Today, who is and will be responsible for funding pension liabilities is a primary consideration in both private and public sector restructurings. The filing of the city of Detroit bankruptcy case is just the most recent example of how this issue is impacting the public sector. In the private sector, the disposition of pension plans and resulting liabilities claims both in and outside of bankruptcy has become a driving consideration in restructurings and merger-and-acquisition due diligence and strategy.

The emergence of private equity funds as a player is well known. One commentator reported that investor commitments have grown from $10 billion in 1991 to $680 billion in 2008. Many private equity funds promote their ability to manage turnarounds as the means to obtain returns in a relatively short period of time. The extent to which the funds themselves can be held liable for unfunded pension and withdrawal liabilities of companies they invest in was recently addressed by the U.S. Court of Appeals for the First Circuit in Sun Capital Partners III LP v. New England Teamsters and Trucking Industry Pension Fund, No. 12-2312 (1st Cir. 2013). In an opinion issued July 24, that the court noted was a case of first impression, the court reversed a decision of the district court and held private equity fund entities could be responsible for withdrawal liability for a pro rata share of unfunded vested benefits to a multiemployer pension fund of a bankrupt portfolio company. In a lengthy opinion, the court analyzed the structure of private equity investment vehicles and the complexities of the withdrawal liability provisions of the Employee Retirement Income Security Act to reach its decision.

Management of Investments by Private Equity Funds

The opinion describes the structure of the Sun Capital enterprise and its involvement with the debtor, Scott Brass Inc. (SBI). According to the opinion, Sun Capital Advisors Inc. (SCAI), a private equity firm founded by its co-CEOs and sole shareholders, Marc Leder and Rodger Krouse, and its affiliated entities, place investments into numerous private equity funds and provide management services to the portfolio companies acquired by the funds. The plaintiffs in this case are two of SCAI’s funds, Sun Capital Partners III LP (Sun Fund III) and Sun Capital Partners IV LP (Sun Fund IV, and, together with Sun Fund III, known as the funds). The funds have no offices or employees, do not make or sell goods, and do not report income other than investment income on their tax returns. The opinion states the funds’ purpose is to invest in underperforming companies and then sell their interests for a profit within two to five years. The opinion notes, “The funds’ controlling stakes in portfolio companies are used to implement restructuring and operation plans, build management teams, become intimately involved in company operations, and otherwise cause growth in the portfolio companies.” The opinion distinguishes the funds from stock holding or mutual fund investments in that the private equity funds directly or indirectly assist and manage the business of the companies they invest in.

The opinion recites that the funds’ partnership agreements vest control of the funds and portfolio companies with their general partners, controlled by Leder and Krouse. The general partners receive annual fees calculated as a percentage of the funds’ profits. Finally, the general partners each have subsidiary management companies that provide management services to the funds for a fee. For the court, it was significant that the funds receive an offset of the fees owed to the general partners in the amount of the management fees paid by the portfolio companies to the general partners’ management companies.

The Acquisition and Involvement with SBI

SBI was a producer of metals used in various commercial and consumer products. Leder and Krouse, in their capacity as the controlling individuals of the “limited partnership committee” of the general partner entities, made the decision to invest in SBI. The acquisition was completed in 2007 when the Sun Capital funds acquired all of SBI’s stock through newly-formed holding companies. The opinion states that subsequent to acquisition, “numerous individuals with affiliations to various Sun Capital entities, including Krouse and Leder, exerted substantial operational and managerial control over SBI.” For example, SCAI individuals were involved in the hiring of salespeople and technology consultants, possible acquisitions and capital expenditures, and management of working capital. SCAI received weekly “flash reports” that contained detailed information about SBI’s revenue, financial data, market activity, sales opportunities, meeting notes and action items.

According to the opinion, the value of SBI’s inventory fell when copper prices declined in the fall of 2008, resulting in a breach of a loan covenant. The lender refused to waive the default, and froze SBI’s credit. SBI was unable to pay its bills. An involuntary Chapter 11 bankruptcy was filed against SBI in November 2008.

Pursuant to a collective bargaining agreement, SBI made contributions to the New England Teamsters and Trucking Industry Pension Fund (TPF), a multiemployer pension fund, on behalf of its employees. The funds claimed that SBI continued to meet its pension obligations to the TPF for more than a year following acquisition. In October 2008, SBI stopped making contributions to TPF, and became liable for its proportionate share of TPF’s unfunded vested benefits. Following SBI’s bankruptcy, TPF made demand upon SBI and the funds to pay SBI’s withdrawal liability of approximately $4.5 million.

