Private Equity Fund Is Not a “Trade or Business” Under ERISA
District court decision refutes 2007 Pension Benefit Guaranty Corporation opinion letter and could provide potential clarity to private equity firms and private equity funds in determining how to structure their investments.
In a significant ruling that directly refutes a controversial 2007 opinion by the Pension Benefit Guaranty Corporation (PBGC) Appeals Board, the U.S. District Court for the District of Massachusetts held in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund that a private equity fund is not a "trade or business" under the Employee Retirement Income Security Act (ERISA) and therefore is not jointly and severally liable for millions of dollars in pension withdrawal liability incurred by a portfolio company in which the private equity fund had a substantial investment. This ruling, if followed by other courts, will provide considerable clarity and relief to private equity funds that carefully structure their portfolios.
The Sun Capital Case
In Sun Capital, two private equity funds (Sun Fund III and Sun Fund IV) invested in a manufacturing company in 2006 through an affiliated subsidiary and obtained a 30% and 70% ownership interest, respectively, in the company. Two years after their investment, the company withdrew from a multiemployer pension plan in which it had participated and filed for protection under chapter 11 of the Bankruptcy Code. The pension fund assessed the company with withdrawal liability under section 4203 of ERISA in the amount of $4.5 million. In addition, the pension fund asserted that the two private equity funds were a joint venture or partnership under common control with the bankrupt company and thus were jointly and severally liable for the company's withdrawal liability.
In response to the pension fund's assessment, the private equity funds filed a lawsuit in federal district court in Massachusetts, seeking a declaratory judgment that, among other things, they were not an "employer" under section 4001(b)(1) of ERISA that could be liable for the bankrupt company's pension withdrawal liability because they were neither (1) a "trade or business" nor (2) under "common control" with the bankrupt company.
Summary Judgment for the Private Equity Funds
After receiving cross-motions for summary judgment, the district court granted the private equity funds' motion for summary judgment. In a lengthy and detailed written opinion, the court made three significant rulings.
First, the court held that the private equity funds were passive investors and not "trades or businesses" under common control with the bankrupt company and thus were not jointly and severally liable for the company's withdrawal liability. In so holding, the court rejected a 2007 opinion letter of the PBGC Appeals Board, which had held that a private equity fund that owned a 96% interest in a company was a trade or business and was jointly and severally liable for unfunded employee benefit liabilities when the company's single-employer pension plan terminated.
A fundamental difference between the legal reasoning of the court in the Sun Capital case compared to the reasoning of the PBGC in the 2007 opinion is the extent to which the actions of the private equity funds' general partners were attributed to the private equity fund. In the PBGC opinion, the Appeals Board concluded that the private equity fund was not a "passive investor" because its agent, the fund's general partner, was actively involved in the business activity of the company in which it invested and exercised control over the management of the company. In contrast, the court in Sun Capital stated that the PBGC Appeals Board "misunderstood the law of agency" and "incorrectly attributed the activity of the general partner to the investment fund."
Second, in responding to what the court described as a "creative" but unpersuasive argument by the pension fund, the court concluded that the private equity funds did not incur partnership liability due to the fact that they were both members in the affiliated Delaware limited liability company (LLC) that the funds created to serve as the fund's investment vehicle in purchasing the manufacturing company. Applying Delaware state law, the court stated that the private equity funds, as members of an LLC, were not personally liable for the liabilities of the LLC. Therefore, the court concluded that, even if the LLC bore any responsibility for the bankrupt company's withdrawal liability, the private equity funds were not jointly and severally liable for such liability.
Third, the court held that, even though each of the private equity funds limited its investment in the manufacturing company to less than 80% (i.e., 30% for Fund III and 70% for Fund IV) in part to "minimize their exposure to potential future withdrawal liability," this did not subject the private equity funds to withdrawal liability under the "evade or avoid" provisions of section 4212(c) of ERISA. Under section 4212(c) of ERISA, withdrawal liability could be incurred by an entity that engages in a transaction if "a principal purpose of [the] transaction is to evade or avoid liability" from a multiemployer pension plan. In so ruling, the court stated that the private equity funds had legitimate business reasons for limiting their investments to under 80% each and that it was not clear to the court that Congress intended the "evade or avoid" provisions of ERISA to apply to outside investors such as private equity funds.
Legal Context for the Court's Ruling
Due to the distressed condition of many single-employer and multiemployer pension plans, the PBGC and many multiemployer pension plans are pursuing claims against solvent entities to satisfy unfunded benefit liabilities. For example, if a company files for bankruptcy and terminates its defined benefit pension plan, the PBGC generally will take over the plan and may file claims against the company's corporate parents, affiliates, or investment funds that had a controlling interest in the company, or the PBGC will pursue claims against alleged alter egos, successor employers, or others for the unfunded benefit liabilities of the plan that the bankrupt company cannot satisfy.
Similarly, if a company contributes to a multiemployer pension plan and, for whatever reason, withdraws from the plan, the withdrawing company will be assessed "withdrawal liability" if the plan has unfunded vested benefits. In general, withdrawal liability consists of the employer's pro rata share of any unfunded vested benefit liability of the multiemployer pension plan. If the withdrawing company is financially unable to pay the assessed withdrawal liability, the multiemployer plan may file claims against solvent entities pursuant to various legal theories, such as controlled group liability or successor liability, or may challenge transactions that have a principal purpose of "evading or avoiding" withdrawal liability.
