Two private equity funds that co-owned a manufacturer that went bankrupt were not responsible for pension fund withdrawal liability the company incurred at the time of its bankruptcy, the 1st U.S. Circuit Court of Appeals has found.
Plaintiffs Sun Capital Partners III, LP (Sun Fund III) and Sun Capital Partners IV, LP (Sun Fund IV), held respective 70- and 30-percent ownership stakes in manufacturer Scott Brass, Inc. When Scott Brass went bankrupt, it withdrew from defendant New England Teamsters & Trucking Industry Pension Fund, resulting in the company owing $4.5 million for its proportionate share of the plan’s unfunded pension liabilities.
A U.S. District Court judge in Massachusetts determined that the plaintiffs were an implied “partnership-in-fact” consciously structured so that each remained below the 80-percent ownership threshold that triggers responsibility under ERISA for a portfolio company’s pension withdrawal liability.
Accordingly, the judge held the plaintiffs jointly and severally liable under the federal Multiemployer Pension Plan Amendments Act.
But the 1st Circuit reversed, holding that the two private equity funds were not a partnership-in-fact under the factors laid out in Luna v. Commissioner, a 1964 decision from the U.S. Tax Court.
Specifically, the 1st Circuit found that while the funds were controlled by the same two individuals, who coordinated to identify, acquire and sell portfolio companies like Scott Brass, the funds operated as distinct business entities with primarily different investors and investments.
“The district court held that there was an implied partnership-in-fact which constituted a control group. We reverse because we conclude the Luna test has not been met and we cannot conclude that Congress intended to impose liability in this scenario,” Judge Sandra L. Lynch wrote for the panel.
“This decision offers a model for PE funds to evade ERISA’s withdrawal liability by using business formations as a shield. The consequence of limiting the entities a multi-employer pension fund may recover from is widely felt.”
— Marshal Garbus, North Kingstown, R.I.
The 25-page decision is Sun Capital Partners III, LP, et al. v. New England Teamsters & Trucking Industry Pension Fund.
Attorneys for the parties could not be reached for comment prior to deadline.
However, Marcia S. Wagner, an ERISA attorney in Boston, said the decision settles a long-running dispute over the particular funds’ liability, including a 2013 1st Circuit decision in the case that a private equity fund could be considered a “trade or business” potentially liable as a member of a controlled group under ERISA.
Wagner also cautioned that the latest decision in Sun Capital was very fact specific and that not every case would necessarily come out the same way.
“But the case reflects that federal common law is available to fill the gaps in ERISA,” she said.
Marshal Garbus of North Kingstown, Rhode Island, who represents pension funds in collection matters, said the decision will make it more difficult for plans to recover from insolvent employers owned by private investors.
“[T]his decision allows PE funds to invest in portfolio companies and exert a substantial degree of control without accepting the obligations of ERISA withdrawal liability,” he said.
Garbus said he was particularly concerned that the court’s application of the Luna test put more weight on the intention of the private equity funds not to create a partnership than their mutual control over the employer.
“This decision offers a model for PE funds to evade ERISA’s withdrawal liability by using business formations as a shield,” Garbus said. “The consequence of limiting the entities a multi-employer pension fund may recover from is widely felt.”
Boston ERISA lawyer Jonathan M. Feigenbaum said the ruling falls along the lines of other 1st Circuit ERISA opinions in choosing not to make broad pronouncements, opting instead to make case-by-case determinations — here, because of a lack of guidance from the federal Pension Benefit Guaranty Corp. or from Congress on the specific issues presented.
“For private equity attorneys, there are some takeaways that probably can be implemented from the 1st Circuit decision on deal structure, at least on how to avoid a partnership-in-fact,” he said. “However, the broader issues of what constitutes a ‘trade or business’ under ERISA and whether Congress intended to impose liability on funds investing in failing businesses have not been resolved.”
Michael F. Connolly, a business litigator in Boston, agreed that the decision would have significance in the private equity sphere, giving guidance to corporate finance lawyers seeking to make sure investment funds are separate and distinct.
More broadly, he said, “the decision certainly suggests that the government agency responsible for pension liability should address situations like this to provide more clarity and not have situations where cases go up to the federal court of appeals twice.”
Partnership in fact?
Sun Capital Advisors, a private equity firm, established a number of funds, including Sun Fund III and Sun Fund IV. The funds invested in underperforming companies in order to turn them around and sell them for a profit.
As part of an acquisition of Scott Brass, the two funds formed and financed a limited liability corporation, Sun Scott Brass, LLC, of which Sun Fund III owned a 30-percent interest and Sun Fund IV owned a 70-percent interest.
The LLC, in turn, formed and financed Scott Brass Holding Corp., a subsidiary holding company, which used the funds’ $3 million investment in the LLC and $4.8 million in debt financing to purchase Scott Brass’ stock. The stock was purchased at 25 percent below fair market value to account for Scott Brass’ known unfunded pension liability.
Ultimately Scott Brass went bankrupt and withdrew from the defendant pension fund.
When the plan sought to collect on Scott Brass’ withdrawal liability, the funds filed an action in U.S. District Court seeking a declaration that they did not assume responsibility.
Judge Douglas P. Woodlock, however, ultimately held that the funds formed a partnership-in-fact and therefore their combined ownership of Scott Brass exceeded the 80-percent threshold, making them jointly and severally liable under ERISA.
The funds appealed.
The 1st Circuit stated at the outset that imposing withdrawal liability in a case like Sun Capital could have negative policy ramifications.
In particular, the panel found, it could disincentivize private investment in underperforming companies with unfunded pension liabilities, worsening the financial stability of multi-employer pension plans.
At the same time, the panel found some indication of a partnership-in-fact. For example, Lynch said, the two men controlling the entities that served as the funds’ general partners “essentially ran things for both the Funds and [Scott Brass].”
Additionally, the funds placed employees of Sun Capital Advisors in two of Scott Brass’ three director positions, enabling the firm to control Scott Brass.
“[T]his pooling of resources and expertise … which the Funds used not only to identify, acquire, and manage portfolio companies, and structure those deals, but to provide management consulting and employees to portfolio companies, including [Scott Brass], is evidence tending to show a partnership,” Lynch stated.
Ultimately, however, the panel found that when applying the Luna factors, there were stronger indicators that there was no partnership-in-fact.
For example, the panel observed, the funds expressly disclaimed a partnership between them. Also, most of the 230 limited partners in Sun Fund IV were not limited partners in Sun Fund III.
Meanwhile, the funds filed separate tax returns and kept separate books and bank accounts, further rebutting assertions of partnership-in-fact status, the court noted.
“Moreover, we are reluctant to impose withdrawal liability on these private investors because we lack a firm indication of congressional intent to do so and any further formal guidance from [the Pension Benefit Guaranty Corp.],” Lynch wrote.
Accordingly, the court concluded that Woodlock’s summary judgment for the pension fund should be reversed.