Employee Solutions, Inc.

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Employee Solutions, Inc.

2929 E. Camelback Road, Suite 220
Phoenix, Arizona 85016-4426
U.S.A.
(602) 955-5556
Fax: (602) 955-3311
Web site: http://www.employeesolutions.com

Public Company
Founded: 1991
Employees: 120
Sales: $164.5 million (1995)
Stock Exchanges: NASDAQ
SICs: 7361 Employment Agencies; 6331 Fire, Marine, and Casualty Insurance; 7374 Computer Processing and Data Preparation and Processing Services

Employee Solutions, Inc. is a national professional employer organization (PEO), leasing employees to companies and assuming responsibility for payroll, benefits, and tax administration. Under the “co-employer” contractual arrangement favored by ESI, a client company continues to be responsible for day-to-day management, including determining job descriptions, setting salaries, and hiring and firing employees. ESI is the second largest employee-leasing company in the United States and the largest that is publicly owned. In 1996, the company had co-employer arrangements with more than 1,100 businesses in 46 states covering more than 28,000 leased employees. In addition to its employee leasing services, ESI provides stand-alone risk management services and workers’ compensation insurance to clients through its wholly owned subsidiary, Camelback Insurance Ltd. In 1996, approximately 17,000 non-leased employees received these services from ESI. For the nine months ended September 30, 1996, ESI revenues were $290.2 million, triple its revenues for the same period in 1995.

Early History: 1982–91

Employee leasing first became popular in 1982, when a provision in the tax code allowed high-wage professionals such as dentists, doctors, and real estate developers to exclude lower paid, leased workers from company pension plans, saving lots of money in taxes. At the time, Employee Solutions chairman and CEO Marvin Brody was an attorney trying to find tax relief for his clients, and he encouraged them to pay someone else to take over their personnel responsibilities and to administer benefits. By 1984, Brody’s clients had nearly 100 employee leasing companies to choose from, with those firms leasing about 10,000 employees to their clients.

When Congress closed the tax loophole as part of the Tax Reform Act of 1986, the future of employee leasing looked uncertain. But Brody discovered that his clients were not eager to take back the payroll and regulatory duties, and the accompanying paperwork, they had turned over to leasing firms. He also recognized that savings could be made in the costs of payroll and benefits by pooling small employers together. “I saw an opportunity for employee leasing to grow because I saw the frustration of my clients,” Brody explained in a 1996 article in Investor’s Business Daily. “I knew that if my clients were worried about costs, plenty of others were, too.”

Brody turned to his friend Harvey Belfer, the founder of Arizona-based Contract Personnel Systems, one of the first 30 employee leasing companies in the U.S., to help him. In 1991, Belfer incorporated a new company, Employee Solutions, in Phoenix and became president. Brody, as a director, provided advice and helped in strategic matters.

Early 1990s: Growth of an Industry

Brody’s perception of the continuing desire for employee leasing was on target. Small companies turned to Employee Solutions and similar firms to cut benefit costs (while often improving the actual benefits) and to reduce paperwork. Larger companies used leasing as a means to reduce their workforce. “There are fewer legal entanglements, so it’s easier to let [workers] go,” the senior subcontract administrator at Lawrence Livermore National Laboratory explained in a 1991 Nation’s Business article.

Leasing companies initially concentrated on small business, generally those with fewer than 110 employees, which could not afford to hire someone to handle just personnel matters. In such organizations, the owner, partners, or other management personnel had to deal with tax reporting, payroll, workers’ compensation, unemployment insurance, and whatever benefits the firm offered.

Typically, a small business would fire its employees one day, the employees would go on the payroll of the employee leasing company, and the next day they would be back at the work site as employees of the leasing firm. The leasing firm was responsible for issuing pay checks; providing health insurance and pensions; paying payroll taxes and preparing payroll reports; and handling legal issues related to employment. The client company remained responsible for day-to-day management, including hiring, supervision, salary setting, job descriptions, and firing.

But as the industry grew to over 1,000 firms by 1991, problems began developing. Three areas of concern were evident in the fast-growing industry: financial stability, workers’ compensation rates, and company-client relationships. Problems in the first area occurred when so much cash suddenly became available to financially unsound or unscrupulous company officials. Too often they would use the money to pay personal debts and fail to purchase the insurance coverage they promised or deposit the required payroll taxes. To correct this on a voluntary basis, the industry’s trade association established strict reporting requirements for its members, including quarterly independent audits to confirm that taxes were deposited on time, that insurance and other benefit programs were funded properly, and that workers’ compensation and other required insurance was in force.

The second major issue had to do with the rates paid by leasing companies for workers’ compensation premiums. Some newly established leasing companies would use their own flawless experience rating rather than a client’s poorer rating to offer lower workers’ compensation rates. The insurance industry also accused some firms of misclassifying workers to obtain lower premiums. The insurance industry wanted to prohibit leasing companies from carrying workers’ compensation coverage at all, and require the client companies to provide the coverage. The employee leasing industry proposed that leasing companies be required to use the client’s experience rating for the first three years, the period at which ratings are adjusted.

Responding to complaints, the U.S. Senate Permanent Subcommittee on Investigations held hearings. The subcommittee found that abuses occurred because no one, neither federal nor state regulators, had clear authority over the industry. For example, many of the leasing companies claimed they were exempt from state insurance regulations under the provisions of the federal Employee Retirement Income Security Act (ERISA).

Between 1991 and 1992, four states passed laws to regulate the industry. Their legislation usually required licensing by a state board and a bond or evidence of a specific net worth, ranging from $50,000 to $100,000. In 1992, Congress considered several bills to clarify who was responsible for regulating the industry but failed to act on any of them.

