Before you borrow, understand crucial labor and employment considerations
When seeking commercial loan financing, both lenders and potential borrowers in the loan transaction typically focus on the very important financial metrics, subject collateral, and loan terms and financial covenants. However, labor and employment considerations play a critical role in a lender’s evaluation process and can significantly influence the terms and success of the loan transaction. Understanding and addressing these issues can improve the employer’s negotiating position, minimize risks, and help ensure a smoother financing process. In this article, we will provide a brief overview of a select number of labor and employment issues lenders and employers should anticipate and address when pursuing commercial loan financing.
Due diligence preparation
Lenders spend considerable time performing due diligence on a potential borrower, including a review of their financial condition and the status of the collateral involved as well as scrutinizing their labor and employment practices to assess operational risks.
Additionally, employers looking to borrow should take reasonable steps to:
- Ensure full compliance with all applicable federal, state, and local labor laws, such as wage and hour, employee classification, and family leave, paid sick leave, and other time-off policies.
- Document and mitigate the effects of any active litigation or known labor disputes and investigations.
- Maintain accurate records about negotiations with unions in the event your workforce is unionized.
- Disclose to the lender all obligations to your employees relating to benefits, such as health insurance, retirement plans, and bonuses.
Conducting an internal audit of your company’s compliance with the foregoing can expedite your disclosure and the lender’s review and approval, ultimately molding the loan documentation to your benefit. If you are in active litigation or have known labor disputes or investigations, you should take affirmative steps to mitigate the impact, as well as make plans to prevent future occurrences.
Being prepared and transparent with respect to employment matters can lead to greater transparency between the parties and tailor loan documentation to better reflect the realities of your labor and employment practices.
Loan covenants
When seeking commercial loan financing, you should be aware that lenders often impose labor-related covenants in loan agreements to address those items discovered within the due diligence process and to mitigate risks associated with the employer’s workforce management. For better or for worse, these covenants can affect how you operate your business. If your employment practices aren’t sufficiently disclosed to those involved, the loan documentation may be drafted to inadvertently cause you to be in default the moment the loan documentation is executed.
Loan covenants typically come in three modes:
- “Affirmative” covenants (i.e., your obligation to do something);
- “Negative” covenants (i.e., your obligation not to do something); and
- “Financial” covenants (i.e., your obligation to meet specific financial ratios and tests).
Affirmative covenants often include an affirmative duty to comply with all applicable laws and regulations and a duty to provide notice to the lender after certain workforce-related developments, such as unionization efforts, employee strikes, and any pending or threatened ligations or regulatory investigations, have occurred. Additionally, the lender may affirmatively require you to provide periodic reports detailing any of the foregoing and items such as labor costs, employee headcounts, and benefits obligations.
Negative covenants are often significant but tailored to fit your actual business structure. These can include restrictions on your ability to conduct mass layoffs or to make significant modifications to employee compensation, pension, or other benefits. These restrictions are geared toward preventing significant or sudden operational disruptions, which often cause significant impacts on your cash flow and ultimate ability to repay the loan.
Financial covenants relating to employment often seek to ensure that the borrower is allocating an appropriate amount of resources to labor costs. These often take the form of debt-to-labor cost ratios (i.e., the ratio of total labor costs to revenue or debt obligations to ensure that employment expenses remain within manageable levels) and minimum earnings before interest, taxes, depreciation, and amortization (EBITDA) requirements, such that when employment costs represent a significant portion of the borrower’s operating expenses, maintaining a minimum EBITDA may indirectly limit its ability to increase wages or benefits.
Especially when the borrower’s workforce is a significant portion of its business, employers should establish strong internal processes to ensure compliance with these covenants, as well as ensuring flexibility within the loan documentation. Failing to meet any of these covenants could trigger default under the loan documentation. Borrowers often seek to obtain flexibility by including qualifications onto the various covenants, such as “materiality” and “knowledge” thresholds, as well as adding sufficient cure periods in the event of a covenant breach and clarifying the problematic definitions.
Bottom line
Labor and employment matters are an essential part of the commercial loan process. Both the lender and the borrower have a vested interest in performing appropriate due diligence into the borrower’s labor and employment practices, as well as appropriately molding the loan documentation to address such matters and the realities of the borrower’s operations. Discussing these matters with an attorney who practices in the states or countries where you are located is necessary to ensure a smooth loan closing and business relationship into the future.
