Withdrawal Liability for Private Capital Equity Funds: The Sun Capital Partners Saga Continues

Sun Capital Partners III, LP v. New England Teamsters and Trucking Industry Pension Fund, 2016 U.S. Dist. LEXIS 40254 (D. Mass. Mar. 28, 2016) holds that two private equity funds under common management are liable to a multiemployer pension plan for withdrawal liability incurred by one of their portfolio companies, despite the fact that neither had the 80% ownership interest required to establish a controlled group between itself and the now-bankrupt employer.  According to the district judge, ownership was not divided 70/30 between the funds.  Instead, the 100% owner was a notional joint venture between them.  The joint venture and the company thus formed a parent-subsidiary controlled group, the plan could assess withdrawal liability against the parent, and, because the parent was unincorporated, that liability passed through to the joint venturers.

This feat of judicial construction, if adopted by other courts, is likely to have a major impact on the private equity industry and perhaps on investors more generally.  The impact could also spread beyond withdrawal liability.  The controlled group rules at issue in the case affect many other areas of employee benefits, including “nondiscrimination” testing in qualified plans and liability to the Pension Benefit Guaranty Corporation (PBGC) upon the termination of under-funded defined benefit plans.

The case is a sequel to a private equity failure.  In early 2007, two Sun Capital private equity funds, Sun Capital Partners III and Sun Capital Partners IV, formed a limited liability company (LLC) in which the former had a 30% and the latter a 70% ownership interest. The LLC, through its own 100%-owned subsidiary, bought all of the stock of Scott Brass, Inc.  The investment was not a success.  By the end of 2008, Scott Brass was in bankruptcy proceedings, and the New England Teamsters pension plan, to which it had been a contributing employer, was looking for some solvent pocket from which to extract withdrawal liability amounting to $4.5 million.  The pension plan sent demands for payment to the Sun Capital funds, which reacted by bringing a declaratory judgment action to establish that they had no liability for this Scott Brass obligation.

Withdrawal liability is the obligation of an employer that ceases contributing to a multiemployer pension plan to pay a share of the plan’s unfunded vested benefits, and, under ERISA, the withdrawn employer’s controlled group is jointly and severally liable for the withdrawal liability.  29 U.S.C. § 1403.  The term “controlled group” is defined in regulations issued by the PBGC that the statue requires to “be consistent and coextensive with regulations prescribed for similar purposes by the Secretary of the Treasury under section 414(c) of” the Internal Revenue Code. 29 U.S.C. § 1301(b)(1).  The PBGC’s regulations take the easy route of adopting the IRS regulations by reference.  29 C.F.R. § 4001.3(a).

The section 414(c) regulations are modeled on the controlled group of corporations principles of section 1563(a) but are adapted to embrace “trades and businesses,” however organized, regardless of whether they are corporations.  26 C.F.R. § 1.414(c)-2.  A “parent-subsidiary” group thus consists of a chain of trades or businesses that meet the 80% control test applicable to a section 1563 controlled group. Id.

The Sun Capital Partners funds denied that either was a member of a controlled group with Scott Brass, relying on two arguments: 1) they were passive investment entities rather than “trades or businesses;” and 2) even if they were trades or businesses, neither owned 80% of the LLC that, in turned, owned 100% of the company.

In the opening round at the district court, Sun Capital Partners III, LP v. New England Teamsters and Trucking Industry Pension Fund, 903 F. Supp.2d 107 (D. Mass. 2012), the court held that the funds were not “trades or businesses,” obviating any need to inquire into the contours of Scott Brass’ controlled group.

The US Court of Appeals for the First Circuit reversed and remanded the case to the lower court, Sun Capital Partners III, LP v. New England Teamsters and Trucking Industry Pension Fund, 724 F.3d 129 (1st Cir. 2013), cert. denied, 134 S. Ct. 1492 (2014).  The First Circuit’s decision endorsed the position taken by the PBGC in a 2007 administrative decision, that a “trade or business” can arise from an investment for profit plus some additional factors indicating that the in-vestment is not merely passive.  Id.  The First Circuit saw “no need to set forth general guidelines for what the ‘plus’ is,” taking “a very fact-specific approach,” as the First Circuit concluded that one of the funds was a “trade or business,” while the record was insufficient to decide about the other.  Id. at 143.  The case was remanded to deal with that point and to determine whether, if both funds were trades or businesses, they formed a controlled group with Scott Brass. Id. at 148-149.

