First Circuit Court of Appeals Addresses Private Equity Fund’s Responsibility for the Unfunded Pension Benefits of Portfolio Companies

August 02, 2013


In a case of first impression, on July 24, 2013, the First Circuit Court of Appeals (the “First Circuit”) held that a private equity investment fund (a “Fund”) could be a “trade or business” for purposes of Title IV of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). Sun Capital Partners III, L.P. et al. v. New England Teamsters and Trucking Industry Pension Fund, 2013 WL 3814984 (1st Cir. July 24, 2013). Accordingly, in the view of the Court, such a Fund could be jointly and severally liable for withdrawal liability for the unfunded pension benefits of a union pension plan incurred by a portfolio company, if the Fund and the portfolio company were found to be trades or businesses under “common control.” The “if” is important, however: the Court remanded to the District Court the question of whether, on the particular facts, the Sun Capital Fund (in the case, three Funds) and the portfolio company constituted a group of trades or businesses under common control for ERISA purposes.


Two Sun Capital Funds,1 each organized as a limited partnership and each managed by general partners controlled by the same two individuals, bought 30% and 70%, respectively, of the equity interests of a limited liability company, which in turn bought all of the equity interests in an active business enterprise, Scott Brass, Inc. Union employees employed by Scott Brass, Inc. accrued benefits under the New England Teamsters and Trucking Industry Pension Fund (the “Pension Fund”) because of contributions made by Scott Brass, Inc. ERISA requires that employers withdrawing from multiemployer (union-based) pension plans pay their share of the plan’s unfunded benefits, called “withdrawal liability.” Under ERISA, all “trades or business” that are under “common control” (broadly defined using an 80% control threshold) with a withdrawing employer are liable for the employer’s unpaid withdrawal liability.

When Scott Brass, Inc. ran into financial difficulties and ceased making contributions to the Pension Fund, ultimately liquidating in bankruptcy proceedings, the Sun Capital Funds sought a declaratory judgment that neither was responsible for any withdrawal liability owing by Scott Brass, Inc. to the Pension Fund. The District Court of Massachusetts agreed, holding that neither was a “trade or business” for purposes of ERISA’s rules regarding trades or businesses under common control. In its view, a trade or business required active management and participation in an active business enterprise, other than through agents.

The View of the First Circuit

The First Circuit disagreed. It concluded that an investor could become a “trade or business” by engaging in what it termed “investment plus;” that is, investment for a profit, but with some or all of the expected return to be derived from directing or influencing the management of the issuers of the underlying investments. In most respects, this analytical approach was not different from that of the District Court. Where the First Circuit departed from the District Court was in concluding that the actions of the two Sun Capital Funds’ agents, their general partner and the persons engaged by the general partner, could be taken into account in determining whether either Fund was a trade or business.

Among the “plus” factors that led the First Circuit to conclude that at least one of the Funds in the present case was a trade or business were the following:

  • the governing instruments and private placement memoranda of the Sun Capital Funds explained that (i) the Sun Capital Funds were to be actively involved in the management and operation of the companies in which they invest (including developing and implementing significant restructuring and operating plans for the portfolio companies, and possibly to the point of signing all checks for a portfolio company) and (ii) the Sun Capital Funds expected to implement significant improvements as to a portfolio company within two years and then exit that investment within two to five years, or earlier, if appropriate;
  • the Sun Capital Funds collectively held controlling stakes, sufficient to carry through on the stated intentions;
  • the Sun Capital Funds designated directors and through service agreements with portfolio companies, the manager engaged by the general partner, the Sun Capital Funds’ agent, provided personnel to portfolio companies, including Scott Brass, Inc., to deliver management and consulting services; and
  • at least one of the Sun Capital Funds benefitted from the fees paid by Scott Brass, Inc. under the above-mentioned service agreements through a corresponding reduction in the Sun Capital Fund’s management fee payable to the general partner.

The First Circuit noted that while none of these factors was dispositive alone, the totality led it to conclude that one of the Sun Capital Funds, at least, was a trade or business. However, as to the other Sun Capital Fund, the record did not show whether that Fund benefitted from the fees paid by Scott Brass, Inc. under the applicable service agreement. Accordingly, it remanded the case to the District Court for a determination as whether the totality of the factors also suggested that Sun Capital Fund was a trade or business. In addition, as the District Court had not ruled on whether Scott Brass, Inc. and either or both of the Sun Capital Funds were under common control for ERISA purposes, the First Circuit also remanded the case to the District Court for a determination on common control.


