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Private Equity and Withdrawal Liability: Lessons from Sun Capital

February 25, 2020Alerts

It is not uncommon for private equity funds to reconsider the desirability of a prospect when they learn that the company contributes to an underfunded multiemployer defined benefit pension fund. But because of the hesitation or outright disinterest by some private equity investors, others see opportunity and value.

A recent decision from the First Circuit Court of Appeals in Sun Capital Partners III, LP v. New England Teamsters and Trucking Industry Pension Fund provided some helpful guidance on the legal framework for when private equity, as an investors in a contributing employer to a multiemployer defined benefit pension fund, may be held liable when the employer triggers a withdrawal and is assessed withdrawal liability.

Background on Withdrawal Liability

Under ERISA, as amended by the Multiemployer Pension Plan Amendments Act of 1980, an employer that exits, or ceases to contribute to, a multiemployer defined benefit pension plan may be liable for their allocable share of the plan’s unfunded vested benefits. “All trades or businesses” under “common control” are treated as a single employer and are jointly and severally for the liability incurred by any of the trades or businesses. The controlled group rules set forth in Section 414 of the Internal Revenue Code, and regulations thereunder, are relied upon in analyzing controlled group relationships.

The controlled group rules are complex, but, in general, if there is either individual or aggregated ownership of at least 80%, common control exists.

Scott Brass, Inc.

Scott Brass, Inc. (SBI) was a contributing employer to the New England Teamsters and Trucking Industry Pension Fund (Fund). Suffering from a decline in prices of raw materials, SBI declared bankruptcy, and as a result triggered a withdrawal from the Fund.

SBI was owned by a holding company; the holding company was owned by 2 private equity funds: Sun Capital Partners III, LP (Fund III) owned 30%, and Sun Capital Partners IV, LP (Fund IV) (together the Sun Funds) owed 70%. The private equity firm Sun Capital Advisors, Inc. sponsored and managed the Sun Funds.

The Fund alleged that the Sun Funds constituted a trade or business under common control and were therefore liable for SBI’s withdrawal liability.

Litigation

In litigation that has spanned more than 11 years with several appeals, there were several salient rulings:

First, is the adoption of what has become known as the “investment plus” test. Under this test, a passive investment, when taken together with additional activities – the “plus” – can give rise to an investor engaging in a “trade or business.” The “plus” test is a fact-sensitive analysis that looks to individual circumstances.

In Sun Capital, the “plus” was established because the Sun Funds received a benefit from the management of SBI beyond what a mere passive investor would receive: the Sun Funds received a management fee for activities undertaken in connection with management services performed for SBI.

Second, “organizational formalisms” can be disregarded and ownership interests can be aggregated to determine whether the collective actions support a finding that a “partnership-in-fact” has been formed. Tabulating the mere numerical ownership interests in Fund III (30%) and Fund IV (70%) a controlled group relationship did not exist because neither owned 80% of SBI.

However a “partnership-in-fact” can be found if tax law partnership factors set forth in a 1964 tax court decision, Luna v. Commissioner, are satisfied, and if the “true intent” of the investors was to coordinate their actions with an “identity of interest” and “unity of decision-making.”

In a highly-fact sensitive analysis the First Circuit applied the Luna multi-factor test and found that, on the balance, a “partnership-in-fact” did not exist.

The First Circuit found compelling that the Sun Funds limited partnership agreements expressly disclaimed any partnership relationship with the other; the creation of a limited liability company, limiting their ability to exercise mutual control and assume responsibilities, undercut the claim that there was an intent to form a partnership; each filed separate tax returns; each maintained separate financial records and bank accounts; they did not invest in the same portfolio companies in parallel to one another at fixed or variable ratios, evidencing “independence in activity and structure;” and the limited partners in the Sun Funds differed.

Takeaways for Private Equity

While the First Circuit’s holding was clearly a fact-intensive analysis and narrow finding, there are several key takeaways for private equity investors to consider when structuring investments. Careful attention must be paid to investment management arrangements with the “investment plus” test in mind. Additionally, when a transaction utilizes investments from multiple funds, their relationships must be closely analyzed to evaluate possible formation of a “partnership-in-fact.”