The district court’s new decision breaks no new ground on the “trade or business” issue.  The parties reiterated their previous arguments, albeit in slightly different dress.  The First Circuit’s conclusion that the funds were more than passive investors stemmed from their general partner’s extensive role in managing Scott Brass and the fact that management fees paid by the company were credited against compensation that the funds would otherwise have paid to the general partner.  The presence of “a direct economic benefit . . . that an ordinary, passive investor would not derive,” 724 F.3d at 143, was evidently a sine qua non of a “trade or business;” one of the First Circuit’s reasons for remanding the case was a lack of evidence in the record concerning the financial arrangements among Scott Brass, the funds, and the general partner.

The effect of the First Circuit’s analysis, as applied by the district court, was to impute the activities and compensation of the funds’ general partner to the funds, flattening the tiered and multifaceted Sun Capital structure into a de facto monad.  Sun Capital Partners III, LP v. New England Teamsters and Trucking Industry Pension Fund, 2016 U.S. Dist. LEXIS 40254 (D. Mass. Mar. 28, 2016).  The not-quite-articulated perception that the structure is a single enterprise whose distinct components have no independent significance underlies the district court’s analysis of the controlled group issue.

Also influencing the district court was a belief that defining a “controlled group” in strict accordance with the text of the IRS regulations would undermine the efficacy of withdrawal liability.

The use of a brightline ownership-based test is in some tension with the purposive approach of the [Multiemployer Pension Plan Amendments Act (Subtitle E of Title IV of ERISA, codified at 29 U.S.C. § 1381ff. (“MPPAA”)] which governs withdrawal liability.  The statute anticipates disregarding business entity formali-ties and preventing responsible parties from contracting around withdrawal liabil-ity. . . .

In contrast, the 80 percent ownership rule appears to provide a roadmap for exactly how to contract around withdrawal liability.  In this case, for example, the Funds forthrightly admit that an important purpose in dividing ownership of port-folio companies between multiple funds is to keep ownership below 80 percent and avoid withdrawal liability.  Sun Capital, 903 F. Supp.2d at 121.  This tension is only heightened when LLCs are employed.  The regulations look to ownership to determine control, but in LLCs (as with the LLCs used here) ownership can be divorced from effective managerial control.  The statute requires that these regulations be “consistent and coextensive” with tax regulations, 29 U.S.C. §1301(b), and arguably these tensions stem irremediably from differences between the goals of MPPAA and the formalisms of the tax code.  The difficulties of applying the current scheme suggest that the relevant political actors should consider whether their enactments can be better harmonized by statute and/or regulation.

Id. at 9-10.  The judge did not, however, shake his head and say that a better outcome would have to wait for “the relevant political actors” to turn their attention to the alleged difficulties.  Instead, he undertook to ameliorate them himself.

In appearance, the ultimate parent of Scott Brass’ controlled group was an LLC whose owners, the two Sun Capital funds, were not responsible for its debts.  In order to hold them responsible, the court had to discover a parent for the LLC with three crucial characteristics:

1. The parent must own 80% or more of the LLC
2. The liability of the parent’s owners for its debts must not be limited
3. The parent must be a “trade or business”

The court found that an additional entity – not documented but implicit in the transaction – existed, “a joint venture or partnership formed by the Sun Funds that is antecedent to the existence of Sun Scott Brass, LLC and sits above it in the Scott Brass ownership structure.” Id. at 10.  While no partnership existed between the funds as a general matter:

A more limited partnership or joint venture, however, is nevertheless to be found, based on the present record.  The Sun Funds are not passive investors in Sun Scott Brass, LLC, brought together by happenstance, or coincidence.  Rather, the Funds created Sun Scott Brass, LLC in order to invest in Scott Brass, Inc.  Between 2005 and 2008, Sun Funds III and Sun Funds IV also coinvested in five other companies, using the same organizational structure.  In each case, they expressly disclaimed any intent to form a partnership or joint venture, a fact that remains relevant – but not dispositive – as to whether a partnership-in-fact was created.  More importantly, prior to entity formation and purchase, joint activity took place in order for the two Funds to decide to coinvest, and that activity was plainly intended to constitute a partnership-in-fact.

