“Controlled group” liability under ERISA— the risk that pension liabilities might spill out of one portfolio company of a private equity fund and be enforced against another portfolio company of that fund, or against the fund itself—is a risk that has long presented uncertainty for private equity professionals due to the absence of any definitive authority on the point.  For years, however, many sponsors took comfort from favorable analogous case law with respect to general tax principles to conclude that the risk of controlled group liability under ERISA being imposed on them or any other portfolio company of the fund was modest, albeit not non-existent.

But amid the disruption of the recent downturn, novel arguments have been made successfully in the bankruptcy and insolvency context to enforce ERISA claims against healthy sister portfolio companies of private equity funds and against the funds themselves on the basis of controlled group liability theories, thereby engendering additional unease within the community about these potential exposures.  These claims arise in two contexts—the first (and less frequent) is in the termination of single-employer pension plans by the Federal pensions regulator, and the second (and more frequent) is in claims made by union-sponsored “multiemployer” pension plans to enforce liabilities when a portfolio company stops contributing to (or “withdraws” from) the plan.

In what we hope will be a positive direction for private equity sponsors in this area, however, a Federal district court in Massachusetts has recently rejected the two principal adverse precedents for private equity funds to emerge during the downturn.  While certainly not the last word on this issue, fund sponsors can again be cautiously optimistic that this decision will establish that controlled group liabilities can not be enforced against a private equity fund.

Background on Controlled Group Liability

ERISA, the Federal pensions statute, imposes joint and several liability for certain pension liabilities not only on the employer that sponsors the plan, but also against each member of its “controlled group.”  For this purpose, the controlled group of a contributing employer generally includes any parent or subsidiary that is a “trade or business” and that sits in an 80% or greater ownership chain (measured, in the case of a corporation, by vote or value, and, in the case of a partnership, by capital or profits).

For example, if Holding Company “H” has two wholly-owned operating subsidiaries, “S-1” and “S-2,” and S-1 incurs a withdrawal liability under a multiemployer (i.e., union) pension plan because S-1 stops contributing, that liability could be enforced not only against S-1 but also against S-2, H and essentially anywhere else within the H controlled group that assets can be found to the extent that the owner of the assets is engaged in a “trade or business” under ERISA.  The policy behind the controlled group liability statute is anti-abuse in nature, namely to prevent an employer from shielding its assets away from the plan’s enforcement reach.

Historically, even in the absence of any definitive controlling authority on this question, most private equity funds have taken the position that they are not part of an employer’s controlled group because they are not engaged in a “trade or business” for purposes of ERISA.  This view has been based largely on the fact that courts have historically relied on general case law and authority regarding the existence of a “trade or business” for tax purposes to determine whether a fund’s activities constitute a “trade or business” for non-tax purposes.  Since the law is viewed as reasonably clear for general tax purposes that, absent unusual circumstances, a private equity fund’s investment activities do not result in a fund being a “trade or business,” it was generally assumed prior to 2007 that funds were not exposed to controlled group liability under ERISA.

2007—The PBGC Advisory Letter

The viability of this assumption first came under pressure in 2007 when an internal appeals board at the Pension Benefit Guaranty Corporation (or PBGC) concluded that a private equity fund could be considered a “trade or business” for ERISA controlled group purposes.  The decision was issued in connection with the PBGC taking over a bankrupt portfolio company’s underfunded pension plan.  The PBGC arrived at its decision under an agency theory, by attributing to the fund all of the activities of the fund’s general partner, which, in the view of the PBGC, had “full control” over the fund’s business and affairs, including the management of the portfolio companies.  In the PBGC’s view, these management activities, coupled with: (1) the receipt of management fees and other fee income by the related management company; (2) the fund’s stated purpose of effecting operational improvements at its portfolio companies, and (3) certain customary shareholder rights held by the fund, made the fund a “trade or business” under ERISA.  Since 2007, this decision has certainly given members of the private equity community pause, but has by no means been viewed as conclusive, due to skepticism that a court would accept an interpretation of “trade or business” under ERISA that diverged from a general tax analysis as well as skepticism that the PBGC would be willing to test that proposition in a Federal court.

2010—The Palladium Decision

Nonetheless, in 2010, a Federal district court in Michigan issued a decision, Sheet Metal Workers’ National Pension Fund v. Palladium Equity Partners, LLC, that adopted the PBGC’s view, not on the merits but for purposes of denying motions for summary judgment.  Although the case arose in the context of enforcement of withdrawal liability under a union pension plan, the controlled group issues were the same as in the PBGC decision, and the resulting court decision was the first judicial endorsement of the position that a fund could constitute a “trade or business” for ERISA purposes, regardless of the general tax analysis.

