Avoid the Single Entity Test in Corporate Transactions
As the economy slowly inches back to health and M&A activity heats up, acquisitive companies buying or merging with companies with one or more significant federal contracts should be aware that one letter from a relatively obscure office within the Department of Labor could deliver with it a raft of cumbersome employment regulations for the entire corporate family.
The Department’s Office of Federal Contract Compliance Programs (OFCCP) is charged with enforcing federal affirmative action and equal opportunity regulations. OFCCP carries out its mission by conducting periodic, unscheduled compliance evaluations of contractors—a process that often begins when it sends a scheduling letter announcing the start of the evaluation.
Normally a business “chooses” whether to become subject to OFCCP’s regulations when it has at least 50 employees and enters into federal contracts valued over some minimum amount, which can be from $10,000 to $100,000 depending on the regulation. Those regulations come with strict reporting requirements, and compliance can be cumbersome for organizations employing a large workforce.
Experienced contractors are typically familiar with the regulatory strings attached to government contracts and prepare accordingly. Because of OFCCP’s expansive interpretation of its own jurisdiction, however, businesses without a government contract may unwittingly subject their entire organization to OFCCP’s regulations simply by acquiring an entity with federal contracts—even if that entity is legally separate and represents only a small fraction of the parent’s business.
OFCCP believes, with some precedent, that it can treat a parent and one or more subsidiaries as a “single entity” for purposes of asserting jurisdiction under OFCCP’s own self-made and multi-factored (i.e., complicated) “single entity test.” This “test” enables OFCCP to tie a non-contracting parent to its federal contractor subsidiary(-ies) to reach the minimum thresholds (e.g., 50 employees, $50,000 in contracts) for regulatory purposes.
According to OFCCP, the test contains five broad factual categories:
Common directors and/or officers
De facto day-to-day exercise of control
Personnel polices emanating from a common or centralized source
Dependency of operations
While these broad categories may appear straightforward, each category has multiple sub-factors that touch upon almost every aspect of the daily interactions between the parent and its subsidiary. The resulting complexity makes the test easy to fail.
Once OFCCP initiates a compliance evaluation, it sends out a 27-part questionnaire (available here) that effectively puts the burden on the businesses to prove they do not operate together as a single entity. Thus, companies that take care to structure their new or existing affiliate relationships with the OFCCP’s test in mind on the front end could save their entire organization millions of dollars in compliance costs.
With OFCCP’s questionnaire and the related case law in mind, below are some general issues to consider with your corporate counsel in structuring a parent-subsidiary relationship to avoid single-entity treatment.
1. Common Ownership
There is no established ownership percentage that would push this factor toward single entity treatment, and comparison across cases is difficult given that this factor is not considered in a vacuum. In fact, this factor often receives the least emphasis, possibly because some level of common ownership is inevitable in a parent-subsidiary context. Standing alone, it generally cannot establish parent liability.
Practically speaking, a wholly owned subsidiary (even an indirect one) would certainly be considered “common ownership,” and a controlling interest by the parent likely would as well. With something less than a controlling interest, however, the test looks past the numbers into the degree of financial control exerted by one party upon the other and to the remaining factors below.
2. Common Directors and/or Officers
As with common ownership, there is no set formula for how much director and officer overlap will be viewed as “too much,” but a majority of overlapping directors actively involved in management of the subsidiary is usually a factually significant overlap.
Even more important, however, is the role officers or directors play in the management of the relevant businesses. Thus, the parent should consider limiting the extent to which the overlapping officers and directors manage the subsidiary’s day-to-day operations. Conversely, OFCCP may also take into account whether any non-overlapping officers or directors are taking an active role in the subsidiary’s business or are instead simply “nonfunctioning” placeholders. Ideally, for single entity avoidance, any outside directors or officers would take an active role.
3. De Facto Day-to-Day Exercise of Control
As one might expect in this area, it is especially important that the two entities observe all corporate formalities. However, such practices alone are not sufficient to preclude single entity treatment, as the test is designed to look past the formalities into the substance of the parties’ interactions.
The test looks at whether the two entities treat themselves as separate entities, both in the marketplace and among themselves, on a day-to-day basis. This includes determining whether the subsidiary has real autonomy to act on its own and enter into contracts without requiring the parent’s approval. Special consideration may also be given to employment-related issues such as whether the subsidiary pays its own employees’ wages (including separate payroll processing) and provides its own, separate benefits package.
4. Personnel Polices Emanating From a Common or Centralized Source
OFCCP affords special importance to this category, which is not surprising given the HR-centric nature of OFCCP’s mission. OFCCP will look at whether the two entities use the same employee handbooks and policies, and whether the subsidiary makes its own routine personnel decisions and has its own HR department. Although it may be unavoidable in the context of a corporate family, a court recently found it significant that employees moving between parent and subsidiary retained their seniority for benefits purposes.
5. Dependency of Operations
When examining this factor, OFCCP will consider whether the two entities share administrative personnel like accounting, in-house legal, IT, and HR. OFCCP will also look at whether the two entities use offices and equipment interchangeably, and/or whether they keep their operations physically and geographically separate.
Because the single entity test considers all the circumstances in a parent-subsidiary relationship, it is not strictly necessary that all single entity factors be absent. Practical business considerations may make that impossible to implement. However, based on the available authority, the more the above considerations tip in favor of “separateness,” the less likely the new or existing subsidiary will be treated as a single entity with the parent for purposes of OFCCP’s regulations, and the less likely the parent will find that has bought more headaches for the overall enterprise than it bargained for.
Jason S. McCarter is a partner in the Atlanta office of Dow Lohnes, where he handles a variety of complex business disputes and regulatory investigations for automotive, utility, and education clients. He also advises clients on lending, UCC, privacy, licensing, and contracting issues. Matthew T. Parrish is an associate in the Atlanta office of Dow Lohnes, where he focuses on complex commercial litigation and communications litigation.