Commercial Loan Financing: 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 only a select number of the 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 the borrower’s financial condition, the status of the collateral involved, as well as scrutinizing the borrower’s labor and employment practices to assess operational risks. Additionally, borrowers should take reasonable steps to do the following:

1. Ensure the employer’s full compliance with all applicable federal, state, and local labor laws, such as
   1. wage and hour,
   2. employee classification, and
   3. family leave, paid sick leave, and other time-off policies;
2. Documenting and mitigating the effects of any active litigation or known labor disputes and investigations;
3. In the event the borrower’s workforce is unionized, maintain accurate records and details with respect to the borrower’s negotiations and management with such unions; and
4. Clearly disclose to the lender all of the borrower’s obligations to its employees relating to employee benefits, such as health insurance, retirement plans, and bonuses.

Conducting an internal audit of the company’s compliance with the foregoing can expedite the borrower’s disclosure and the lender’s review and approval of the same, ultimately molding the loan documentation to the borrower’s benefit. If the employer is in active litigation or has known labor disputes or investigations, the borrower should take affirmative steps to mitigate the impact of those on the borrowing entity, as well as make plans to prevent future occurrences. The more prepared and transparent the borrowing entity is with respect to employment matters can lead to greater transparency between the parties and tailor loan documentation to better reflect the realities of the borrower’s labor and employment practices.

Loan Covenants

When seeking commercial loan financing, employers 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 a borrower operates its business. If the borrower’s employment practices are not sufficiently disclosed to those involved, the loan documentation may be drafted to inadvertently cause the borrower to be in default the moment the loan documentation is executed.

Loan covenants typically come in three modes:

1. “Affirmative” covenants (i.e., the borrower’s obligation to do something);
2. “Negative” covenants (i.e., the borrower’s obligation not to do something); and
3. “Financial” covenants (i.e., the borrower’s obligation to meet specific financial ratios and tests).

Affirmative covenants often include an affirmative duty to comply with all applicable laws and regulations, a duty for the borrower to provide notice to the lender after certain workforce-related developments have occurred, such as unionization efforts, employee strikes, and any pending or threatened ligations or regulatory investigations. Additionally, the lender may affirmatively require the borrower 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 the borrower’s actual business structure. These can include restrictions on the borrower’s ability to conduct mass layoffs, and restrictions on the borrower’s ability to make significant modifications to employee compensation, pension, or other benefits. These restrictions are geared towards preventing significant or sudden operational disruptions, which often cause significant impacts on the borrower’s 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 these forms:

1. Debt-to-labor cost rations, i.e., the ratio of total labor costs to revenue or debt obligations to ensure that employment expenses remain within manageable levels, and
2. Minimum EBITDA requirements, such that when employment costs represent a significant portion of the borrower’s operating expenses, maintaining a minimum EBITDA may indirectly limit such borrower’s ability to increase wages or benefits.

Especially when the borrower’s workforce is a significant portion of the borrower’s 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 the employer is located is necessary to ensure a smooth loan closing and business relationship into the future.

This article, slightly modified to note recent updates, was featured online in the Great Lakes Employment Law Letter and published by BLR®—Business & Legal Resources. Reproduced here with the permission of BLR®—Business & Legal Resources.