In an opinion issued in October 2012, the Federal District Court of Massachusetts provided clarity on the question of whether a private equity fund can be liable for the ERISA pension obligations of its portfolio companies, including multiemployer withdrawal liability and defined benefit pension plan underfunding. This summer, the U.S. Court of Appeals for the First Circuit had a different interpretation. The case was Sun Capital Partners v. New England Teamsters & Trucking Industry Pension Fund.

The issue was whether a private equity firm is engaged in a trade or business for purposes of the Internal Revenue Code’s controlled group rules. Generally, under section 414(c) of the code, two or more trades or businesses under common control are treated as a single entity for various employee benefit plan purposes. As such, they are jointly and severally liable for pension plan funding obligations and multiemployer plan withdrawal liability. Common control includes a parent-subsidiary relationship where the parent owns at least 80 percent of the subsidiary.

In 2007, the Pension Benefit Guaranty Corp. (PBGC) asserted that private equity funds are engaged in a trade or business for this purpose. Therefore, if the fund owned at least 80 percent of a portfolio company, it would be liable for the company’s pension and multiemployer plan liabilities.

In the Sun Capital case, the company’s Sun Fund Capital III acquired 30 percent interest in Scott Brass Inc. in 2006 and Sun Fund Capital IV acquired 70 percent interest. In 2008, Scott Brass withdrew from the New England Teamsters & Trucking Industry Pension Fund, in which it had been a participating employer, and filed for bankruptcy. The pension fund, citing the PBGC’s 2007 opinion, asserted $4.5 million of withdrawal liability against both Scott Brass and Sun Capital. The latter filed a declaratory judgment action asserting it was not engaging in a trade or business and therefore was not within a controlled group with Scott Brass. The court agreed.

The court found that PBGC had incorrectly applied the law of agency by attributing activities of a private equity fund’s general partner—which provided some management and advisory services to the fund’s portfolio companies for a fee—to the fund itself. Merely holding passive investment interests, regardless of the size of those investments, did not mean the fund was engaged in a trade or business. The court noted that Sun Capital did not have employees or office space, or make or sell any goods. Additionally, Sun Capital’s tax returns only listed investment income in the form of dividends and capital gains. The fact it had the power to elect certain Scott Brass directors resulted from Sun Capital being a shareholder, not an active manager.

Accordingly, the court ruled Sun Capital had no withdrawal liability. The pension fund had argued the principal purpose for structuring the transaction with a 70/30 ownership split between Sun Capital’s Fund III and IV was to avoid the controlled group rules and withdrawal liability. But the court reasoned that, at the time of the transaction in 2006, Sun Capital had no expectation of withdrawal liability and therefore did not structure the transaction to avoid it. The court found nothing wrong with structuring the transaction to limit potential exposure to an uncertain, unplanned liability.

On appeal, the PBGC argued that a private equity fund should have joint and several responsibility for the withdrawal liability of its portfolio company if (1) it was engaged in an activity with the primary purpose of income or profit; and (2) it conducted that activity with continuity and regularity.

While the appeals court did not adopt the PBGC’s approach per se, it nonetheless adopted what it called the “investment-plus” standard. In this case, the court determined that Sun Fund IV had undertaken sufficient activities, in addition to merely being an investor, that it was acting as a trade or business. As a result, it could be jointly and severally liable for SBI’s withdrawal liability if it also met the controlling interest (80 percent ownership) test.

The case was remanded to the district court to determine whether Sun Fund III had received any special economic benefit from an offset of fees paid by SBI, and to determine whether the funds had a controlling interest in SBI under the Multiemployer Pension Plan Amendment Act.

Although the district court has not issued its decision on remand, there is clearly more to come in the Sun Fund case and private equity firms should understand that this is an evolving legal area.

The court found that PBGC had incorrectly applied the law of agency by attributing activities of a private equity fund’s general partner—which provided some management and advisory services to the fund’s portfolio companies for a fee—to the fund itself.