Private Equity Funds Liable for Withdrawal Liability of Portfolio Company

What you need to know:

On March 28, 2016, the US District Court for the District of Massachusetts held, on remand from the First Circuit, that two related private equity funds were jointly and severally liable for multiemployer pension plan "withdrawal liability" obligations of one of their portfolio companies. In reaching this conclusion, the court determined that the funds were under “common control” with the portfolio company because the funds had formed a "partnership-in-fact" and were engaged in a "trade or business.”

What you need to do:

Fund sponsors should review existing and potential portfolio company investments where a portfolio company sponsors a single-employer defined benefit pension plan, or contributes to a multiemployer pension plan for unionized employees, with heightened scrutiny and discuss the risks associated with such investments and strategies for limiting potential liability with their advisors.

Background

As discussed in more detail in our prior Choate Alert, in Sun Capital Partners III, LP v. New England Teamsters and Trucking Industry Pension Fund the US Court of Appeals for the First Circuit became the first federal appellate court to consider whether a private equity fund can be liable under ERISA for the withdrawal liability incurred by a portfolio company. In that case, two private equity funds, Sun Capital Partners III, LP (“Fund III”) and Sun Capital Partners IV, LP (“Fund IV”), indirectly owned 30% and 70%, respectively, of Scott Brass, Inc. (“Scott Brass”).

The First Circuit determined that the general partner of Fund IV was sufficiently involved in the management of Scott Brass to make the fund a “trade or business” for purposes of Title IV of ERISA. The First Circuit avoided creating a bright-line test to determine whether a private equity fund is a trade or business for purposes of ERISA and instead created a facts-and-circumstances-based “investment plus” test that focused on the fund’s structure and operation, including the flow of management fees.

The First Circuit left several related questions for the District Court to decide, including whether Fund III was a trade or business and whether either or both of the funds were under “common control” with Scott Brass. When trades or businesses (whether or not incorporated) are under common control, the employees of all of these entities are treated as employed by a single employer and the related entities are jointly and severally liable for withdrawal liability.

Prior to this case, there was general consensus among funds and their advisors that private equity funds were not "trades or businesses" and so could not be under common control with their portfolio companies, regardless of the percentage of the portfolio company owned by the fund. As a result, funds generally believed that they were shielded from any withdrawal liability to which their portfolio companies might become subject.

Summary of the Case on Remand

The District Court, applying the First Circuit’s “investment plus” test, found that Fund III was a trade or business because management fees it paid to its general partner were offset by management fees paid by Scott Brass. Since both Fund III and Fund IV were found to be engaged in a "trade or business," the court moved on to the question of whether the Funds were under common control with Scott Brass.

In general, common control requires 80%+ ownership of one entity by another. Since Fund III owned 30%, and Fund IV owned 70%, of a limited liability company that indirectly owned 100% of Scott Brass, neither fund owned, directly or indirectly, 80% or more of Scott Brass. As a result, neither fund appeared to be under common control with Scott Brass.

The District Court, however, relying on general federal income tax principles, looked past the funds’ investment in the topco LLC in which both funds had invested and found that Fund III and Fund IV had formed a “partnership-in-fact" above the LLC. In coming to this conclusion, the District Court focused on several factors, including: (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."

The District Court reached this conclusion despite the fact that the two funds had different general partners, filed separate partnership tax returns, had separate financial statements and bank accounts, were not parallel funds, had largely non-overlapping sets of limited partners, had expressly disclaimed an intent to form a partnership or joint venture in the operating agreement of the LLC and, other than their five co-investments, had largely non-overlapping sets of portfolio companies.

The District Court went on to find that this partnership-in-fact was a trade or business that was under common control with Scott Brass and was liable for Scott Brass’s withdrawal liability. The Funds, as partners in the partnership-in-fact, were jointly and severally liable for Scott Brass’s withdrawal liability. This holding is likely to be appealed to the First Circuit for review.

Implications

After the District Court’s decision, private equity funds now need to assume that they may be liable not only for the multiemployer pension plan withdrawal liability of 80%-plus owned portfolio companies, but also for withdrawal liability of portfolio companies in which the aggregate ownership of the fund and another fund managed by the same sponsor reaches the 80% threshold.

The District Court’s decision creates new precedent in Massachusetts which may be followed by courts in other jurisdictions. While the decision applies on its face only to multiemployer pension plan withdrawal liability, courts could, at the urging of the PBGC, extend the ruling to impose liability on funds for single-employer defined benefit pension plans that are underfunded at termination or to secure enhanced contributions when the portfolio company sponsoring the plan has a reduction of its workforce, as is permitted under ERISA.

The court’s decision does not directly address whether control group status can be avoided by direct co-investment of a fund’s limited partners or through club deals with other private equity funds, or whether these investors would themselves be viewed as partners of a “partnership-in-fact” with the private equity fund that leads the investment.

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 these risks into account. If two or more related funds that are subject to the “partnership-in-fact” analysis together control other portfolio companies that do not themselves contribute to multiemployer pension plans, then those other portfolio companies must assess not only the risk of imposition of withdrawal liability but must also determine how to handle the representations, covenants and default provisions of their own credit agreements.

While the decision does not directly implicate tax law, it may give rise to arguments by some that the nondiscrimination testing rules for tax-qualified retirement plans, the Affordable Care Act coverage and reporting obligations for group health plans, the liability for COBRA compliance, and the Section 409A rules for nonqualified deferred compensation plans should be applied in a manner that treats the plans of portfolio companies as if they were sponsored by a single employer.