UPDATED: The 1-2-3s of Counting Employees in Private Equity Firms Under Federal COVID-19 Legislation
No employer is immune from the storm of legislation Congress has passed in response to the COVID-19 pandemic. Private equity firms, in particular, face uncharted seas when trying to determine how these new laws will affect the firm and its portfolio companies. This determination carries significant implications for a private equity firm’s financial and legal status in the short and long term. In this alert, we explain the coverage tests under the Families First Coronavirus Relief Act (FFCRA) and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act)—tests which are not the same and which may yield different results.
The FFCRA covers private employers with fewer than 500 employees. The number of employees for purposes of the FFCRA is measured as of the date that an employee requests leave, so coverage can change over time based on changes in an employer’s workforce through hiring, layoffs, and terminations.
The Department of Labor’s (DOL) guidance and final regulations require employers to count both full-time and part-time employees, including temporary employees who are jointly employed. In addition, where one corporate entity has an ownership interest in another, it must count all employees of both entities if they are “joint employers.” Moreover, an organization comprised of multiple entities counts all employees of all the entities if they are an “integrated employer.” These two tests rely on different factors, and if either one is satisfied, the employees are aggregated to determine employer coverage for FFCRA mandatory leave purposes. Remember that aggregation yields a higher employee count, making it less likely the entities will be a covered employer (unlike the FMLA where aggregation is more likely to result in coverage).
Joint Employer Test
Private equity firms should consider whether they are joint employers with their portfolio companies. Typically, one entity with separate establishments or divisions is considered a single employer for purposes of the FFCRA, and all of the employees are counted for FFCRA coverage. By contrast, when there are separate legal entities, as is the norm for private equity sponsors and their portfolio companies, and an entity has an ownership interest in the other entities, they are presumed to be separate employers and their employees are counted separately to determine coverage under the FFCRA—unless they are joint employers under the Final Rule on Joint Employer Status promulgated under the Fair Labor Standards Act (FLSA), which took effect in March 2020.
The joint employer rule identifies four factors focused on the control exercised over individual employees to determine whether entities are joint employers: (i) hiring and firing authority; (ii) supervising and controlling work schedules and conditions; (iii) determining pay rates; and (iv) maintaining employment records. All factors are relevant, but maintenance of employment records alone will not be determinative. The FLSA rule also clarified that merely providing an employee handbook or forms to an entity does not make joint employer status more or less likely.
In a typical private equity arrangement, the sponsor and its separate portfolio companies are unlikely to meet this joint employer test, in which case each separate entity’s workforce count stands alone. However, this is a fact-specific inquiry, and private equity sponsors should consider their specific circumstances. If enough factors indicate the sponsor is a joint employer with one or more portfolio companies, their employees will be combined when determining the employee count. If the combined employees total 500 or more, the entities are not required to provide FFCRA leave.
Integrated Employer Test
The analysis does not stop there. The DOL regulations also apply a second analysis—the integrated employer test under the FMLA (separate from the joint employer test)—to evaluate whether the employees of affiliated entities should be aggregated to determine the workforce count under the FFCRA. This test is broader than the joint employer test, and, as a result, private equity firms are more likely to meet this test.
In determining whether separate businesses are integrated employers, the DOL considers four company-wide factors: (i) common management; (ii) interrelation of operations; (iii) centralized control of labor relations; and (iv) degree of common ownership or financial control. This test originated under the National Labor Relations Act. According to some courts, the “common ownership” factor is the least significant, and the centralization of labor relations (including human resources), is the most important, looking at such issues as hiring, onboarding, discipline, firing, training, policies, benefit plans, etc.
Frequently, private equity firms are structured to confer a degree of independence and lack of direct control over portfolio companies. If these facts support a finding that the entities are not an integrated employer, then each entity’s workforce count stands alone to determine FFCRA coverage, increasing the likelihood that one or more entities will have fewer than 500 employees and be a covered employer. In other cases, private equity firms may provide significant guidance to their portfolio companies and oversight of human resources and legal compliance. Doing so may make the entities integrated employers, depending on the extent of involvement, thus requiring that their employee counts be aggregated for FFCRA coverage purposes.
In evaluating these questions, funds should keep in mind the bigger picture when drawing conclusions about joint or integrated employer status. Other labor and employment laws use similar tests to determine coverage and shared liability among affiliated entities. In these other contexts, the entities may not wish to be considered one for legal purposes. Consideration of these broader consequences is important when evaluating status as an integrated employer for FFCRA coverage purposes.
CARES Act Coverage
Congress also recently passed the CARES Act, including the Paycheck Protection Program (PPP) administered by the Small Business Administration (SBA), an expansion of the SBA’s existing Section 7(a) assistance loan program. The PPP, like the FFCRA, adopted a coverage provision based, in part, on whether the borrowing entity has under or over 500 employees. Both the PPP and FFCRA include full-time and part-time employees in the count.
