In 2013, the First Circuit sent shockwaves through the private equity industry when it held that two Sun Capital funds were “trades or businesses” under ERISA and potentially part of a controlled group that included Scott Brass, Inc. (SBI), a bankrupt portfolio company owned in part by the funds. Sun Capital Partners III, LLP v. New England Teamsters & Trucking Indus. Pension Fund, 724 F.3d 129 (1st Cir. 2013), cert. denied, 82 U.S.L.W. 3509 (U.S. Mar. 3, 2014). The U.S. Supreme Court recently denied the Sun Capital funds’ appeal of the First Circuit decision, and the Sun Capital funds are now litigating these controlled-group liability issues in the district court.
Basic Aspects of Controlled-Group Liability
ERISA provides that entities within the same controlled group are jointly and severally liable for the following:
- Multiemployer plan withdrawal liability
- Single employer pension underfunding liability;
- Minimum funding obligations; and
- Pension Benefit Guaranty Corporation premiums
Additionally, for purposes of the Internal Revenue Code (Code), the minimum coverage and nondiscrimination requirements for qualified retirement plans are tested on a controlled-group basis and the members of a controlled group may be liable for penalties imposed on any group members for its failure to meet minimum funding obligations.
The controlled-group rules are highly technical; however, at their core, the following must exist in order for there to be a controlled group:
- The members of the controlled group can be individuals (acting as sole proprietors), corporations, estates, trusts, partnerships or limited liability companies. However: If a non-corporate entity is not a trade or business, it cannot be part of a controlled group, irrespective of its ownership interest. Unfortunately, there is no definition of “trade or business” in ERISA or the Code for this purpose. For Code or ERISA purposes, a corporation cannot form a controlled group with a non-corporate entity unless the corporation is a trade or business. For Code purposes, two or more corporations can form a controlled group without all such corporations having to be trades or businesses.
- If a non-corporate entity is not a trade or business, it cannot be part of a controlled group, irrespective of its ownership interest. Unfortunately, there is no definition of “trade or business” in ERISA or the Code for this purpose.
- For Code or ERISA purposes, a corporation cannot form a controlled group with a non-corporate entity unless the corporation is a trade or business.
- For Code purposes, two or more corporations can form a controlled group without all such corporations having to be trades or businesses.
- There generally must be interlocking ownership between the entities. For example, one entity’s ownership of 80 percent or more of another entity can result in a controlled group, but brother-sister controlled groups are also possible.
Sun Capital Partners Case History — In Brief
Two Sun Capital funds invested in SBI and collectively owned 100 percent of that company. In connection with its bankruptcy, SBI withdrew from the New England Teamsters & Trucking Industry Pension Fund (the Teamsters Plan), a multiemployer pension plan. The Teamsters Plan, like many multiemployer pension plans, was underfunded and asserted that the two Sun Capital funds were responsible for SBI’s withdrawal liability of over $4.5 million.
The Sun Capital funds obtained a declaratory judgment from the U.S. District Court for the District of Massachusetts that they were not “trades or businesses” and therefore could not be grouped with SBI for purposes of withdrawal liability.
The First Circuit reversed the district court and adopted an “investment plus” standard. The court of appeals concluded that Sun Capital Partners IV “was not merely a ‘passive’ investor, but sufficiently operated, managed and was advantaged by its relationship with its portfolio company. . . . We also conclude that further factual development is necessary as to [Sun Capital Partners III].” The First Circuit did refuse to find that the 70 percent/30 percent ownership structure was a transaction designed to “evade or avoid” withdrawal liability in violation of ERISA, a ruling that gives some comfort to private equity funds.
The court of appeals remanded the case to the district court to determine whether the requisite ownership existed between the Sun Capital funds and SBI to establish joint-and-several liability among the three entities. See our prior article for a discussion of the court of appeals decision.
Sun Capital on Remand
The Sun Capital funds have now moved for summary judgment in the district court, arguing that (i) Sun Capital Partners IV did not meet the First Circuit’s “investment plus” criteria for “trade or business” status at the time of withdrawal from the multiemployer plan and (ii) the “common control” element of ERISA Section 4001(b)(1) is lacking among the Sun Capital funds, so that their joint ownership of 100 percent of SBI does not establish controlled-group liability. Sun Capital Partners III, LLP, supra, on remand, Case 1:10-cv-10921 (D. Mass). The Sun Capital funds contend that there was no explicit or implicit “Sun Fund III/IV Partnership,” and that such an alleged joint venture could be no more than a passive investor.
The Sun Capital funds may find it difficult to prevail on summary judgment, given the detailed fact-specific nature of these issues and the district court’s earlier reversal by the court of appeals. The district court may be inclined to find that disputed issues of fact prevent summary judgment and require trial on the merits.
Because of such disputed factual issues, the district court in Board of Trustees, Sheet Metal Workers’ National Pension Fund v. Palladium Equity Partners, LLC, 722 F.Supp. 2d 845 (E.D. Mich. 2010) denied the summary judgment motion of a private equity firm that also disputed controlled-group withdrawal liability as owners of a bankrupt company. That case settled before trial.
Lender Defeats Withdrawal Liability Claim
In Hotel 71 Mezz Lender LLC v. Nat’l Ret. Fund, No. 13 C 03306, 2014 U.S. Dist. LEXIS 27016 (N.D. Ill. Mar. 3, 2014), a mezzanine lender that bought the assets of a bankrupt hotel to protect its loan became the target of a multiemployer plan’s withdrawal liability claim. The plan alleged that the lender was a trade or business due to its controlling interest in the hotel. The court disagreed and found that its passive investment was insufficient to establish the hotel lender as a trade or business in the hotel’s controlled group.
In coming to its decision, the district court relied on the two-part test established in Comm’r v. Groetzinger, 480 U.S. 23 (1987), which looks at whether the organization has engaged in an activity:
- With continuity and regularity; and
- For the primary purpose of income or profit.
The district court cited activities such as creating a formal business entity, having employees and claiming business exemptions and deductions as indicators of the existence of a trade or business. The hotel lender was a formal business entity, but did not possess any of the other facts indicating it was a trade or business.
Despite the favorable result for this lender, the case shows the aggressiveness of multiemployer plans in pursuing claims for withdrawal liability. In addition, the case turned on the facts, thereby leaving lenders little comfort that a different court could not come to a different conclusion.
What to Do Now
Private equity funds should carefully consider their ownership structures in light of the Sun Capital litigation. Some may decide to use an investment from a parallel fund or another unrelated minority investor (which could include management rollovers) to reduce the risk of creating a controlled group between a fund and its portfolio companies.
Private equity funds should also take the following actions to help lower their risk:
- Be wary of investing in companies that sponsor defined benefit pension plans or that contribute to multiemployer plans and perform thorough due diligence.
- Know the controlled-group rules.
- Minimize or avoid active management (including hiring or firing employees) of portfolio companies.
- Be mindful of private placement memoranda that describe extensive involvement in the operation of portfolio companies.
- Avoid fee-offset arrangements between funds and non-fund entities for management services provided to portfolio companies.
These steps may not be practical for all funds.
Lenders should also be aware of controlled-group liabilities that can impact their borrowers, and potentially make the lenders targets for multiemployer plan withdrawal liability or pension plan liability claims.