Private equity firms and other alternative asset managers that become directly involved in the day-to-day business activities of portfolio companies run the risk of being held directly liable for the Worker Adjustment Retraining Notification (“WARN”) Act violations of those entities. The Court of Appeals for the Second Circuit recently clarified the standards that apply to such liability, and other courts have further defined the contours of acceptable and riskier behavior.

In Giuppone v. BH S&B Holdings LLC, 737 F.3d 221 (2d Cir. 2013), York Capital, Bay Harbour Management, and certain of their affiliates faced possible liability for alleged violations by the successor entity to Steve and Barry’s Industries, Inc. In analyzing the plaintiff’s claims, the Second Circuit formally adopted a five-factor test created by the Department of Labor (the “DOL”) to determine whether related entities should be considered to be a single employer for purposes of the WARN Act. Under the five-factor test, a court considers: (1) common ownership; (2) common directors or officers; (3)  de facto exercise of control; (4) unity of personnel policies emanating from a common source; and (5) dependency of operations. In adopting this standard, the court specifically rejected York Capital’s suggestion that the test the court had applied in Coppola v. Bear, Stearns & Co., 499 F.3d 144 (2d Cir. 2007), which by its terms applied to lenders to distressed companies, should also apply to private equity investors. While only a handful of cases relied upon the DOL’s test prior to 2011, it has now become the prevalent analysis applied by courts analyzing the potential liability of related entities for violations of the WARN Act.

In analyzing the nature of the relationships between the private equity firms and the employing entity, the following factors were most significant:

  • Common Ownership: The firms had different ownership than the employing entity, given that two separate private equity firms had invested. Note that a private equity sponsor that owns all of the equity of a portfolio company would be at risk with respect to this factor. See, e.g., Young v. Fortis Plastic, LLC, 294 F.R.D. 128 (N.D. Ind. 2013) (Monomoy Capital Partners’ motion to dismiss WARN Act claims denied; Monomoy owned all of the equity of the employer).
  • Common Directors or Officers: Because four of seven board members were appointed by the private equity firms, the court found that this factor favored the plaintiff. Nonetheless, it noted that this factor is of limited value, as courts assume that directors are wearing their “subsidiary hats” when acting on behalf of a downstream entity.
  •  de facto Control: Courts repeatedly emphasize that this is the most important factor in the DOL’s test. Here, the court found that the plaintiff failed to allege that the investors had controlled the decision-making process, ruling that the alleged conduct occurred at the level of the holding company, as the parent to the employing entity.

A Cautionary Tale

The fate of the investor in the Young v. Fortis Plastics, LLC case demonstrates how an investor may find itself subject to potential liability. There, the plaintiff alleged that Monomoy Capital Partners L.P. was the sole owner of Fortis, and the court thus found that this factor favored the plaintiff, but the plaintiff failed to make any allegations regarding overlapping directors and officers, unity of personnel policies, or dependency of operations. As to the de facto exercise of control factor, the plaintiff alleged the closing of the Fortis facility was “ordered by Defendants,” which was defined to include both Fortis and Monomoy, named specific Monomoy employees he alleged were involved in the exercise of control over Fortis through weekly calls, and alleged that Monomoy received $500,000 in management fees from Fortis.

These relatively thinly-pleaded allegations were found to be sufficient to withstand a motion to dismiss. Of course, on a full factual record, Monomoy may well be able to establish facts that preclude liability and justify summary judgment dismissing the plaintiff’s claims. In the meantime, it will be forced to incur the costs and distraction of defending the litigation.

Avoiding Liability

As discussed in the January 2012 edition of FundsTalk, to reduce the risk of liability investors should strive to ensure separation from the employer’s decision to lay off employees or close facilities. Certainly, this does not require that the third party abstain from all involvement in the employer’s financial matters, but specific decisions and determinations should be left to the management and board of directors of the employer. Direct orders or instructions to conduct layoffs or plant closings should be avoided; establishing expense reduction requirements or requiring financial covenant compliance are far less likely to lead to liability. Greater care is called for when a single private equity firm is the sole or primary investor in the employing entity.

Critically, the corporate formalities must be observed. Appropriate documentation should reflect that the relevant decisions were made by the employer’s officers or board of directors, not the investor, including through board resolutions, minutes of meetings, and internal memoranda. Demonstrating a lack of control over the determination will go a long way toward insulating the third party from liability for any WARN violations by the employer.