First Circuit Holds Sun Capital Funds Not Liable for Portfolio Company Withdrawal Liability
On November 22, 2019, the U.S. Court of Appeals for the First Circuit (the “Circuit Court”) reversed a lower court decision and held that three private equity funds sponsored by Sun Capital Advisors, Inc. (collectively, the “Sun Capital Funds”), were not liable for the multiemployer pension plan withdrawal liability of a bankrupt portfolio company co-owned by the Sun Capital Funds. While the decision was undoubtedly a victory for the Sun Capital Funds, the fact-dependent nature of the decision leaves many areas of uncertainty going forward for private equity funds investing in portfolio companies subject to pension liabilities.
“Controlled Group” Liability
When an employer withdraws from a multiemployer pension plan, the Employee Retirement Income Security Act of 1974 (“ERISA”) requires the withdrawing employer to pay its allocable share of the plan’s unfunded pension liabilities. In addition to subjecting the employer to this so-called withdrawal liability, ERISA imposes such liability, jointly and severally, on each member of the withdrawing employer’s “controlled group,” which includes every trade or business under common control with the employer. ERISA further provides that where a transaction is engaged in with a principal purpose of evading or avoiding withdrawal liability, such liability “shall be determined and collected without regard to such transaction.”
The ERISA controlled group regulations provide that a trade or business is under common control with an employer to the extent it owns a controlling interest in the employer (or vice versa) — with a “controlling interest” generally defined as an 80% or greater ownership interest (based on total share capital or total voting power in the case of an employer classified as a corporation for federal tax purposes, and on the basis of capital or profits interests in the case of an employer classified as a partnership for federal tax purposes). Thus, for a private equity fund to be part of a portfolio company’s controlled group for withdrawal liability purposes, the fund generally would need to own 80% or more of the portfolio company and be engaged in a trade or business. Similar controlled group liability rules apply with respect to an employer’s liability for the unfunded pension obligations of a terminated single employer defined benefit pension plan.
The Sun Capital litigation traces back to the October 2008 withdrawal of Scott Brass, Inc. (“SBI”), while on the verge of bankruptcy, from the New England Teamsters and Trucking Industry Pension Fund (the “Pension Fund”). At the time of its withdrawal, SBI was 100% owned by the Sun Capital Funds — specifically, Sun Capital Partners III, LP, Sun Capital Partners III QP, LP (together with Sun Capital Partners III, LP, “SCP III”), and Sun Capital Partners IV, LP (“SCP IV”). The Sun Capital Funds’ ownership interest in SBI was held indirectly through Sun Scott Brass LLC (“SSB”) — a limited liability company in which SCP III and SCP IV held, respectively, direct 30% and 70% interests — and Scott Brass Holding Corp., a wholly owned subsidiary of SSB and the direct owner of SBI.
In December 2008, the Pension Fund demanded that SBI pay its withdrawal liability of approximately $4.5 million. After further investigation, the Pension Fund also demanded payment from the Sun Capital Funds, asserting that they had entered into a partnership or joint venture in common control with SBI and were therefore jointly and severally liable for SBI’s withdrawal liability. In June 2010, the Sun Capital Funds filed a lawsuit in the District Court for the District of Massachusetts (the “District Court”) seeking a declaratory judgment that they could not be held liable for SBI’s withdrawal liability because none of the funds was a “trade or business” under “common control” with SBI. The Pension Fund filed a counterclaim alleging that the Sun Capital Funds were jointly and severally liable for SBI’s withdrawal liability, and further alleging that the decision by the Sun Capital Funds to split their investments in SSB so that SCP III owned 30% and SCP IV owned 70% — both below the 80% controlling interest threshold — was done to “evade or avoid” withdrawal liability in violation of ERISA.
In 2012, the District Court held that (i) the Sun Capital Funds were engaged in passive investment activity and therefore were not “trades of businesses” subject to withdrawal liability and (ii) the decision by the Sun Capital Funds to invest in a 30%/70% ratio in SSB did not give rise to a transaction to “evade or avoid” withdrawal liability. The following year, on appeal, the Circuit Court reversed the District Court’s decision in part, holding that SCP IV constituted a “trade or business” for withdrawal liability purposes, while also holding that the agreement to divide ownership of SSB between SCP III and SCP IV could not serve as a basis for imposing withdrawal liability.
