In an important decision, the U.S. First Circuit Court of Appeals recently ruled that two separate but related private equity funds – Sun Capital Partners III and Sun Capital Partners IV – are not jointly and severally liable for the multiemployer plan withdrawal liability of one of their portfolio companies. While this decision has generally been well-received by the private equity community, it does not eliminate the possibility that in certain circumstances a private equity fund (and, by implication, all of its portfolio companies that are under “common control”) could be held liable for underfunded pension liabilities of one of such portfolio companies.

In 2010 the two Sun Capital funds filed a declaratory judgment action seeking to establish that they were not liable for the withdrawal liability associated with one of their portfolio companies – Scott Brass, Inc. Scott Brass, which filed for bankruptcy protection in 2008, was a participating employer in a multiemployer pension plan as required by its collective bargaining agreement with the New England Teamsters union. ERISA and its associated regulations provide that all “trades or businesses” under “common control” with the relevant employer are liable for such multiemployer pension plan withdrawal liabilities. Accordingly, following the company’s withdrawal from the plan, the pension fund sought to impose the withdrawal liability on the two private equity funds on the basis that they were “trades or businesses” under “common control” with Scott Brass.

The case has had a number of twists and turns since the 2010 filing, and this most recent decision was the second time the First Circuit has ruled on the issues raised in the litigation. In a 2013 decision, the First Circuit had established, not without controversy, that the private equity funds constituted “trades or businesses” in that their business model involved active management of their portfolio companies. That is, the funds were more than mere “passive investors.” In arriving at this determination, the First Circuit had in particular focused on the fact that the two private equity funds received a direct benefit from the active management of the portfolio company because the management fees the funds were obligated to pay to the general partners of the funds were partially offset by management fees paid by the portfolio company to the general partners’ affiliated management company.

The remaining issue was to determine whether the two Sun Capital funds were under “common control” with Scott Brass. ERISA and its associated regulations import the IRS tests for control in this context, which in general are based on 80% ownership. Here, the two Sun Capital funds had divided their respective ownership in Scott Brass 70/30 in part to avoid the potential withdrawal liability. Nonetheless, the pension fund asserted their ownership could be conflated because the two funds had formed a “partnership-in-fact” and that therefore each of the funds, as a “trade or business” in the same “control group” with Scott Brass, was jointly and severally liable. Indeed, the pension fund persuaded the Federal District Court of Massachusetts of the correctness of this view in a 2016 decision.

It was this 2016 holding that the First Circuit has reversed in its most recent decision. The court analyzed the existence of a partnership under the factors established for federal tax law and found that although there were certain facts that supported the finding of a partnership, overall most of the facts did not. These facts most persuasive to the court included:

• the funds did not have identical limited partners;

• the funds did not always invest in the same companies in the same proportions;

• the funds filed separate tax returns and maintained separate books and bank accounts;

• the funds expressly disclaimed an interest in forming a partnership; and

• the pooled investment vehicle for the two funds was organized as a limited liability company, which evidenced an “intent” not to form a partnership.

The court’s conclusions appear to be based, at least in part, on the clear disincentive a decision imposing liability would create with respect to “much-needed private investment in underperforming companies with unfunded pension liabilities.”

Over the years, the litigation has surfaced a number of issues that remain, particularly in view of the fact that this most recent decision expressly did not overturn the earlier finding that the two Sun Capital funds constituted “trades or businesses” for purposes of ERISA and its associated regulations. This raises the central question of whether a single private equity fund with more than 80% ownership could be liable for the unfunded pension withdrawal liabilities of its portfolio company. Interestingly, there is at least one existing case which has raised this issue – ultimately one dependent on the relevant facts and circumstances – in a different jurisdiction. Likewise, there remains the question of how transparently a fund can structure around the 80% ownership test – whether by creative manipulation of the equity capital structure or by arranging additional third-party investment – for the sole purpose of avoiding liability. Even the question of “how to calculate 80%” is not straightforward, as arrangements common in the private equity business model such as non-voting preferred stock, management ownership and different forms of equity incentive vesting conditions complicate the analysis and raise the possibility of creative legal structuring.

Conclusions

While the most recent First Circuit decision has been welcomed by the private equity community, it should be viewed with the following practical guidance:

• This decision is limited in applicability to the First Circuit (Maine, Massachusetts, New Hampshire, Puerto Rico and Rhode Island) and is not binding or dispositive in other jurisdictions, although it may provide persuasive authority.

• This decision is based on the particular facts and circumstances at hand. Different facts may lead to a different conclusion in other litigation, even in the First Circuit.

This decision serves as an important reminder of the myriad complexities associated with investing in companies with pension liabilities and the need to assess and structure such investments carefully.