Loan Underwriting’s New Frontier – Employee Relations


One of the biggest fears people have when buying a used car is that they will get a lemon.  Cars are complex; sellers can be unscrupulous, and so people understand that the potential for disaster lurks in every transaction.  Just as consumers fear buying a lemon, lenders fear making loans that won’t be repaid.  After all, businesses are complex, borrowers can be less than honest, and regulators, as of late, have not been sympathetic to lending decisions that didn’t work out as planned.  So, just as consumers take well-known steps to avoid buying a lemon, lenders use traditional commercial loan underwriting procedures in order to analyze a prospective borrower’s ability to repay a loan. If the prospect operates in a specialized industry, those traditional standards are supplemented with industry-specific guidelines.  Those practices have, and continue, to serve lenders well; however, savvy lenders know that the traditional underwriting practices need to be augmented with doses of intuition and due diligence in order to ensure that the prospect doesn’t turn out to be a lemon.

No borrower is perfect, and potential liabilities can come in many forms, some obvious, some hidden.  Environmental concerns and real property related issues have long been recognized as areas for concern.  Today, I suggest that lenders consider a new form of ticking time bomb, namely, employee relations.

While the number of workers nationally covered by unions is at historic lows, the number of labor-specific laws, particularly in labor-dominated states such as Maryland, has increased.  Employers in Maryland face an ever-increasing gauntlet of labor laws with which they must contend.  Whether the laws be local initiatives, for example on issues such as minimum wages or non-discrimination; State laws, for example, on mandated leave; or even Federal mandates, such as Obamacare or federal contractor recordkeeping requirements, employers in Maryland today, and their lenders, cannot afford to ignore the importance of complying with labor statues.

A good indicator of a business’ prospects is its employees.  Analyzing a business’ workforce by a number of metrics is a common way to measure profitability and future prospects.  But, it is rare that lenders, or their underwriters, review an employer’s compliance with employment laws.  The failure to do so means they may be missing an important clue to potential future liability that could threaten the prospect’s ability to repay a loan or even viability as an on-going business. 

Some examples highlight how common situations can lead to potentially catastrophic losses.  Consider the misclassification of employees.  It is not uncommon for employers to classify employees as independent contractors, rather than employees.  While it is a complicated area of the law, it is crucial that the decision as to employee classification not be made haphazardly.  Why?  Misclassification of employees could mean that they would be denied access to certain benefits and protections to which they are entitled to by law, such as minimum wage, overtime compensation, family and medical leave, and unemployment insurance.  Denial of those benefits could trigger huge liability for an employer.

By way of example, focusing on the wage factor reveals how the failure to misclassify can quickly spin into a huge liability.  In Maryland, employers violating wage and hour laws are subject to liability for treble, as in triple, the damages (i.e., the wages that were not paid), plus, liquidated damages, plus payment of the employee’s (or as in most cases the ex-employee’s) attorney fees.   Let’s look at a real life example: in the case of a residential lawn care service which paid an employee bi-weekly based on the total number of hours worked over a two week pay period, instead of paying overtime for weeks in which the amount of hours exceeded 40.  The loss calculus was as follows:  unpaid overtime wages claimed (liquidated damages) of $1,500; plus, treble damages of $1,500 x 3 = $4,500; plus attorney’s fees estimated at $5,000.  The total amount claimed was $11,000.  Basically, a years’ worth of earnings for this small employer, gone!  And, to add insult to injury, if the company can’t pay this amount, that failure could result in PERSONAL liability to the business owner.  This type of liability must be taken seriously.

Wage problems don’t just arise in the context of small businesses.  Today, employee-rights focused law firms are openly advertising for wage-hour claim business on television and the internet because they know the wage-hour statutes are complicated, compliance is difficult, and errors, even accidental, mean they are likely to get paid (by the employer, of course).  In fact, while a small business, such as the lawn service described above might be subject to one or two employee claims, medium and large enterprises are more likely to face class action suits because they are the entities most likely to have employees whose salaries or classifications may be been erroneously calculated, and they are likely to have the financial capacity to pay any resulting judgment or settlement.

Maryland is home to many Federal government contractors.  Those entities not only face the same wage and hour issues as normal businesses, but they also face their own gauntlet of federal labor requirements.  And, in those cases, not only is substantive compliance important, but recordkeeping requirements can be burdensome and failure to comply with them, even if there is substantive compliance with the law, can also lead to serious liability, the termination of existing government contracts, or debarment from awards of future contracts.  Again, these types of potential liabilities cannot be ignored.

In many cases of potential liability, there is insurance to cushion any blows that might arise.  Unfortunately, while a prospect may claim to be, or believe they are, protected from employment-related claims because they have Employment Practices Liability Insurance (“EPLI”), the truth is that typical EPLI won’t ensure that the borrower doesn’t turn out to be a lemon. 

EPLI coverage is insurance that insures against losses due to a number of typical employment claims, including:

  • Sexual harassment
  • Discrimination
  • Wrongful Termination
  • Breach of Employment Contract
  • Negligent evaluation
  • Mismanagement of employee benefit plans
  • Family and Medical Leave Act

EPLI policies will reimburse the costs of defending a lawsuit in court and for judgments and settlements, but EPLI policies typically do not pay for punitive damages or civil or criminal fines; and, EPI policies do not cover losses related to wage and hour claims which, as noted above, are the claims that will reveal the borrower to be a lemon.

Until recently, insurance coverage for wage and hour claims was non-existent.  Today, such coverage exists, but the catch with these policies is that they are very expensive and typically come with very large deductibles.  Hence, due to those attributes, the average small or medium-sized business will not have, and is unlikely to be able to afford, wage and hour liability insurance. 

So, how can you tell if you are about to lend money to a lemon?  You can’t, but a little due diligence on the prospect’s labor and employment practices can easily reveal red flags.  For example, each of the following represent a potential red flag that could signal that a prospect harbors the potential for employment law liability:

  • Lack of employment manuals and formal job descriptions;
  • Lack of employment policies;
  • Failure to display mandated employment posters;
  • No or inadequate employment practices training for managers;
  • Lack of dedicated internal or professional external HR function;
  • Poor or non-existent pay and/or employment law record-keeping;
  • Extensive use of independent contractors; and
  • Frequent employee turnover.

As Benjamin Franklin once famously said, “an ounce of prevention is worth a pound of cure.”  Just examining the foregoing items with respect to each prospect can help lenders identify prospective borrowers that might face serious future employment-related liabilities before they make a commitment to lend.  With many legislative and regulatory bodies, particularly in Maryland, focused on employee rights issues, given the harsh penalties for violations, screening for potential employment-related liability should be as common as the practice of obtaining environmental assessments in real estate secured transactions.

Our Firm has helped many companies deal with their employment law issues.  We can help you evaluate loan prospects, develop screening criteria, or simply answer any questions that you might have about employment law issues.  Of course, if you believe your prospect needs help, please make a referral so we can represent them directly giving you confidence that your loan prospect has properly addressed its employment law issues. Employment law issues will continue to demand attention and we are always available for questions or consultations at any time. Don’t hesitate to give us a call.

Tony Salazar is an attorney with the Business and Transactional practice group at Davis, Agnor, Rapaport & Skalny, LLC. For questions about this article, please do not hesitate to contact Tony at 410.995.5800 or via email.