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October 2003

Tri-State Employment Services, Inc. v. The Mountbatten Surety Company: Under New York law, there is a legal presumption that a Professional Employment Organization or a "PEO," as it is commonly known

At a time when bonded contractors are frequently turning to Professional Employment Organizations or "PEOs," as they are commonly known, to fulfill their payroll and human resources responsibilities, New York's highest court, the New York Court of Appeals, has addressed a critical question which has become increasingly important to payment bond sureties - Is a Professional Employment Organization a proper claimant under a labor and materials payment bond? The Court has answered the question in the negative.

In Tri-State Employment Services, Inc. v. The Mountbatten Surety Company, Inc., 99 N.Y.2d 476, 758 N.Y.S.2d 595 (2003), Tri-State Employment Services, a professional employment organization or "PEO," sought to recover under a labor and materials payment bond issued by The Mountbatten Surety Company, as surety, on behalf of Team Star Contractors, Inc., as principal, in connection with a construction project in Quincy, Massachusetts. Tri-State had entered into an oral agreement with Team Star to provide "employee leasing services" to Team Star in connection with the Project. These services consisted of Tri-State handling Team Star's payroll obligations including payment of employees' payroll, wages, taxes, insurance premiums and union benefits in connection with Team Star's performance on the project.

Team Star provided Tri-State with a list of employees who were then transferred to the payroll of Tri-State, who, in turn, "leased" the employees back to Team Star for its use in connection with the project. The only hiring paperwork given to the employees were new W-4 and I-9 forms which were completed and submitted by the employees to Tri-State. Once the employees were placed on its payroll, Tri-State processed and distributed their payroll checks based on time sheets faxed to them on a regular basis by Team Star indicating the employee's name and hours worked. Upon issuing the payroll checks, Tri-State would simultaneously issue an invoice to Team Star reflecting the payroll costs plus a markup of 19% to cover taxes, insurance and Tri-State's own fee.

In December 1998, Team Star, stopped making timely payments to Tri-State. As a pre-condition to continuing their arrangement, the parties entered into a "Memorandum of Understanding" which memorialized in writing that Tri-State had provided "labor and payroll services" to Team Star and that Team Star owed Tri-State $1,113,251.90 for the services provided. In the Memorandum, Team Star and its president also agreed to execute confessions of judgment for the amount due to Tri-State, which they ultimately did execute.

In or about March 1999, when Team Star again failed to make payment to TriState, Tri-State brought an action against Mountbatten in the United States District Court for the Southern District of New York seeking to recover the amounts due and owing to Tri-State under Mountbatten's labor and materials payment bond. Mountbatten moved for summary judgment dismissing the action on the grounds that Tri-State was not a proper claimant under the bond having provided neither labor nor materials in connection with the project.

The District Court granted defendant's motion for summary judgment holding that Team Star was not a proper claimant under Mountbatten's labor and materials payment bond. Tri-State Employment Services, Inc., v. The Mountbatten Surety Company, Inc., 2001 U.S. Dist. Lexis 6279 (S.D.N.Y May 7, 2001). In reaching this holding, the Court acknowledged that, "[w]hile a PEO might serve more administrative functions than a creditor, it basically provides credit in the form of payroll services. A PEO certainly does not provide `labor and materials' as the terms are used in the language of the Bonds ... [t]he Bonds' definition of [labor and material] cannot be reasonably interpreted to include payroll and human resources." The Court further concluded, "[p]laintiff s efforts to characterize itself as a joint employer of the laborers on the project to which the Bonds apply does not make it the provider of labor and material itself. The fact that plaintiff paid taxes on these employees and were financially liable for them in certain instances does not change the fact that it did not furnish labor. . . [p]laintiff simply did not provide labor and material to [the project] and thus is not a proper claimant."

Tri-State appealed the decision to the Second Circuit Court of Appeals. In TriState Employment Services, Inc., v. The Mountbatten Surety Company, Inc., 295 F.3d 256 (2d Cir. 2002), the Second Circuit questioned whether a PEO such as Tri-State is more analogous to "(1) a creditor that finances payroll expenses, (2) an administrative services vendor that provides payroll and human resource services, (3) the employer of the construction workers, or (4) a joint employer - together with the client - of the workers."

Ultimately, the Second Circuit declined to render a decision acknowledging that the "case presented novel and potentially dispositive state-law questions." Accordingly, the Second Circuit certified the following question to the New York Court of Appeals: "In the circumstances presented, is a PEO, under New York law, a proper claimant under a labor and materials surety bond?"

The New York Court of Appeals accepted certification and answered the question in the negative. The bond at issue in Tri-State defines a "claimant" as "one having a direct contract with the Principal or with a Subcontractor of the Principal for labor, material or both, used or reasonably required for use in the performance of the contract" and provides that "labor and materials" include "that part of water, gas, power, light, heat, oil, gasoline, telephone service or rental of equipment directly applicable to the contract." The Court acknowledged that that the parties agreed that the bond language might cover providers of labor, but disagreed as to whether a PEO, such as Tri-State, falls within that class of protected claimants.

