By Robert Q. Johnson, ESOPs, Benefits & Compensation

Private equity funds have been looking for a reprieve after the Sun Capital litigation ended with a surprising loss to the industry. They may now have the chance to revisit the outcome in another jurisdiction and with better facts.

Sun Capital

The Sun Capital litigation was most notable for finding that a private equity fund was engaged in a “trade or business” for ERISA purposes. Previously the prevailing view, with a few exceptions, was that private equity funds were more akin to passive investors. The difference is important for many reasons, but in Sun Capital the fund became responsible for the entire withdrawal liability imposed by a multiemployer (union) pension fund following the portfolio company’s bankruptcy. The litigation also resulted in some other novel findings that arent relevant here, including the ruling that parallel investment funds were a “partnership-in-fact” that together owned the required 80% discussed below.

Heres how we got there: Under ERISA, any entity within the same “controlled group” as an employer is jointly and severally responsible for the employer’s withdrawal liability, which is a shortfall an employer owes a union pension plan upon certain events. In this context, a controlled group exists when a “trade or business” owns at least 80% of another entity. (There are other methods of forming a controlled group as well.)

So if a private equity fund is not a “trade or business” it does not have to pay the withdrawal liability of its portfolio companies. On the other hand, if a private equity fund is found to be a “trade or business” the fund is responsible to pay the entire withdrawal liability (about $4.5 million in the Sun Capital case). The designation as a “trade or business” forming a controlled group also impacts fundsand potentially the other portfolio companies in which the fund owns at least 80%with respect to routine benefits compliance like retirement plan nondiscrimination testing, Affordable Care Act determinations, deferred compensation arrangements, and related tax issues.

In the Sun Capital case, the First Circuit Court of Appeals ruled that the fund was a trade or business largely based on the significant control the fund exercised over, and the management fees it received from, the bankrupt portfolio company that incurred the pension withdrawal liability. The fund’s affiliated management entities and the fund’s representatives were heavily involved in management of the portfolio company. The Court of Appeals also found it significant that the fees paid by the portfolio company to the fund’s affiliated management entities offset the fee that the fund’s investors owed to the fund manager. The resulting standard is called the “investment-plus” test, and the upshot is that too much involvement with, and compensation from, a portfolio company can turn a private equity fund into a trade or business, not just a passive investor.

Trilantic Capital

Now a new case seeks a different ruling on slightly more favorable facts. The backstory is essentially the same as that in Sun Capital: In 2008, Trilantic Capital Partners IV, LP, a private equity fund, purchased through various subsidiaries almost all of a company called Angelica Corporation, a supplier of medical linens and laundry services. The company had its own pension plan and contributed to several multiemployer plans on behalf of its large unionized workforce. The company’s finances declined and it was forced into bankruptcy in 2017. Shortly after, the PBGC and the multiemployer plans told Trilantic that they intended to seek the pension shortfall of over $60 million from Trilantic as a member of Angelica Corporations controlled groupthe same theory approved in the Sun Capital litigation.

Trilantic sued in federal court asking for a ruling that it wasn’t an employer in the same controlled group as Angelica Corporation. It claimed the fund was merely a passive investor that acted consistently with that roleas a shareholder it appointed the companys board members, but otherwise had no management rights, management or consulting fees, day-to-day oversight of hiring or firing, etc. The fund also claimed it received no payments from the company at all; its only ability to profit was from its ownership stake increasing in value. The pension funds have since pushed back, arguing that Trilantic was more intimately involved in company management than Trilantic claimed (and also that Trilantic must arbitrate the case before going to court).

The Trilantic case is pending in a different jurisdiction than the Sun Capital casea Manhattan federal district court, which falls within the New York-based Second Circuit Court of Appeals, as opposed to the Boston-based First Circuit where the Sun Capital litigation took place. So the court considering the Trilantic case is not required to follow the rule in Sun Capital.

A few things may happen. The court could send the matter to arbitration, which is the standard method for resolving multiemployer plan withdrawal liability. It could hear the case and distinguish its facts to rule that Trilantic was a passive investor without explicitly approving or rejecting the higher investment-plus standard. It could adopt the investment-plus test but find that the facts here fall short of “plus,” or alternatively that Trilantic did have the required level of involvement to constitute a trade or business. Or it could reject the higher standard, finding that even hands-on management is consistent with the status of a passive investor, resulting in circuit split. Any decision the court does issue will most likely be appealed. Alternatively, the parties may settle the matter among themselves, but given the amounts involved that outcome seems less likely.

The bottom line is that few, if any, private equity funds or their sponsors are entirely hands-off, completely passive investors. The ultimate issue then comes down to a matter of degreehow much control, involvement, or economic benefit does it take to become a trade or business as opposed to a passive investor. The answer has significant implications not only for multiemployer pension fund withdrawal liability, but also for more routine aspects of tax and benefits compliance. Hopefully this case will shed some light.

In the meantime, careful analysis is required before entering any transaction that could result in a controlled group where the portfolio company (or another portfolio company already owned by the fund) could have ERISA liabilities. Due diligence to understand the potential cost, as well as a corresponding adjustment to the transaction price, should take place early on where significant ERISA exposure is possible. In some cases, fund sponsors may wish to limit their involvement and management fees from the portfolio company if ERISA claims are likely. In the end, though, there will be some guesswork involved until a clearer standard is announced.

The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2024.