Ownership and management of portfolio companies by private equity, venture capital or hedge funds require an understanding of the extent of control that the parent may exercise over the subsidiary when it falters or requires a restructuring of operations, including a reduction in workforce. A decision of the Second Circuit Court of Appeals offers an important lesson on the importance of insulating the parent company from liability for failure to give sufficient prior notice to employees of the termination of their employment by the portfolio company, as may be required by federal law.
This decision is a reminder that the integrity of a portfolio company’s governance must be respected. Having an independent board of directors of, and separate managers and officers at, the portfolio company should ensure that it is the portfolio company, and not the parent, that determines whether to downsize and lay off the subsidiary’s workers and incurs any resulting liability.
A fundamental reason to form a separate legal entity to possess and operate business assets is to isolate liability and insulate related parties, such as equity sponsors and investors, from exposure to claims. Said differently, shareholders or members, be they private equity firms or other equity owners, seek to limit their liability for the acts of the operating venture to the venture itself – so that the owners of the venture are clearly removed from liability (and ideally pre-emptively from the cost of defending an otherwise extortion lawsuit asserting some implied liability against the “deep pocket”). While veil-piercing claims are always a possibility, if corporate formalities of governance and management are respected and adhered to, and equity interests exercise the “ordinary” incidents of ownership, it should be relatively difficult for a plaintiff’s lawsuit to survive a parent’s summary judgment motion on plaintiff's attempted imputation of claims to the parent entity.
The integrity of containing liability to the operating entity, and shielding the equity investor, was weakened by a recent decision of the Second Circuit Court of Appeals, at least when it comes to the potential imposition of liability for an employer’s failure to give the requisite minimum sixty days’ advance notice of mass layoffs or plant closings to its employees as required under the Worker Adjustment Restraining and Notification Act (“WARN Act”). Not having previously pronounced its views on this specific subject, the Second Circuit recently held in Guiippone v. BHY S&B Holdings LLC, et al. that the plaintiffs therein, a class action group of former employees, previously denied by the U.S. District Court (SDNY) in prosecuting their claims, could, in fact, pursue their liability claims against their employer company and its parent company (the sole member and manager of the operating entity) for the failure by the employer and potentially its parent company to give the subsidiary entity’s workers sufficient advance notice of the termination of their employment under the WARN Act. 
Guippone and the other plaintiffs were employed by Steve & Barry’s, a retail chain of department stores, which filed for chapter 11 in July, 2008. In August, 2008, a group of venture capital funds created a limited liability company (Parent) which, in turn, created, as its acquisition vehicle, a limited liability company (Subsidiary). Subsidiary purchased the assets qua business and continued the employ of personnel of Steve & Barry’s department stores. Parent was the sole member and manager of Subsidiary.
Following Subsidiary's purchase of Steve & Barry’s assets and business, Subsidiary faced a liquidity crisis of its own caused by the sweep of bank accounts by its lender and default and termination of Subsidiary's financing. Discussions began among Parent’s board members advocating that a plan of liquidation be put in place immediately for Subsidiary, which would include massive immediate layoffs. Subsidiary’s officers then presented Parent’s board with a liquidation analysis and recommended layoffs. Parent’s board voted to terminate Subsidiary’s senior management team and replace it with an advisory crisis management firm to manage the wind-down. The advisory firm promptly requested that Parent’s board authorize the Subsidiary to file for reorganization under chapter 11 of the Bankruptcy Code and authorize Subsidiary to implement staff reductions, including giving notice to affected employees. Parent’s board approved the recommendation of the crisis management firm. Subsidiary immediately filed for bankruptcy. Two days earlier, Subsidiary began sending WARN Act and termination notices to its employees, and continued to issue such notices after the bankruptcy case was filed.
Some factual findings by the Court: Subsidiary did not have its own board of directors or managers. Subsidiary was managed by Parent, its sole member and manager. Parent chose Subsidiary's CFO and coordinated the subsidiary's retention of the CFO. Parent had negotiated Subsidiary's financing facilities. Parent and Subsidiary had some common board members and officers. Thus, arguably, the decision to terminate Subsidiary's employees was made by the Parent's board. The failure to have a clear distinction between Parent and Subsidiary governance, and the absence of an independent Subsidiary board, along with other factors that might suggest that Subsidiary was not free or capable to make its own decisions, including some over-lapping management, were collectively viewed by the Second Circuit Court as creating a question of fact for trial as to whether Parent should face liability as a conjoined “single employer” with Subsidiary under the WARN Act.
When does a Parent exercise de facto control over a Subsidiary?
In some jurisdictions, the test for imputation of WARN Act liability upon a parent company is a five-part test. Such test will now be the measure in the Second Circuit, as so enunciated and born out of Department of Labor regulations and Third Circuit law, for determining whether an operating employer subsidiary and the holding parent should be treated as a "single employer" such that WARN Act liability should be imposed on the parent. 
