A recent decision of the United States District Court of the District of Massachusetts provides some much-needed clarity for private equity funds on how to structure their investments to avoid controlled-group liability. In 2007, the Appeals Board of the Pension Benefit Guaranty Corporation (PBGC) issued an opinion that a private equity fund engaged in a "trade or business" and was, together with certain of its subsidiaries, considered to be a single employer under the Employee Retirement Income Security Act (ERISA). This finding, coupled with the fact that the fund owned at least 80% of the portfolio company, meant that the fund could be held responsible for the portfolio company’s pension-related liabilities. The decision in Sun Capital Partners III, LP v. New England Teamsters and Trucking Industry Pension Fund expressly rejected the reasoning of the 2007 PBGC opinion, upholding the longstanding position that investment funds are not a trade or business and therefore not a member of their portfolio companies’ controlled group.
Under ERISA and the U.S. Internal Revenue Code (Code), each member of a controlled group (which includes a corporation’s subsidiaries, parent and other subsidiaries of the parent that are a trade or business, provided that an 80% ownership threshold is met) is jointly and severally responsible for various pension-related liabilities, including minimum funding requirements, underfunded pension liabilities, termination premiums and/or withdrawal liability under a multiemployer pension plan.
The phrase "trade or business" is not defined in ERISA, and courts must look at tax law precedents to interpret its meaning. To be engaged in a trade or business, the activity undertaken by the entity must be done with continuity and regularity, and the primary purpose for engaging in the activity must be to generate income or profit. Sporadic or one-off activities do not qualify as a trade or business.
Prior to the 2007 PBGC opinion, it was generally thought that a private equity fund was not a trade or business, and therefore could not be part of its portfolio companies’ controlled group. All the investments of a private equity fund would be in controlled groups, separate and apart from each other, and the fund would not be considered a common parent.
In its 2007 decision, the PBGC Appeals Board rejected the argument that the private equity fund was not engaged in a trade or business, instead holding that the fund was engaged in the business of selecting, acquiring, monitoring and disposing of investments. In addition, the board found that the fund had a stated purpose of creating a profit, which was supplemented by management fees, consulting fees and interest (i.e., the fund did not just receive passive investment income). Further, it found that the activity was continuous, as well as regular. Thus, according to the PBGC, the fund and its portfolio company were part of the same control group (because the fund held the requisite 80% ownership) and was therefore jointly and severally responsible for the pension liabilities of its portfolio company. This decision, while disputed by many practitioners, was cause for concern for private equity funds.
Sun Capital Decision
In Sun Capital, the New England Teamsters and Trucking Industry Pension Fund (Teamsters Fund), a multiemployer pension plan, brought a claim against two Sun Capital funds for the payment of withdrawal liability relating to the withdrawal of one of its portfolio companies when it went bankrupt. The Teamsters Fund asserted that the Sun Capital funds were part of the bankrupt company’s ERISA controlled group. The U.S. District Court for the District of Massachusetts, in granting Sun Capital’s motion for summary judgment, expressly rejected the 2007 PBGC opinion, holding that a passive investment is not sufficiently continuous or regular to be a trade or business. The Court noted that not only was the PBGC’s opinion "unpersuasive," but it conflicted with relevant tax law precedents.
The Court found that the PBGC had misapplied agency law in its 2007 decision by incorrectly attributing the activities of the general partner to the private equity fund. Income or profit earned by management fees, consulting fees and carried interest was erroneously attributed to the private equity fund; these activities were, in fact, those of the general partner. The Sun Capital funds did not have an office or employees, did not sell goods and were merely one-time passive investors in the portfolio company. Even on their tax returns, the Sun Capital funds reported only capital gains and dividends – both of which are investment income.
Sun Capital had structured its investment in a 70/30 percentage split between two different equity funds. The Teamsters Fund agreed that this split was deliberately designed to get around the 80% ownership rule and avoid ERISA liability. The Court rejected this notion, holding instead that the ERISA rules against evading or avoiding liability are meant to apply to sellers, and not meant to apply in the context of equity fund investment. A decision to invest less than 80% in a company is not a decision to evade ERISA liability.
Implications of the Decision
While the matter of private equity funds’ responsibility for controlled-group liabilities is not fully settled, the Sun Capital decision is a well-reasoned decision that we hope will be followed by other courts. The decision supports the position that a private equity fund does not engage in a trade or business and, therefore, is not part of its portfolio companies’ controlled group. Private equity funds looking to minimize risks of ERISA controlled-group liability would do well to understand and apply the lessons of the Sun Capital case, such as maintaining the legal and operational separation between the fund and the general partner, or structuring the investment through two or more funds to break the 80% ownership threshold. The Teamsters Fund has appealed the decision of the Federal District Court, so the final word may still be yet to come.
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