In Palladium, two multiemployer pension plans sought to impose ERISA liabilities against a family of private equity funds and their related management company.  The plaintiffs argued that the limited partnerships and the management company were trades or businesses and thus liable, and that the court should treat them all as a single entity for purposes of calculating the 80% threshold necessary to form a controlled group.  (Otherwise, no entity would meet the 80% ownership threshold and so there would be no controlled group liability even if the fund were deemed to be engaged in a trade or business.) The case was subsequently settled without further litigation of these issues.

Although it is a published decision of a court, Palladium, like the PBGC advisory letter, was perceived as weak authority within the private equity community because: (1) as noted above, it was not a decision on the merits, and its conclusions were never tested on appeal; (2) although it endorses the PBGC position on the “trade or business” issue, its conflict with general tax principles results in an analogous departure from historical precedent; (3) its disregard of the separate entity status of the different limited partnerships in the fund family runs contrary to well-established tax and corporate authority on which practitioners rely in structuring and operating private equity funds, and (4) its inclusion of an affiliated investment manager in a controlled group was perceived as just plain wrong, as it runs directly contrary to the express provisions in the controlled group rules, which are based on control resulting from equity ownership.

2012—The Sun Capital Decision

Like Palladium, Sun Capital involved an effort by a union multiemployer pension plan to assert a withdrawal liability claim against private equity funds, in this case managed by Sun Capital.  In summary, two different Sun Capital funds (Fund III and Fund IV) acquired Scott Brass, a manufacturer.  Scott Brass eventually went bankrupt, and around the time of the bankruptcy Scott Brass ceased contributing to the pension plan.  Setting their sights on the only deep pocket available, the plan asserted that the Sun Capital funds were members of the Scott Brass controlled group in an action brought in Federal court in Massachusetts.

Analyzing the tax authority on the issue of whether investment activities can result in a “trade or business,” the district court concluded that the activities of the Sun Capital funds did not constitute a “trade or business” for purposes of assessing withdrawal liability.  The court noted that the funds had no employees, did not own office space, did not make or sell any goods and had no income other than passive investment income.  The court in Sun Capital attached no weight to the fact that (as is nearly always the case) the activities of the funds, of the general partner and of the affiliated management company could be traced to a small number of individuals (in this case, two individuals).  The district court expressly gave no weight to the 2007 PBGC decision, which it found to be “unpersuasive” and “incorrect” and to reflect a “misunderstanding of] the law.”  Unlike the PBGC in its 2007 advisory letter and the court in Palladium, the court respected the separate entities of the general partners and management company and refused to impute their activities to the funds under any agency or similar theory.

Separately but equally importantly, the district court respected the division of the investment among different members of the fund family.  The district court noted that Sun Capital’s Fund III purchased 30% of the Scott Brass equity, while Fund IV purchased 70%.  This bifurcation was made in part for the express purpose of breaking the 80% controlled group chain and thereby avoiding exposure to any risk of withdrawal liability if the investment were to fail (as it ultimately did).  The district court in Sun Capital concluded that this kind of structuring did not violate a separate veil-piercing provision of ERISA.  Although allocating investment opportunities among different funds can create very challenging conflict issues and other potential issues for sponsors, under the right circumstances sponsors may consider this type of structural defense when evaluating acquisitions of “old-economy” targets that sponsor pension plans or contribute to multiemployer plans.

While we hope that the Sun Capital decision is the beginning of the end of the risk that a private equity fund can be viewed as a “trade or business” under ERISA, it will certainly take some time for the law to be classified on these issues.  A starting point will be future activity in the Sun Capital case itself, as the decision is currently being appealed to the First Circuit.  In our view, future battles are most likely to arise in the same manner as in the Sun Capital decision—in the multiemployer plan context.  This is so for two reasons.  First, withdrawal liability is by far a more common way in which controlled group issues tend to arise.  Second, the administrators of the multiemployer plans are fiduciaries to plan participants and, thus, separately liable under ERISA for failure of duty, and their perceived failure in chasing all available assets could open them to fiduciary claims by plan participants.  (The PBGC is not subject to the same fiduciary scrutiny in the plan termination context, and so is likely to have more flexibility in a negotiation.)  Consequently, for the time being at least, private equity sponsors should continue to view the risk of controlled group liability under ERISA as a meaningful component of their diligence, and, where appropriate, may wish to consider structural risk-reduction mechanisms such as were used by Sun Capital.