In an opinion issued on October 18, 2012, the Federal District Court of Massachusetts provided clarity and relief for private equity firms on the significant, but murky, question of whether a private equity fund can be liable for the ERISA pension obligations (including multiemployer withdrawal liability and defined benefit pension plan underfunding) of its portfolio companies.

At the heart of this issue is whether a private equity firm is engaged in a “trade or business” for purposes of the Internal Revenue Code’s “controlled group” rules.  Generally, under section 414(c) of the Internal Revenue Code, two or more “trades or businesses” under “common control” are treated as a single entity for various employee benefit plan purposes and are jointly and severally liable for pension plan funding obligations and multiemployer plan withdrawal liability.  Common control includes a parent-subsidiary relationship where the parent owns at least 80% of the subsidiary.

A lingering and unanswered question over the years has been whether a private equity fund is engaged in a “trade or business” for purposes of these controlled group rules.  If so, then depending on the fund’s structure and ownership of its portfolio companies, the fund itself could be held jointly and severally liable for pension and multiemployer plan liabilities of its portfolio companies.

In 2007, the Pension Benefit Guaranty Corporation (PBGC) issued an opinion, which asserted the PBGC’s view that private equity funds are engaged in a trade or business for this purpose and, therefore, if the fund owned at least 80% of a portfolio company, it would be jointly and severally liable for the portfolio company’s pension and multiemployer plan liabilities.

This issue was met head on by the Federal District Court in Massachusetts in Sun Capital Partners v. New England Teamsters & Trucking Industry Pension Fund.  In this case, Sun Capital, through its separate funds, Sun Fund Capital III and Sun Fund Capital IV, acquired Scott Brass, Inc. in 2006 (Sun Fund Capital III acquired a 30% interest and Sun Fund Capital IV acquired a 70% interest).  In 2008, Scott Brass withdrew from the New England Teamsters & Trucking Industry Pension Fund (Pension Fund), in which it had been a participating employer, and filed for bankruptcy.  The Pension Fund, relying on the PBGC’s 2007 opinion, asserted $4.5 million of withdrawal liability against both Scott Brass and Sun Capital.  Sun Capital, in turn, filed a declaratory judgment action asserting that is was not engaging in a trade or business and was, therefore, not within a controlled group with Scott Brass.

The court agreed with Sun Capital.  Specifically, the court found that the PBGC had incorrectly applied the law of agency by attributing activities of a private equity fund’s general partner (which had provided certain management and advisory services to the fund’s portfolio companies for a fee) to the fund itself.  The court found that merely holding passive investment interests (regardless of the size of those investments) did not result in the fund engaging in a trade or business.  To support its position, the court reasoned that Sun Capital did not have employees, or office space, nor did it make or sell any goods.  Additionally, Sun Capital’s tax returns only listed investment income in the form of dividends and capital gains.  Furthermore, the fact that Sun Capital has the power to elect certain directors of Scott Brass was merely an activity performed in its capacity as a shareholder, not as an active manager.

Finally, the court disagreed with the Pension Fund in its argument that Sun Capital should be responsible for the withdrawal liability because a principal purpose of structuring the transaction with a 70%/30% ownership split between Sun Capital Fund III and Sun Capital Fund IV was to avoid the controlled group rules and the ultimate withdrawal liability.  In this connection, the court reasoned that, at the time of the transaction in 2006, Sun Capital did not have an expectation of withdrawal liability and, therefore, they did not structure the transaction to avoid it.  The court found nothing wrong with structuring the transaction to limit potential exposure to an uncertain, unplanned liability (as opposed to structuring the transaction to avoid a known withdrawal liability).

The Pension Fund will be appealing this case and, therefore, the ultimate outcome of this important issue is still uncertain.  However, the District Court’s opinion provides clarity and is clearly an important win for private equity funds.