U.S. Court of Appeal Decision on Pension Plan Liability Has Significant Implications for U.S. Private Equity Funds

The U.S. Court of Appeals for the First Circuit in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund recently overturned a decision of the U.S. District Court of the District of Massachusetts by holding that at a private equity fund was engaged in a "trade or business". This decision marks the first time that a U.S. appellate court has considered the issue of whether or not a private equity fund can be held liable for pension plan deficits of portfolio companies under the Employee Retirement Income Security Act (ERISA), and is contrary to 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 or the Code.

For background information and full analysis of the District Court decision, please see our December 10, 2012 bulletin U.S. Private Equity Fund Is Not Responsible for Pension Liabilities of Portfolio Companies.

The District Court Decision

The District Court held that the two private equity funds owned by Sun Capital Advisors Inc. (Sun Fund III and Sun Fund IV—together, the Sun Funds) were not engaged in a trade or business but were merely passive investors in the portfolio company Scott Brass Inc. (SBI). The District Court highlighted that the Sun Funds had no employees, office space or products, did not report income other than investment income on their tax returns and that they each made a single investment in SBI (Sun Fund IV held a 70% ownership interest in SBI, and Sun Fund III held the remaining 30% ownership interest). The District Court further held that the activities of the Sun Funds’ general partners and managers in providing management services to SBI could not be attributed to the Sun Funds for the purpose of determining if the Sun Funds constituted a "trade or business" under ERISA.

The Court of Appeals Decision

The Court of Appeals rejected the District Court’s approach in interpreting the phrase "trade or business", ruling that interpreting the phrase in accordance with tax law precedents was not appropriate, noting that the U.S. Supreme Court has been reluctant to uniformly define the phrase "trade or business" under the Code. Instead, the Court of Appeals adopted the "investment plus" approach, in which a fund can be held to be a trade or business if it engages in activities beyond those of a passive investor. The "investment plus" approach was adopted by the Appeals Board of the Pension Benefit Guaranty Corporation in a 2007 opinion, and the Court was persuaded that a form of “investment plus” analysis is appropriate in determining if a trade or business exists. The Court did not establish criteria to define what constitutes "investment plus", noting that the determination is very fact-specific and cautioning that no single factor was dispositive.

The Court of Appeals considered the terms of the various partnership agreements, management agreements and private placement memos, and determined that the Sun Funds made the investment in SBI for the principal purpose of making a profit, and became actively involved in the day-to-day management and operation of SBI. The general partners of the Sun Funds had the authority to make decisions on employment matters such as the hiring, compensation and termination of employees. Furthermore, the Sun Funds were able to place employees of affiliate entities in two of the three board of director positions of SBI, thereby controlling the board. The Court focused on Sun Fund IV’s management fee offset provision, which is a customary feature of private equity funds. In the opinion of the Court, Sun Fund IV received a direct economic benefit from actively managing SBI to which an ordinary, passive investor would not otherwise be entitled.

The Court also rejected the Sun Funds’ argument that they did not directly take action with respect to SBI as they had no employees. Applying Delaware partnership law, the Court held that the general partners and managers were acting as agents of the Sun Funds, and their actions could be attributed to the Sun Funds themselves. The Court also noted that the limited partnership agreements for the Sun Funds gave the general partners exclusive authority to act on behalf of the funds and to provide management services to SBI.

The organizing documents of Sun Fund III did not contain an offset provision, so the Court of Appeals remanded the decision back to the District Court to determine if (i) Sun Fund III received an economic benefit from a fee offset, and therefore also qualified as a trade or business; and (ii) the 80% common control requirement for ERISA liability exists.

The Court of Appeals upheld the District Court’s ruling—though for different reasons—that the 70%/30% division of the Sun Funds’ investment in SBI did not fall under the ERISA rules against evading or avoiding liability. The Court reasoned that the purpose of the “avoid or evade” rule is to undo transactions, not to create a transaction that never existed.

Implications of the Court of Appeals Decision

The Sun Capital decision establishes that a private equity fund investor can be engaged in a trade or business and potentially be responsible for ERISA control group liabilities. If common control exists in the Sun Capital case remains to be decided. Private equity funds should structure investments in portfolio companies that contribute to multiemployer pension plans or sponsor defined benefit plans with care, including considering structuring investments through two or more independently managed funds to break the 80% ownership threshold.

The Court acknowledged that the Sun Funds were "venture capital operating companies" (VCOCs) in accordance with U.S. Department of Labor plan asset regulations. Under the plan asset regulations, if an entity such as a private equity fund has significant benefit plan investors, the benefit plan looks through the investment in the equity interest and the assets of the fund are treated as plan assets and the managers of the entity’s assets are treated as ERISA fiduciaries unless an exception applies (such as for VCOCs). In order for a private equity fund to maintain its VCOC status, the fund must exercise management rights with respect to one or more of its portfolio companies. However, as seen in Sun Capital, taking an active role in management increases the risk that the private equity fund will be considered a trade or business.

In addition to the pension liability issues, a determination that a private equity fund is engaged in a trade or business for tax purposes could have adverse consequences for the general partner, tax exempt limited partners and non-U.S. limited partners particularly with respect to the taxation of profits interests, unrelated business taxable income, and effectively connected income.

The Court of Appeals was cautious not to develop a strict test on what constitutes "investment plus", instead stating that the analysis was to be conducted based on a case-by-case basis. How the "investment plus" approach will be applied in the future remains to be seen, but the lack of a particular set of criteria creates uncertainty for private equity funds.