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First Circuit Finds that a Private Equity Fund Can Be Liable for the Pension Obligations of its Portfolio Company

In Sun Capital Partners III, L.P. et al. v. New England Teamsters & Trucking Industry Pension Fund, No. 12-2312, 2013 WL 3814985 (1st Cir. July 24, 2013), the First Circuit held that a private equity fund could be liable for its bankrupt portfolio company’s withdrawal liability imposed under Title IV of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) on the basis of the private equity fund constituting a “trade or business” under ERISA’s controlled group rules. By way of background, ERISA generally requires employers that withdraw from a union-sponsored pension plan (also known as a “multiemployer plan”) to pay their proportionate share of the plan’s funding obligations for vested but unfunded benefits accrued by the employer’s union employees at the time of the withdrawal. The withdrawal liability provisions under Title IV of ERISA are intended to protect remaining employers that participate in a multiemployer plan from being saddled with the underfunded pension liabilities attributable to the employees of employers that withdraw from the plan. Under ERISA’s controlled group rules, withdrawal liability imposed under Title IV of ERISA is shared jointly and severally among a contributing employer and each “trade or business” under common control with the contributing employer.

The Sun Capital Partners decision is notable because it represents the first decision at the Federal appellate court level to address the issue of whether a private equity fund (including its other commonly-owned portfolio companies) can be liable for the pension obligations of one of its insolvent portfolio companies on the basis of the private equity fund constituting a “trade or business”. As a threshold matter, in order for a controlled group to exist between a private equity fund and its portfolio company, two conditions must be satisfied: (i) the private equity fund must be a trade or business, and (ii) the private equity fund must be under “common control” with the portfolio company.[1] Historically, the prevailing viewpoint had been that private equity funds were not carrying on “trades or businesses”, and therefore, were not treated as members of the same controlled group with their portfolio companies, even though the common control prong was met. In Sun Capital Partners, by rejecting the private equity fund’s argument that it was not carrying on a “trade or business,” the First Circuit opened the door for ERISA pension underfunding liabilities of portfolio companies to reach the private equity funds that own them.

In fleshing out the trade or business issue, the Sun Capital Partners court found that the private equity fund actively participated in the management of its portfolio company (albeit through affiliated entities). The First Circuit points out that the private equity fund (i) received management and consulting fees through its affiliates and (ii) received a direct economic benefit in the form of offsets against the management fees that it would have otherwise paid to its general partner. The private equity fund’s partnership agreement was also a major factor in the court’s decision because it gave the private equity fund’s general partner the exclusive authority to act on behalf of the fund and it granted actual authority for the general partner to provide management services to portfolio companies. The First Circuit also rejected the argument that the “management” activities were carried out by the general partner and not carried out by the private equity fund itself. The First Circuit remanded the case to the district court for further proceedings, including the determination of whether a controlled group relationship existed between the private equity fund and its bankrupt portfolio company.

The take away from the Sun Capital Partners decision is that private equity funds and other pooled investment vehicles should carefully consider the financial impact of investments into potential portfolio companies that have funding obligations to pension plans that are subject to Title IV of ERISA. Moreover, there may be planning opportunities for structuring investments in such portfolio companies that would allow private equity funds to properly address ERISA’s controlled group rules.

Furthermore, companies with underfunded defined benefit plans should consider many different strategic options prior to filing for bankruptcy protection because filing for bankruptcy protection may not offer a successful method to avoid pension liability. Companies often file for bankruptcy protection to avoid significant pension liability. A debtor terminates a costly pension plan and the Pension Benefit Guaranty Corporation (the “PBGC”) becomes one of the largest unsecured creditors in the bankruptcy, bearing all of the costs of the terminated plan and often recovering pennies on the dollar in bankruptcy. Lawmakers seeking to recover or avoid substantial losses attributable to bankruptcy filings of companies with underfunded defined benefit plans have enacted laws intended to reduce the financial strain on PBGC’s pension insurance program, e.g., §4006(a)(7) of ERISA that provides for a special “termination premium” to PBGC in certain events, including certain distress terminations of a defined benefit plan. The Second Circuit inOneida Ltd. v. PBGC, 562 F.3d 154 (2nd Cir. 2009), held that a reorganized debtor was liable for the special termination premiums under §4006(a)(7) of ERISA arising from termination in bankruptcy of a pension plan (where debtor's executive testified that it would remain liable for pension liability post-emergence). We note that the Sun Capital Partners decision, together with Oneida, represent successful attempts by the government to chip away at the PBGC's losses. Investors and lenders should be wary of the types of specific activities engaged in the Sun Capital Partners case that will now be relied on by bankruptcy courts in the First Circuit and reviewed by bankruptcy courts in all other circuits as the government pursues these claims with vigor in future cases.

