Seyfarth Synopsis: In a long-awaited decision with significant impact for the private equity industry, in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund, the United States Court of Appeals for the First Circuit held that two Sun Capital private equity investment funds did not create an implied partnership-in-fact in their purchase and management of a portfolio company. As a result, pension fund withdrawal liability incurred as part of the portfolio company’s bankruptcy was not imposed against the investment funds.
Case Background
Declining copper prices caused Scott Brass, Inc. (“Scott Brass”), a brass manufacturing company, to file for bankruptcy, and subsequently withdraw from a multiemployer pension fund (“MEPP”), incurring withdrawal liability. At the time Scott Brass went bankrupt, it was held by a holding company owned by SSB-LLC, which, in turn, was jointly owned by two Sun Capital private equity funds— Sun Fund III (30% share) and Sun Fund IV (70% share) (“Funds”). The portfolio company was managed and operated by a separate Sun controlled management company. While the Funds had some overlap of limited partners and investments, each Fund maintained separate tax returns, financial books, and bank accounts. In addition, the Funds expressly disclaimed in their respective limited partnership agreements any partnership with each other. However, the Funds vested exclusive control over the general partners’ “material partnership decisions” in limited partnership committees headed by two individuals who founded and serve as the co-CEOs and sole shareholders of the private equity firm that established the Funds.
When Scott Brass was assessed withdrawal liability, the pension fund also sent the liability demand to the Funds, claiming that they had entered into a joint venture or partnership in common control with Scott Brass and thus were jointly and severally liable under control group rules for commonly controlled trades or businesses. The Funds initially sought a declaratory judgment action that they were not subject to MEPP withdrawal liability because they were not part of a joint venture or partnership and because neither of the Funds was a “trade or business.” The district court granted summary judgment to the Funds based solely on the “trade or business” portion of withdrawal liability. The First Circuit remanded the case back to the district court to determine whether one of the Funds engaged in “trade or business” and the issue of common control. A parent-subsidiary control group generally only exists where at least eighty percent of the subsidiary ultimately is owned by the parent. Neither Sun Fund ultimately owned eighty percent of Scott Brass, but if the Funds were in partnership together then the partnership would own 100% of Scott Brass and would be jointly and severally liable. This time, the district court found that the Funds formed a “partnership-in-fact” to acquire and operate Scott Brass and that the partnership-in-fact engaged in a “trade or business” in its operation of Scott Brass. As a result, the district court held that the Funds were jointly and severally responsible for Scott Brass’s withdrawal liability.
On appeal, the Funds challenged the district court’s ruling that the Funds formed a de facto partnership.
The First Circuit’s Opinion
Since the Pension Benefit Guaranty Corporation (“PBGC”) did not provide any formal guidance on how to determine common control specifically under the Multiemployer Pension Plan Amendments Act of 1980, the First Circuit applied the multi-factor partnership test in Luna v. Commissioner, 42 T.C. 1067 (1964) to determine whether the Funds formed a partnership-in-fact.
The Luna factors articulated by the Tax Court are:
- “The agreement of the parties and their conduct in executing its terms”;
- “the contributions, if any, which each party has made to the venture”;
- “the parties' control over income and capital and the right of each to make withdrawals”;
- “whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income”;
- “whether business was conducted in the joint names of the parties”;
- “whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers”;
- “whether separate books of account were maintained for the venture”; and
- “whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.”
The First Circuit found that some Luna factors supported finding a de facto partnership. For example, the Funds jointly developed restructuring and operating plans for target companies before acquiring them. In addition, because the same two individuals essentially ran both the Funds and Scott Brass, the organizational control factor favored a partnership-in-fact finding. Finally, there was a pooling of resources and expertise that both the Funds and Scott Brass utilized.
Yet, the Court held that other facts rebutted partnership-in-fact formation. First, the Funds expressly disclaimed any partnership between themselves, which went against factors one, five, and six. Moreover, most of the limited partners in Sun Fund IV were not limited partners in Sun Fund III. Additionally, the Funds filed separate tax returns, had separate books, and maintained separate bank accounts. Also, the Funds did not operate in parallel, showing some independence in operations and structure. Finally, because an LLC was formed to acquire Scott Brass, it went against factor five (Funds were prevented from conducting business in their “joint names”) and factor eight (Funds were limited in how they could “exercise[] mutual control over and assume[] mutual responsibilities for” Scott Brass).
It is worth noting that in considering the Luna factors, even though many of the “day to day” activities of the Funds -- developing restructuring plans, two individuals running the funds, pooling resources and expertise, etc. -- seemed to weigh in favor of a partnership-in-fact, the Court ultimately gave more weight to the Luna factors more closely associated with corporate formalities -- an express disclaimer of partnership, separate books and records, setting up an LLC to acquire the portfolio company, etc.
In addition to Luna, the First Circuit touched upon the conflicting policy choices between dis-incentivizing “private investment in underperforming companies with unfunded pension liabilities,” and the PBGC having to step in to pay a reduced pension benefit if the fund becomes insolvent. The Court was ultimately “reluctant” to impose withdrawal liability on the investment funds because of a lack of congressional intent and formal guidance from PBGC.
Therefore, the Court reversed the entry of summary judgment for the plaintiff pension fund and remanded back to the district court to enter summary judgment for the Funds.
Implications for Private Equity Firms
The private equity business model is highly dependent on courts and government agencies adhering to core principles of corporate and tax law. PE funds are almost always organized separately from the firm itself and the funds utilize various corporate mechanisms to pool resources and ultimately invest in portfolio companies. The District Court’s now-reversed finding would have allowed pension funds (and potentially other creditors) to more easily “pierce the corporate veil” of the portfolio company and go “further up the chain” for monies owed, representing a threat to this core business model.
But while the First Circuit decision is a victory for Sun Capital and PE firms more broadly, the First Circuit’s analysis and lengthy legal battle show that there is no “silver bullet” legal defense preventing pension funds and other creditors from pursuing these theories. In fact, the First Circuit did not draw a bright-line rule that PE investment funds can never be liable for withdrawal liability. Rather, each case will turn on its own unique facts.
PE funds like Sun Capital which respect corporate formalities and treat their businesses as separate entities in the way that corporate and tax law intended can find themselves shielded from these unwanted liabilities; other investment funds which are not as careful in the way that they operate may not find themselves in as fortunate a position, even under the First Circuit’s PE-friendly decision.
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