Id. at 13.  The joint venture arose, then, from the funds’ “acting together or in concert with re-spect to specific investments” and making “a conscious decision to split their ownership stake 70/30” so that neither would be exposed to withdrawal liability if Scott Brass failed.  Id. at 14.

Given the record before me, no reasonable trier of fact could find that the Sun Funds’ joint operation of Scott Brass was carried out solely through their LLC or that their relationship was defined entirely by the agreements governing the LLC.  The record is not clear on the precise scope of their partnership or joint venture – which portfolio companies were covered, the date on which the relevant partner-ship or joint venture was formed, and so forth – but it is clear beyond peradven-ture that a partnership-in-fact existed sufficient to aggregate the Funds’ interests and place them under common control with Scott Brass, Inc.

Id. at 14.  And was this somewhat nebulous entity a “trade or business”?  The court regarded the “partnership-in-fact” as embracing not just the decision to invest jointly, but all of the funds’ subsequent activities relating to Scott Brass. Because the court had found that those activities constituted a “trade or business,” the vehicle for carrying them on was a “trade or business,” also.

A few observations:

1. The district court’s analysis is infused with the perceived need to address “tensions stem[ming] irremediably from differences between the goals of the MPPAA and the formalisms of the tax code.”  Id. at 10.  Are the goals of MPPAA and the pertinent portion of the Internal Revenue Code, section 414(c), in fact different?
   
   Section 414(c) provides that all members of a controlled group are to be treated as a sin-gle employer for most qualified retirement plan purposes.  The reason for aggregating the group’s legally separate entities is precisely to limit the ability of plan sponsors to sidestep qualification requirements by establishing multiple entities (a not unusual pre-414(c) practice).
   
   It was evident from an early date that section 414(c) did not do a complete job, and the IRS was unsuccessful in enforcing the spirit of the law in preference to its letter.  See, e. g., Lloyd M. Garland, M.D., F.A.C.S., P.A., 73 T.C. 5 (1979).  Congress responded by enacting additional rules that define “affiliated service groups” (I.R.C. § 414(m)), which are treated similarly to controlled groups, but those rules affect only tax qualification requirements.  In other words, “the relevant political actors” did act to remedy a perceived problem identical to the one that concerned the Sun Capital Partners district court, but they did not extend that remedial action to ERISA Title IV and withdrawal liability (nor would Scott Brass and the Sun Capital Partners funds form an affiliated service group if section 414(m) did have a broader reach).
   
   
2. The court believed that, without a broad concept of “partnership-in-fact,” the controlled group rules furnished “a roadmap for exactly how to contract around withdrawal liability.”  Sun Capital Partners, 2016 U.S. Dist. LEXIS 40254 at 10.  It did not attend to the need for reasonable certainty in business transactions.  In place of a road map, this decision presents a “Jackson Pollock canvas.”  If acting in concert on profit-seeking ventures is all that is needed to create a distinct “trade or business,” controlled groups will form unpredictably, flowing from judicial whim.  Co-investors outside the private equity context are often brought together by factors other than “happenstance or coincidence.”  Are all common investments not resulting from mere coincidence to be regarded as potential partnerships-in-fact?
   
   
3. The statute states unequivocally that ERISA Title IV controlled group principles must “be consistent and coextensive” with those of Title I of ERISA and the qualification requirements of the Internal Revenue Code.  If the district court is right in Sun Capital Partners, the same analysis should apply to such questions as what employers must be aggregated to determine whether pension plans are “discriminatory” (I.R.C. §§ 401(a)(4) and 410(b)).  Sun Capital Partners III and IV had joint ownership of other portfolio companies.  Are all of them subsidiaries of a joint venture, and therefore a single parent-subsidiary controlled group?  That question was not significant for the case at hand, but it would be important for the portfolio companies’ “nondiscrimination” tests and many other aspects of their qualified plans’ operations.  Knowing the answer is definitively important to both qualification compliance and plan design.
   
   
4. While the theories espoused in these cases, if ultimately accepted by the courts, would have a major impact on existing private equity structures, planning around them in the future should not be difficult.  All that is needed is to leave a fraction over 20% of each portfolio company in the hands of unrelated investors.  Private equity firms may find ways to do that without undermining their business model.  Less sophisticated entities may, however, stumble into inadvertent “controlled groups” and unanticipated liabilities.