Generally, under the PPP, borrowers with fewer than 500 employees will qualify for loans, unless SBA has established a higher employee-based size for a particular industry. In addition, some employers with more than 500 employees may qualify if they otherwise meet SBA’s tangible net worth and average net income standards. How and whether entities aggregate employees for counting purposes under the PPP and SBA rules is very different from the FFCRA.
In SBA’s Frequently Asked Questions, most recently updated on April 23, the SBA clarified that PPP borrowers are subject to the SBA’s existing affiliation rules. Under those rules, the SBA considers two businesses to be affiliates if: (a) one controls or has the power to control the other; or (b) a third party controls or has the power to control both businesses. Notably, it does not matter whether control is actually exercised, just that it exists. Under existing SBA rules, control includes “negative control,” such as when a minority shareholder has the ability to block action by the entity’s board or shareholders.
SBA considers factors such as ownership, management, previous relationships with or ties to another concern, and contractual relationships, in determining whether affiliation exists. The SBA has highlighted the following factors when considering if two businesses are affiliates, including specifically in the circumstances when a business receives an investment from private equity:
- An entity is an affiliate of another if the entity owns or controls, or has the power to control, 50 percent or more of the concern’s voting stock, or owns a voting block under 50 percent but large compared to all other outstanding blocks.
- Affiliation exists if stock options, convertible securities, and agreement to merge rights have been granted, and they confer the power to control.
- If one or more officers, directors, managing members, or general partners who control a business entity control the board of directors and/or the management of another entity, the two are affiliates.
In a Clarifying Letter on the affiliation rules, issued on April 4, 2020, SBA specifically addressed whether private equity and other investment firms are subject to the SBA affiliation rules. They are. SBA stated that private equity companies remain subject to the existing affiliation rules, except that the CARES Act removed the common-investment and economic-dependence affiliation rules from the equation. Also, pursuant to the CARES Act, SBA waived certain affiliation rules for businesses with not more than 500 employees that are assigned a NAICS code beginning with 72 (lodging, accommodation, and food service); any business concern operating as a franchise with a franchiser identification code; and any business concern receiving financial assistance from a Small Business Investment Company (SBIC).
This application of the affiliation rules was reiterated in the SBA’s most recent Interim Final Rule, released on April 24, 2020. The SBA clarified that hedge funds and private equity firms are primarily engaged in investment or speculation, and such businesses therefore are ineligible to receive a PPP loan. However, they also affirmed that SBA affiliation rules do not necessarily prohibit a portfolio company of a private equity fund from being eligible for a PPP loan. Rather, portfolio companies must apply the affiliation rules like any other business that is subject to outside ownership and control.
The SBA’s updated FAQs also instruct that after reviewing applicable affiliation rules, all borrowers, including portfolio companies, must also assess their economic need for a PPP loan. Specifically, all borrowers must take into account their current business activity, and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business.
Notably, in its Interim Final Rules, the SBA has clarified that the CARES Act waives the affiliation rule for borrowers who receive financial assistance from an SBA-licensed SBIC in any amount. This includes loans, debt with equity features, and guarantees. Even if the borrower has an investment from other, non-SBIC investors, the affiliation rules are still waived. For borrowers that fit within this definition, entities that are related based on any of the above-listed categories (ownership, securities, management or identity of interest) will not be considered for determining employee count.
A key question remains as to at what point in time the borrower should determine its workforce count for PPP loan eligibility purposes. Initially, in its April 4 letter, SBA directed employers to average the number of individuals employed in the 12 calendar months preceding the date of the loan application. However, four days later, in its updated FAQs, SBA changed the rule. Today, under the FAQs, borrowers are instructed to use their average employment over the previous 12-month period or from calendar year 2019. It remains unclear which measure is controlling if the results differ (i.e. over vs. under 500 employees).
Intersection of FFCRA and PPP
In short, application of the above affiliation rules for PPP loans are markedly different than the joint employer or integrated employer tests used under the FFCRA. As a result, there may be differing outcomes. For example, a private equity fund may not qualify as an integrated employer for FFCRA leave purposes (i.e. triggering coverage for some entities), but may nonetheless conclude that it is an affiliated entity with one or more portfolio companies for purposes of the PPP loan program, thus precluding eligibility as a borrower. Of course, in that scenario, the entities providing FFCRA leave could be eligible for the payroll tax credits under the FFCRA.
Ballard Spahr’s Labor & Employment Group is well versed in the FFCRA and the PPP, and is available to assist you with compliance questions and practical advice in the tempestuous times of COVID-19.