Conducting Due Diligence for Independent Contractor Misclassification Liability: A Guide for Private Equity Firms and Their Portfolio Companies

The publisher of this legal blog and Matthew Kane, the General Counsel and Chief Compliance Officer of Z Capital Group, LLC, wrote an article as guest authors for Private Equity Law Report entitled “How to Evaluate Portfolio Companies for Independent Contractor Misclassification Liability.”  The article, published on June 18, 2019, is available to subscribers of PELR and is summarized below, followed by a suggested process by which newly-acquired portfolio companies of private equity (PE) firms can enhance their compliance with independent contractor (IC) laws shortly after the acquisition.

Summary of the Article

Lawsuits by couriers and drivers against a host of gig economy companies such as Grubhub, Instacart, Postmates, Uber and Lyft, alleging that they have been misclassified as ICs instead of employees, have received considerable media coverage.  Recently, both Lyft and Uber stated in their recent initial public offering documents filed with the IRS that IC misclassification claims are a major legal issue – even though Uber has enjoyed some successes in these types of legal challenges. But the issue of IC misclassification exposure is not limited to companies in the gig economy; traditional businesses have likewise experienced similar legal and regulatory challenges in the past decade.

The PELR article discusses the array of IC misclassification claims that have been brought as class and collective action lawsuits, the materiality of the risks, and the abundance of multi-million dollar settlements of these types of cases.

PE firms regularly conduct due diligence of legal risks that could impact potential investments. Few PE firms, though, consider IC misclassification exposure with a sufficient degree of knowledge and insight needed to make well-informed decisions about whether to invest in a particular company that is built on an IC business model or relies on a considerable number of ICs to supplement its workforce. The PERL article details the steps PE firms can take to conduct this type of due diligence.

The article also discusses how PE firms can obtain a better appreciation of the nature and amount of the potential exposure and how to value a contemplated transaction that poses an IC misclassification risk.  Finally, the article briefly notes the types of actions that PE firms can suggest to their portfolio companies to undertake, post-closing, to maximize compliance with IC laws.

This blog post supplements that article, providing an in-depth analysis of the post-closing steps that a PE firm’s portfolio companies can take to substantially minimize their exposure to IC misclassification liability – without altering the company’s underlying business model.

Elaboration of How to Enhance IC Compliance Post-Closing

The PELR article references generally how newly acquired portfolio companies can enhance their IC compliance post-closing, noting that many companies have resorted to a legal process such as IC Diagnostics™.

IC Diagnostics is a process that examines whether a group of workers not being treated as employees would satisfy the applicable tests for IC status under governing state and federal laws, and then offers a number of practical, alternative solutions to enhance compliance with those laws.

There is no universal IC test under all federal laws, and most states have IC tests that not only vary from the federal laws but also differ from the laws in other states – even though some IC tests appear to be similarly worded. This creates a greater challenge for companies operating nationwide or in a number of different states, but there are ways by which those challenges can be met or minimized.

Initial assessment of IC compliance

The first step in a process like IC Diagnostics is the assessment of dozens of relevant factors indicating IC or employee status. While some tests have over 20 factors that are considered and others have as few as two or three, many of the factors themselves take into account a host of additional considerations. For example, some tests for IC status set forth two or three prongs that must be met and can include, as one prong, whether the business directs and controls the workers involved under contract and in fact.  In determining direction and control, courts and administrative agencies have identified well over 48 factors. So, even a test that seems abbreviated can lead to a consideration of dozens of factors bearing on direction and control.

Of course, not all IC business models are capable of becoming compliant with applicable IC laws. If they are not suitable for an IC relationship, presumably the private equity firm has abandoned their interest in acquiring the company. Thus, the following methodology assumes the business model has already achieved a minimal level of IC compliance or can be adjusted to achieve an enhanced level of compliance with IC laws.

