Sunshine Act Deadline Approaching

Are you familiar with the new Sunshine Act regulations?  One of our partners, Jesse Witten, explains here why private equity firms with medical device and pharma portfolio companies need to be aware of the new Sunshine Act regulations.  Companies must begin to collect data on August 1, 2013, and the first annual report will be due on March 31, 2014 and will be available on the CMS public website.

This newsletter addresses two key issues currently confronting private equity firms:

  1. The SEC's increasing focus on private equity firms that are engaging in activities that would require them to register as broker-dealers under the Securities and Exchange Act; and
     
  2. The potential implications to private equity firms of a recent Delaware Court decision addressing the role of private equity firms in making key management decisions on behalf of portfolio companies.

Private Equity Firms: Potential Broker-Dealer Issues 

The SEC has become increasingly focused on investigating whether private equity sponsors are engaging in activities that would require them to register as broker-dealers under the Securities Exchange Act.  Section 3(a) of the Exchange Act defines a broker as “any person engaged in the business of effecting transactions in securities for the account of others” and a dealer as “any person engaged in the business of buying and selling securities for such person’s own account.”  David Blass, Chief Counsel of the SEC’s Division of Trading and Markets, stated recently that the SEC staff noted that some fund sponsors are: (1) paying transaction-based compensation to fund personnel for marketing fund interests and/or (2) receiving transaction-based compensation for supposed investment banking or other broker activities relating to one or more of a fund’s portfolio companies.[1]  According to Blass, receiving transaction-based compensation is a “hallmark” of being a broker-dealer; he suggested that fund sponsors review these areas of concern prior to an SEC examination.

Marketing of Fund Interests

Blass pointed to a recent SEC enforcement action against a private equity firm, Ranieri Partners, to illustrate the problems for private equity firms surrounding fundraising and marketing fund interests. The SEC found that Ranieri Partners had violated the broker-dealer registration provisions under the Exchange Act because the firm had paid transaction-based compensation to a consultant that actively solicited private fund investors but the consultant was not registered as a broker-dealer.[2]  The SEC ultimately reached a settlement with Ranieri Partners in connection with this enforcement action.  In addition to penalties against the fund sponsor and the consultant, Blass suggested that the fund investors may have the right to rescind their investments in the fund because the transactions were conducted by an unregistered broker-dealer.  He stated that this case and others like it demonstrate the “serious consequences for acting as an unregistered broker, even where there are no allegations of fraud.”

Some private equity firms have explored reliance on the “issuer exemption” under Rule 3a4-1 of the Exchange Act, which provides a nonexclusive safe harbor under which associated persons of certain issuers can participate in the sale of an issuer’s securities without being considered a broker.  According to Blass, private equity firms have not been able to make use of this safe harbor because it is difficult for such firms to meet one of the conditions necessary to claim the exemption from registration. Those conditions include: (1) limiting the offering and selling of securities only to broker-dealers and other specified types of financial institutions; (2) performing substantial duties other than in connection with transactions in securities and not participating in selling an offering of securities more than once every 12 months; and (3) limiting activities to the delivery of written communication by means not involving oral solicitation by the associated person of a potential investor.

Investment Banking Activities

Another area that Blass addressed was the receipt of compensation by private equity firms in connection with investment banking-type services provided to their portfolio companies, such as negotiating transactions, identifying and soliciting purchasers or sellers of the securities of the company, or structuring transactions.   Blass stated that receiving transaction-based compensation for these investment banking services may cause a fund sponsor to be considered a broker as the fund and the sponsor can be considered distinct entities with distinct interests.  Blass explained that if a sponsor receives transaction-based compensation, it has a stake in the transaction, which could be a conflict of interest that broker-dealer dealer registration is designed to address.  However, he noted that if the fund sponsor’s advisory or management fee is wholly reduced by the transaction-based compensation, there are no broker-dealer registration concerns.


[1] David W. Blass, A Few Observations in the Private Fund Space, Address Before the Trading and Markets Subcommittee of the American Bar Association, Washington, D.C. (Apr. 5, 2013), available at: http://www.sec.gov/news/speech/2013/spch040513dwg.htm.

[2] Ranieri Partners LLC, Exchange Act Release No. 69091 (Mar. 8, 2013).  

WARN Act Considerations for Private Equity Firms

By David J. Woolf

A recent Delaware court ruling was an eye-opener for private equity firms and other entities owning controlling stakes in faltering businesses.  Breaking from the norm, the Delaware District Court in Woolery v. Matlin Patterson Global Advisers, LLC refused to dismiss private equity firm MatlinPatterson Global Advisers, LLC (MatlinPatterson) and affiliated entities from a class action lawsuit brought under the WARN Act alleging that the 400-plus employees of Premium Protein Products, LLC (Premium), a Nebraska-based meat processer and MatlinPatterson portfolio company, had not received the statutorily mandated 60 days advance notice of layoffs.