In ruling that SCP IV constituted a trade or business, the Circuit Court identified several factors which distinguished the Sun Capital Funds from passive investors, including statements in their organizational and offering documents explaining that the Sun Capital Funds were actively involved in the management and operations of their portfolio companies, and their ability, as holders of a controlling stake in SBI, to appoint Sun Capital personnel to director positions and otherwise participate in the management and operation of SBI. The Circuit Court also noted that the fees paid by SCP IV to its general partner were reduced by the fees paid by SBI to Sun Capital personnel for management and consulting services, thereby providing SCP IV with a direct economic benefit distinct from what an ordinary passive investor would receive. Although the Circuit Court cautioned that no single factor was dispositive, it is noteworthy that the court did not reach a determination as to whether the funds comprising SCP III were trades or business, citing its inability to determine from the record whether SCP III received an economic benefit in the form of fee offsets. The Circuit Court remanded the case to the District Court to determine both the “trade or business” issue as to SCP III, as well as the issue of whether the Sun Capital Funds were under “common control” with SBI.
In 2016, on remand, the District Court held that the funds comprising SCP III were, along with SCP IV, trades or businesses for withdrawal liability purposes, noting that these funds also benefitted from fee offsets and citing many of the same factors identified in the Circuit Court’s 2013 opinion. On the issue of common control, the District Court noted that the ownership stake of each Sun Capital Fund in SBI, when considered separately, fell below the 80% threshold necessary to establish a controlling interest. However, the District Court determined, based on the definition of “partnership” under the Internal Revenue Code and related case law, that despite being formally separate entities, the Sun Capital Funds operated as a de facto partnership in connection with their investment in SBI, and that this partnership constituted a trade or business that held a controlling interest in SBI. As part of its analysis, the District Court noted, in support of the general proposition that ownership interests can sometimes be aggregated across formally separate business entities for purposes of common control determinations, that both it and the Circuit Court had in prior opinions treated Sun Capital Partners III, LP, and Sun Capital Partners III QP, LP, as a single fund due to “their close connection and general pattern of investing together in a fixed proportion.”
Circuit Court Decision
In its most recent decision, the Circuit Court reversed the District Court, holding that the Sun Capital Funds did not form a de facto partnership and therefore were not jointly and severally liable for SBI’s withdrawal liability. In making this determination, the Circuit Court considered the same authorities as the District Court – most notably Luna v. Commissioner, a U.S. Tax Court decision setting forth various factors considered relevant to determining the existence of a de facto partnership. The Circuit Court noted that while certain factors identified in Luna supported a conclusion that the Sun Capital Funds formed a de facto partnership to assert common control over SBI, consideration of all of the Luna factors supported the opposite conclusion.
The Circuit Court identified the following factors as supporting the existence of a de facto partnership:
- the Sun Capital Funds acted collectively in seeking out investment opportunities and developing restructuring and operating plans for target companies prior to acquisition;
- each of the Sun Capital Funds was substantially controlled by the two founders of Sun Capital Advisors; and
- the Sun Capital Funds pooled their resources and expertise through Sun Capital Advisors.
In contrast, the Circuit Court identified the following factors as weighing against recognizing a de facto partnership:
- the Sun Capital Funds expressly disclaimed the existence of any partnership between the funds;
- most of the limited partners of SCP IV were not limited partners in the funds comprising SCP III;
- the Sun Capital Funds filed separate tax returns, kept separate books and maintained separate bank accounts;
- SCP III and SCP IV (unlike the two funds comprising SCP III) did not invest primarily in the same companies at a fixed or even variable ratio;
- the Sun Capital Funds formed a limited liability company — SSB — through which to acquire SBI and otherwise conduct their operations, further evidencing an intent not to establish a de facto partnership; and
- the Sun Capital Funds formally organized themselves as limited liability business organizations under state law.
