The investor community, and particularly private equity funds, are breathing a sigh of relief after a recent decision by the U.S. Court of Appeals for the First Circuit in Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, No. 16-1376, 2019 WL 6243370 (1st Cir. Nov. 22, 2019) (Sun Capital Partners). The First Circuit held that two private equity funds were not liable for their bankrupt portfolio company's unfunded defined benefit pension plan liability or for the withdrawal liability assessed by a multiemployer pension plan. The private equity fund community's concerns stemmed from the fact that the district court, in analyzing a fact pattern often used by private equity funds, found the funds liable through novel reasoning—that the private equity funds and portfolio company had created "an implied partnership-in-fact" and thus were under common control for pension liability purposes. The First Circuit reversed, finding no such partnership and thus no common control for pension liabilities.

The First Circuit reversed the district court even though there was evidence that the private equity funds knew the portfolio company's pension plan was underfunded when they bought the company, paid less consideration for the company due to such liability and structured the ownership interests in the acquisition so as to insulate the private equity funds from the potential pension fund liability. Thus, Sun Capital Partners eradicates the one federal court decision that found liability for an ownership structure commonly employed by private equity funds that invest in distressed companies with pension liabilities.

Background

Scott Brass, Inc. (SBI), a closely held private company based in Rhode Island, was a market-leading manufacturer of premium brass, copper, and other metals used in cars, jewelry, and other consumer products. SBI employed around 180 people in its three factories in Rhode Island and Indiana, and shipped 40.2 million pounds of metal in 2006.

SBI obtained financing loans from Wachovia Capital Finance Corporation of New England (Wachovia). Pursuant to an agreement dated Feb. 9, 2007, Wachovia advanced SBI a line of credit secured largely by, and capped at 80% of the value of, SBI's metals inventory. The value of such metals inventory dropped precipitously in fall 2018 due to the global financial crisis: the price of copper, which had peaked at $3.96 per pound in April 2008, dropped to $2.16 per pound by that October. Accordingly, Wachovia ceased funding SBI's manufacturing operations. SBI's attempts to secure financing elsewhere failed.

Faced with insufficient working capital and 18 months of declining sales, SBI closed all of its factories in October 2008. On Nov. 21, 2008, three of SBI's creditors filed an involuntary petition for SBI's bankruptcy under Chapter 11 of the Bankruptcy Code. The bankruptcy court determined that SBI had $41 million in liabilities and $30 million in assets as of Dec. 9, 2008. SBI consented to the petition. On Dec. 23, 2008, the bankruptcy court converted the case into a bankruptcy under Chapter 7 of the Bankruptcy Code.

At the time of the petition, SBI's second largest creditor was the New England Teamsters & Trucking Industry Pension Fund. The Teamsters Fund is a multiemployer pension plan that, as the name suggests, is a defined benefit pension plan to which more than one employer has an obligation to contribute pursuant to one or more collective bargaining agreements. When an employer "permanently ceases to have an obligation to contribute" to a multiemployer pension plan, the employer must pay its pro rata share of any underfunding, so-called withdrawal liability. (The Multiemployer Pension Plan Amendments Act of 1980 (MPPAA) amended the Employee Retirement Income Security Act of 1974 (ERISA).) Each members of an entity's controlled group of corporations is jointly and severally liable for withdrawal liability, even if not a direct contributor to a multiemployer pension plan. (The controlled group rules are complex, but are generally viewed in terms of parent/subsidiary (with 80% or more ownership) and brother-sister corporate groups. See ERISA §1563(a).)

Here, SBI was obligated to contribute to the Teamsters Fund via a collective bargaining agreement with its unionized employees. As part of its bankruptcy, SBI ceased to have an obligation to contribute to the Teamsters Fund and the Teamsters Fund assessed withdrawal liability of $4.5 million to SBI. Withdrawal liability is an unsecured debt. When the bankruptcy trustee finished distributing the SBI estate on July 15, 2013, there was nothing left to settle the withdrawal liability.

Seeking deeper pockets, the Teamsters Fund demanded that SBI's owners, Sun Fund III and Sun Fund IV (together, the Sun Funds), two Delaware limited partnerships, pay SBI's liability. In 2006, while SBI was still solvent and contributing to the Teamsters Fund, the Sun Funds formed Sun Scott Brass, LLC (SSB), a Delaware corporation and a vehicle for investing in SBI. Sun Fund III paid $900,000 in exchange for 30% of SSB, while Sun Fund IV paid $2.1 million for the other 70%. SSB then formed a subsidiary, Sun Brass Holding Corporation (SBHC), which in turn used the Sun Funds' $3 million contribution and an additional $4.8 million in financing to buy out SBI for 75% of its fair market value on Feb. 8, 2007. Notably, the Sun Funds had discounted SBI's value to account for the risk of liability posed by its unfunded pension.