[1] The “common control” prong of the analysis generally requires 80% or greater of common ownership, and can be triggered despite the appearance of lesser ownership due to complex attribution rules. As a simple example, if a private equity fund owns 80% or greater of a portfolio company, then the common control prong would be met. A full discussion of the common control prong is beyond the scope of this article.

Copyright © 2020, Sheppard Mullin Richter & Hampton LLP.National Law Review, Volume III, Number 219


About this Author

Martin Smith, Employee Benefits Legal Specialist, Sheppard Mullin

Martin J. Smith is a partner in the Employee Benefits and Executive Compensation Group of the Tax Practice in the firm's Los Angeles office.

Areas of Practice

Mr. Smith has over thirty years of experience as an ERISA attorney in the benefits consulting field.  Mr. Smith’s experience includes designing, implementing, and helping administer both tax qualified retirement plans (such as defined benefits plans, profit-sharing plans, and 401(k) arrangements), and nonqualified plans (such as deferred compensation plans, supplemental executive retirement plans, stock...

Michael Chan, Tax, Employee Benefits, Attorney, Sheppard Mullin, law firm

Mr. Chan is a partner in the Tax, Employee Benefits, and Executive Compensation Practice Groups in the firm's Los Angeles office.

Areas of Practice

Retirement Plans

Mr. Chan counsels employers with respect to the design, administration and legal compliance of qualified retirement plans, including defined benefit plans, employee stock ownership plans, tax-sheltered annuities and defined contribution plans. His experience in this area includes (i) advising plan sponsors (in addition to plan administrators, trustees and other plan fiduciaries) with respect to their fiduciary obligations, including reporting and disclosure requirements, under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), (ii) representing plan sponsors seeking amnesty under the Internal Revenue Service's Employee Plans Compliance Resolution System and the Department of Labor's Voluntary Fiduciary Correction Program, and (iii) assisting plan sponsors with various other compliance issues that arise in the day-to-day operations of qualified retirement plans.

Jason Schendel, Attorney, Sheppard Mullin

Mr. Schendel is a partner in the Corporate Practice Group in the firm's Palo Alto and San Francisco offices.

Areas of Practice

Mr. Schendel's practice focuses on advising public and private companies in mergers & acquisitions, securities offerings, corporate governance, SEC reporting, and general corporate matters.  Mr. Schendel also has extensive experience working with private equity funds in connection with fund formation, general fund operating matters, and buy-side M&A.

Jung Son, corporate, investment, finance, attorney, Sheppard Mullin, law firm

Jung Yeon Son is a partner in the Corporate Practice Group in the firm's Palo Alto office. Ms. Son’s practice is focused on the formation and operation of private investment funds, including private equity, venture capital and hedge funds, as well as on advising companies and sponsors with respect to mergers & acquisitions, securities offerings, corporate governance, SEC reporting, and general corporate matters. 

Carren Shulman, Finance and Bankruptcy Lawyer, Sheppard Mullin

Carren B. Shulman is a partner in the firm's Finance and Bankruptcy Practice Group and a member of the firm's Executive Committee.

Areas of Practice

Ms. Shulman focuses her practice on bankruptcy and business reorganization, commercial litigation, and creditors’ rights.  For twenty years she has represented debtors, committees, chapter 11 trustees, trade creditors and lenders in bankruptcy and out of court workouts, and has advised corporate trustees in default administration.  Ms. Shulman also...