February 19, 2021

Labor and Employment Due Diligence for Transactions

New York Law Journal

The broad purpose of conducting due diligence for transactions is twofold: first, to give confidence to a buyer that a target company is what the seller of that company holds it out to be, and second, to ensure that the target is materially compliant with laws that regulate the business of the target. Accountants and corporate lawyers typically focus on the first part, and subject matter legal specialists are engaged for the second part, which typically includes tax, environmental, intellectual property, information technology, real estate, executive compensation/ERISA, and labor and employment.

Where non-compliance is discovered in the course of due diligence, there are two issues: (1) What is the financial risk of exposure if government action is taken, or a lawsuit (perhaps a class action) is filed and (2) what is the cost of coming into compliance (and how will that cost affect EBITDA)?

Labor and employment (L&E) due diligence rarely can, but sometimes does, cause a buyer to walk away from a deal. For example, a large chain of small retail stores has one store manager per store, and a number of “assistant store managers,” who are classified as being exempt from the laws requiring payment of overtime, even though they are scheduled to work 10 hour days, six days a week. L&E due diligence reveals that there are fewer than two full time equivalents reporting to the assistant store managers, and that they spend almost all of their time stocking shelves, helping customers, and running cash registers, which means that they are almost certainly misclassified as being exempt from overtime. Both the exposure is enormous (about a year’s pay for each misclassified store manager), and the cost of coming into compliance would require either paying the assistant store managers overtime pay for the 20 hours they work in addition to 40 in a week (or another 30 hours of pay, based on an overtime rate of time and one-half), or hire another employee or two per store, to make up the hours over 40 in a week worked by the assistant store managers. Retail has a very thin profit margin. In this situation, the buyer valued the company as a multiple of its EBITDA, and the cost of compliance would have had a material impact on the EBITDA, which warranted a price reduction. When the seller would not give it, the buyer decided not to go forward.

In another situation where the buyer pulled out of the transaction, the target company, a staffing agency, held itself out as a major solution for hospitality employers because all of its employees were documented workers, eligible to work in the United States, and they could work in their customers’ establishments. A review of I-9 forms, however, told a very different story. Only 15% of the I-9 forms were properly filled in, and half of the remaining 85% had documentation that on their face appeared to be fake documents. The core value of the target company in fact did not exist.

Another target company provided to the data room what appeared to be a recently signed collective bargaining agreement (with typewritten names for signatures), but a visit to the union’s website revealed that bargaining had only just commenced a few days before. When the target could not produce collective bargaining agreements with “wet signatures,” the seller explained that there was a mistake, and the document posted to the data room was the employer’s first offer to the union. The buyer did not feel there was any “mistake,” and concluded that if the seller and target were being dishonest about this part of their operations, there could be more dishonesty involved.

A price reduction in one large deal, valued close to $1 billion dollars, was obtained where the target had implemented its last, best final offer in collective bargaining, after reaching impasse with the union. A major problem was that the target’s final offer included terms that were non-mandatory subjects of bargaining, making the implementation of that final offer wholly illegal. The target learned through the sale process that it had violated the National Labor Relations Act in its dealings with its union, and there was a major price reduction (cessation of contributions to union pension and welfare funds were involved), with the buyer cleaning up the mess after the transaction closed, using the money saved in the price reduction to do so.

It is important to bring L&E specialists into the due diligence process. In one deal, the corporate attorneys involved thought that a settlement agreement with the U.S. Department of Labor was immaterial, because it required a payment of less than $10,000 for a job title that was misclassified as being exempt from overtime. What the corporate lawyers did not understand was that there was a commitment in the settlement agreement to reclassify all employees in the job title in question, and that reclassification was never done, with hundreds of employees hired into the misclassified position. A large class action followed. In another deal, the corporate lawyers involved took comfort in the fact that a target company with thousands of employees had only three charges on file with the Equal Employment Opportunity Commission, or EEOC. But when an L&E specialist looked at the three charges the specialist saw that one of the three charges was filed not by an employee of the target, but was filed by a Commissioner of the EEOC. Upon closer review, it was revealed that the Commissioner’s charge was seeking years of backpay relief for hundreds of job applicants not hired because of medical issues. In essence, the corporate lawyers thought they were looking at a box of candles, but one of those candles was in fact a stick of dynamite. It takes an experienced, and specialized, eye to see the difference.