The Teamsters Fund sought to hold the Sun Funds jointly and severally liable for SBI's withdrawal liability—even though the Sun Funds did not meet the statutory ownership requirements (i.e., 80% ownership) to be part of SBI's controlled group. The Teamsters Fund argued that the Sun Funds knowingly assumed the risk of withdrawal liability when buying SBI. The Teamsters Fund's legal theory was that the Sun Funds were in the same control group with SBI because, it argued, the Sun Funds had formed a partnership in fact (if not in form), and thus controlled 100% of SBI.

The operation and management of the Sun Funds did suggest they were closely associated. Sun Capital Advisors (SCA), founded, owned, and managed by Marc Leder and Rodger Krouse, created both funds as passive investment vehicles—without offices, employees, or products. SCA pooled investors' capital in those funds, suggested underperforming companies for the funds to acquire, worked out the acquisition deals, and advised the companies the funds acquired. Management companies within each of the Sun Funds—Sun Capital Partners Management III, LC, and Sun Capital Partners Management IV, LC—contracted with SCA to obtain SCA's management advice. The management companies, in turn, contracted with the portfolio companies to provide SCA's advice to the portfolio companies. The Sun Funds, sometimes working together, then restructured the companies and attempted to sell them for a profit a few years after their purchase. In operating SBI, the Sun Funds not only worked together but also, according to First Circuit's record, never disagreed with each other. The Sun Funds even coordinated to keep each individual fund's share of SBI below 80% in part to avoid withdrawal liability.

Furthermore, both Sun Funds vested exclusive control in the same two men who controlled SCA—Marc Leder and Rodger Krouse. The Sun Funds were limited partnerships, each of which was managed by its general partner—Sun Capital Advisors III, LP, and Sun Capital Advisors IV, LP—in exchange for a portion of the fund's commitments and profits and an annual management fee of 2% of the fund's commitments. These general partners, which were also limited partnerships, were managed by their respective limited partnership committees. Leder and Krouse, limited partners within both of the Sun Funds' general partners who, with their spouses, received more than 60% of the general partners' profits, were the sole members of both committees. Thus, in addition to controlling SCA, which advised the Sun Funds and their portfolio companies, Leder and Krouse controlled the Sun Funds themselves. In SBI's case, the men used this power to control the portfolio company too. Leder and Krouse directed the Sun Funds to make two of SBI's three directors SCA employees.

On paper, however, the Sun Funds were not partners but distinct businesses. The funds had different investors: Sun Fund III had 124 investing limited partners and Sun Fund IV had 230. Of those investors, which included individuals and institutions, only 64 overlapped. The funds also maintained separate records and bank accounts, filed separate tax returns, and did not invest in the same entities in the same proportions. Moreover, both of the Sun Funds' limited partnership agreements specifically denied that they were engaged in a partnership together. In SBI's case, the Sun Funds also operated SBI through SSB LLC, a limited liability company, which relative to a partnership, limited the ways in which the funds could share control and responsibility.

Procedural History

Seeking to head off liability for SBI's withdrawal from the Teamsters Fund, the Sun Funds sued for a declaratory judgment in the U.S. District Court for the District of Massachusetts (the district court) on June 10, 2010. The Sun Funds asked the district court to declare, contrary to the Teamsters Fund's assertions, that each fund was not a trade or business or under common control with SBI. The Teamsters Fund counterclaimed, alleging that, despite the Sun Funds' corporate structure and division of control, the two funds were jointly and severally liable under the MPPAA. The Teamsters Fund also alleged that, by dividing the Sun Funds' ownership 70-30, as opposed to 80-20, the two had deliberately attempted to avoid liability in violation of ERISA.

In September 2011, both parties moved for summary judgment. The district court granted the Sun Funds summary judgment on Oct. 18, 2012. According to the court, the Sun Funds were not liable under the MPPAA because they were not trades or businesses, and they were not liable under 29 U.S.C. §1392(c) because the statute did not apply to outside investors. The Teamsters Fund appealed to the U.S. Circuit Court of Appeals for the First Circuit. The First Circuit affirmed the district court's decision with respect to 29 U.S.C. §1392(c), but remanded the case to the district court to determine whether Sun Fund III was a trade or business and whether the Sun Funds were under common control with SBI. The district court decided both that Sun Fund III was a trade or business and that the Sun Funds had formed a partnership, which, owning 100% of SBI, qualified as under common control with SBI. The Sun Funds appealed the district court's partnership and common control decisions to the First Circuit.

