The Worker Adjustment and Retraining Notification Act, 29 U.S.C. §2101 et seq. (1988) (WARN or the Act), requires advance notice of large layoffs and awards damages when the required notice is not given. In a WARN situation, there is always a company in financial difficulty, and plaintiffs seeking damages under the Act have become increasingly aggressive in seeking an entity with greater asset liquidity than what the failed company has to offer. Sometimes these plaintiffs target the financial institution that stopped lending money to the failed company prior to the layoffs. When the failed company is a portfolio company of a private equity fund, the plaintiffs may go after the private equity fund, asserting that together, the fund and the failed portfolio company constitute a single employer.

In one WARN case brought against a lender, the U.S. Court of Appeals for the Third Circuit ruled that when plaintiffs assert that another party should be deemed a single "business enterprise" with the failed company, the courts should apply the five-factor test laid out in the Department of Labor's WARN regulations:

(i) common ownership,

(ii) common directors and/or officers,

(iii) de facto exercise of control,

(iv) unity of personnel policies emanating from a common source, and

(v) the dependency of operations.

Pearson v. Component Tech., 247 F.3d 471 (3d Cir. 2001) (citing 20 C.F.R. §639.3(a)(2)). Courts are following the Pearson case in the context of private equity funds. E.g., Guippone v. BH S & B Holdings, 737 F.3d 221, 226 (2d Cir. 2013); In re Jevic Holding, 492 B.R. 416, 424 (Bankr. D. Del. 2013), aff'd, 526 B.R. 547 (D. Del. 2014), aff'd, 656 F. App'x 617 (3d Cir. 2016).

In private equity cases, the sponsor or fund nearly always concedes the first two factors (common ownership and common directors and/or officers), but those two factors alone are insufficient to impose liability on a private equity sponsor or fund. See, e.g., Guippone v. BH S & B Holdings, No. 09 CIV.1029 (CM), 2010 WL 2077189, at *5 (S.D.N.Y. May 18, 2010), aff'd, 737 F.3d 221 (2d Cir. 2013).

Instead, the courts closely focus on the remaining three factors:

(iii) de facto exercise of control,

(iv) unity of personnel policies emanating from a common source, and

(v) the dependency of operations.

Factors (iv) and (v) are typically not present in the private equity context—a fund does not expect its portfolio companies to have uniform personnel policies nor interdependent operations. See Azzata v. Am. Bedding Indus. (In re Consol. Bedding), 432 B.R. 115, 122 (Bankr. D. Del. 2010) (finding that where one company is an investment company and the other a mattress manufacturer, "it seems unlikely that Plaintiffs could ever demonstrate an integration of operations satisfying" this factor.).

The de facto exercise of control factor is the most critical. This factor involves the tension between, on the one hand, an investor monitoring its portfolio company's profitability and, on the other hand, an investor taking control of the portfolio company's activity. This tension is particularly acute where the investor makes the decision that gives rise to the WARN liability (i.e., ordering the shutdown). The leading and most often-cited case addressing this topic is In re Jevic Holding, which involved Sun Capital:

The case law with respect to this factor is clear. The Court must consider "whether the parent has specifically directed the allegedly illegal employment practice that forms the basis for the litigation." Pearson, 247 F.3d at 491; see also In re APA Transp. Corp. Consol. Litig., 541 F.3d 233, 245 (3d Cir. 2008) ("The core of this factor is whether one company 'was the decision-maker responsible for the employment practice giving rise to the litigation.'") (citation omitted). This factor is "not intended to support liability based on a parent's exercise of control pursuant to the ordinary incidents of stock ownership." Pearson, 247 F.3d at 503.

In re Jevic, 492 B.R. at 426-27.

The bankruptcy court concluded that there was no evidence that Sun Capital directed Jevic to shut down, and the court rejected the plaintiffs' argument that Sun Capital should be liable for WARN damages because its decision to withhold further funding caused the shutdown:

The Debtors retained the ultimate responsibility for keeping the company alive and therefore, Sun Cap did not incur WARN Act liability by refusing to make an additional investment. Pearson, 247 F.3d at 505. It is undisputed that the Debtors made the decision to shut down the company. The WARN notice was signed by the Debtors, not Sun Cap, and it is not alleged that Sun Cap played a direct role in the employees' termination … . Sun Cap's decision to cut off funding was not a "de facto exercise of control" over the Debtors' decision to close its doors.

In re Jevic, 492 B.R. at 429.

In another private equity WARN case, private equity sponsor Castle Harlan avoided WARN liability for reasons similar to those advanced by Sun Capital in In re Jevic. Richards v. Advanced Accessory Sys., No. 09-11418, 2010 WL 3906958 (E.D. Mich. Sept. 30, 2010):

Pursuant to a Management Agreement with [the portfolio company, AAS], Castle Harlan provided "business and organizational strategy, financial and investment management, advisory and merchant and investment banking services." Castle Harlan received management fees from AAS for these services. Castle Harlan was not, however, involved with the day-to-day operation of AAS. Specifically, Castle Harlan (1) played no role in meeting with customers or in seeking new or additional business, and (2) provided no administrative, human resources, or purchasing services, and did not have a role in the preparation of AAS personnel policies.