In rendering its decision, the Court considered the four possible categories into which a PEO might fit, previously identified by the Second Circuit, to help determine whether a PEO is a proper bond claimant. The Court declined to preclude Tri-State's claims as a matter of law on the grounds that it was simply a creditor or an administrative services vendor, acknowledging that while the services typically provided by a PEO are similar to those of an administrative services vendor or a creditor, PEOs sometimes contract to provide additional services for individual clients. The Court also declined to adopt a "legal employer" or "joint employer" standard in determining whether a PEO is a proper bond claimant since, according to the Court, the bond at issue, by its terms, protects those having a direct contract with the principal or a subcontractor of the principal, and does not speak of "employers." In addition, acknowledging conflicting decisions out of the State of California, the Court also declined to adopt the employer standard since it felt that determining whether a given PEO is a worker's employer raises fact questions that may unnecessarily complicate whether a PEO is a proper bond claimant.

Instead, the Court of Appeals ultimately held that a PEO's primary role as a provider of administrative and human resources and as a payroll financier gives rise to a presumption that a PEO does not provide labor to a contractor for purposes of a payment bond claim. However, the Court recognized that the inquiry is essentially factual and that there may be a scenario where the PEO would exercise sufficient direction and control over worksite employees as to overcome the presumption and qualify as a provider of labor within the language of the bond. The Court went on to outline the factors one should consider in determining whether a PEO is a provider of labor, including:

the PEO's involvement in selecting and screening the workers for hire, and whether it used its own criteria in doing so; the PEO's affirmative representations to the workers that it is their employer; the nature of the documentation exchanged between the workers and the PEO at the start of the working relationship (such as handbooks, manuals and employment forms); the PEO's involvement in training, supervising and disciplining the workers and in otherwise retaining control over the workers or directing their behavior; whether the PEO, rather than the contractor, determined which workers could be terminated; and whether the PEO withheld workers, rather than its services, upon nonpayment by the contractor.

Upon applying these factors to the circumstances presented by the Tri-State - Team Star relationship, the Court of Appeals held that Tri-State, as a matter of law, was not a provider of labor to the project. In reaching this conclusion, the Court noted that Tri-State did not demonstrate that it was involved in selecting Team Star's workers, that the workers received or completed any documents other than W-9 and 1-4 tax forms, or that Tri-State held itself out as the workers' employer other than issuing their payroll checks. The Court also noted that there was no indication that Tri-State retained control over the workers including their hiring, training, supervision, discipline or termination. Moreover, the Court was further swayed by the fact that when Team Star failed to pay, Tri-State withheld its own services - not the workers. In light of these undisputed facts, the Court concluded that Tri-State's "self-characterization as the workers' employer and provider of labor rings hollow" and held that under the circumstances presented, Tri-State was not a proper claimant under a labor and materials payment bond.

The holding in Tri-State should prove to be a beneficial tool for payment bond sureties who are facing an increasing number of claims against their bonds by PEOs such as Tri-State. However, it should be noted that as PEOs have become more prevalent in recent years, states have begun to regulate the industry. These statutes may have an impact on the determination of a PEO's status as a proper payment bond claimant.

New York enacted the New York Professional Employer Act, which went into effect on March 23, 2003. In Tri-State, the Court refused to entertain Tri-State's argument that the New York Professional Employer Act was retroactive and determinative of the issue before the Court, expressly leaving the issue of the legal status of a PEO for purposes of a surety bond under the New York Professional Employer Act for another day.

The New York Professional Employer Act found at New York Labor Law § 915 et seg._, outlines the specific rights and responsibilities of PEOs operating within the State of New York. The Act, among other things, provides that in order for an entity to conduct business as a PEO it must be registered with the Department of Labor, pay an initial and yearly renewal registration fee and be subject to annual and quarterly financial reporting requirements. In addition, a PEO is required to have a written professional employer agreement with its clients in which the PEO reserves a right of direction and control over the worksite employees, assumes responsibility for the withholding and remittance of payroll-related taxes and employee benefits for worksite employees and retains authority to hire, terminate and discipline the worksite employees. Furthermore and most importantly, while the Act provides that a PEO shall be considered a coemployer of the worksite employees for purposes of withholding state income tax, coverage under the workers' compensation law and sponsoring welfare benefit plans it also provides at § 922(6)(b) that "worksite employees are not automatically deemed pursuant to this section to be employees of the [PEO] for purposes of ... surety bonds ... unless the worksite employees are included by specific reference in the professional employer agreement and applicable prearranged employment contract, insurance contract or bond." In light of the forgoing provisions, it would appear that the decision in Tri-State should have continuing vitality in New York notwithstanding the enactment of the New York Professional Employer Act. While attempts may be made to tailor professional employer agreements so as to expressly reference worksite employees as employees of the PEO for purposes of surety bond claims, the Act also requires that the worksite employees be specifically referenced in the bond.

This is unlikely, particularly since a surety bond generally incorporates by reference only the bonded contract between the principal and the obligee and does not incorporate "downstream" agreements such as a professional employer agreement that may be entered into by the surety's principal. Moreover, the mere fact that a PEO reserves a right of direction and control over the worksite employees and retains authority to hire, terminate and discipline the worksite employees in its professional employer agreement should not, in and of itself, make the PEO a proper payment bond claimant. One could argue that a court would still need to engage in the factual analysis outlined in Tri-State, on a case by case basis, to determine if the PEO actually exercised sufficient direction and control over the worksite employees to overcome the presumption set forth in Tri-State and qualify as a provider of labor to the project.

To date, no New York court has addressed the impact of the New York Professional Employer Act upon a PEO's legal status as a payment bond claimant. Until the New York courts hold otherwise, Tri-State sets forth the current law in New York on the issue of whether a PEO is proper claimant under a labor and materials payment bond and certainly, at the very least, provides guidance to courts in other jurisdictions on how to determine whether a specific PEO is a proper payment bond claimant.