the District Court determined only income diversification is a goal that two independent entities could pursue on their own; and
- there was no evidence of independence in their co-investments (no evidence that they sometimes co-invested with other entities, or that there was ever any disagreement between the Funds regarding operation of the LLC).
In aggregating the ownership of Fund III and Fund IV, the District Court did not distinguish between parallel funds (which are designed to invest on a proportionate, side-by-side basis in the same portfolio) and successor funds, such as Fund III and Fund IV (which are designed to create different portfolios but typically co-invest in no more than a limited number of investments).
Trade or Business under Common Control with SBI
Finally, the District Court held that the de facto partnership formed by the Funds, which put the Funds in common control with SBI, was engaged in a trade or business under the First Circuit’s “investment plus” standard for the same reasons as the Funds (i.e., its purpose was to make a profit and it was involved in the active management of portfolio companies). As such, the District Court found that the Funds are jointly and severally liable for the withdrawal liability incurred by SBI.
The District Court’s decision in Sun Capital II is significant to private equity firms and investors, and firms should give careful consideration to the structure and operation of their funds and investments where portfolio companies have multi-employer pension or defined benefit liabilities. Where a fund (and any of its related funds) will own 80 per cent or more of a portfolio company, a private equity firm should apply more extensive due diligence in examining the pension liabilities of target companies and negotiate appropriate representations and indemnities. Where exposure to such liabilities is material, firms will need to consider bringing in unrelated co-investors to own 21 per cent or more of the portfolio company. In addition, given the emphasis of the courts in Sun Capital I and Sun Capital II on the receipt of fees from portfolio companies and the resulting management fee offset, firms will need to consider whether to modify such arrangements, as well as how to increase the separation of their funds and portfolio management.