District Court Holds that Private Equity Funds Were a Trade or Business in Common Control with Portfolio Companies

Practical Law Legal Update w-001-8261 (Approx. 9 pages)

District Court Holds that Private Equity Funds Were a Trade or Business in Common Control with Portfolio Companies

by Practical Law Employee Benefits & Executive Compensation

Background

Sun Capital Advisors, Inc. (SCAI) sponsors two private equity funds, Sun Capital Partners III, LP (Sun Fund III) and Sun Capital Partners IV, LP (Sun Fund IV), (together, the Sun Funds) that invest in underperforming companies. SCAI provides capital to the Sun Funds and, through related entities, takes an active role in the management of the Sun Funds' portfolio companies. For ERISA purposes, the Sun Funds are venture capital operating companies (VCOCs) (see Practice Note, Venture Capital Operating Companies: Overview and Structuring Considerations).

In 2007, the Sun Funds purchased Scott Brass, Inc. (SBI), a closely-held corporation that contributed to the New England Teamsters and Trucking Industry Pension Fund (the TPF). The general partner of Sun Fund IV, through a subsidiary, contracted with SCAI to provide management and consulting services to SBI. At the time the Sun Funds purchased SBI, they established Sun Scott Brass, LLC as the vehicle for investing in SBI.

In October 2008, due to its poor business performance, SBI stopped contributing to the TPF, which made it liable for its proportionate share of the TPF's unfunded vested benefits. An involuntary Chapter 11 bankruptcy proceeding was brought against SBI in November 2008. In December 2008, the TPF demanded that SBI pay its estimated withdrawal liability of $4.5 million. The TPF also demanded this amount from the Sun Funds, asserting that they were part of a joint venture or partnership under common control with SBI, and were therefore jointly and severally liable for the entire amount of SBI's withdrawal liability under ERISA.

In response, the Sun Funds filed a declaratory judgment action in the US District Court for the District of Massachusetts, seeking a declaration that they were not subject to withdrawal liability because they did not meet MPPAA's two requirements for withdrawal liability as set out in ERISA Section 4001(b)(1) (29 U.S.C. § 1301(b)(1)). Specifically, the Sun Funds alleged they were not:

A "trade or business" under ERISA.
Part of a joint venture or partnership under common control with SBI.

On October 18, 2012, the district court held that the Sun Funds were not a "trade or business" under MPPAA because they did not:

Have any offices or employees.
Make or sell goods or report income other than investment income on their tax returns.
Engage in the general partner's management activities.

The district court did not reach the issue of common control.

The TPF appealed the court's decision to the US Court of Appeals for the First Circuit. On July 24, 2013, the First Circuit, presented with a case of first impression:

Reversed the district court's grant of summary judgment in favor of Sun Fund IV on the issue of withdrawal liability, holding that Sun Fund IV was a "trade or business" for purposes of the two-prong controlled group test under ERISA Section 4001(b)(1).
Vacated the district court's grant of summary judgment in favor of Sun Fund III, remanding the case to the district court to determine whether:
- Sun Fund III was more than a passive investor so as to constitute a trade or business; and
- the two funds were under common control with SBI.
Affirmed the district court's holding, though on different grounds, that the Sun Funds did not engage in a transaction to evade or avoid liability under ERISA Section 4212 (29 U.S.C. § 1392).

(See Legal Update, Private Equity Funds Can Be Responsible for Withdrawal Liability of Portfolio Companies: First Circuit.)

Outcome

On March 28, 2016, the district court issued its decision, addressing the two questions posed by the First Circuit on remand.

Sun Fund III and IV Were Trades or Businesses

When analyzing this case on appeal, the First Circuit held that an "investment plus" approach should be used when evaluating the existence of a trade or business in this context. This involves a very fact-specific analysis that considers a number of factors (none of which is dispositive on its own). On the basis of this analysis, the First Circuit held that Sun Fund IV was a trade or business because it met the investment plus test based on:

The purpose of the Sun Funds' investment in SBI.
The Sun Funds' role in the management and operation of SBI.
The direct economic benefit Sun Fund IV received from its active management of SBI, which was a benefit that an ordinary, passive investor would not receive. Specifically, Sun Fund IV received an offset against the management fees it otherwise would have paid its general partner for managing the investment in SBI. The First Circuit was unable to determine whether Sun Fund III also received this benefit and left this question to the district court on remand.

On remand, the district court applied the investment plus analysis to the offsets that were generated by the Sun Funds. The Sun Funds clarified that Sun Fund III did receive and use offsets against the management fees it otherwise would have paid its general partner, so the district court held that Sun Fund III was a trade or business.

The court also rejected the Sun Funds' contention that the First Circuit relied on an erroneous factual determination in holding that Sun Fund IV is a trade or business. The Sun Funds had clarified that Sun Fund IV's general partner waived its management fees during the years before the bankruptcy, so Sun Fund IV was not able to use the offsets it generated. The offsets that were generated but not used by Sun Fund IV are referred to as "carry-forwards." Under the carry-forward arrangement, when the directors fees, corporate services fees, investment banking fees, net fees, or private place fees are applied against and exceed the management fee for the immediately succeeding six-month period, the excess is carried forward to reduce the management fee payable in the following six-month periods.

