• The Top Compensation Red Flags Lurking in Business Transactions
  • February 27, 2012 | Author: Jill Sebest Welch
  • Law Firm: Barley Snyder - Lancaster Office
  • Start-up companies seeking venture capital. Businesses positioning for an IPO. Owners looking to sell the company. What are the top compensation red flags uncovered during due diligence by investors and purchasers and their attorneys? When businesses make representations and warranties that they have operated the company in compliance with all laws, have they audited their compensation practices? Are companies at risk when they agree to indemnify the investor or buyer against claims made by government agencies or former employees? Are the non-compete agreements designed to protect a company’s business interests assignable to the purchasing company?

    Not only is it critical for business leaders to think about these employment related issues when conducting business transactions, it is also important to involve the company’s human resources professionals or even outside employment counsel early in the due diligence process. Companies that take this proactive approach are better positioned for business transactions, including asset purchase agreements, stock purchases, and government contracts.

    Representations and Warranties in Sales Agreements
    Companies make representations and warranties in their sales agreements about a host of employment-related issues. For example:

    • Seller has properly classified each employee as “exempt” or “non-exempt” under the FLSA or any state, local or foreign counterpart and properly compensated each “non-exempt” employee in accordance with the FLSA or such other applicable laws.
    • Seller has properly classified each individual who provides services to the Company either as an “employee” or an “independent contractor” and properly effected any applicable employment and income tax withholdings with respect to such individual.
    • Seller has maintained and currently maintains adequate insurance as required by applicable law with respect to workers’ compensation claims and unemployment benefit claims.
    • Seller has withheld and paid all required taxes and reported the amounts paid or owing to any employee, independent contractor, creditor, stockholder or other third party.
    • No Company Benefit Plan provides benefits which are subject to taxation under Section 409 of the Code. Except as set forth in the attached schedule, Seller is not a party to or bound by any employment agreement, and the Shareholders have provided to the Purchaser true, correct and complete copies of each employment agreement.

    These “reps and warranties” may be pro-forma, but do companies know whether these oft-requested statements are accurate? Have they performed an audit of their compensation practices prior to the sale to assess whether their employees are properly classified as exempt? Have they reviewed all independent contractor relationships to make sure that they meet the IRS test? Have they reviewed employment agreements to know whether a non-compete covenant will survive the transaction and protect the purchaser? These compensation red flags are lurking in business transactions and business leaders and human resources professionals need to be able to spot and address them prior to the closing.

    Attestations in Government Contracts
    Government agencies are demanding similar assurances in their contracts with businesses and suppliers. For example, on December 1, 2011, the Department of Agriculture’s Office of Procurement and Property Management issued a final rule that requires its contractors to attest that they and their subcontractors, to the best of their knowledge, are in compliance with all applicable labor laws. The rule will effectively add the clause to USDA contracts that currently exceed $150,000.

    The Department warns that it will vigorously pursue action against any contractor that violates relevant labor laws while providing supplies and/or services under the government contract. This may include filing a claim under the False Claims Act. The Department has also vowed to cooperate with the enforcement of other agencies’ labor laws as appropriate.

    Top Red Flags In Today’s Labor Climate
    The time is now for business leaders and human resources professionals to recognize these red flags and their relevance to business transactions and to work proactively in the due diligence process. Recent improvements in the economy and an uptick in business transactions come at a time when federal and state government agencies are “upping the enforcement ante” on all of
    these fronts.

    1. The Company treats its employees as independent contractors
    The United States Department of Labor (“DOL”) is seeking over $15 million for a new multi-agency “Misclassification Initiative” that will strengthen and coordinate federal and state efforts to enforce labor violations that result from the misclassification of employees as "independent contractors." The DOL also aims to hire 107 employees to support field investigator training and conduct an additional 3,250 investigations to deter such violations in the future. Moreover, in September 2011, the DOL entered into a Memorandum of Understanding with the IRS to share information to reduce incidences of employee misclassification. Meanwhile, the IRS has already embarked upon an extensive random audit (of about 6,000 employers) on this issue and a review of the entire current system. At the state level in 2010, Pennsylvania enacted the Construction Workplace Misclassification Act was enacted which makes it both a civil and a criminal offense in Pennsylvania for a contractor to knowingly misclassify an employee as an independent contractor.

    2. The Company classifies all of its workers as “exempt” from overtime rules
    Wage and hour cases under the federal Fair Labor Standards Act (“FLSA”) and Pennsylvania’s counterpart, the Pennsylvania Minimum Wage Act (“PMWA”), have proliferated against companies across Pennsylvania and other states. Recent trends in this litigation focus on the alleged misclassification of employees in jobs such as customer service representatives, account representatives, mortgage loan officers, and assistant managers. Companies may put all of their employees or supervisors on “salary” and never record hours worked or pay them overtime. While this may be an easier pay practice to administer, simply calling an employee “salaried” does not make him/her exempt from minimum wage and overtime requirements, and it puts companies at significant risk for legal action, including expensive class action litigation. This is a risk that purchasers do not want to assume.

    3. Section 409 Compliance
    The Code Section 409A requirements affect more than what we typically think of as deferred compensation. They also pertain to separation pay and other post-termination benefits, and give rise to a number of concerns that exist with current employment agreements that provide for severance benefits. These concerns surface in business transactions, particularly those that may trigger payout of severance or may result in termination of employment agreements.

    The regulations do provide some very useful exceptions, which permit companies to structure severance plans and employment contracts to avoid the application of Section 409A. These exceptions cover (1) short term deferrals; (2) involuntary termination; (3) good reason termination; (4) reimbursement of non-taxable benefits under an employment contract and certain incidental post-employment benefits such as outplacement services, moving expenses and the like that do not exceed the limitation of elective deferrals under Code Section 402(g); and (5) in kind benefits. Employment agreements need to be analyzed to determine if either an exception applies or if 409A compliance revisions are needed.

    4. Assuming the Seller’s Non-Compete Agreements Will Protect The Buyer
    The assumption that a non-compete covenant between an employee and the selling company is automatically assignable and inures to the benefit of the purchasing company may not be correct, and a review of employment and non-compete agreements as part of due diligence is important. This is a matter of state law, and in Pennsylvania, whether non-compete agreements are assignable depends on whether the agreement includes an express assignment provision and the type of transaction -- a stock purchase agreement or an asset purchase agreement. These are a few of the employment issues commonly raised during the mergers and acquisitions due diligence process. Increasingly, they are surfacing in routine business transactions as well. Human resources professionals who recognize these issues and are involved early in the process can better position their company for a successful transaction.