The following factors in the Guippone case for imposing WARN Act liability upon the Parent were relevant to the Second Circuit in finding that plaintiff-employees presented sufficient evidence and issues to create a question of fact for a jury’s consideration:
Authorizing layoffs is a function of being an employer. For liability under the WARN Act, to the extent the parent entity assumes the role of the decisionmaker responsible for employment protocol for or over its subsidiary's employees, the parent will be viewed as having de facto control and hence potential liability to its subsidiary's employees.
Best Practices to Shield from Single Employer Liability under the WARN Act
How do private equity sponsors and other upstream owners protect themselves from imputed WARN Act liability? Be sure to repose and permit independent decision making within the operating business entity, and, particular to WARN Act liability, within the human resources management area of the operating entity. Have a separate and distinct functioning board of managers or board of directors for the operating entity. Avoid boards comprised of the same individuals for both the subsidiary’s and the parent’s boards. Avoid commonality of officers among the affiliated entities.
The limited liability companies in Guippone were formed under Delaware law, which allows the day-to-day oversight of the affairs of a limited liability company to be vested in the members of the LLC or in a manager appointed by them. The District Court relied on the absence of any abuse of corporate formalities and the legitimacy of the Parent’s exercise of ordinary powers of ownership in granting summary judgment in favor of Parent and its private equity investor members. However, for WARN Act liability, the Second Circuit stated that Parent, based upon the facts, could be liable if it exercised de facto control over Subsidiary and if Parent specifically directed the actions that are alleged to violate the WARN Act.
Mass layoffs may not be on the forefront of the minds of the equity sponsors when a business venture is formed, but it should. Create an inter-entity structure that puts in place independent boards and officers, so as to avoid the argument that the parent exercises de facto control over the operating company and its employment practices sufficient to trigger "single employer" liability under the WARN Act for the parent company. Though there are defenses to WARN Act liability, including the “faltering company” defense and the “unforeseen business circumstances defense,” the employer’s parent’s best and first line of defense is the absence of any liability ab initio by ensuring the subsidiary’s free will to administer its affairs and hence the parent’s lack of actual or de facto control over the operating company’s employment activities.
 Potential “deep pocket” exposure under the WARN Act is not a far cry from imposing liability under ERISA on a parent for the unfunded pension plan liabilities of its portfolio company where the parent exercises sufficient control to be treated as a “single employer” with its portfolio company. Liability can flow if the private equity fund’s degree of management of the portfolio company indicates that it is operating a “trade or business” with the portfolio company, as opposed to simply receiving profits or incurring losses like a passive investor. See Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund, 724 F.3d 129 (1st Cir. 2013). For a full discussion of the impact of this decision, read Jeffrey R. Banish, Aurora Cassirer, Jonathan A. Kenter & John Owen Gwathmey’s “Private Equity Funds - Beware of Potential Exposure to ERISA Pension Liabilities of Your Portfolio Companies,” TerraLex Connections (Oct. 1, 2013)(last visited 2/18/14).
 The five-part test considers the following factors: (1) common ownership, (2) common directors and/or officers, (3) de facto exercise of control, (4) unity of personnel policies emanating from a common source, and (5) the dependency of operations. Dept. of Labor Regulations codified at 20 C.F.R. § 639.3(a)(2); Pearson v. Component Tech. Corp., et al. No one factor is controlling and all factors do not have to be present. Fact-specific inquiry as to control by the parent over the employment practices, policies and decisions of the operating subsidiary will be the focus and likely outcome determinative.
Mitchel H. Perkiel, Partner, firstname.lastname@example.org
Mitchel H. Perkiel is a partner in the Bankruptcy practice area at Troutman Sanders LLP with more than thirty years experience in complex corporate restructures, business reorganizations, chapter 11 proceedings, and out-of-court workouts throughout the country and cross-border, having represented debtors, creditors, equity holders and investors, banks and other secured or unsecured lenders, creditors’ committees, insurance companies, consultants, liquidators, acquirers of distressed businesses and assets, and other parties impacted or affected by troubled company and financially-distressed situations.
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Carolyn Peterson Richter, Partner, email@example.com
Carolyn Peterson Richter is a partner in both the Finance and Bankruptcy groups at Troutman Sanders LLP. Her practice focuses on representing lenders and borrowers in debt financings, cash flow and asset-based loans, and a wide variety of structured financings, including securitizations, solar financings, titling trust transactions, and letter-of-credit transactions. She has extensive experience in structuring credit transactions to address insolvency-related risks and in enforcing remedies or restructuring debt. She is a Fellow of the American College of Commercial Finance Lawyers and serves on its Board of Regents.
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