April 21, 2016

Sun Capital Decision Implicates Private Company Investing

A federal district court recently held that two private equity funds were liable for the pension plan withdrawal liability of one of their portfolio companies by finding that each fund was engaged in a “trade or business” and that the funds had formed a “partnership-in-fact” that was a trade or business under common control with their portfolio company. The court focused heavily on the funds’ management fee offsets and carryforwards, as well as the investigative activities carried out by the funds prior to making their investment. This may have broad implications in how private investment funds structure their investments, and funds should consider possible ways to mitigate this exposure.

On March 28, 2016, the U.S. District Court for the District of Massachusetts (the District Court) delivered a controversial opinion in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund (Sun Capital), ruling that two private equity funds were jointly and severally liable for the withdrawal liability of their bankrupt portfolio company. Under the Multiemployer Pension Plan Amendments Act, withdrawal liability is imposed not only upon the withdrawing employer, but also upon each other trade or business (whether or not incorporated) under common control with the withdrawing employer. In issuing its ruling, the District Court held that (i) each private equity fund was engaged in a “trade or business” (and not merely a passive investor) and (ii) the funds had formed a “partnership-in-fact,” which was a trade or business under “common control” with their portfolio company.


In early 2007, Sun Capital Partners III, LP (Sun Fund III) and Sun Capital Partners IV, LP (Sun Fund IV and, together with Sun Fund III, the Funds) made a $3 million investment in Scott Brass, Inc. (SBI), which investment was funded 30 percent by Sun Fund III and 70 percent by Sun Fund IV. The specific split between the Funds was partially motivated by, and the purchase price reflected a significant discount because of, a known unfunded pension liability in the multiemployer pension fund to which SBI contributed. In making their investment in SBI, the Funds had employed a common structure: they formed a new LLC, which held all the stock of a newly formed holding corporation, which in turn directly held the interests in SBI. In late 2008, SBI stopped making contributions to the pension fund and entered involuntary bankruptcy proceedings. In December 2008, SBI was given notice of the estimated withdrawal liability to the pension fund of approximately $4.5 million, and in 2010, the Funds sought a declaration that they were not jointly and severally liable for the withdrawal liability because they were (i) not a trade or business and (ii) not under common control with SBI.

Although the District Court initially ruled in 2012 that neither Fund was a trade or business, upon appeal in 2013 (as described in our August 5, 2013, client alert), the First Circuit Court of Appeals reversed that decision with regard to Sun Fund IV and remanded the case to the District Court to determine (i) whether Sun Fund III was also a trade or business, and (ii) whether the Funds were under common control with SBI for purposes of determining whether the Funds were jointly and severally liable for the withdrawal liability imposed on SBI.

In 2016, the District Court answered both questions in the affirmative and determined that the Funds are jointly and severally liable for the pro rata share of the withdrawal liability.

Trade or Business

Although the Funds argued that they were not trades or businesses because they were merely “passive” investors, under the “investment plus” standard adopted by the First Circuit and applied by the District Court, the District Court determined that the activities of, and benefits to, both Funds demonstrated sufficient “plus” to hold that each was a trade or business. In making this determination, both the First Circuit and the District Court focused heavily on the management fee offsets and carryforwards in the Funds’ arrangement with their respective general partners. SBI had entered into a management agreement with a subsidiary of each Fund’s general partner to provide management services to SBI for a fee. The Funds also owed fees to their respective general partners, but these fees were offset by any management fees paid by SBI under the management agreements, and any “excess” would be carried forward to reduce future management fees. The courts held that such fee offsets and carryforwards conveyed a valuable economic benefit to each Fund that an ordinary, passive investor would not derive.  Moreover, the courts also cited the limited partnership agreements and offering memoranda of the Funds that stated that each Fund was actively involved in the management and operation of the portfolio companies. Although the “investment plus” standard is by definition a fact-specific inquiry, the factors cited by the courts are common enough in private equity fund investments to implicate many private equity transactions.

Common Control

The relevant inquiry in Sun Capital – whether the Funds were part of a “parent-subsidiary” group with SBI for purposes of determining if they were under “common control” – turned on whether the Funds had a “controlling interest” in SBI. Under ERISA, a “controlling interest” for this purpose is defined as an 80 percent ownership stake. Because Sun Fund III’s interest in the LLC was 30 percent and Sun Fund IV’s interest in the LLC was 70 percent, neither Fund had a controlling interest in SBI unless their ownership interests were aggregated.

The District Court aggregated the Funds’ interests by finding that the Funds had formed a “partnership-in-fact” above the LLC for the purpose of making investments, including the investment in SBI, and that this partnership-in-fact was also a trade or business. The District Court made this finding in spite of the fact that the Funds had expressly formed a partnership in the form of the LLC for the purpose of investing in SBI. The District Court dismissed the Funds’ argument that their relationship was solely defined by the LLC, reasoning that the Funds’ operation of SBI was not carried out solely through the LLC. The District Court further found that the period of joint investigation and action prior to forming the LLC was indicative of that partnership-in-fact being a trade or business. Therefore, this partnership-in-fact was found to be the ultimate parent in SBI’s “controlled group,” and the withdrawal liability flowed through the partnership-in-fact to the Funds.

Implications of Sun Capital

  • Other ERISA Plan Liability. Although the Sun Capital decision was limited to multiemployer pension plan liability, and was likely motivated in part by policy considerations unique to multiemployer pension plans, the legal principles behind the Sun Capital decision may extend to other pension liability (e.g., unfunded liability under a traditional defined benefit pension plan), as well as the application of the coverage and discrimination rules applicable to 401(k) and other defined contribution plans that are dependent upon “controlled group” status.
  • Club Deals. The District Court’s finding that, notwithstanding the LLC entity that was formed by the Funds for purposes of making its investment in SBI, the Funds had formed a “partnership-in-fact” above the LLC could implicate club deals whereby unaffiliated investment funds form a syndicate to invest collectively in a portfolio company.
  • Credit Agreements. Representations and default provisions in credit agreements typically pick up liabilities arising out of multiemployer and pension plans contributed to by other members in the portfolio company’s controlled group. Applying Sun Capital in these instances could mean that withdrawal liability triggered by one portfolio company implicates the credit facilities of other portfolio companies.
  • VCOC Management Rights. Many private equity funds operate as “venture capital operating companies” (VCOCs) in order to avoid their assets being treated as “plan assets” for certain purposes of Title I of ERISA and Section 4975 of the Internal Revenue Code. One of the requirements for VCOCs is that they obtain and exercise management rights with respect to their portfolio companies. Obtaining and exercising VCOC management rights could be an additional factor relevant under the courts’ “investment plus” standard.

Private equity, venture capital and other types of private investment funds have typically derived comfort that they would not be liable for the pension liability of their portfolio companies either by relying on being passive investors (i.e., not a trade or business) and/or investing through multiple funds to avoid any one fund holding more than 80 percent of any portfolio company. However, after Sun Capital, funds will need to more carefully structure their transactions and activities, and investment funds will need to give serious consideration when investing in a portfolio company with any multiemployer pension plan liability.