The Sun Funds argued that the carry-forwards do not provide a direct economic benefit because they do not:

Have an impact on the financial performance or position on the Sun Funds in the periods in which they accumulate.
Satisfy the constructive receipt or economic benefit tests used for recognition of income.

The district court rejected these arguments because the First Circuit did not intend that the trade or business determination on remand be guided by the accounting conventions adopted by the Sun Funds or the tax rules on timing of receipt of income. Rather, the First Circuit couched the question it presented to the district court in broad terms: whether the Sun Funds received any benefit from the offset of management fees. The district court found that the carry-forwards provided Sun Fund IV with benefits not available to the ordinary passive investor who does not engage in management activities. Therefore, Sun Fund IV received a direct economic benefit from the carry-forward arrangement, which means that Fund IV was a "trade or business" under ERISA Section 4001(b)(1) (29 U.S.C. § 1301(b)(1)).

Common Control

The First Circuit also asked the district court on remand to determine whether the Sun Funds are under common control with SBI.

Two or more trades or businesses are under common control if they are members of a parent-subsidiary group (the relevant category here), a brother-sister group, or a combined group of trades or businesses (26 C.F.R. § 1.414(c)-2). A parent-subsidiary group exists if a controlling interest in each of the organizations other than the parent organization is owned by one or more of the other organizations and the common parent organization owns a controlling interest in at least one of the other organizations. A controlling interest is defined as 80% ownership. (26 C.F.R. § 1.414(c)-2(b).) Here, Sun Fund III held a 30% ownership interest in the portfolio company and Sun Fund IV held a 70% ownership interest in the company.

At the time the Sun Funds purchased SBI, they created Sun Scott Brass, LLC to invest in SBI. Although both parties agreed that the Sun Funds formed a jointly controlled business entity, the Sun Funds argued that the joint entity is fully and exclusively embodied in Sun Scott Brass, LLC. But on remand, the district court looked past the Sun Funds' choice to use an LLC structure in assessing their withdrawal liability because:

Under MPPAA, organizational liability must reflect the economic realities of business entities, not just organizational forms.
The LLC in this case was a way to coordinate the Sun Funds, and an attempt to limit liability, rather than a truly independent entity.

The court surveyed partnership tax law to help determine whether a partnership existed between the Sun Funds. In Commissioner v. Tower and Commissioner v. Culbertson, the US Supreme Court provided factors that factfinders should review to help determine whether, for tax purposes (and, by extension, for MPPAA purposes), the partners really and truly intended to join together for the purpose of carrying on business and sharing in the profits or losses or both, including:

The partnership agreement.
The conduct of the parties in execution of its provisions.
The statements of the parties.
The parties' relationship.
The parties' respective abilities and capital contributions.
The actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent.

(327 U.S. 280, 286-97 (1946); 337 U.S. 733, 742 (1949)).

And in Luna v. Commissioner, the Tax Court provided a list of factors to help determine whether a partnership exists:

The agreement of the parties and their conduct in executing its terms.
The contributions, if any, which each party has made to the venture.
The parties' control over income and capital and the right of each to make withdrawals.
Whether each party was a principal and co-proprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income.
Whether business was conducted in the joint names of the parties.
Whether the parties filed federal partnership returns or otherwise represented that they were joint venturers.
Whether separate books of account were maintained for the venture.
Whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.

(42 T.C. 1067, 1077-78 (1964).)

The court observed that there were several factors showing that the Funds did not intend to be joined together as a partnership:

Sun Fund III and Sun Fund IV have separate financial statements, separate reports to their partners, separate bank accounts, largely non-overlapping sets of limited partners, and largely non-overlapping portfolios of companies in which they have invested.
When the Sun Funds co-invested, as in Sun Scott Brass, LLC, their agreements disclaimed any intent to form a partnership or joint venture.

Furthermore, the factors conventionally used to determine the existence of a general partnership, such as those that would reflect operational and institutional overlap between the Funds, are not evident here. And yet, the court held that the two Funds coordinated with one another and engaged in joint action in a way sufficient to create a partnership (what the court termed a partnership-in-fact) because:

The Sun Funds were not passive investors who simply happened to invest in the same entity. Joint activity took place when the Sun Funds decided to co-invest in SBI: together they created Sun Scott Brass, LLC for the specific purpose of investing in SBI. According to the court, that joint activity was intended to constitute a partnership-in-fact. The Sun Funds disclaimed any intent to form a partnership and argued that they did not engage in joint action because they specifically intended to form the LLC. But the court stated in a footnote that the proper inquiry is whether the Sun Funds intentionally engaged in conduct that would support the existence of a partnership. An entity is not shielded from withdrawal liability under MPPAA merely because it intended to be shielded from withdrawal liability.
Between 2005 and 2008, Sun Fund III and Sun Fund IV also co-invested in five other companies, using the same organizational structure, and prior to each purchase, joint activity took place in order for the funds to co-invest.
The Sun Funds made a conscious decision to split their ownership stake 70%/30% for reasons that demonstrate the existence of a partnership. The Funds did not independently decide on this division in ownership. Elaborating on this point, the court explained that the funds had several goals (and these goals stem from the Funds' top-down decision to allocate responsibilities jointly):
- Sun Fund III was nearing the end of its investment cycle while Sun Fund IV was earlier in its own cycle;
- a preference for income diversification between the Funds; and
- to keep each Fund below 80% ownership to avoid withdrawal liability (which, ironically, the court viewed as a decision that reflects an identity of interest and unity of decision-making between the Funds, and therefore a basis for establishing withdrawal liability here).
The Sun Funds' joint action continued through the period of operation of the portfolio companies.
No evidence was given that the Sun Funds sometimes co-invested with each other but sometimes co-invested with other outside entities.
No evidence was given that the Sun Funds ever disagreed over how to operate Sun Scott Brass, LLC.

Here, the court aggregated the Funds' ownership interests because a partnership in fact existed between them. Essentially, the two Funds were organizationally separate but not actually independent of one another in their co-investments. The partnership-in-fact sat atop Sun Scott Brass, LLC, which the court viewed as a site of joining together and forming a community of interest between the Funds. This partnership-in-fact was sufficient to aggregate the Funds' ownership interests and place them under common control with the portfolio company.

In support of its partnership-in-fact holding, the court referred to the decision of the US District Court for the Eastern District of Michigan in Bd. of Trs., Sheet Metal Workers' Nat'l Pension Fund v. Palladium Equity P'rs, LLC (722 F. Supp. 2d 854 (E.D. Mich. 2010)). In Palladium, a pension fund sued three private equity funds over withdrawal liability under MPPAA. The funds had invested in a group of companies that went bankrupt and withdrew from the pension plan, but the funds:

Disclaimed any intent to form a partnership.
Owned over 80% of the companies (enough for common control under the withdrawal liability regulation), but no individual fund owned more than 57% of them.

However, the private equity funds in Palladium shared a single general partner and financial advisor, and the general partner was authorized to act as the agent for all three funds. Perhaps most importantly, Palladium dealt with parallel funds that entered into a single securities purchase agreement and invested in the same proportion to each other.

The Palladium court held that it could not determine whether the three funds were a joint venture or a partnership as a matter of law and denied cross-motions for summary judgment. The case settled before fact-finding could be completed. The district court in Sun Capital cited Palladium as favorable precedent even though the private equity funds in Palladium were parallel funds and the Sun Capital Funds are nonparallel funds that have few overlapping investments and do not make common investments in fixed proportion.

Commonly Controlled Funds Are a Trade or Business Together

Finally, the district court in Sun Capital held that not only was each Sun Fund a trade or business, but the partnership-in-fact existing between the two Funds was itself a trade or business as a matter of law, because:

The partnership's purpose was to make a profit.
The partnership was actively involved in the active management of SBI. For example, the Sun Funds placed employees of SCAI in two of the three director positions on the board of SBI, which indicates a joint effort to control it.
In seeking out potential portfolio companies in need of extensive intervention, the Sun Funds engaged in a period of joint investigation and joint action before creating Sun Scott Brass, LLC.

In the absence of an express partnership agreement, the conduct of the Funds gave rise to both the existence of the partnership-in-fact and the trade or business purpose of that partnership.

Withdrawal Liability

The court concluded that the Sun Funds are jointly and severally liable for the pro rata share of unfunded vested benefits owed to the TPF by SBI because:

Each Fund is a trade or business.
The Funds acted as a partnership-in-fact when they invested in SBI.
As a partnership-in-fact, the Funds' ownership interests are aggregated and the partnership is in common control with SBI.
The partnership-in-fact is a trade or business.

The sum of these holdings is that the two requirements of withdrawal liability under ERISA Section 4001(b)(1) are met.

Practical Implications

Sun Capital is a significant decision for the private equity industry, and private equity funds and their counsel should familiarize themselves with the decision and its implications.

The district court's holding that Sun Fund III was a trade or business under the investment plus standard was not surprising following the First Circuit's decision regarding Sun Fund IV, although the two decisions taken together run counter to the common assumption that private equity funds investing in this context are not trades or businesses for purposes of withdrawal liability.

More importantly, the district court's decision surprised many in the private equity world by holding that the two Sun Funds formed a partnership-in-fact by how they structured their investment in SBI and through their involvement in the management of SBI, even though:

They used an investment structure that is common in the private equity world.
This case involved nonparallel funds that have non-overlapping investments and use different investment strategies.

Therefore, if the decision stands on appeal, it could impact many private equity funds and result in significant restructuring of investments that have some connection to multiemployer pension plans, because merely ensuring that each fund falls below the 80% threshold will not be enough to avoid a finding of common control, if the funds' consolidated ownership interests exceed 80%.

Faced with this possibility, private equity funds and their counsel should pay close attention to subsequent developments in this case. The district court's decision is likely to be appealed to the First Circuit.

District Court Holds that Private Equity Funds Were a Trade or Business in Common Control with Portfolio Companies | Practical Law