Two Private Equity Funds Saddled With Pension Liability of Bankrupt Portfolio Company

 
On March 28, 2016, a Massachusetts District Court ruled that two affiliated private equity funds (Sun Capital Partners Fund III, LP and Sun Capital Partners Fund IV, LP) were jointly and severally liable for the unfunded vested benefits owed to a multiemployer pension fund by its bankrupt portfolio company, Scott Brass, Inc. In 2013, the First Circuit ruled that a private equity fund can be a “trade or business” for purposes of ERISA, which struck a blow at the private equity industry’s first line of defense to avoiding pension plan withdrawal liability. Now, on remand, the District Court ruled that the two funds cannot avoid ERISA pension liability, even though the two funds split ownership of a company 70%/30% (that is, with neither fund owning the threshold 80% required by the ERISA statute). The court found that the economic reality was that the Sun Capital Funds together formed a partnership-in-fact that owned 100% of the portfolio company and thus are liable for the entire ERISA pension liability.1
1.     The bankrupt portfolio company Scott Brass Inc. was owned by an intermediate holding corporation (formed by the Sun Capital Funds) which was in turn was owned by a limited liability holding company Sun Scott Brass, LLC (formed by the Sun Capital Funds) which in turn was owned 30% by Sun Capital Fund III and 70% by Sun Capital Fund IV.
ERISA’s Two-Pronged Test for Pension Plan Withdrawal Liability:
Two key questions drive the court’s determination of whether a private equity fund will be saddled with the ERISA pension liability of a bankrupt portfolio company: (1) whether the fund is engaged in a “trade or business”; and (2) whether the fund is under “common control” with or has a “controlling interest” of at least 80% in the portfolio company.
1. “Trade or Business”
The First Circuit determined that Sun Capital Fund IV and the District Court held that Sun Capital Fund III, like many traditional private equity funds, were involved in a “trade or business” because the funds were not simply passive investors. Rather, the funds satisfied the First Circuit’s nebulous “investment-plus” standard based on the following facts:

  • The general partners of the two Sun Capital Funds are Sun Capital Advisors III and Sun Capital Advisors IV, and those general partners are each controlled by Sun Capital’s two senior managing principals.
  • Sun Capital’s senior managing principals are also the co-CEOs of Sun Capital Advisors, Inc., which advises Sun Capital Fund III and Sun Capital Fund IV, structures their deals, and provides management consulting and employees to the portfolio companies owned by the Sun Capital Funds.
  • The Sun Capital Funds’ limited partnership agreements and private placement memos explain that the Funds are actively involved in the management and operation of the companies in which they invest.
  • The Sun Capital Funds’ limited partnership agreements give the general partner of each Sun Capital Fund exclusive and wide-ranging management authority.
  • The Sun Capital Funds were able to place employees of Sun Capital Advisors in two of the three director positions at the bankrupt portfolio company, resulting in Sun Capital Advisors employees controlling the bankrupt portfolio company’s board and effectively controlling the management and operation of the portfolio company.
  • Under the Sun Capital Funds’ limited partnership agreements, the applicable general partner is required to make a capital commitment to the Fund, and the Fund is required to pay an annual management fee to the general partner based on a percentage of the Fund’s aggregate commitments or invested capital. The general partner may offset its capital commitment by the amount of any annual management fee that it otherwise agrees to waive.
  • The Sun Capital Funds’ limited partnership agreements also provide for a reduction to the annual management fee payable to the general partner – any fees earned by Sun Capital Advisors and its affiliates and principals from portfolio companies would offset the management fee.
  • When no management fees are owed or the amount of management fee offsets is greater than the management fees owed to the general partner for any period, such fee offset is “carried forward” and can be used to offset future management fees owed by the Sun Capital Funds to their general partners.
  • There was a direct economic benefit to the Sun Capital Funds that an ordinary, passive investor would not derive: an offset or carryforward against the management fees the Funds otherwise would have paid their general partners for managing the investment in the bankrupt portfolio company. In fact, the portfolio company made payments of more than $664,000 to SCP Management IV (an affiliate of the general partners), 30% of which was allocated to Sun Capital Fund III and 70% of which was allocated to Sun Capital Fund IV (based on their pro rata investment amounts). As a result, Sun Capital Fund III was able to obtain the benefit of a management fee offset and Sun Capital Fund IV was able to obtain the benefit of a management fee carryforward.
2. Controlled By or Under Common Control at 80% Level
The District Court determined that Sun Capital Fund III and Sun Capital Fund IV acted like a “joint venture” whose collective stakes exceeded the 80% ERISA liability threshold2 sufficient to demonstrate a controlling interest of the bankrupt portfolio company because:

  • The Supreme Court previously determined for tax purposes that a “partnership” is not limited only to those entities that identify themselves formally as partnerships, but instead can include any persons that join together for the purpose of carrying on business and sharing in the profits.
  • Sun Capital Fund III (which consists of two parallel funds that invest together in the same proportion in each of their investments) and Sun Capital Fund IV, while formally independent entities whose investor groups do not completely overlap, ultimately made their investment and business decisions under the direction of Sun Capital Advisors’ senior managing principals.
  • While the Sun Capital Funds’ co-investment agreements disclaimed any intent to form a partnership or joint venture and contained no obligation for the Funds to act in concert, their limited partnership agreements are almost identical and the Funds are operated similarly.
  • While the Sun Capital Funds prepare and file separate partnership tax returns, maintain separate financial statements and bank accounts, provide separate reports to their partners and have largely non-overlapping sets of limited partners and largely non-overlapping portfolios of companies in which they have invested, the Funds engaged in joint activity to pursue the investment in the portfolio company and to create a limited liability holding company solely for the purpose of making the joint investment in the portfolio company.
  • During the few years before and after their joint investment in the portfolio company, the Sun Capital Partner Funds co-invested in five other portfolio companies, using the same organizational structure, but did not provide any evidence of making joint investments with other outside investors.
  • There was no evidence of disagreement between Sun Capital Fund III and Sun Capital Fund IV over how to operate the limited liability holding company, as might be expected from independent members actively managing a business.

