United States: Court Rules that Private Equity Funds May Be Responsible for Portfolio Company’s Pension Liability

For the first time, a federal court of appeals has ruled that two private equity funds are "trades or businesses" that could be liable for the multiemployer pension plan withdrawal liability of one of their portfolio companies. Sun Capital Partners III LP v. New England Teamsters & Trucking Indus. Pension Fund, U.S. App. LEXIS 15190 (1st Cir. July 24, 2013). The ruling reverses a district court decision favorable to the funds and is a wake-up call for private equity funds whose portfolios include companies that contribute to multiemployer plans or sponsor single-employer pension plans with substantial unfunded benefit liabilities. This article discusses the case and key considerations for funds when investing in such companies.


Scott Brass, Inc., a portfolio company of Sun Capital Partners III, LP and Sun Capital Partners IV, LP (the Sun Funds), was a contributing employer to the New England Teamsters & Trucking Industry Pension Fund (the Teamsters Plan), a multiemployer plan. Like most multiemployer plans today, the Teamsters Plan was not fully funded, and under ERISA, as amended by the Multiemployer Pension Plan Amendments Act of 1980, an employer withdrawing from the plan is liable for the employer's share of the plan's unfunded vested benefits.

Moreover, under ERISA all trades or businesses under common control (the controlled group) are jointly and severally liable for certain pension benefit obligations of any employer in the controlled group, including multiemployer plan withdrawal liabilities, unfunded pension benefit liabilities of single-employer plans, minimum funding obligations and Pension Benefit Guaranty Corporation (PBGC) premiums. However, the term "trade or business" is not defined in ERISA or the Internal Revenue Code (Code), nor in PBGC or Treasury regulations, and has not been given a definitive, uniform definition by the United States Supreme Court.

In recent years multiemployer plans have aggressively litigated against alleged controlled-group members to recover withdrawal liability payments that the contributing employer was unable to make. In Board of Trustees, Sheet Metal Workers Nat'l Pension Fund v. Palladium Equity Partners, LLC, 722 F. Supp. 2d 854 (E.D. Mich. 2010), the district court relied on a 2007 PBGC Appeals Board decision to find that a private equity fund could be liable for unpaid withdrawal liability as a trade or business controlled-group member or alter ego of the contributing employer.

When Scott Brass withdrew from the Teamsters Plan and filed for bankruptcy, the plan demanded that the Sun Funds pay Scott Brass' $4.5 million withdrawal liability. The Sun Funds sued for a declaratory judgment that they were not responsible for the withdrawal liability because:

  • The Sun Funds were not part of a joint venture or partnership and therefore did not meet ERISA's common-control element; and
  • Neither Sun Fund was a trade or business.

The district court ruled in the Sun Funds' favor. It rejected the analysis of the 2007 PBGC decision and instead relied on two Supreme Court tax cases (Higgins v. Comm'r, 312 U.S. 212 (1941) and Whipple v. Comm'r, 373 U.S. 193 (1963)) and found the Sun Funds were not trades or businesses.

The First Circuit's Decision

On appeal, the First Circuit determined that the district court erred in applying Higgins and Whipple and followed the PBGC's analysis of the controlled-group issue. Acknowledging that its decision was "very fact-specific," the First Circuit concluded that the Sun Funds are trades or businesses based on the following factors:

  • The Sun Funds invest in portfolio companies with the principal purpose of making a profit;
  • The Sun Funds were actively involved in the management and operation of the companies in which they invest;
  • The general partners of the Sun Funds may make decisions about hiring, terminating and compensating agents and employees of the various portfolio companies;
  • The general partners receive a percentage of the total commitments to the Sun Funds and a percentage of profits as compensation;
  • The Sun Funds sought out as portfolio companies, organizations in need of extensive intervention with respect to their management and operations, to provide such intervention and then to sell the companies; and
  • The Sun Funds' controlling stake in Scott Brass placed them and their affiliate entities in a position where they were intimately involved in the management and operation of the company. This active involvement provided a direct economic benefit to at least one of the funds in the form of an offset against management fees it would have otherwise paid its general partner for management of Scott Brass, which an ordinary investor would not receive.

The First Circuit distinguished the Higgins and Whipple cases because those cases interpreted "trade or business" for purposes of determining whether the taxpayer properly deducted certain expenses and did not consider what "trade or business" meant for purposes of controlled-group withdrawal liability.

The Court of Appeals held that activities of related Sun Fund entities could be attributed to the Sun Funds because "the general partner of Sun Fund IV, in providing management services to [Scott Brass], was acting as an agent of the Fund" under Delaware partnership law and under Sun Fund partnership agreements that authorized the Sun Funds' general partners to provide management services to portfolio companies and hire, terminate and compensate agents and employees of the Sun Funds and their portfolio companies.

The 2007 PBGC decision on which the First Circuit relied applied the following two-part test to determine whether an organization was a trade or business:

  • Whether the entity was engaged in an activity with the primary purpose of income or profit; and
  • Whether the activity was conducted with continuity and regularity.

In its decision, the PBGC found that the private equity fund was a trade or business due to:

  • The size of the fund and its profits;
  • The management fees paid to the fund's general partner;
  • The advisory services provided by its agent and fees received for those services; and
  • The controlling stake the fund held in the operating company.

This "investment plus" standard was followed not only by the First Circuit in Sun Capital, but also previously by the district court in Palladium Equity Partners.

The First Circuit decided only the "trade or business" issue in the case; whether "common control" exists between the Sun Funds and Scott Brass will be determined on remand to the district court.

