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Mass Layoffs When Section 363 Sales Fail and Cases Convert: Third Circuit Adopts Probability Standard for WARN Act Liability

On August 4, 2017, the Third Circuit Court of Appeals issued its ruling in Varela v. AE Liquidation, Inc. (In re AE Liquidation, Inc.), 2017 U.S. App. LEXIS 14359 (3d Cir. 2017), holding that WARN Act liability is triggered only when a mass layoff becomes probable – “that is, when the objective facts reflect that the layoff was more likely than not.” In doing so, the Third Circuit joined the Fifth, Sixth, Seventh, Eighth and Tenth Circuits, which have unanimously adopted this heighted standard as well.

The AE Liquidation case was a chapter 11 case involving a long and tortured effort to sell substantially all of the debtor’s assets to an insider stalking horse purchaser. The sale was premised on the buyer receiving necessary funding that had been promised by a state owned Russian bank. The assets were marketed through a postpetition sale process, which failed to result in any competing bids, and following a multi-day sale hearing, the sale was approved. Ordinarily, a section 363 sale process results in a winning bid without any financing contingencies. In this case, however, the parties were waiting on the Russian bank to be recapitalized and for senior levels of the Russian government, including then-Russian Prime Minister Putin, to approve the funding for the transaction.

After months of what turned out to be empty promises that the bank had been recapitalized and funding had been approved, or that those things were about to happen any day, the debtor determined that it was administratively insolvent and temporarily furloughed most of its employees in order to conserve cash and survive until the funding came through and the sale closed. Of course, that never happened. While Prime Minister Putin was still “thinking about” the deal, the debtor simply ran out of cash, the cases were converted to a chapter 7 liquidation, and the temporary furlough was converted into a formal mass layoff for all employees.

Having received virtually no notice before being laid off, the employees filed a class action adversary proceeding in the bankruptcy court alleging a violation of the WARN Act requirement for employers to give employees at least 60-days’ notice before a mass layoff. The debtor argued that it was exempt from notice under the “unforeseeable business circumstances” exception, a statutory exception to liability under which the employer must demonstrate (1) that the business circumstances causing the layoff were not reasonably foreseeable, and (2) that those circumstances in fact were the cause of the layoff. The bankruptcy court ruled in favor of the debtor, and that ruling was affirmed by the District Court for the District of Delaware. This appeal followed.

In addition to considering whether the debtor met all procedural and technical requirements under the circumstances (yes, it did) and whether the failure of the sale and the fact that the debtor ran out of money in fact caused the layoff (yes, they did), the Third Circuit focused on whether the failure of the sale was reasonably foreseeable at various dates leading up to the mass layoff. The Court noted that the term “reasonably foreseeable” was not defined in the WARN Act statutes, and that whether something was reasonably foreseeable requires a fact specific analysis on a case-by-case basis.

In order to strike an appropriate balance between the needs of employees and the purpose of the WARN Act, on the one hand, and the needs of a company in financial distress, on the other hand, the Court held that “reasonably foreseeable” should be deemed synonymous with probable. The Court explained:

Companies in financial distress will frequently be forced to make difficult choices on how best to proceed, and those decisions will almost always involve the possibility of layoffs if they do not pan out exactly as planned. If reasonable foreseeability meant something less than a probability, nearly every company in bankruptcy, or even considering bankruptcy, would be well advised to send a WARN notice, in view of the potential for liquidation of any insolvent entity.

Applying this standard, the Court held that, despite the history between the parties, the months of empty promises of funding by the Russian bank, and the determination that the debtor was administratively insolvent, the prospects for the sale to close successfully still remained fifty-fifty. No outcome was more probable than the other one. As such, the eventual shutdown and layoff was not probable under the circumstances until cash had been depleted and the cases had been converted, leaving the employees with virtually no notice before losing their jobs permanently.

Despite what might seem like a harsh result, this heightened standard for liability has now been adopted by every Circuit level court to consider the issue. Chapter 11 debtors must be mindful that potential WARN Act liability and the protection afforded by the “unforeseeable business circumstances” exception depend upon whether the cause of the mass layoff was reasonably foreseeable, and at what point in time the layoff shifted from being simply a possibility into being a probability. This, of course, is an amorphous line in the sand that will differ in every case. But, if the line into probability is crossed, debtors stand to face the risk of significant WARN Act liability.

© Copyright 2017 Squire Patton Boggs (US) LLP

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About this Author

Elliot M. Smith, Squire Patton Boggs, Insolvency Lawyer, Bankruptcy Attorney
Senior Associate

Elliot Smith focuses his practice on all aspects of business restructuring and insolvency, with a particular emphasis on complex business reorganizations under chapter 11 of the United States Bankruptcy Code.  Elliot has experience representing debtors, committees of unsecured creditors, DIP financing lenders, secured and unsecured creditors, asset purchasers, trustees, avoidance action defendants and other parties in chapter 11 cases throughout the US. He also has experience representing parties in chapter 7 liquidation cases as well as in connection with out-of-court...

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