Sun Capital Court Finds that Common Industry Practices Exposed PE Funds to Pension Plan Liabilities

Background of the Sun Capital Dispute

In 2006, Scott Brass Inc. (SBI) was acquired by three investment funds linked to the Sun Capital Partners Inc. group for approximately $7.8M ($3M invested by the funds and $4.8M funded by debt). SBI participated in an underfunded multiemployer (or union) defined benefit pension plan, and when SBI declared bankruptcy in 2008, the pension plan assessed $4.5M in withdrawal liabilities against SBI. The pension plan pursued payment of the withdrawal liabilities from the deep pockets of the three Sun Capital funds who owned SBI: Sun Capital Partners III, LP (SCP-III), its parallel fund Sun Capital Partners III QP, LP (SCP-IIIQ) and Sun Capital Partners IV, LP (SCP-IV). As noted in our prior client alerts, the district court¹ initially held that the Sun Capital funds could not be liable for such amounts, but the U.S. Court of Appeals for the First Circuit² reversed the decision and held that the funds might be liable under “controlled group” principles, thereby setting the stage for this new district court decision.³

Controlled Group Pension Liability

Under certain circumstances, each member of a “controlled group” of companies can be jointly and severally liable for any other member’s liabilities to a defined benefit pension plan (whether a single employer or multiemployer pension plan) pursuant to the Employee Retirement Income Security Act of 1974 (“ERISA”). A “controlled group” includes any group of corporations or unincorporated “trades or businesses” under “common control.”⁴ For this purpose, “common control” exists in all entities in an unbroken chain of parent-subsidiary relationships⁵ of at least 80 percent ownership (based on voting power or economic interest).

Funds Were “Trades or Businesses” Under “Investment Plus” Standard

In its 2013 Sun Capital decision, the First Circuit held that where a PE fund’s activities went beyond mere passive investment it could be a “trade or business.” Under a loosely defined “investment plus” standard, the First Circuit held that SCP-IV was a trade or business based on the active involvement of SCP-IV⁶ in advising, staffing and overseeing SBI and, most critically, based on the special economic benefits obtained by SCP-IV from its close involvement in SBI, benefits that an ordinary investor could not obtain. Specifically, the First Circuit noted that when SCP-IV’s subsidiary management company contracted to provide services to SBI, the fees paid by SBI to the management company reduced the management fees owed by SCP-IV to its general partner. The court characterized this common type of offset arrangement as a direct economic benefit for SCP-IV, and a clear basis to distinguish SCP-IV from a passive investor. The First Circuit remanded the case to the district court to determine if SCP-III had obtained a similar economic benefit (and thus was engaged in a trade or business) and whether SBI was under the common control of the Sun Capital funds.

In the new decision, the district court found that both SCP-III and SCP-IV had received management fee offset rights in connection with SBI, which rights constituted special economic benefits for purposes of the “investment plus” standard. The court also clarified that, even where a PE fund’s realization of gain from such an offset arrangement is conditional upon the occurrence of uncertain future events, the conditional offset right still constituted a sufficient economic benefit if it would have value to a third party.

Investment Coordination Resulted in a Partnership-in-Fact

The district court found that, notwithstanding their “trade or business” status, the Sun Capital funds were not necessarily aggregated into a controlled group with SBI. Consistent with standard practice, none of the funds met the 80 percent ownership threshold needed to establish common control: SCP-IV held just a 70 percent interest in SBI, and SCP-III and SCP-IIIQ cumulatively held a 30 percent interest.

However, the court found that the Sun Capital funds had unintentionally created a “partnership-in-fact” under federal common law, which partnership owned 100 percent of SBI and, thus, was in a controlled group with SBI. The existence of this undocumented partnership-in-fact was based upon the funds’ coordination of their organizational activities prior to and after acquiring SBI, including a joint effort to control SBI, rather that independent efforts to exert control, e.g. through membership on SBI’s board of directors. The court noted that, consistent with industry practice, SCP-III, SCP-IIIQ and SCP-IV coordinated their decisions to invest in SBI and then jointly formed an acquisition LLC that consummated the SBI purchase. Furthermore, after the acquisition, the Sun Capital funds never disagreed as to how SBI should be operated, as might be expected if the funds operated independently.

Download: Sun Capital Court Finds that Common Industry Practices Exposed PE Funds to Pension Plan Liabilities

1. Pillsbury Client Alert, Limiting Private Equity Fund Exposure to the ERISA Obligations of Portfolio Companies (November 2012).
2. Pillsbury Client Alert, PE Fund Deemed a 'Trade or Business'—May Be Liable for Portfolio Companies' Pensions, (August 2013).
3. No. 10-cv-10921-DPW, 2016 WL 1253529 (D. Mass. Mar. 28, 2016), available at https://www.gpo.gov/fdsys/pkg/USCOURTS-mad-1_10-cv-10921/pdf/USCOURTS-mad-1_10-cv-10921-1.pdf.
4. All corporations under common control are separately defined to constitute a controlled group, but unincorporated entities (e.g., LLCs and partnerships) are only included in a controlled group if they are classified as trades or businesses.
5. Less often, entities may be aggregated into a controlled group based on certain types of brother-sister relationships.
6. As discussed in our prior client alert, SCP-IV itself took no actions, but the First Circuit imputed the activities of SCP-IV’s general partner (staffed with members of the Sun Capital Partners, Inc. leadership team) to SCP-IV.