Sun Capital Update: Court Of Appeals Reverses District Court's Finding Of Constructive Partnership Between Private Equity Funds

On November 22, 2019, the First Circuit Court of Appeals held in Sun Capital Partners III, LP, et al. v. New England Teamsters & Trucking Industry Pension Fund, 1 that two private equity funds, Sun Capital Partners III, LP ("Fund III") and Sun Capital Partners IV, LP ("Fund IV", and together with Fund III, the "Funds") were not liable for approximately $4.5 million in multiemployer pension plan withdrawal liability of their bankrupt portfolio company. The First Circuit reversed a 2016 District Court decision finding that the Funds had created an implied partnership-in-fact.

Although the First Circuit found in favor of the Funds, its opinion suggests that courts might imply a partnership-in-fact, and private equity funds could be found liable for the pension obligations of their portfolio companies, depending on the relevant facts and circumstances. 2 While the decision relates to a private equity fund, and thus has several important implications for private equity firms as discussed in more detail below, the issues at play could also have implications for other alternative investment managers, including venture capital funds, family offices and sovereign wealth funds.

Background

Sun Capital Advisors, Inc. ("SCAI"), a private equity firm, established both Funds. In 2006, the Funds acquired Scott Brass, a brass and copper manufacturing business which was a participant in the New England Teamsters & Trucking Industry Pension Fund, a multiemployer pension plan (the "Pension Plan"). The Funds completed the Scott Brass acquisition by forming and financing a limited liability company, Sun Scott Brass, LLC ("SSB LLC"), with Fund III owning 30% and Fund IV owning 70% of SSB LLC. SSB LLC then formed and financed a wholly-owned subsidiary holding company, Scott Brass Holding Corporation, which purchased all of the outstanding stock of Scott Brass.

In 2008, Scott Brass filed for bankruptcy and subsequently withdrew from the Pension Plan, incurring withdrawal liability. A dispute arose as to whether the Funds were members of Scott Brass' controlled group, 3 such that they could be held jointly and severally liable for the withdrawal liability under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). The analysis of that dispute by the District Court centered around whether the Funds had formed, through their actions even if not through legal documentation, a general partnership (the so-called "partnership-in-fact") that could be said to hold their respective interests in SSB LLC. If they did, that partnership-in-fact would be the common parent entity of a controlled group, and its partners, the Funds, would be liable for its obligations as its general partners under partnership law.

The dispute was litigated in the U.S. District and Circuit Courts for several years. 4 In 2016, the U.S. District Court for the District of Massachusetts held that the Funds were liable for Scott Brass' obligations to the Pension Plan, concluding that the Funds' coordinated efforts in forming SSB LLC resulted in the Funds having formed a partnership-in-fact that was engaged in a "trade or business" under ERISA. The Funds appealed the District Court's decision.

The First Circuit's Decision

The First Circuit examined the question of whether, in spite of their "express corporate structure", the Funds had created a partnership-in-fact which was the parent entity in the Scott Brass controlled group. 5 The Court looked to Federal tax law in its analysis, ultimately finding that no partnership-in-fact existed between the Funds.

Furthermore, the Court noted that it was reluctant to impose withdrawal liability on private investors because it lacked a "firm indication of congressional intent to do so and any further formal guidance from the [Pension Benefit Guaranty Corporation]." 6 The Court did not address the question of whether the Funds were engaged in a trade or business. (A failure to find that the Funds were engaged in a trade or business would have been separate grounds for finding no liability under ERISA.)

The Luna Factors

The First Circuit's analysis turned on the application of a multi-factor partnership test adopted in 1964 by the Tax Court in Luna v. Commissioner ("Luna"). 7 Notably, the Court indicated that the Luna factors applied because "[m]erely using the corporate form of a limited liability corporation cannot alone preclude...