Hidden Due Diligence Risk in Mergers, Acquisitions, and Investments: Independent Contractor Misclassification Oftentimes Overlooked by Private Equity Firms, Hedge Funds and Other Investors

About the Authors:

Richard J. Reibstein (labor), Lisa B. Petkun (tax), and Andrew J. Rudolph (employee benefits), are the co-heads of Pepper Hamilton's Independent Contractor Compliance practice, an interdisciplinary group of 25 labor, tax, and employee benefits attorneys. They publish a legal blog on the subject at www.IndependentContractorCompliance.com.

Many due diligence reviews in mergers, acquisitions, and investments have ignored the issue of independent contractor (IC) misclassification liability. This is a difficult exposure to identify unless the legal team digs below the information typically provided by the seller or available in public records. In view of the crackdown by federal and state governments on the misclassification of employees as ICs, an increase in state misclassification legislation, and a steady stream of class action lawsuits claiming that certain workers have been disguised as ICs, due diligence efforts should not overlook this often hidden exposure.

What to Examine During Due Diligence?

IC agreements should be closely examined when conducting due diligence for investors, including private equity firms and hedge funds; these agreements can often reveal a material IC misclassification exposure. It may also be prudent to request Form 1099s from a seller for at least the past two to three years. An abundance of Form 1009s may indicate there is the potential for substantial IC misclassification liability, especially where IC agreements, once examined, appear to have been drafted by lawyers insufficiently familiar with the nuanced legal distinctions between ICs and employees under applicable federal and state laws. Indeed, some IC agreements have been used by government regulators and plaintiffs' lawyers as their "Exhibit A" to prove IC misclassification or to help obtain certification of a class action.

An absence of 1099s may not necessarily indicate that there is no IC misclassification liability. Some companies may not be issuing Form 1099s to single-member LLCs, as required by law, if a Form W-9 was not properly completed by the LLC member. Further, where independent contractors have been required to incorporate by the service recipient, no 1099s are likely to be issued; however, some administrative agencies and courts treat requirements imposed by the hiring party upon contractors to incorporate, or to become franchisees or owners of the business for which they are performing services, as illusory or a sham designed to circumvent tax and labor laws. Such business requirements imposed on contractors have also been treated by regulatory agencies and courts as an exercise of control over the worker that can be used to "pierce the IC veil."

It is also prudent in an acquisition context to ask the seller to list all its IC relationships including those with LLCs, C or S corporations, and partnerships, and the amount paid to such entities over each of the past two to three years. Such information can better illuminate the extent of any IC misclassification.

Determining Exposure to IC Misclassification Liability

Due diligence in this area can start with the same legal diagnostic tools used when companies examine their own IC misclassification exposure. This should include an assessment of the risk examining over 48 factors found by the courts and administrative agencies to be pertinent to the determination of IC status, leading to a designation of the risk using an IC compliance scale or another legal tool designed to measure a company's IC misclassification risk. The number of ICs and the states in which the ICs work can also be critical inasmuch as a concentration of ICs in a particular state may require a re-determination of the risk. Moreover, some states have quirky IC statutes, while others may use the common law test in some legal contexts (such as wage laws), but not in other contexts (such as workers' compensation laws). It is fair to say that some states are relatively hospitable to the use of ICs while a few are downright inhospitable - both by statute and enforcement practices of state workforce agencies. Familiarity with all of these state-specific nuances is indispensable to determining a company's IC misclassification risk, especially if the ICs are located in multiple jurisdictions.

After the necessary documents have been requested and properly examined by the prospective purchaser, there may be a need for pinpoint follow-up inquiries and requests for further documentation to determine the degree of risk, extent, and potential cost of any IC misclassification. In an acquisition, the assessment of this exposure may prompt the negotiation of special indemnification provisions or representations and warranties protecting the purchaser.

Likewise, in the context of a contemplated investment by a hedge fund, private equity firm, or other institutional investor in a company determined to have significant exposure to IC misclassification liability, this type of due diligence may lead the investor to "pass" on the contemplated investment.

A Post-Closing Use of Due Diligence

Any company that acquires another without having engaged in pre-closing IC misclassification due diligence should consider conducting its diligence post-closing, especially if it learns that there are a multitude of ICs being paid from the accounts payable ledger. While it is more advantageous to discover this risk in advance of entering into the transaction, discovery through post-closing diligence is far better than remaining in the dark.

Sometimes, pre-closing due diligence reveals only a part of the risk and the full extent of any IC misclassification cannot be fully determined until after the transaction has closed. This is where post-closing diligence can be most useful, inasmuch as the purchaser will then have full access to all pertinent information.

Where a significant risk of IC misclassification liability is revealed using legal diagnostic tools during
pre- or post-closing diligence, a purchaser has a valuable opportunity to take affirmative steps to minimize or eliminate misclassification liability on a prospective basis. As discussed in our white paper, IC relationships can be restructured to enhance the level of IC compliance. Whether or not restructuring is needed, most IC agreements require considerable revisions and should be re-documented with state-of-the-art IC provisions. Other alternatives to minimize IC misclassification liability include reclassification (voluntarily or through a government program) or redistribution of ICs. Which alternatives are most suitable often depends on the risk assessment and the particular needs of the service recipient.

As a matter of timing, these and other types of post-closing changes are not uncommon events for recently acquired businesses. They should be accomplished in a thoughtful manner with suitable communications to affected workers soon after new ownership takes over. These types of insightful adjustments to existing IC relationships can substantially diminish the likelihood that any past IC misclassification exposure will become an issue in the future.



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