Ruling Against Sun Capital Should Give Private Equity Reason For Pause
In late March, the U.S. District Court of the District of Massachusetts issued a decision in a case closely watched by the private equity and venture capital community, holding two Sun Capital private equity funds jointly liable for $4.5 million in withdrawal liability of a portfolio company, Scott Brass Inc.
Applying the First Circuit’s “investment plus” standard, the court ruled both Sun Capital funds were engaged in a “trade or business” for the purposes of shared liability. And while neither fund by itself owned 80 percent of Scott Brass - the threshold required for a private equity fund to be part of a controlled group with a portfolio company - the court ruled the two were a “partnership-in-fact” that owned all of the company.
The case is important because it established a precedent for the imposition of liability on private equity investment funds for pension liabilities of a portfolio company. And the district court’s decision could have broad implications if other courts adopt its reasoning.
Sun Capital Background
The case dates to 2008, when Scott Brass Inc., a maker of brass and copper coils and a portfolio company of the Sun Funds, declared bankruptcy. When that happened, Scott Brass withdrew from the New England Teamsters & Trucking Industry Pension Fund and incurred $4.5 million in withdrawal liability. Unable to secure payment directly from Scott Brass, the fund demanded payment from two Sun Capital funds, Sun Fund III and Sun Fund IV, which owned 30 percent and 70 percent of the company, respectively.
Under the Employee Retirement Income Security Act of 1974, members of a controlled group are liable for the pension obligations of every other member of the group. But in order for a private equity fund to be part of a controlled group with a portfolio company there must (a) be common control (i.e., the a parent organization owns at least 80 percent of each organization in the chain) and (b) the fund must be a “trade or business.”
Historically, private equity funds have argued they are not engaged in a trade or business. This view was challenged in a 2007 opinion by the Appeals Board of the Pension Benefit Guaranty Corp., a federal agency created under ERISA, which said that a private equity fund firm should be considered a trade or business. The PBGC based its position, in part, on the finding that portfolio management involved continuous business activities.
The District Court of Massachusetts rejected this opinion in its initial ruling and found in favor of the Sun Capital funds. But the Court of Appeals for the First Circuit overturned the district court’s decision in July 2013. In its opinion, the appeals court held that in some circumstances, a private equity fund can be a trade or business. More specifically, it said that while passive investment alone wasn’t enough to make an investor a trade or business, “investment plus” (i.e., some economic benefit not generally received by a passive investor) could.
Applying this “investment plus” test, the appeals court found one of the two funds, Sun Fund IV, was indeed a trade or business. It said the fund was more than a passive investor, in part, because the controlling interest it held in the portfolio companies put it in a position where it would be intimately involved in the company’s management and operations. The court also focused on an agreement between Scott Brass and an affiliate of Sun Fund IV. The agreement created the potential for a management fee offset, which the court said provided a significant economic benefit to the Sun Fund. The case was remanded to the district court with instructions the judge look at whether the other fund, Sun Fund III, was also engaged in a trade or business. The lower court was also instructed to decide whether the two funds had the requisite ownership to be considered part of a controlled group with Scott Brass.
District Court’s Decision
The District Court of Massachusetts, in a decision on March 28, answered yes to both questions. With respect to the first - whether Sun Fund IV was a trade or business - the court similarly focused on the management fee offset both Sun Capital funds were entitled and decided the offset was an economic benefit that made the fund a trade or business.
The second hurdle was the issue of ownership, which was complicated by the fact that two Sun Funds had different investors, separate lifecycles and their portfolios were largely different. Still, the court decided they formed a single “partnership-in-fact” with respect to their investment in Scott Brass, and therefore, together, owned 100 percent of the company. The court appears to have based its decision on a few factors in particular. One was that each of the funds’ general partners were managed by the same two individuals, Marc Leder and Rodger Krouse, the co-CEOs of Sun Capital Advisors. There was also evidence that the funds worked with one another to operate their investment in Scott Brass and make management decisions. This included coordination in their investigation of the company before investment, as well as coordination in control after the investment was made.
The March 28 decision in the Sun Capital case represents a pivotal decision on an issue that affects many private equity investment funds. Some unanswered questions remain, including whether the court’s analysis would apply similarly to other ERISA liabilities and areas of tax law where a controlled group analysis is relevant. Still, the decision might embolden multiemployer pension funds to try to collect withdrawal liability from private equity funds, particularly when the private equity funds are managed by the same sponsor and those funds collectively own 80% or more of the portfolio company. Private funds should therefore evaluate the economic arrangements with respect to their portfolio companies and consider whether co-investment by related funds might impact their ownership position.