It should be noted that most of the factors weighing against recognition of a de facto partnership were also identified by the District Court in its opinion. But while crediting the District Court “for its careful and reasoned analysis of the complex facts and law at hand,” the Circuit Court faulted the District Court for giving insufficient weight to these mitigating factors. Despite its determination that SCP III and SCP IV did not operate as a de facto partnership, the Circuit Court continued to treat Sun Capital Partners III, LP, and Sun Capital Partners III QP, LP, as a single fund. On this point, the Circuit Court explained that while SCP III “technically comprises two funds . . . [b]ecause these are parallel funds, share a single general partner, and invest nearly identically, we treat them as one entity . . . .”
Implications for Private Equity Funds
Although the Circuit Court’s recent decision could be seen as a victory for private equity funds, the limitation of the holding to the specific facts at issue leaves open the possibility that under other circumstances, related funds — particularly those that operate in parallel, investing exclusively or primarily in the same portfolio companies at a fixed ratio — could be treated as de facto partnerships, resulting in the aggregation of their ownership percentages for purposes of common control determinations.
In order to reduce the risk of their funds being deemed to be de facto partnerships, advisors whose funds co-invest with each other should consider the factors the Circuit Court identified as weighing against the existence of a de facto partnership (e.g., expressly disclaiming any intent to establish a de facto partnership, filing separate tax returns, maintaining separate books and accounts, and formally establishing an acquisition vehicle through which to conduct their operations).
While the latest decision may have temporarily muted the impact of the Circuit Court’s 2013 opinion, the significance of the 2013 ruling that SCP IV constituted a trade or business should not be discounted. In the First Circuit, private equity funds continue to be at risk of being characterized as trades or business for withdrawal liability purposes.
The Circuit Court’s decision also may prove persuasive to courts outside the First Circuit. Another private equity fund sponsor, Trilantic Capital Partners, is currently involved in ongoing litigation in New York and Illinois (under the jurisdiction of the Second and Seventh Circuits, respectively) where the key question at issue is whether a single private equity fund is liable for certain single employer and multiemployer pension liabilities of its portfolio company.
Operators of private equity funds should assume that if a fund has an 80% or greater ownership stake in a portfolio company, there is a risk that the fund (and possibly other portfolio companies in which the fund has an 80% or greater interest) could be liable for any pension liabilities of the portfolio company. A fund’s activities and fee arrangements should be carefully analyzed to identify factors that could support a finding that the fund is actively involved in the management of a portfolio company. Furthermore, parallel funds that are controlled by the same individuals and predominantly invest in lockstep should assume their ownership interests in portfolio companies will be aggregated for purposes of common control determinations. To the extent investors have been avoiding private equity funds that may invest in portfolio companies with substantial pension liabilities, we believe the Circuit Court’s decision provides a possible road map for mitigating pension liability risk.
We will continue to monitor any future developments in the area. Please let us know if you have any questions or would like to discuss application of this recent decision or any other matter.
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This article is for general information purposes only. It is not intended as legal advice, and you should not consider it as such.
 29 U.S.C. § 1392(c).
 Sun Capital Partners III v. New England Teamsters & Trucking Indus. Pension Fund, 172 F. Supp. 3d 447, 461 (D. Mass. 2016), rev’d in part, 943 F.3d 49 (1st. Cir. 2019).
 42 T.C. 1067 (1964) (“Luna”).
 The factors identified by the U.S. Tax Court in the Luna decision included:
- the agreement of the parties and their conduct in executing its terms;
- the contributions the respective parties have made to the venture;
- the parties’ control over income and capital and the right of each to make withdrawals;
- whether the parties shared a mutual proprietary interest in net profits and an obligation to share in losses;
- whether one party was the agent or employee of the other;
- whether business was conducted in the joint names of the parties;
- whether the parties filed Federal partnership returns or otherwise represented to persons with whom they dealt that they were joint venturers;
- whether separate books of account were maintained for the venture; and
- whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.
 Sun Capital Partners III, 943 F.3d at 60.
 Id. at 52 n.1.