Key Considerations for Private Equity Funds in General

Private equity funds should note the following when considering investment in companies that sponsor defined benefit pension plans or contribute to multiemployer plans:

  • The logic of Sun Funds is not limited to multiemployer plan withdrawal liability, but applies to all controlled-group employee benefit obligations, including single-employer pension termination liability, minimum-funding obligations, PBGC premiums and potentially ERISA Section 4062(e) "downsizing" liability. Investors need to understand the extent of these potential liabilities, how these liabilities are triggered and whether expensive "mass-withdrawal" liabilities are possible.
  • Due diligence concerning potential withdrawal liability is essential when considering investment in employers contributing to a multiemployer plan. Withdrawal liability generally does not appear on an entity's books until the liability is actually triggered but employers can and should get annual estimates of their withdrawal liability. Investors and lenders should carefully evaluate potential withdrawal liability of the employer and whether a withdrawal has previously occurred for which the employer has yet to be notified of its withdrawal liability. Also, they need to understand that the sale of the employer or underperforming lines of business could result in a withdrawal from the multiemployer plan that could trigger withdrawal liability.
  • Private equity funds should carefully consider the structure of investment where an employer in the target company participates in a multiemployer plan. The First Circuit based its decision on the following factors:
    • Private placement memoranda that described the Sun Funds' involvement in the operation of portfolio companies;
    • The ability of the Sun Funds' general partners to engage in hiring, terminating and managing the portfolio company; and
    • Profits received by the Sun Funds based on fees received by non-fund entities for services provided to the portfolio companies.
  • Communications between the private equity fund entities and the portfolio company could be significant in determining whether a private equity fund is actively engaged in management of the portfolio company.
  • ERISA rules concerning common control must be clearly understood in developing structures that minimize the risk of controlled-group liability. The First Circuit refused to find that the Sun Funds' structure was a transaction designed to "evade or avoid" withdrawal liability in violation of ERISA. This part of the decision may prove useful to private equity funds.
  • The PBGC filed an amicus brief in support of the Teamsters Plan and will certainly seek to use the First Circuit's decision as authority for asserting controlled-group liability against private equity funds where portfolio companies terminate pension plans with unfunded benefit liabilities.

Sun Capital 's holding may also affect the tax qualification of retirement plans sponsored by the portfolio companies owned by a private equity fund. For example, assume that Fund F owns 80 percent or more of Portfolio Companies A, B and C, and that each of those companies sponsors a qualified retirement plan.

  • If F were a trade or business, then the employees of F (should it have any employees) and A, B and C would be treated under Code Section 414(c) for various qualified plan provisions under the Code as if they were all employed by a single employer. These provisions include the minimum coverage requirements of Code Section 410(b). Whether any plan of A, B or C satisfies Section 410(b) would therefore depend in part on how many persons were employed by all of the companies, and how many were "highly compensated" under Code Section 414(q).
  • If F were not a trade or business, then A, B and C would each test their respective plans on a stand-alone basis.

Most, if not all, private equity funds have to date not considered themselves as trades or businesses and have therefore not considered Section 414(c) applicable. Post-Sun Capital, this may have to be re-evaluated.

At some point, the Internal Revenue Service may issue guidance for testing qualified plans in light of Sun Capital, particularly if other courts of appeals reach similar results.

Special Issues for Private Equity Funds Having Significant Benefit Plan Investors

The First Circuit noted in its decision that the Sun Funds were "venture capital companies" (VCOCs) under the "plan-asset" regulation of the Department of Labor (DOL), 29 C.F.R. Section 2510.3-101. Under Section 2510.3-101(a), in general, if an ERISA benefit plan is an investor in an entity (excluding a mutual fund or a publicly-traded company, but including a private equity fund) that is at least 25 percent owned by ERISA benefit-plan investors, then:

  • The assets of the plan are considered to include both its equity interest in the entity and an undivided interest in each of the underlying assets of the entity (such as a private equity fund's portfolio companies); and
  • Any person (such as the manager of a private equity fund) who exercises authority or control as to the management or disposition of such underlying assets, and any person who provides investment advice with respect to such assets for a fee (direct or indirect), is a fiduciary under ERISA of the investing plan.

One exception to the general rule is where the entity (such as a private equity fund) is a VCOC. 29 C.F.R. Section 2510.3-101(d). Private-equity funds having investors who are ERISA benefit plans sometimes structure themselves as VCOCs in order to avoid the DOL regulation. The requirements under the regulation for an entity to be a VCOC include the following:

  • At least 50 percent of the entity's assets (other than short-term investments pending long-term commitment or distribution to investors), must be invested in venture capital investments or certain "derivative investments." A "venture capital investment" is an investment in an operating company as to which the investor has or obtains "management rights," i.e., contractual rights directly between the entity and the operating company to substantially participate in, or substantially influence the conduct of, the management of the operating company.
  • The entity must annually actually exercise management rights as to one or more of the operating companies in which it invests.

Accordingly, in order for a private equity fund benefit to retain its VCOC status, so that the managers of the fund would not be considered ERISA fiduciaries of its benefit-plan investors, the fund has to take an active role in the management of one or more of its portfolio companies. Doing so, however, makes it more likely that the fund would be considered a trade or business. Although the Sun Capital court expressly rejected the Teamsters Fund's argument that a VCOC is necessarily a trade or business, active involvement in the management and operation of Scott Brass was a significant factor in the court's determination that the Sun Funds were trades or businesses.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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