According to the plaintiffs, when Premium’s performance began to decline in 2008, the defendants became more involved in Premium’s day-to-day operations. The defendants made key business strategy decisions (e.g., the decision to enter the kosher food market) and terminated Premium’s existing President and installed a new President.  In June 2009, the defendants decided to “furlough” all of Premium’s employees virtually without notice and close the plant.  In November 2009, the defendants converted the furlough to layoffs, and Premium filed for bankruptcy.  According to the plaintiffs, Premium’s head of human resources raised WARN Act concerns in June, when the defendants decided to close the plant and furlough the employees, but the defendants ignored the issue. 

With Premium in bankruptcy, the plaintiffs named MatlinPatterson and the other defendants as the targets of their WARN Act claim, asserting that they and Premium were a “single employer.”  The Court applied the Department of Labor’s five-factor balancing test to determine whether the defendants and Premium constituted a single employer, namely: (1) whether the entities share common ownership; (2) whether the entities share common directors or officers; (3) the existence of de facto exercise of control by the parent over the subsidiary; (4) the existence of a unity of personnel policies emanating from a common source; and (5) the dependency of operations between the two entities.  This test often favors private equity firms and, on balance, it appeared to favor the defendants in this case.  The Court found that the plaintiffs had made no showing as to three of the five factors.  Nevertheless, the Court decided not to grant the defendants’ motion to dismiss.  The Court held that the complaint alleged that the defendants had exercised de facto control over Premium and it gave that factor determinative weight in rendering its decision.

In determining whether to grant a motion to dismiss, a court must accept all plaintiff allegations as true. Given the severity of the plaintiffs’ allegations in Woolery, the Court’s decision did not come as a total surprise.  The allegations presented an ugly picture of a private equity firm making some of the most critical decisions on behalf of the company (to close the plant and lay off employees) without regard for the WARN Act’s notice requirements.  The Court’s application of the five-factor balancing test is nevertheless a cautionary tale for private equity firms facing similar predicaments and presents a potential conundrum: do nothing and watch your investment sink or become actively involved and risk WARN Act liability.

So what is a private equity firm, lender or majority investor to do?  Obviously, the best scenario is to build in the required 60-day notice period or, if applicable, utilize WARN Act exceptions, including the “faltering company” and “unforeseen business circumstances” exceptions.  Even where that is not possible, private equity firms and other controlling investors need not take a completely hands-off approach.  They would, however, be best-served (at least for WARN Act purposes) to do the following:

  • Provide only customary board-level oversight and allow the employer’s officers and management team to run the employer’s day-to-day operations;
     
  • Although Board oversight and input can occur, continue to work through the management team on major decisions, including layoffs and potential facility closures;
     
  • Avoid placing private equity firm or lender employees or representatives on the employer’s management team;
     
  • Have the employer’s management team and retained advisors execute contracts with the employer, not the private equity firm or lender, and have the contracts, for the most part, create obligations only to the employer; and
     
  • Allow the employer to maintain its own personnel policies and practices, as well as Human Resources oversight and function

In these cases, the courts are primarily concerned with (a) a high degree of integration between the private equity firm or lender and the actual employer, particularly with respect to day-to-day operations, and (b) who the decision-maker was with regard to the employment practice giving rise to the litigation (typically the layoff or plant closure decision).  Private equity firms and lenders that have refrained from this level of integration have had success in avoiding WARN Act liability and returning the focus of the WARN Act discussion to the actual employer.  Indeed, just two weeks after the Woolery case, the District of Delaware Bankruptcy Court, in In Re Jevic Holding Corp., granted summary judgment for Sun Capital Partners, Inc. and its affiliates, even though Sun Capital was providing some level of oversight over the employer and Sun Capital’s refusal to provide an additional investment arguably triggered the bankruptcy filing and layoffs at issue.  The Court so ruled because, overall, Sun Capital was not exercising de facto control over the employer and, most critically, was not involved in the decisions to terminate employees or shut down facilities.  We expect that this trend will continue and that Woolery, although an important cautionary tale, should not create an issue for the prepared lender or equity firm.

If you have any questions regarding this article or would like to find out more information, please contact David Woolf at (215) 988-2614 or David.Woolf dbr.com.

Source: Drinker Biddle Client Alert