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.
Any labor lawyer worth his or her salt knows of the National Labor Relation Board’s Browning- Ferris decision, which radically changed the definition of a “joint employer” under NLRB case law [Full Disclosure: Seyfarth Shaw represents Browning-Ferris in this proceeding]. Similarly, any private equity lawyer worth his or her salt is aware of several rulings emanating from the United States Court of Appeals for the First Circuit and District Court of Massachusetts involving private equity firm Sun Capital Partners which threatened to hold several Sun affiliated investment funds responsible for withdrawal liability imposed at a bankrupt portfolio company.
As one of the rare lawyers whose practice straddles both of these areas, I have been intently following each case for some time now. While Browning-Ferris is still up in the air while the NLRB determines through rulemaking and a DC Circuit remand what the Board considers the proper joint-employer standard is, the First Circuit delivered the likely final word on Sun Capital this past Friday, finding that the two Sun Capital controlled funds were not a partnership-in-fact under tax law and thus were not jointly responsible for the portfolio company’s withdrawal liability.
The Sun Capital case was a significant one in private equity for the same reasons that Browning-Ferris has reverberated so much in traditional labor law. In both cases, courts and governmental agencies have arguably eviscerated core principles of corporate law and tax law to find “deeper pockets” for alleged labor and employment related liabilities, potentially at the expense of deterring private investment in failing businesses.
In its decision, the First Circuit immediately recognized this tension, noting that imposing withdrawal liability on investment funds “would likely dis-incentivize much-needed private investment in underperforming companies with unfunded pension liabilities.” The Court went on to note that “this chilling effect could, in turn, worsen the financial position of multiemployer pension plans.” On the other hand, if no withdrawal liability was imposed on the investment funds and the pension fund becomes insolvent, then the workers themselves, some with as much as 30 years of service, would receive a greatly reduced pension payout (totaling a maximum of $12,870 annually) through the Pension Benefit Guarantee Corporation. Suffice to say, cases such as these can present difficult public policy questions.
Whether the two Sun affiliated investment funds constituted a “partnership-in-fact” was critical because a parent-subsidiary control group is jointly and severally liable for pension fund liabilities only when at least eighty percent of the subsidiary is owned by the parent. Neither fund affiliated with Sun ultimately owned 80 percent of the portfolio company, but if the funds were in partnership together then the resulting “partnership-in-fact” would have owned 100% of the portfolio company and thus would have been jointly and severally liable for the portfolio company withdrawal liability— the deep pockets found.
Ultimately, the First Circuit did not draw a bright-line rule that PE investment funds can never be liable for withdrawal liability at a portfolio company. Rather, the First Circuit borrowed a multi-factor test from a fifty-five year old tax law case (Luna v. Commissioner, 42 T.C. 1067 (1964)) (which, it should be noted, was decided before a single PE firm was ever founded!) and held that Sun Capital’s two investment funds did not create a partnership-in-fact such that there was common control of the portfolio company sufficient to require the imposition of withdrawal liability.
To be sure, the First Circuit found that some of the Luna factors supported finding a de facto partnership. For instance, the funds jointly developed restructuring and operating plans for target companies before acquiring them. In addition, the same two individuals essentially ran both the funds and the management company in charge of the portfolio company. The Court also noted that there was a pooling of resources and expertise that both the funds and the portfolio company utilized.
Yet, the Court held that other facts rebutted partnership-in-fact formation. First, the funds expressly disclaimed any partnership between themselves. Moreover, most of the limited partners in each fund were not the same. 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 actually acquire the portfolio company, the Funds were prevented from conducting business in their “joint names” and were limited in how they could “exercise mutual control over and assume mutual responsibilities for” the portfolio company.
What’s most interesting is that 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 finding, the Court ultimately gave more weight to the Luna factors more closely associated with corporate formalities—an express disclaimer of partnership, separate books, setting up an LLC to acquire the portfolio companies, etc. The Court also seemed uneasy with striking down core tenets of corporate law without at least some input from Congress or the PBGC on the issue, even saying in its closing paragraphs that its decision was partially based on a “reluctance” to impose withdrawal liability without a “firm indication of congressional intent to do so and any further formal guidance from the PBGC.” The Court further noted that the lack of congressional intent meant that “two of ERISA and the MPPAA’s principle aims—to ensure the viability of existing pension funds and to encourage the private sector to invest in, or assume control of, struggling companies with pension plans—are in considerable tension here.”
The case is a strong reminder that corporate formalities do matter and that PE funds, like Sun Capital, which respect corporate formalities and treat their businesses as separate entities in the way that corporate and tax law intends can find themselves shielded from unwanted liabilities at their investments; 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 otherwise PE-friendly decision.