The First Circuit's Decision

The First Circuit reversed. Reviewing the case de novo—or without deference to the district court's findings—the appellate court held that the Sun Funds had not formed a partnership. As a result, for purposes of MPPAA, the Sun Funds were not under common control with SBI and therefore, regardless of whether they qualified as trades or businesses, not liable for SBI's withdrawal from the Teamsters Fund under the MPPAA.

In determining whether the Sun Funds were partners, the First Circuit first found that an organization's form under state law was not dispositive. Instead, the federal tax code's definition of partnership was determinative because the MPPAA required that its "common control" regulations be consistent with certain treasury regulations that incorporated such definition. Furthermore, the MPPAA required piercing the corporate veil and looking past corporate form to how the businesses really function. In fact, according to the court, Congress added the "common control" provision to the MPPAA specifically to prevent a company from circumventing its employee benefit obligations by conducting itself through separate entities. Consequently, the court rejected the Sun Funds' arguments that, because they owned SBI through a limited liability corporation (LLC), and because the district court found they had not abided by superficial partnership principles, the funds could not be partners.

Second, the First Circuit determined whether the Sun Funds were partners under federal tax law. To do so, it applied an eight-factor test from Luna v. Commissioner, 42 T.C. 1067 (1964), a U.S. Tax Court case, expressly analyzing five of the eight factors with the factual record. Factor (1), the entities' agreement and performance of that agreement, was mixed. It weighed partially in favor of classifying the Sun Funds as partners due to the two funds' lack of disagreement in operating SSB LLC. This, the court reasoned, showed performance of an agreement. On the other hand, the funds' denying a partnership in their respective limited partnership agreements showed there was no agreement. The language in the limited partnership agreements also counted against the funds being deemed a partnership when the court considered factors (5), whether business was conducted under both entities' names, and (6), whether the parties presented themselves as partners.

Another factor that the court viewed as mixed in analyzing whether a partnership existed was factor (8), joint control over and joint responsibility for the venture. For example, Leder and Krouse controlled both funds and, via the funds' appointment of SCA employees to SBI's board of directors, SBI too. Still, the court found the funds' operation of SBI through an LLC countered this weight by limiting how the funds could jointly control and be held responsible for SBI. Furthermore, because the Sun Funds operated SBI as an LLC—specifically, Sun Scott Brass, LLC—they did not operate it under their names, as would have weighed in favor partnership in factor (5).

The First Circuit also found the Sun Funds' separate books and tax returns and mostly different investors counted against partnership in considering factors (6), presentation as partners, and (7), keeping separate or joint books. The court did not expressly consider the factors (2), each entity's contributions to the business; (3) its control over money from the business; and (4) whether it was a principal in the business or another's agent.

On balance, the First Circuit found that, the Sun Funds had not formed a partnership under Luna and were therefore not subject to withdrawal liability under the MPPAA. In support of this outcome, the court distinguished cases in which courts had found partnerships. Unlike the entities in those cases, the Sun Funds were limited liability organizations in form, and were jointly investing in another business rather than just fracturing into different businesses. Accordingly, the First Circuit found that Congressional intent did not counsel against this outcome. It reasoned that one goal of ERISA and the MPPAA is to protect existing pension plans, but another is to encourage outside investment in faltering companies that might otherwise fail to fund their plans. Together the goals did not suggest the Sun Funds should be found liable.

Conclusion

The First Circuit's decision in Sun Capital Partners clears away a cloud of pension uncertainty hanging over portfolio companies owned by private equity funds through a typical structure that relies upon ownership by separate funds controlled by the same private equity manager. Pension liability can involve staggering amounts, particularly when a multiemployer pension plan is involved. The Sun Capital Partners decision sends a relatively clear message that common control by a private equity manager is, by itself, not sufficient to impose control group liability for unfunded pensions.

While the Teamsters Fund's initial reaction may be one of disappointment, a more considered view should reflect the importance of new capital investment in unionized companies. Generally speaking, investors in private equity funds want the financial and business acumen of the fund manager the investor selected to oversee and control management of the funds' portfolio companies. As a practical reality, the skills and experience of the private equity fund manager are even more critical when the portfolio company has an unfunded pension liability or a large retiree medical responsibility. Continued employment and continuing retiree medical benefits are associated with continuing operations. Encouraging investment and protecting workers should not be competing goals. The Sun Capital Partners decision permits, if not promotes, a dialogue that should be a part of distressed investing in unionized companies.

Corinne Ball is a partner in the New York office of Jones Day. Miguel Eaton is a partner in the Washington, D.C. office of Jones Day.