Tweaking the IC relationship where needed

There are three principal alternatives to enhancing IC compliance: restructuring, re-distribution (for example, using a workforce management company to engage the workers), and reclassification (either voluntarily or through a program like the IRS settlement classification option). Most PE firms would like to see their new acquisitions retain their IC business model.  But unless the company is one of those few with a business model that can pass scrutiny under an array of IC laws, most portfolio companies will need to restructure (or tweak) their IC relationships so that they can fairly argue that they meet all applicable state and federal tests for IC status – or at least all but the most restrictive state law tests.    

For most businesses, there is typically a need only for a modest amount of restructuring of their IC relationships; for a few others, it may need to be a bit more substantial – but in either case the objective is not to change the business model but rather to retain its essential components in a sustainable and customized manner.

Re-documenting the IC relationship in a state-of-the-art manner

Restructuring should be undertaken in tandem with re-documenting the IC relationship. This is a comprehensive undertaking that is intended to assure that two key business and legal objectives are met: (1) that the restructuring and documentation of the IC relationship is thorough, practical, and sustainable, while maintaining the key components of the company’s business model; and (2) that the restructured IC relationship is articulated within an updated or new agreement containing state-of-the-art provisions that are designed expressly for the particular business – without any empty recitals or misstatements of how the relationship will be implemented.

Well drafted IC agreements serve many valuable purposes including providing a first line of defense against administrative proceedings and audits by regulatory agencies and against class and collective action and individual lawsuits by workers claiming to have been misclassified as ICs.

Re-implementation of the IC relationship

Companies should take steps to ensure that what is set forth in a re-documented IC agreement is implemented in practice on a short-term and long-term basis.  If not implemented in this fashion, businesses are needlessly providing arguments to class action lawyers and government regulators that their IC agreement is little more than a piece of paper that is contradicted by the actual facts and, as such, should be disregarded.  Worse, some class action lawyers and regulators argue that some IC agreements are not much more than a thinly disguised sham indicative of willful misclassification.

As part of the re-implementation, internal company communications with the ICs and about them should be articulated in a manner consistent with an IC relationship – and not indicative of an employment relationship. While some of the changes may be nothing more than semantics, mere word changes alone often do not suffice.  Websites and marketing materials should be also be reviewed and revised to articulate the IC relationship. There are state-of-the-art ways to effectively accomplish this.

Avoid model IC agreements and standardized approaches

“One size fits all” solutions are typically ill-fitting, and “quick fixes” or shortcuts intended to enhance IC compliance usually disserve the objective of meaningfully minimizing or eliminating IC misclassification liability.  The use of standard, model, or “form” IC agreements tend to cause businesses to overlook the need to structure, document, and implement a sustainable IC model that fits a company’s business model; those customized approaches are far more likely to withstand legal scrutiny under applicable legal tests.

Bona fide restructuring, re-documentation, and re‑implementation need not be prohibitively expensive or time-consuming.  Once undertaken and completed in a reasonably short period of time, these steps can place a portfolio company in an enviable place: an enhanced state of IC compliance that can minimize the likelihood that a governmental agency, class action lawyer, union, or employee seeking unemployment or workers’ compensation will attempt to challenge the IC relationship – and if a challenge is raised, these steps can maximize the likelihood that the IC relationship will be upheld as valid.

Don’t Forget an Effective Arbitration Clause with Class Action Waiver

Portfolio companies can eliminate most class actions by use of a well drafted arbitration clause with class action waiver. Such clauses can lead to a class member having to litigate his or her case on an individual basis. A poorly drafted arbitration clause may result in the company having to defend itself in a class action if the business did not take full advantage of the current state of the law. Some of the many drafting tips for such clauses can be found in our November 14, 2018 blog post entitled “How to Effectively Draft Arbitration Clauses with Class Action Waivers in IC Agreements.”

Plaintiffs’ class action lawyers are vigorously challenging such contractual provisions.  While the law favors the use of such clauses, the law is constantly changing at the federal and state level.  That reality strongly suggests that if a portfolio company already has an existing arbitration clauses in its independent contractor agreements, those provisions should be reexamined and updated in tandem with the company’s effort to enhance its compliance with laws governing the use of ICs.

Written by Richard Reibstein

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