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The Sun Capital Case: New Liability Concern for Private Funds Extends Beyond Pension Liability




by:
Edward V. Wilson
Husch Blackwell LLP - Kansas City Office

 
May 9, 2014

Previously published on May 2, 2014

Recently the food and agribusiness industry has seen a significant increase in private equity activity. These private equity funds should keep in mind new liability concerns raised by the Sun Capital case.

Business owners rely on the legal generality that the owners of an entity are not liable for the debts of that entity. However, there are exceptions to this rule, and one comes from the world of pension withdrawal liability. Pension withdrawal liability may be imposed on a party that is not the company obligated to the pension fund if such party is part of the same “controlled group” under ERISA. In the past, a private fund and its portfolio companies were not typically considered part of a controlled group; however, the Sun Capital ruling in 2013 determined that under certain circumstances, private funds and their portfolio companies could be considered part of a controlled group.

The controlled group rules are complex, but generally two conditions must be satisfied: (1) the party must be under “common control” with the company obligated to the pension fund; and (2) the party must be a “trade or business.” The “common control” test is fairly objective. In general, an 80% threshold for voting rights or economic ownership demonstrates the common control of multiple entities. However, the “trade or business” test is more subjective, and prior to the Sun Capital case, the general consensus was that a private fund was not a “trade or business.” Historically, the argument was that a private fund’s passive investment in a portfolio company was not sufficient to constitute a trade or business.

However, in 2013 the U.S. Court of Appeals for the First Circuit held in Sun Capital that, under certain circumstances, a private fund could be considered a trade or business and therefore could be held responsible for the pension liabilities of its portfolio companies. The court adopted what is being referred to as an “investment plus” test for determining whether a private fund is a trade or business. The court indicated that something more than passive investment must be present, but did not provide any guidelines for identifying such factors. That being said, the court did find that the following factors, taken together, were enough to establish that Sun Capital was a trade or business:

  • Sun Capital’s investment documents stated that Sun Capital would be actively involved in the management and operation of portfolio companies;

  • Sun Capital’s general partners had authority to participate in the management of portfolio companies, including hiring, terminating, and compensating employees;

  • Sun Capital’s controlling stake in the relevant portfolio company allowed it to participate in the management and operation of the company to a degree well beyond that of a passive investor; and

  • One of the Sun Capital funds received a direct economic benefit from managing the relevant portfolio company. (Payments by the portfolio company to the fund’s general partner for management services were offset against the management fees the fund was required to pay to the general partner.)

The ramifications of a private fund and its portfolio companies constituting a controlled group extend well beyond liability for pension deficits. Many funds’ portfolio companies have no unpaid pension liabilities. However, virtually every private fund and its portfolio companies will encounter one or more of the following compliance challenges if they are treated as a controlled group. The plans and employment history of all members of the controlled group must be monitored and considered for, among other things:

  • Discrimination and eligibility testing for retirement and health plans and deferred compensation arrangements;

  • Determining whether the employer mandate under health care reform applies;

  • Calculating contribution limits;

  • Analyzing whether the employee has incurred a separation from service for purposes of vesting and receiving a distribution under qualified and non-qualified plans;

  • Applying the COBRA rules;

  • Testing cafeteria plans for discrimination;

  • Applying the HIPAA rules;

  • Applying the qualified retirement plan minimum participation rules;

  • Determining deadlines to remit 401(k) or non-qualified deferred compensation plan distributions; and

  • Determining the ability to terminate a 401(k) or non-qualified deferred compensation plan.

Due to the Sun Capital ruling, private funds should be very mindful of being treated as part of the same controlled group with their portfolio companies. Some of the rules that would apply to a controlled group may be applied regardless of a fund’s controlled group status. However, for many private funds, compliance with these rules is possible only if their controlled group status is accurately known. Because many, if not most, private funds and/or their portfolio companies are uncertain of their status, they risk failing to comply with the applicable benefits rules.



 

The views expressed in this document are solely the views of the author and not Martindale-Hubbell. This document is intended for informational purposes only and is not legal advice or a substitute for consultation with a licensed legal professional in a particular case or circumstance.
 

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Author
 
Edward V. Wilson
Practice Area
 
Investments
 
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