Keep on the Sunny Side: PE Funds Notch Important Win in Sun Capital

In the latest round of the long-running Sun Capital litigation, two Sun Capital private equity funds won an important victory in the First Circuit in Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, No. 16-1376, 2019 WL 6243370 (1st Cir. Nov. 22, 2019 (Sun Capital III). In this case, the appeals court reversed an earlier district court decision that held, based in part on a novel and controversial "partnership in fact" theory, that two Sun Capital funds were responsible for the pension liabilities of a portfolio company in which they had co-invested. The basis for the reversal was not a rejection of the partnership in fact theory, but rather that the facts in this case did not support the finding of a partnership. Sun Capital III is a welcome decision for private equity (PE) funds, because PE funds are generally structured and operated in a manner similar to the Sun Capital funds, and they should therefore not be deemed to form partnerships in fact merely because they co-invest. While the Sun Capital decisions are not limited to PE funds, these are the investors most likely affected by the First Circuit's theories.

Partnership in Fact Under Sun Capital

The Sun Capital litigation involves two key questions relating to the potential exposure of co-investing funds to the pension liabilities of their portfolio companies. The first question is whether a PE fund may be deemed a "trade or business." This is important because all trades or businesses under "common control" (generally, an 80% or greater ownership link) are jointly and severally liable for the pension liabilities of every other member of the controlled group. While PE funds generally take the position that they are not "trades or businesses," the courts in earlier rounds of the Sun Capital litigation held that PE funds can be "trades or businesses" if they are sufficiently active in the management and operation of their portfolio investments (and the courts found that Sun Capital's funds were each a trade or business).¹ Sun Capital III does not address the trade or business question.

Sun Capital III addresses a second question: whether multiple PE funds that each own less than 80% of a portfolio company, but collectively own 80% or more of the company, may be deemed to be in a controlled group with the portfolio company. Previously, the district court answered this question in the affirmative, holding that the two affiliated Sun Capital funds were in a controlled group with their portfolio company under the "partnership in fact" theory, despite the fact that neither PE fund individually owned at least 80% of the company.² The First Circuit reversed the district court's ruling, based on an analysis of the facts in the case, and found that the two affiliated Sun Capital funds did not form a partnership in fact with respect to their investment in the portfolio company, and thus were not liable for the company's withdrawal liability.

Importantly, the First Circuit did not reject the partnership in fact theory. Instead, the First Circuit applied an eight-factor test taken from a 1960s tax case, Luna v. Commissioner, 42 T.C. 1067 (1964), to determine whether partnership in fact existed, including: the agreement of the parties and conduct in executing its terms; the contributions each party has made to the venture; the parties' control over income and capital and the right to make withdrawals; whether each party was principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share in 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 the business was conducted in the joint names of the parties; whether the parties filed federal partnership tax returns or otherwise represented 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 noted that some of Sun Capital's facts supported finding a partnership, while other did not:

• Facts supporting the finding of a partnership in fact included that (i) the co-investing funds worked together to identify potential portfolio companies and to develop plans for operating and restructuring them, and (ii) the same two individuals essentially managed both funds.
• The court found other facts rebutted the formation of a partnership in fact. The court gave heavy weight to the fact that the two co-investing funds invested in the portfolio company through an LLC that they formed and, in the fund's limited partnership agreements, they expressly disclaimed any partnership or joint venture with each other. The court also pointed to the fact that the two funds (i) filed separate tax returns, (ii) kept separate books, (iii) maintained separate bank accounts, (iv) did not operate in parallel, and (v) had largely different investors. These factors led the court to conclude that the funds had not formed a partnership in fact and were not under common control with the portfolio company.

Lessons for Co-Investing Funds

Although the First Circuit did not reject the partnership in fact theory, PE funds are generally structured and operated in a manner similar to the Sun Capital funds, and they should similarly not be deemed to have formed partnerships in fact merely because they co-invest, based on the same factors as applied to the Sun Capital funds. This is particularly true of unaffiliated funds that may work together to identify potential portfolio investments and develop plans for operating and restructuring them but do not have the same individuals managing the funds. Funds should take care, however, to expressly disclaim the formation of any unintended partnership when they co-invest with other funds. In addition, to the extent the commercial deal permits, co-investing funds should minimize the level of their coordination of investment prior to making their investment, and for affiliated funds, have different persons act on each fund's behalf.

Please do not hesitate to contact us with any questions.

© Arnold & Porter Kaye Scholer LLP 2019 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.