The process of L&E due diligence is not a cookie-cutter approach. A publicly held, strategic buyer has little if any tolerance for non-compliance (for fear of derivative shareholder actions), while a private equity buyer may have been open to taking on risk, as long as it can be quantified. But not all private equity buyers are the same—some have investors who are union benefit funds, and state pension funds, and in those cases, there may be a high placement on value for ESG (Environmental, Social and Corporate Governance), in which case full compliance takes high priority.

The process of L&E due diligence is not a matter of sending lawyers into the data room to look for things of interest. It should be methodical, with a list of both documents that need to be seen, and a list of issues of what the specialist is looking for. In other words, the specialist needs to know what has to be looked at, and what is being looked for. L&E due diligence is not an audit—there is not enough time in a deal, and not enough information in a data room, for a full audit. Issues should be assessed in a practical way, with the issues creating the most risk of exposure being prioritized.

When documents requested are not promptly provided, or subject matter experts of the target are not made available for specific areas of inquiry, a yellow flag is being raised: Why is the target or seller not cooperating? Most often, it is because they are discovering for the first time themselves that they have a non-compliance issue. But it is best for all parties to get all of the non-compliance issues on the table, so that both past liability and future compliance can be addressed, and their costs assessed.

When L&E due diligence is undertaken it is important up front to have an understanding with the client buyer as to what the scope of review will be. Often, accounting firms and separate human resource consultants are brought into the L&E space as part of the deal process, and everyone in that space should know their respective roles, so that there is no overlap, or duplication of effort. An L&E lawyer’s role is not usually to determine whether a vacation policy is generous or sparse, or what financial reserves are necessary because of vacation obligations—the lawyer’s role is to make sure that the vacation policy is compliant with the laws of all states in which the target operates.

Starting about six years ago, the insurance industry has been offering insurance for representations and warranties made by the seller and target in sale agreements—for both asset and stock transactions. This has now become prevalent in deals. The benefit for the seller is that there is a lesser need to place money into escrow for contingent liabilities. A benefit for the buyer is that if something is amiss post-closing, there is no need to sue the seller for a breach of a representation or warranty—it is an insurance claim. The underwriters for the insurance company want to know what it is that they are insuring, and will expect to see the L&E due diligence report (along with all other due diligence reports). It is important for the L&E lawyer to obtain from the insurer a non-reliance letter—the due diligence report is created for the buyer, and not the insurer, but the insurer can use the due diligence report to inform its own process of due diligence. The non-reliance letter should also include within its scope the underwriter’s calls with the subject matter specialists involved in due diligence. The agendas for the underwriters’ review of due diligence have informed the due diligence process.

The issues addressed in L&E due diligence typically involve the topics listed below, though some industries may compel different priorities, or additional areas of inquiry. These topics do not include ERISA benefits or executive compensation, which are separately addressed by specialists in those areas. These are listed in order of priority and levels of risk of exposure:

• Classification of employees for purposes of overtime

• Classification of individuals as independent contractors

• Litigation volume/frequency/types of cases

• COVID-19 impact/compliance

• All hours worked are paid (pre-shift/post-shift/travel)

• Meal and rest breaks are compliant

• Minimum Wage is paid to non-exempt employees, and minimum salaries are paid to exempt employees

• Overtime is paid, at the proper rate (including factoring in bonuses)

• Payroll periods, and pay days related to payroll periods, are compliant

• Collective bargaining agreement review, and labor relations

• Union organizing activity for non-union operations

• On-boarding (I-9s, background checks, drug testing, wage statements)

• Harassment and Diversity training

• Employee Handbook review

• Compliance status of paid time off

• Minors/unpaid interns

• Staffing agency arrangements

• Recruiting/application/interviewing processes

• Non-compete, intellectual property, non-disclosure agreements are enforceable and an asset deal is assignable

• OSHA compliance

• Family and Medical Leave Act compliance

• EEO-1 Forms

• Federal/state/local government contractor status

• Recent terminations and layoffs (WARN compliance, problematic patterns), and releases are compliant and enforceable

Reprinted with permission from the February 19, 2021 issue of New York Law Journal © 2021 ALM Media Properties, LLC. Further duplication without permission is prohibited.  All rights reserved.



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