Under ERISA, liability for unfunded or underfunded employee benefit plans is not limited to the employer that sponsors a single-employer plan and is not limited to the employer that contributes to a multiemployer pension plan. Instead, ERISA liability extends to all members of the employer's "controlled group." Members of an employer's controlled group generally include those "trades or businesses" that are under "common control" with the employer. In parent-subsidiary controlled groups, for example, the parent company must own at least 80% of the subsidiary to be part of the controlled group. Under ERISA, being part of an employer's controlled group is significant because all members of the controlled group are jointly and severally liable for the employee benefit liabilities that the company owes to an ERISA-covered plan.
Private Investment Funds as "Trades or Businesses"
Historically, private investment funds were not considered to be part of an employer's controlled group because they were not considered to be a "trade or business." Past rulings generally have supported the conclusion that a passive investment, such as through a private equity fund, is not a trade or business and therefore cannot be considered part of a controlled group.
In 2007, however, the Appeals Board of the PBGC issued a contrary opinion, concluding a private equity fund that invested in a company that eventually failed was a "trade or business" and therefore was jointly and severally liable for the unfunded employee benefit liabilities of the company's defined benefit pension plan, which was terminated by the PBGC. Although the 2007 PBGC opinion letter was disputed by many practitioners, it was endorsed by at least one court.
The Palladium Capital Case
In Palladium Capital, a related group of companies participated in two multiemployer pension plans. The companies became insolvent, filed for bankruptcy, withdrew from the multiemployer pension plans, and were assessed more than $13 million in withdrawal liability. Unable to collect the withdrawal liability from the defunct companies, the pension plans initiated litigation against three private equity limited partnerships and a private equity firm that acted as an advisor to the limited partnerships. The three limited partnerships collectively owned more than 80% of the unrestricted shares of the defunct companies, although no single limited partnership owned more than 57%.
Based on the specific facts of the case, and relying in part on the PBGC's 2007 opinion, the U.S. District Court for the Eastern District of Michigan denied the parties' cross-motions for summary judgment. Among other things, the court stated that there were material facts in dispute over whether the three limited partnerships acted as a joint venture or partnership regarding their portfolio investments, whether the limited partnerships were passive investors or "investment plus" investors that actively and regularly exerted power and control over the financial and managerial activities of the portfolio companies, and whether the limited partnerships and their financial advisor were alter egos of the companies and jointly liable for the assessed withdrawal liability. Because there were genuine issues of material fact regarding each of these issues, the court denied each party's motion for summary judgment.
Significance of the Sun Capital Decision
In concluding that a private equity fund is not a "trade or business," the Sun Capital decision directly refutes the 2007 PBGC opinion letter and its reasoning. If the Sun Capital decision is followed by other courts, it will provide welcome clarity to private equity firms and private equity funds in determining how to structure their investments. Among other things, both private equity funds and defined benefit pension plans would benefit from knowing whether or under what circumstances a fund's passive investment in a portfolio company can constitute a "trade or business" thus subjecting the private equity fund to potential controlled group liability. Similarly, both private equity firms and private equity funds need to know whether a court will attribute to the private equity fund the actions of a general partner or financial or management advisors in determining whether the investment fund is sufficiently and actively involved in the operations and management of a portfolio company to be considered a "trade or business."
The Sun Capital decision was rendered, as noted above, against a backdrop in which the PBGC and underfunded pension plans are becoming more aggressive in pursuing new theories of liability against various solvent entities to collect substantial sums that are owed to the employee benefit plans by insolvent and bankrupt companies. Until the law becomes more developed and clear regarding the various theories of liability that are now being asserted against private equity funds investing in portfolio companies that are exposed to substantial employee benefits liability, it would be prudent for private equity firms and investment funds to do the following:
- Structure carefully their operations and investment vehicles.
- Be cautious in determining whether any particular fund should acquire a controlling interest in a portfolio company that faces substantial unfunded pension liability.
- Ensure that the private equity fund is a passive investor and does not exercise "investment plus" power and influence over the operations and management of its portfolio companies.
- Conduct thorough due diligence into the potential employee benefits liability of a portfolio company, including "hidden" liabilities, such as withdrawal liability, that generally do not appear on corporate balance sheets and financial statements.
- Be aware of the risks in structuring a transaction in which an important objective is to elude withdrawal liability.
Similarly, until the law becomes more developed and clear, multiemployer pension plans may wish to devote particular attention to the nature and structure of both strategic and financial owners of the businesses that contribute to their plans and should weigh and balance the risks to which they are exposed by different ownership approaches.
. Sun Capital, slip op. at 17.
. Id. at 29-30.
. See e.g., Whipple v. Comm'r., 373 U.S. 193, 202 (1963).
. See, e.g., Bd. of Trs., Sheet Metal Workers' Nat'l Pension Fund v. Palladium Equity Partners, LLC (Palladium Capital), 722 F. Supp. 2d 854 (E.D. Mich. 2010).