On July 24, 2013, the First Circuit U.S. Court of Appeals (the “Circuit Court”) reversed a prior District Court ruling that found two related private equity funds were not conducting a “trade or business” that would make them liable for the obligations owed to a multi-employer pension plan, in which one of their jointly-owned portfolio companies was a participant. To understand the potential impact of this case, it is important to remember that Title IV of ERISA provides that “trades or businesses” that are members of a “controlled group of corporations” under common control are jointly and severally liable under ERISA for certain types of liabilities owed by the other members of their controlled group. The applicable case involved withdrawal liability owed to a multi-employer pension plan. However, the case could also have implications for liabilities related to single employer defined benefit pension plans and COBRA obligations.
The Sun Capital case
The First Circuit issued its ruling in Sun Capital Partners III v. New England Teamsters & Trucking Industries Pension Fund. The case related to Scott Brass, Inc., a company that was owned by two separate, but related, private equity funds. The funds were both limited partnerships established and managed by the same general partner.
The case relates to obligations owed to a multi-employer pension trust incurred when one of the private equity funds’ jointly-owned investments, Scott Brass, Inc. went out of business and ceased participating in the pension trust. Scott Brass had been making contributions to the pension trust on behalf of its union employees. When it ceased doing business, the pension plan determined that it had incurred a complete withdrawal from the multi-employer pension plan and was liable for its pro-rata portion of the pension trust’s unfunded liability at such time. Scott Brass's liability, referred to as “withdrawal liability”, is jointly and severally owed by Scott Brass, and by any other “trade or business” (whether or not incorporated) which is under common control with Scott Brass.
Like many private equity firms, the ownership and management structure surrounding the funds is quite complicated. The two private equity funds that made the actual investment in Scott Brass were established as limited partnerships and had no officers or employees and did not manufacture or sell any products or services. The funds simply made the investment into Scot Brass as passive investors. However, the general partners of the two funds indirectly operated a management company that received a management fee from the private equity funds and was vested with the responsibility of managing the investments of the funds and providing certain managerial and governance roles for the funds and the portfolio companies owned by the funds.
The key issue considered by the court was whether the funds, through their related entities, were simply mere passive investors in Scott Brass, or whether, as a result of the management roles directly and indirectly played by the general partners, were conducting a “trade or business” that resulted in the funds being part of Scott Brass’ controlled group of corporations under ERISA. The District Court had previously relied on the fact that the funds merely invested in Scott Brass and did not have employees or provide management or other services to the company. However, the Circuit Court looked through the funds to the role and activities of the general partner of the funds. In doing so, the Circuit Court reversed the District Court ruling and found that the fund holding the majority of the investment in Scott Brass (and possibly the minority fund as well) was a “trade or business” for these purposes.
For purposes of making this determination, the Circuit Court elected to use a form of an “investment plus” test previously utilized by the Seventh Circuit in another case. The Circuit Court found that simply investing to make a profit is not enough to be treated as a “trade or business”. More involvement is needed according to the reasoning of the Circuit Court. In this case, the Circuit Court looked at a number of factors including the activities taken by the related parties of the general partners of the funds and the private placement memos used by the general partners to raise capital for the funds. The memos specifically discussed that a “principal purpose” of the partnership is the “manag[ement] and supervisi[on]” of its investments. In addition, the Court looked at the relationships provided by the general partners and their related affiliates and relied on the fact that the general partners were empowered through their own partnership agreements to make decisions about hiring, terminating, and compensating agents and employees of the funds and of the fund’s portfolio companies. In addition, the Circuit Court found that the funds received a direct benefit from management fees paid by Scott Brass to the general partner and its affiliates.
The Circuit Court found that the combination of the above factors satisfied the “plus” requirement of the “investment plus” test. The Circuit Court also found that the general partners, in directly and indirectly providing management services to and receiving management fees from Scott Brass, were acting as agents of the funds. Based upon the totality of the relationships, the court determined that the fund owning a majority of the investment in Scott Brass was a “trade or business” jointly and severally liable for the obligation owed to the multi-employer pension plan. In addition, the court remanded the case back to the District Court to review, among other things, certain factors to determine whether the minority investor fund also met that standard.
Actions taken in an attempt to avoid or evade liability under ERISA
As a side issue, Section 4212(c) of ERISA instructs courts to apply withdrawal liability determinations “without regard” to any transaction, the principal purpose of which is to “evade or avoid” such liability. The court found that the intention of the ERISA "evade or avoid" provision is to put the parties back to the status quo prior to the action taken to avoid the controlled group treatment.
In this case, after an initial letter of intent was entered into between the seller of Scott Brass and one of the private equity funds, the transaction was changed to have the purchase made by both of the funds. The pension trust claimed that the intention behind splitting the investment between the two funds was to avoid either fund meeting the 80 percent ownership test normally used to determine whether companies are under common control. The pension trust argued that this intention was enough to allow the court to disregard the split under ERISA.
The Circuit Court determined that ERISA Section 4212(c) does not provide a court with the power to force something to occur that never occurred. In other words, the provision may have allowed a court to disregard the sale of ownership by one of the funds to the other fund in an attempt to reduce its ownership level. However, in this case, neither of the funds owned any of Scott Brass prior to the investment. Even if a court could find that the funds purposefully designed their investments to keep them both below the 80 percent level, disregarding the event would not put either of the funds above the 80 percent ownership level. In making this determination, the Circuit Court relied on the fact that the initial letter of intent to purchase Scott Brass, which was entered into by only one of the funds, was not a binding letter of intent. It is not clear whether the Circuit Court may have concluded differently had the initial letter of intent been a binding commitment to purchase Scott Brass by one of the private equity funds.
What does the Sun Capital case mean for private equity firms?
The holding in Sun Capital potentially would appear to place a greater burden on private equity firms and their portfolio investments for withdrawal liability owed to multi-employer pension plans operating in the jurisdiction of the First Circuit (Maine, Massachusetts, New Hampshire, Puerto Rico, and Rhode Island). In addition, the ruling, assuming it is not appealed or reversed, could have similar repercussions for other controlled groups- type liabilities under ERISA; such as unfunded defined benefit plans and COBRA obligations. Whether other Circuit Courts decide to proceed in this direction remains to be seen. The District Court case that was overruled by the First Circuit Court of Appeals appeared to provide a roadmap for how to structure funds in order to avoid this treatment. Unfortunately, by reversing the District Court ruling, the Circuit Court determined that the structure of the private equity funds in this case did not avoid this treatment.
If this case stands and other jurisdictions follow its lead, this could potentially have a chilling impact on the strategic options for distressed companies with these types of liabilities.
Private equity funds that have invested in, or are considering investing in companies with underfunded single or multi-employer defined benefit pension plan obligations, should do some planning before making any binding commitment that could eventually result in them inheriting such liability. Furthermore, if the Circuit Court’s analysis regarding the use of the “avoid or evade” provisions of ERISA is expanded, this could make it more difficult for private equity firms that are already invested in such companies to make changes to their ownership or management structure to reduce or avoid future liabilities.
Structural issues surrounding private equity firms and these ERISA issues are complicated. We suggest that you consult with knowledgeable attorneys and advisors to help you consider how the Sun Capital ruling may impact your particular situation. For more information, please contact:
John M. Wirtshafter
David A. Agay
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