Most telling, the court noted: “Notably, the Funds made a conscious decision to split their ownership stake 70/30 for reasons that demonstrate the existence of a partnership. The Funds assert three motivations for this split: [(1)]that Sun [Capital] Fund III was nearing the end of its investment cycle while Sun [Capital] Fund IV was earlier in its own cycle, [(2)] a preference for income diversification, and [(3)] a desire to keep each Fund below 80 percent ownership to avoid withdrawal liability. With the exception of income diversification, which two truly independent entities could also pursue in parallel but on their own, these goals are instinct with coordination and show joint action. . . [T]hese goals stem from top-down decisions to allocate responsibilities jointly. Entities set up with rolling and overlapping lifecycles and coordination during periods of transition offer advantages to the Sun [Capital] Funds group as a whole, not just to each Fund. And the choice to organize Sun Scott Brass, LLC, so as to permit each of the Sun [Capital] Funds coinvesting to remain under 80 percent ownership, is likewise a choice that shows an identity of interest and unity of decision-making between the Funds rather than independence and mere incidental contractual coordination. A separate entity which is perhaps best described as a partnership-in-fact chose to establish this ownership structure and did so to benefit the plaintiff Sun [Capital] Funds jointly.”

2.     For partnerships and LLCs, a controlling interest is ownership of at least 80% of the profits interest or capital interest of the entity. For corporations, a controlling interest is ownership of at least 80% of the total combined voting power or total value of shares of all classes of stock.
Key Takeaways:
Although this case almost certainly will be appealed, there are several takeaways to consider while we await further guidance:

  • The first test for ERISA liability – the “trade or business” test based on the investment-plus standard – will most likely apply to a private equity fund if the fund is formed as a limited partnership, if the fund’s general partner has its own capital commitment to the fund, if the general partner is owed a management fee that can be offset by portfolio company fees received in connection with its investments (either currently or as a carryforward against future periods), and if the private equity fund derives economic benefits from portfolio company investments more than an ordinary, passive investor.
    • Other, non-traditional investment vehicles (such as those formed by “fundless” or “independent” sponsors) where the person or entity driving the investment decision derives economic benefits from portfolio company investments more than an ordinary, passive investor may similarly be considered a “trade or business” for purposes of ERISA liability. The more these non-traditional vehicles look and operate like private equity funds as a result of their active management of the portfolio company, the ability to earn a management fee, and the ability to obtain other benefits above and beyond return on its equity investment, the greater is the risk of tripping the “trade or business” prong of the test.
  • The second test for ERISA liability – the 80% common control test – cannot be avoided simply by having two or more affiliated private equity funds structure their ownership in an investment vehicle such that no individual fund’s ownership exceeds 80%.
    • Private equity funds that share a general partner or have an agreement or history of investing together in a fixed proportion will likely meet this second prong if their ownership in a portfolio company exceeds 80% in the aggregate (as is typical with “parallel funds”).
    • Private equity funds with different general partners and independent investment portfolios may nonetheless be deemed to be acting under “common control” when the investment decisions of those funds are formally or informally made by the same group or substantially the same group of senior fund managers (as is typical with a fund and its “successor” fund that share in investment opportunities while the first fund’s investment period is still active).
    • Investors who have a “partnership-in-fact” (which is a very fact-intensive analysis) that each own individually less than 80% of a portfolio company, but collectively own more than 80% of such portfolio company, will likely meet the second-prong of the test. While courts will review the written agreements between or among the investors to find evidence of whether the investors have a partnership to act jointly, courts will also review the history of the parties’ actions inside and outside of the particular company investment to determine if the investors have a pattern of taking coordinated actions, acting jointly or otherwise synchronizing themselves smoothly for the benefit of the investor group.
    • Note that shares held by employees, which are typically subject to vesting or rights of first refusal, are not considered outstanding for purposes of the common control analysis. Therefore, if an operating company is owned 70% by a trade or business and 30% by management whose shares are subject to substantial restrictions, the trade or business will be deemed to own 100% of the operating company.
  • Structuring an acquisition in a manner such that unaffiliated third-party investors (with no history of coordination with the private equity fund sponsor) hold greater than 20% of a portfolio company, where the third-party investors have the ability to make their own independent decisions with respect to that investment, should allow the private equity fund sponsor (and the unaffiliated third party) to avoid ERISA liability. This may provide a significant opportunity for private equity funds or other investors who are willing to make minority investments in portfolio companies alongside a private equity fund sponsor. Fund sponsors should also consider whether the co-investors should participate directly in the portfolio company rather than through an aggregator special-purpose vehicle that is sponsor-managed.
Any private equity fund, independent sponsor or other investor that has questions about ERISA withdrawal liability or structuring an upcoming transaction in light of the risks set forth in this update should contact Michael Falk (mfalk@winston.com or (312) 558-7232), Eva Davis (evadavis@winston.com or (213) 615-1719), Brad Mandel (bmandel@winston.com or (312) 558-7218) or any member of your Winston deal team.
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