Richards, 2010 WL 3906958 at *2. Concluding that "Castle Harlan's management of AAS was limited to ensuring its financial success and played no part in the day-to-day operations of" the portfolio company, the court found no WARN liability on the part of the private equity sponsor. Id. at *8.

Similarly, in Cleary v. Am. Capital, Ltd., American Capital was not faulted for the aggressive acts of its appointed directors attempting to save its portfolio company:

[T]he actions undertaken by American Capital, however aggressive, were consistent with those of (an ultimately unsuccessful) attempt to protect its investment. These include proposing and assisting the recruitment of "new management," and the ferreting out of an accurate and complete understanding of the company books … While a WARN Act plaintiff should not be held to the nearly impossible burden of demonstrating a complete merger of identities between the defunct employer and its former equity owner, at a minimum a plaintiff must establish control by the later over the "the allegedly illegal employment practice that forms the basis for the litigation." Pearson, 247 F.3d at 491. Plaintiffs offer no material evidence that the decision of [portfolio companies] NewStarcom and Constar to terminate all employees and file for bankruptcy was made by American Capital, nor any plausible reason why American Capital, as an unsecured creditor, would have thought it in the interest of its shareholders to do so.

Cleary v. Am. Capital, Ltd., 59 F. Supp. 3d 249, 258-59 (D. Mass. 2014).

While courts found that private equity funds and sponsors did not exercise de facto control in the cases described above, this was not the case in DeRosa v. Accredited Home Lenders, 420 N.J. Super. 438, 22 A.3d 27, 36 (App. Div. 2011). In DeRosa, a New Jersey appellate court (applying the Pearson‑approved five-factor DOL test to the New Jersey version of WARN) assessed the alleged activities of a fund sponsored by Lone Star Funds, in an appeal taken from a lower court's summary judgment decision in favor of the Lone Star fund. Id.

Before the court was Accredited Home Lenders, a failed sub-prime mortgage lender that was purchased by a string of holding companies in 2007 to become a portfolio company of Lone Star Fund V (LSFV). LSFV's investments were managed by a related company called Hudson Advisors. LSFV, Hudson and the holding company of Accredited were all parties to an asset advisory agreement. After Lone Star's purchase of Accredited, there was some testimony indicating that the portfolio company's "senior managers were no longer 'calling the shots.'" DeRosa, 420 N.J. Super. at 447. The shutdown was sudden. Instead of the shutdown announcement coming from an executive of Accredited, Hudson's director of portfolio management (who was holding himself out as an employee of Lone Star) announced the shutdown in person. Id. at 448. Reversing the lower court's summary judgment decision in favor of both Lone Star and Hudson, the court held with respect to the question of de facto control:

As to this factor, the record reflects that after LSFV Accredited purchased Accredited Holding, Hudson, LSFV and Accredited Holding entered into an asset advisory agreement pursuant to which Hudson provided oversight and support services to Accredited. According to [Accredited division manager] Mohan, during this time period, Accredited's senior management lost day-to-day control of the business. Prushan, who was employed by Hudson, was involved in evaluating Accredited's business, and in planning and implementing the shutdown of the office.

Giving plaintiff all favorable inferences, the record reflects that LSFV, through Hudson, exercised control over Accredited and ordered the closure of the office. The trial court also recognized that this presented a factual dispute that was unresolvable on summary judgment.

DeRosa, 420 N.J. Super. at 460-61. The case was remanded, and a review of the docket indicates that the parties filed a stipulation of dismissal very soon after the decision.

Schultze Asset Management, a family investment fund run by its patriarch, suffered an even worse result in In re Tweeter. In a rare outcome, summary judgment was granted against the family fund because of its involvement with its portfolio company, Tweeter.

The Court finds that the Plaintiff has established de facto control by [Schultze Asset Management (SAM)] of the Debtor's employment practice. The [Tweeter CEO] Granoff termination letter evidences SAM's control over the Debtor, especially the portion that states, "we felt we needed tighter control of Tweeter within our own organization." George Schultze repeatedly called for reductions in payroll to increase profits. Further, George Schultze ordered Kelerchian to terminate employees of the Debtor in 2007, demonstrating his control over the Debtor's employment practice. With SAM employees on the Debtor's board, SAM's inside counsel supervising their actions, and SAM employees directly involved with terminating employees of the Debtor, the Court finds that SAM's exercise of de facto control over the Debtor on the WARN Act issue was particularly egregious. See Pearson, 247 F.3d at 504 (concluding that if the de facto exercise of control is "particularly egregious," then liability is warranted).

In re Tweeter OPCO, 453 B.R. 534, 545 (Bankr. D. Del. 2011).

There are three main takeaways for private equity funds and sponsors from these WARN cases trying to tag them with WARN liability. First, do not step into the day-to-day affairs of the portfolio company. Second, do not direct the portfolio company from above to lay off workers and/or shut down. These decisions are properly in the domain of the directors of the troubled company, even if those directors are appointed by the private equity fund (and it is better for these boards to have independent directors who are meaningfully involved in the decision-making). Third, all communications to employees about the layoffs should originate from the portfolio company itself, and no one else.

Gerald T. Hathaway is a partner at Faegre Drinker Biddle & Reath.