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First Circuit Hands Down Significant Private Equity Ruling in Sun Capital Litigation

In an important decision, the U.S. First Circuit Court of Appeals recently ruled that two separate but related private equity funds – Sun Capital Partners III and Sun Capital Partners IV – are not jointly and severally liable for the multiemployer plan withdrawal liability of one of their portfolio companies. While this decision has generally been well-received by the private equity community, it does not eliminate the possibility that in certain circumstances a private equity fund (and, by implication, all of its portfolio companies that are under “common control”) could be held liable for underfunded pension liabilities of one of such portfolio companies.

In 2010 the two Sun Capital funds filed a declaratory judgment action seeking to establish that they were not liable for the withdrawal liability associated with one of their portfolio companies – Scott Brass, Inc. Scott Brass, which filed for bankruptcy protection in 2008, was a participating employer in a multiemployer pension plan as required by its collective bargaining agreement with the New England Teamsters union. ERISA and its associated regulations provide that all “trades or businesses” under “common control” with the relevant employer are liable for such multiemployer pension plan withdrawal liabilities. Accordingly, following the company’s withdrawal from the plan, the pension fund sought to impose the withdrawal liability on the two private equity funds on the basis that they were “trades or businesses” under “common control” with Scott Brass.

The case has had a number of twists and turns since the 2010 filing, and this most recent decision was the second time the First Circuit has ruled on the issues raised in the litigation. In a 2013 decision, the First Circuit had established, not without controversy, that the private equity funds constituted “trades or businesses” in that their business model involved active management of their portfolio companies. That is, the funds were more than mere “passive investors.” In arriving at this determination, the First Circuit had in particular focused on the fact that the two private equity funds received a direct benefit from the active management of the portfolio company because the management fees the funds were obligated to pay to the general partners of the funds were partially offset by management fees paid by the portfolio company to the general partners’ affiliated management company.

The remaining issue was to determine whether the two Sun Capital funds were under “common control” with Scott Brass. ERISA and its associated regulations import the IRS tests for control in this context, which in general are based on 80% ownership. Here, the two Sun Capital funds had divided their respective ownership in Scott Brass 70/30 in part to avoid the potential withdrawal liability. Nonetheless, the pension fund asserted their ownership could be conflated because the two funds had formed a “partnership-in-fact” and that therefore each of the funds, as a “trade or business” in the same “control group” with Scott Brass, was jointly and severally liable. Indeed, the pension fund persuaded the Federal District Court of Massachusetts of the correctness of this view in a 2016 decision.

It was this 2016 holding that the First Circuit has reversed in its most recent decision. The court analyzed the existence of a partnership under the factors established for federal tax law and found that although there were certain facts that supported the finding of a partnership, overall most of the facts did not. These facts most persuasive to the court included:

  • the funds did not have identical limited partners;

  • the funds did not always invest in the same companies in the same proportions;

  • the funds filed separate tax returns and maintained separate books and bank accounts;

  • the funds expressly disclaimed an interest in forming a partnership; and

  • the pooled investment vehicle for the two funds was organized as a limited liability company, which evidenced an “intent” not to form a partnership.

The court’s conclusions appear to be based, at least in part, on the clear disincentive a decision imposing liability would create with respect to “much-needed private investment in underperforming companies with unfunded pension liabilities.”

Over the years, the litigation has surfaced a number of issues that remain, particularly in view of the fact that this most recent decision expressly did not overturn the earlier finding that the two Sun Capital funds constituted “trades or businesses” for purposes of ERISA and its associated regulations. This raises the central question of whether a single private equity fund with more than 80% ownership could be liable for the unfunded pension withdrawal liabilities of its portfolio company. Interestingly, there is at least one existing case which has raised this issue – ultimately one dependent on the relevant facts and circumstances – in a different jurisdiction. Likewise, there remains the question of how transparently a fund can structure around the 80% ownership test – whether by creative manipulation of the equity capital structure or by arranging additional third-party investment – for the sole purpose of avoiding liability. Even the question of “how to calculate 80%” is not straightforward, as arrangements common in the private equity business model such as non-voting preferred stock, management ownership and different forms of equity incentive vesting conditions complicate the analysis and raise the possibility of creative legal structuring.

Conclusions

While the most recent First Circuit decision has been welcomed by the private equity community, it should be viewed with the following practical guidance:

  • This decision is limited in applicability to the First Circuit (Maine, Massachusetts, New Hampshire, Puerto Rico and Rhode Island) and is not binding or dispositive in other jurisdictions, although it may provide persuasive authority.

  • This decision is based on the particular facts and circumstances at hand. Different facts may lead to a different conclusion in other litigation, even in the First Circuit.

This decision serves as an important reminder of the myriad complexities associated with investing in companies with pension liabilities and the need to assess and structure such investments carefully.

©2019 Drinker Biddle & Reath LLP. All Rights Reserved

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About this Author

David Denious, Corporate Finance Lawyer, Drinker Biddle
Partner

David S. Denious advises clients on leveraged acquisitions and dispositions and corporate finance transactions. Dave represents a wide variety of private equity firms, family offices and similar financial sponsors on leveraged buyout, "going private," recapitalization, and other control transactions and the debt and equity financing relating to such transactions. He also has extensive experience representing both investors and issuers in growth capital and other non-control equity investments. In addition, Dave has counseled numerous strategic clients on...

215-988-2529
John Stoddard, Business attorney, Drinker Biddle
Partner

John E. Stoddard III has advised businesses and their officers, directors and owners on a broad range of legal and business matters for over three decades. He assists private equity firms and middle-market companies on transactional work such as mergers and acquisitions, divestitures, leveraged recapitalizations, private placements and joint ventures, throughout the U.S. and internationally. Utilizing his broad experience and hands-on approach, John focuses on providing practical, cost-effective solutions that address the legal and business needs of the clients he serves.

609-716-6504
Gerald Hathaway, Labor and Employment Lawyer, Drinker Biddle
Partner

Gerald T. Hathaway represents domestic and international corporations of all sizes, including Fortune 500 and Global Fortune 500 companies, in major labor and employment matters. His practice includes advising on the labor and employment aspects of local, national and international corporate transactions and financial restructuring. Jerry’s practice also includes reductions in force, including Worker Adjustment and Retraining Notification Act (WARN) and Older Workers Benefit Protection Act compliance. His clients include private equity funds, major...

(212) 248-3252
Gregory J. Ossi ERISA Lawyer Drinker Biddle
Partner

Gregory J. Ossi advises his clients on ERISA litigation and labor law matters. He regularly counsels employers on a broad range of employee benefits matters, with an emphasis on multiemployer pension liability, including withdrawal liability issues and claims, as well as other health plan issues.

In addition to his work in the employee benefits area, Greg counsels and litigates disputes regarding union organizing, unfair labor practice charges, and labor issues arising from mergers, acquisitions and bankruptcy. Greg’s clients come largely from the energy production...

(202) 230-5393
Neil Haimm, Mergers & acquisitions lawyer, Drinker Biddle
Partner

Neil K. Haimm assists private equity firms and public and private companies with mergers and acquisitions, joint ventures and other strategic transactions, as well as venture and growth capital investments.

Neil has more than 30 years of experience as a corporate lawyer.

215-988-2612