A March 2016 decision by the U.S. District Court in Massachusetts in Sun Capital Partners III, LP, et al v. New England Teamsters and Trucking Industry Pension Plan (“Sun Capital”) said that a private equity fund that engages in activities beyond passive investment may be part of a controlled group that is liable for withdrawal liability of its portfolio company.
Although the story is not over, there are cautionary lessons that should not be ignored.
In this case, Sun Capital Advisors provided services to three private equity funds: Sun Capital Partners III QP, Sun Capital Partners III (together, “Sun Fund III”), and Sun Capital Partners IV (“Sun Fund IV”). All three had invested in a series of holding companies that owned the portfolio company Scott Brass Inc. , a Cranston, RI-based re-roller of copper, brass, and bronze used in the electronics, hardware, and jewelry industries (www.scottbrass.com). When the portfolio company went bankrupt, the multiemployer pension plan claimed $4.7 million in withdrawal liability and went up the ownership chain in search of parties to share the joint liability.
Moving through the two holding companies that had no assets, the pension plan found that Sun Fund IV owned 70 percent and the Sun Fund III owned 30 percent. For traditional controlled groups, 80 percent ownership is generally the minimum ownership.
At first look, there was no controlled group. But after the court’s decision, the controlled group may now include private equity funds where a partnership-in-fact can link funds with less than 80 percent ownership investment because of the substantial overlap between the way the funds operated.
In the recent Sun Capital decision, the district court tagged all private equity funds jointly for the withdrawal liability.
In a series of cases from the district court to the Court of Appeals for the First Circuit and back to the district court, the pension plan challenged the controlled group concepts. In the recent Sun Capital decision, the district court tagged all private equity funds jointly for the withdrawal liability. That decision has now been appealed back to the First Circuit Court of Appeals.
Investment plus test
In its prior decision the First Circuit Court of Appeals in Boston decided that to distinguish a passive investor from being a trade or business that may have control, the “investment plus” test applied, looking at factors such as:
- Written partnership agreements that the private equity fund would be actively involved in the management of the portfolio company;
- Broad authority granted to general partners to participate in portfolio company management, possibly including authority to hire or fire agents and employees of the portfolio company;
- Participation in management of the portfolio company beyond that of a passive investor, due in large part to a significant or controlling ownership interest in the portfolio company; and
- Provision for an economic benefit not available to an ordinary passive investor, such as a management fee offset.
Sun Fund IV, the 70 percent owner of the portfolio company, met the investment plus test and was thus in a trade or business under the First Circuit decision. That court relied on the fact that Sun Fund III and Sun Fund IV enjoyed reductions in the management fees it owed the general partner on account of the management fee the portfolio company paid the general partner of its subsidiary management company – a management fee offset. The district court went on to note that even if the private equity funds had not had management fee offsets, the agreements provided future benefits that would be considered a direct economic benefit for the “investment plus” factor test for trade or business status.
Common control test
While neither Sun Fund III nor Sun Fund IV had 80 percent control individually, if they could be tied together in common control, their 100 percent combined ownership would be controlling over the portfolio company. The private equity funds were each separate entities with separate financial statements, bank accounts and non-overlapping limited partners. Further, they were not parallel funds that invested in the same portfolio companies; Scott Brass was a common investment but not all investments were common.
As a result, the court found that the joint operation of the portfolio company through a common LLC holding company resulted in a partnership-in-fact.
Although the funds disclaimed in their documents any intent to form a partnership, the court nevertheless looked at the joint activity in setting up the investment in the portfolio company, including the coordination of investing, the structure for management and the expressed intent to avoid the controlled group rules with the 70/30 split. As a result, the court found that the joint operation of the portfolio company through a common LLC holding company resulted in a partnership-in-fact.
This partnership supported the aggregation of the holdings and therefore the control needed to find the private equity funds to be in a controlled group with the portfolio company and jointly liable for the withdrawal liability.
How to avoid similar trouble
Under the Sun Capital case as it stands now, a private equity fund must be both in a trade or business and in common control with one or more other funds or businesses, either through an aggregation under regular controlled group rules or by a partnership-in-fact to be a controlled group member with the portfolio company. So what does it take to avoid the Sun Capital result?
- Avoid investment in any portfolio company with any current or past obligation to a multiemployer pension plan;
- Never invest 80 percent or more in a portfolio company with any related private equity funds or other related entities; and
- Become a passive investor, removing management rights and other rights a significant investor would have.
The Sun Capital decision suggests that a direct economic benefit to the fund that is not otherwise available to investors is an important factor in finding the fund to be a trade or business.
If a group of funds have common adviser management, consider aggregating only enough funds to meet the 80 percent test and wall off the other funds from the controlled group.
It might be possible to find that private equity funds co-investing in a portfolio company but otherwise unrelated (having totally different general partners and management advisers) were in a partnership-in-fact and could be jointly liable for the withdrawal.
The impact may be far reaching.
Once there is a controlled group, even one glued together under partnership-in-fact concepts, the exposure to liability may grow. In addition to multiemployer plan withdrawal liability, other scenarios may emerge, including:
- Single employer pension liability, particularly on plan termination or significant underfunding;
- 401(k) plan testing on a controlled group basis could require aggregation of portfolio companies;
- Affordable Care Act (ACA) shared responsibility taxation and reporting on a controlled group basis could require aggregation of portfolio companies for annual reporting or turning a small exempt employer into an “applicable large employer”; and
- If portfolio companies are aggregated, moving employees from one portfolio company to another may not be considered as a termination of employment by one and hire by another but merely a transfer, making benefit distributions and adjustments difficult.
While waiting for the decision of the First Circuit Court of Appeals, private equity funds and their portfolio companies should take a close look at their current structures and consider alternatives and strategies to implement if the next Sun Capital decision affirms the lower court.
About the author
Kathy Solley is a partner in Nelson Mullins Riley & Scarborough’s Atlanta office, where she practices executive compensation, employee benefits and ERISA law. She works with public and private companies on their employee benefits needs, counseling on day-to-day plan administration as well as the impact of employee benefits and compensation for mergers, acquisitions, and divestitures. She may be reached at email@example.com or by phone at (404) 322-6375.
© 2016 Private Equity Professional • 8-25-16