District Court Grants Summary Judgment

TPF asserted in its demand the funds and SBI were jointly and severally liable for SBI’s withdrawal liability because the funds had entered into a partnership or joint venture in common control with SBI. The funds commenced an action in the U.S. District Court for the District of Massachusetts seeking a declaratory judgment that the funds were not subject to withdrawal liability. Section 1301(b)(1) of ERISA provides that “all employees of trades or businesses (whether or not incorporated) which are under common control shall be treated as employed by a single employer and all such trades or businesses as a single employer.” This provision of ERISA essentially allows for piercing of the corporate veil when two conditions are met to impose liability on an entity other than the one obligated to the pension fund: (1) the entity must be under “common control” with the obligor, and (2) the organization must be a “trade or business.” The parties filed cross-motions for summary judgment.

The district court entered summary judgment for the funds on the basis of the “trade or business” prong. The district court concluded the funds were not “trades or businesses” because they did not have any offices or employees, did not make or sell goods or report income other than investment income on their tax returns, and were not engaged in their general partners’ management activities. Because the district court found the funds were not “trades or businesses,” the court did not address the “common control” element. TPF appealed.

First Circuit Finds Funds Engaged in ‘Investment Plus’

The court began its discussion of withdrawal liability by noting that Congress enacted ERISA to create a disincentive for employers to withdraw from multiemployer plans and to provide a means to recoup a fund’s unfunded liabilities. Employers withdrawing from multiemployer plans must pay their proportionate share of the fund’s vested but unfunded benefits.

The court observed the term “trade or business” is not defined in ERISA or U.S. Department of the Treasury regulations, and no definitive, uniform definition has been adopted in decisions of the Supreme Court. Further, the Pension Benefit Guaranty Corp. (PBGC) has not adopted regulations defining or explaining the term “trade or business.” The only guidance provided by the PBGC was an appeals letter, an unpublished ruling made by a one-member PBGC appeals panel in a prior controversy. According to the appeals letter, in order to be a “trade or business,” the entity must (1) be engaged in an activity with the primary purpose of income or profit; and (2) conduct that activity with continuity and regularity. The court characterized this approach as “investment plus.” The PBGC argued in its amicus brief that the funds met this test.

The court noted that because the PBGC’s letter was not the result of public notice and comment, it was only entitled to deference if it was persuasive. That being said, the court found that the PBGC’s analysis was persuasive, and the same “investment plus” approach would have been applied even without deference by the court using its own independent analysis. The court declined to set forth what the “plus” guidelines should be, and held that a case-by-case analysis of all factors should be undertaken. The opinion acknowledges that “a mere investment made to make a profit, without more, does not itself make an investor a trade or business.” However, in addition to investing, the funds had undertaken additional activities as to SBI.

First, the court noted that SCAI’s own private placement memorandum stated that SCAI and its funds actually manage their investments. Second, the court cited numerous provisions in the funds’ partnership agreements to describe how the funds were actively involved in the management and operation of the portfolio companies in which they invested. Third, as is typically done by private equity funds, the funds placed SCAI employees in two of the three director positions at SBI, resulting in control of the board. SCAI provided personnel to SBI for management and consulting services. These management agreements provided a direct economic benefit to Sun Fund IV that an ordinary, passive investor would not receive. Sun Fund IV received an offset against the management fees it would otherwise have paid to its general partner for managing the investment in SBI. The court concluded that these factors together satisfied the “plus” in “investment plus.”

The court vacated the summary judgment in favor of Sun Fund IV. However, with respect to Sun Fund III, the court could not determine if the fund received an economic benefit from the management fee offset. Therefore, the court left that factual issue and the ultimate “trade or business” conclusion regarding Sun Fund III for the district court to resolve on remand.

Private Equity Beware

The organizational structure, management and administration of the funds’ investments in the SBI portfolio company in this case is typical of how private equity funds generally structure and manage their investments. In fact, the funds acknowledged that the two funds invested in SBI in percentages of 70 percent and 30 percent, respectively, to avoid the statutory 80 percent ownership threshold in ERISA for parent control liability. As such, this opinion represents a wake-up call for private equity funds that entities with no employees, offices or specific activities may be characterized as a trade or business for purposes of withdrawal liability. The court even noted that it is unfortunate regulations had not been promulgated after public notice that warned the private equity sector that such a result could occur.

Unfortunately, it is unclear how much involvement by a fund in a portfolio company will trigger the “investment plus” standard. Until that happens, private equity investors face an unclear risk of liability for their portfolio companies’ pension withdrawal obligations.

Andrew C. Kassner is the chair of the corporate restructuring practice group of Drinker Biddle & Reath, practicing in the firm’s Philadelphia and Wilmington, Del., offices. He can be reached at or 215-988-2554.

Joseph N. Argentina Jr. is an associate in the firm’s corporate restructuring practice group in the Philadelphia and Wilmington offices. He can be reached at or 215-988-254