Paul Weiss on Sun Capital ERISA Case
By Lewis R. Clayton, Robert C. Fleder and Udi Grofman
Private equity funds are considering the impact of the widely-discussed Sun Capital ruling, which increases the risk that funds will be responsible for ERISA obligations of portfolio companies.
ERISA makes all “trades or businesses” in a “controlled group” liable for each other’s pension obligations. Those obligations can include responsibility for minimum funding contributions and payment of unfunded liabilities when a plan terminates or a portfolio company withdraws from a multiemployer (union-sponsored) plan. Well-established case law holds that investment activity alone is not a “trade or business” under the tax code. Many practitioners have accordingly believed that a private equity fund is not a “trade or business” and therefore has no responsibility for ERISA liabilities of portfolio companies.
In Sun Capital, 724 F.3d 129, a multiemployer pension plan and the PBGC (which guarantees pension liabilities) sought to impose on three Sun Capital Advisors funds ERISA withdrawal liability that arose when a portfolio company entered bankruptcy. Announcing a multi-factor “investment-plus” approach, the First Circuit Court of Appeals found that one of the funds was engaged in trade or business and not simply an investor. The factors the Court noted – including the fund’s avowed purpose to identify companies “in need of extensive intervention,” its active involvement in portfolio company management and the fact that management fees paid by the fund were offset by fees paid to Sun by portfolio companies – apply to many private equity groups. Refusing to be pinned down, the Court declined to provide even “general guidelines” for its investment –plus test and cried out for regulation, expressing “dismay” that the PBGC had not given guidance “to the many parties affected.”
The Sun Capital decision may be vulnerable because it clashes with tax precedent in an area where ERISA was designed to be in harmony with the tax code. But unless the Supreme Court intervenes or other Circuits disagree, the holding will govern in the First Circuit and may be persuasive elsewhere.
That shifts the focus from “trade or business” to another requirement for the imposition of ERISA liability where there is little clear precedent– whether a fund and its portfolio companies are part of a “controlled group.” A fund and its portfolio companies may be part of a “controlled group” only when the fund owns 80% or more of the companies in question. To minimize potential liability in deals involving underfunded defined benefit plans (no risk arises from defined contribution plans), funds may wish to stay below the 80% threshold, perhaps by bringing in outside investors. Whether the holdings of parallel funds and funds within the same private equity group (or the holdings of outside investors closely associated with a fund manager) can be aggregated to satisfy the 80% threshold are novel and unsettled issues that may be addressed in further trial court proceedings in Sun Capital (similar questions were considered in a Michigan district court ruling in Palladium, 722 F.Supp.2d 854). To resolve these fact-based issues, courts likely will weigh evidence concerning the relationships among such funds and investors.
Unless Sun Capital is overruled or proves to be an outlier, funds will likely react by bolstering due diligence regarding pension plans, seeking representations and indemnities covering pension obligations and avoiding 80% ownership. Funds may also mention the risk of ERISA liability in disclosure documents. An unintended and unfortunate consequence may be to discourage investment in troubled companies with poorly funded pensions. Portfolio companies within a controlled group may also have to bear or report liability for ERISA liabilities of other companies within the group.
Finally, while the Sun Capital court confined its decision to ERISA, mischief would ensue if its holding were extended to tax questions regarding income received by foreign investors and the line between ordinary income and capital gains. Any such result would upset settled rules on which funds and their investors have long relied. The IRS and the Treasury are aware of the issue and say they are proceeding with care.