The management powers described in the First Circuit opinion in some respects appear more extensive than is typical.2 Nevertheless, any Fund that is promoted as intending to benefit investors from applying the strategic and management prowess of its general partner and affiliates to the management of portfolio companies should be aware there is a substantial risk that the Fund will be a trade or business for ERISA purposes.

What ultimate implications that has under ERISA depends on the answer to a further question: is the Fund, if a trade or business, also under common control with one or more of its portfolio companies? The First Circuit sent that question back to the District Court. As common control generally means 80% or more ownership, however, the irony of the Sun Capital decision is that while the Pension Fund prevailed in the First Circuit, it may yet lose the case if it cannot overcome the 70%/30% split of ownership between the two Sun Capital Funds. Using multiple Funds to own 80% or more of a portfolio company is not certain to avoid the common control rules, however. As mentioned in footnote 1, one of the Sun Capital Funds is in fact two. It was only treated as a single Fund by all concerned because the two were operated in complete parallel. Accordingly, any split of ownership among Funds operated by the same managers needs to be considered carefully.

Moreover, because the statutory language at issue under ERISA cross-referenced certain provisions of the Internal Revenue Code (the “Code”) related to employee benefits, the First Circuit’s decision may have potential implications beyond the narrow issue decided in the case. For example, the Code treats trades or businesses under common control as if they constituted one employer for certain employee benefit purposes, including for determining whether various types of employee benefit arrangements, including pension, 401(k) and certain health and welfare plans, satisfy minimum coverage, nondiscrimination and other requirements of the Code for favorable tax treatment. “Trade or business” is as yet undefined for this specific purpose under Code and the Sun Capital decision does not specifically address this question. But it is nevertheless difficult to conceive of the term having a different meaning for purposes of the Code’s benefit-related provisions than under ERISA because, among other reasons, the respective purposes of having common control rules in ERISA and the Code are so similar: in the former case, to ensure a business cannot avoid its pension obligations by using multiple entities and the latter case, to ensure a business cannot avoid Code requirements by using multiple entities.

Finally, it is unclear whether the rationale employed by the First Circuit in its decision would apply beyond the ERISA/employee benefit context. If the First Circuit’s “trade or business” analysis were applied to private equity and other funds more broadly, however, there could be material impacts on the tax consequences associated with forming and investing in those funds. In particular, applying the First Circuit’s “trade or business” analysis could re-characterize what funds typically treat as capital gains into ordinary business income, which would adversely affect tax-exempt investors seeking to minimize their “unrelated business taxable income”, non-U.S. investors seeking to minimize their “effectively connected” income, and sponsors seeking capital gains treatment with respect to their carried interest in a fund.


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1One of the Sun Capital Funds was in fact an amalgamation of two Sun Capital Funds, a distinction ignored by the parties and the courts because those two Sun Capital Funds invested and were managed in complete parallel, e.g., each taking the same percentage of every investment in which either invested. It is not uncommon for ownership of portfolio companies to be divided among related funds, including those with parallel investment strategies, and so the court’s description of the fund as “technically two different funds . . .” [emphasis added] raises concerns about whether portfolio company ownership by related funds may be aggregated for other purposes discussed below (including for purposes of the Internal Revenue Code and for purposes of determining whether investment in a fund by benefit plan investors meets the “significance” threshold discussed in footnote 2 below).

2Note, however, that there are independent reasons under ERISA why private equity funds would desire significant management rights in a portfolio company. The fiduciary, prohibited transaction and other provisions of ERISA apply to a plan’s “assets.” Under ERISA and Department of Labor regulations, the assets of a plan that invests in certain types of investment funds may include not only the fund interests held by the plan, but also the underlying assets of the fund, if investment in the fund by “benefit plan investors” is “significant” (generally speaking, 25% or more). However, this look-through rule does not apply to a fund which qualifies as a “venture capital operating company” or “VCOC,” or a “real estate operating company” or “REOC,”even if investment in such fund by benefit plan investors is significant. But in order to qualify as a VCOC or REOC, the fund must satisfy a number of requirements including that it have and exercise substantial management rights over the companies in which it invests. So a fund which has previously used its status as a VCOC or REOC to avoid certain ERISA complications may now find that there are new ERISA issues to consider.

This article was originally published by Bingham McCutchen LLP.