[Editor’s Note: The following post is authored by Arnold & Porter LLP]
In a decision with significant implications for private equity funds and their investors, the First Circuit Court of Appeals held in Sun Capital that a Sun Capital Advisors private equity fund was a “trade or business” for purposes of ERISA’s Title IV controlled group rules. Under the court’s rationale, private equity funds would be exposed to joint and several liability for unpaid pension liabilities under Title IV of ERISA that apply on a controlled group basis where a sufficient ownership link exists between the fund and the portfolio company. Moreover, the rationale would expose one portfolio company to another portfolio company’s controlled group liabilities where sufficient common ownership is present.
ERISA Controlled Group Liability
Under Title IV of ERISA, all members of a controlled group are jointly and severally liable for ERISA Title IV liabilities that are imposed on a controlled group basis, including defined benefit plan termination liability, multiemployer plan withdrawal liability, and PBGC premiums. In order for an entity that is a partnership, such as a private equity fund, to be a member of a controlled group, the partnership must (i) be a “trade or business,” and (ii) be under “common control” with one or more other entities. In general, “common control” is present if there is an 80% or more ownership link (direct or indirect) between entities. Although in many cases private equity funds are under common control with some or all of their portfolio companies, they have historically taken the position that they are not “trades or businesses” based on case law developed under the Internal Revenue Code with respect to what constitutes a “trade or business.”
The Sun Capital Decision In Sun Capital, a multiemployer pension plan sought to collect from two Sun Capital private equity funds withdrawal liability incurred by a bankrupt portfolio company that was 70%-owned by one of the funds and 30%-owned by the other. Relying principally on case law establishing what constitutes a “trade or business” for Internal Revenue Code purposes, the district court in Sun Capital ruled that neither of the funds were trades or businesses and therefore were not liable for the portfolio company’s withdrawal liability. The First Circuit reversed the district court, applying a facts and circumstances analysis to find that the activities of one of the funds were sufficient to give rise to a trade or business. In reaching its conclusion, the court pointed to a number of factors, including the following:
- The fund invested “in portfolio companies with the principal purposes of making a profit.”
- Statements in the fund’s private placement memorandum and partnership agreement to the effect that the fund would be “actively involved in the management and operation” of its portfolio companies.
- The power of the fund’s general partner to “make decisions about hiring, terminating, and compensating agents and employees of the Sun Funds and their portfolio companies.”
- The appointment by the Sun Capital funds of two out of the three members of the bankrupt portfolio company’s board of directors.
- The provision of management and consulting services to the bankrupt portfolio company by an affiliate of Sun Capital.
- The offsetting of fees payable by the fund to its general partner by fees paid directly to the fund’s general partner by the bankrupt portfolio company.
Significantly, the First Circuit rejected the fund’s argument that management activities engaged in by the fund’s separate management entity should not be taken into account. Rather, the First Circuit concluded that the management entity was acting as the fund’s agent such that its activities should be attributed to the fund.
Although the First Circuit ruled on the trade or business status of one of the funds, it remanded the case to the district court to determine whether the second fund was a trade or business and whether either of the funds were under “common control” with the bankrupt portfolio company. For the private equity fund industry, whether the 70%-30% ownership split between the two funds prevents either of the funds from being treated as being under “common control” with the portfolio company is a key issue to watch on remand.
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