In a case that will put fear in the heart of many private equity investors, particularly those who invest in distressed situations, the United States Court of Appeals for the First Circuit has held that a private equity fund constituted a "trade or business" for purposes of determining whether the fund owed withdrawal liability to a multiemployer pension plan of a bankrupt company in which the fund had invested. The court concluded that the fund was not merely a "passive" investor," but had sufficiently operated, managed, and was advantaged by its relationship with the company. See Sun Capital Partners III, LP v. New England Teamsters and Trucking Industry Pension Fund (1st Cir. 2013) 2013 WL 3814984.
To impose withdrawal liability on an organization other than the employer obligated to the plan, two conditions must be satisfied: (1) the organization must be under "common control" with the obligated organization, and (2) the organization must be a "trade or business." Neither ERISA nor PBGC regulations define a "trade or business" for purposes of the withdrawal liability rules. Historically private equity investors have maintained that their investment funds are merely "passive investors" that are not involved in a trade or business.
In Sun Capital Partners III, LP, the court found that the fund was intimately involved in the management and operation of the portfolio company. Through a series of appointments, the fund was able to place employees of its management company in two of the three director positions of the portfolio company, resulting in the management company employees controlling the board of the portfolio company. Additionally, the court placed heavy emphasis on the fact that the fund's management company provided management and consulting services to the portfolio company through a series of service agreements, and that individuals from the management company were deeply involved in the management and day-to-day operation of the portfolio company. Moreover, the First Circuit said, because the fund received an offset against the management fees it otherwise would have paid its general partner, in the amount of the fees paid to the management company by the portfolio company, the fund's active involvement in management under the service agreements provided a direct economic benefit to the fund that an ordinary, passive investor would not have received. The sum of all these factors caused the First Circuit to conclude that the fund was a trade or business.
This case raises direct questions regarding fund investments in companies that face potential multi-employer pension fund withdrawal liabilities. In these cases, private equity firms will do well to carefully reassess their management arrangements, particularly those that involve fee-for-services arrangements between the management company and the portfolio company. In addition, however, Sun Capital Partners III, LP raises even more significant issues concerning income tax treatment of funds and limited partners, particularly ERISA investors, who have historically assumed that their investments were passive for income tax purposes. If the Sun Capital Partners III, LP rationale were to be applied more broadly, outside the ERISA context, the consequences could be enormous.
If you have any questions regarding the Sun Capital Partners III, LP ruling, ERISA, or private equity funds, please contact Bill McCartan.