The third area of concern dealt with the legal relationship between a leasing company and its clients. Initially, leasing companies considered themselves sole employers, assuming legal responsibility for employment matters such as wrongful discharge and employment discrimination, along with payroll taxes and workers’ compensation. By the early 1990s, the industry trend began shifting to one of’ ‘co-employer,” with the leasing company sharing legal responsibility but not assuming it completely.

Magazine articles at the time explained employee leasing and offered examples of successful experiences. But they also outlined the pitfalls and often included questions to ask a leasing company before signing a contract.

ESI Grows: 1991–96

Into this market came Employee Solutions in 1991. Like other employee leasing firms, ESI began as a small, local firm. But Brody and Belfer had a goal of becoming a national, full-service PEO.

Within two years of starting the company, Brody and Belfer took ESI public. In August 1993, the company began trading on the NASDAQ Small Cap Market. That year ESI also began executing an aggressive growth strategy, acquiring the Prescott Group, Inc., an Arizona company, in February, and Pro Pay, Inc. in October. These additions contributed to increased revenues for the year which reached $48.6 million, with net income of $109,550. At the end of 1993, Employee Solutions leased approximately 2,600 employees.

While one of ESI’s major attractions to clients was the handling of payroll processing and regulatory compliance, ESI also offered its clients a wide range of employee benefits. Companies could choose from a menu of benefit packages, including major medical, preferred provider organization (PPO), three different health maintenance organizations (HMO); dental care; vision care discounts; group term life insurance; accidental death and dismemberment insurance, pension plans, and 401(k) plans. Because ESI was insuring a large pool of leased employees, it could take advantage of benefits offered to large corporations at a much lower cost than its clients could negotiate individually.

Company Perspectives:

The Company seeks to strengthen its leadership position in the PEO [professional employer organization] industry by providing client companies with comprehensive and flexible outsourcing services to meet their human resource needs. The Company believes its size, full range of employee outsourcing solutions, nationwide presence, and sophisticated risk management/workers’ compensation programs give it a distinct competitive advantage.

In 1994, internal expansion became a second prominent factor in ESI’s growth strategy (in addition to acquisitions). The company moved into the southeastern section of the country, where it operated as Employee Solutions-East, Inc., and opened regional offices in Atlanta; Irvine, California; and Chicago. In Atlanta, the company’s new training facility began preparing a cadre of independent sales representatives.

ESI also expanded its benefit offerings, organizing a workers’ compensation program with American International Group and Reliance National Indemnity Company. This meant the company could offer its own workers’ compensation coverage to its leasing clients and reduce its exposure to a catastrophic risk. Under this program, ESI was responsible for the first $250,000 on a claim. Any amount above that would be covered by Reliance or AIG under a reinsurance policy. ESI also received approval to form a wholly owned captive insurance company, Camelback Insurance Ltd.

Employee Solutions took a three-step approach to workers’ compensation. First, it rigorously screened potential clients, examining a firm’s claim history, premium payments, and job classifications, and conducting an on-site inspection. Only about half of all applicants passed this screening. Once a company was accepted as a client, ESI’s risk management department designed a safety program for it to educate workers about risks at that particular workplace and to introduce practices or equipment that could reduce injury rates. The final step in the process was to aggressively manage claims once they were filed. In most cases, this involved determining where an injured employee received treatment and bargaining with suppliers to get competitive treatment costs. The company also encouraged workers to take “light-duty” jobs until they were able to return to their old job. This strategy helped reduce clients’ workers’ compensation expenses by more than 50 percent according to an analyst report about the company by Ladenburg, Thalmann & Co. ESI’s loss ratio—the cost of claims as a percentage of premiums collected—was less than 30 percent, compared to an industry average of 75 percent.

In November 1994, Marvin Brody was named chief executive officer in addition to serving as chairman of the board. As of the end of the year, ESI had tripled the number of leased employees to approximately 3,600, leased to about 450 clients in 20 states.

In 1995, the company established ESI Risk Management Agency, Inc. (RMA) as a wholly owned subsidiary. RMA made it possible to offer risk management/worker’s compensation services to medium-sized companies on a stand-alone basis, without requiring them to lease employees. The company used this option primarily as a marketing tool. ESI’s goal was to establish its credibility with stand-alone clients through RMA and then convert risk management clients into full leasing status. By mid-year, Camelback Insurance Ltd. was handling most of ESI’s risk management/worker’s compensation services program, in coordination with Reliance.

At the beginning of the year the company took over Employment Services of Michigan, Inc., a dormant business that had leased drivers to transportation companies, and renamed it Employee Solutions-Midwest, Inc. This allowed the company to move into Michigan, Ohio, and Minnesota, and it opened a regional office in Detroit.

During the year ESI created ESI America, a wholly owned subsidiary, through which it purchased Hazar, Inc., a national staff leasing company. ESI paid over $7 million for Hazar and several of its subsidiaries, receiving in return approximately 4,100 leased employees and expanding into key markets in California, Illinois, New York, and New England. “The Hazar acquisition basically doubled our size,” Brody told Robin Grugal of Investor’s Business Daily. The growth resulting from these purchases was in addition to internal growth of between 35-40 percent a year anticipated by Brody.

At year’s end, ESI’s revenues had doubled from the previous year to $164.5 million, and net income stood at $3.8 million, almost ten times that in 1994. The number of employees leased by ESI increased to 11,000, and an additional 3,500 non-leased employees received risk management/worker’s compensation services through RMA.

In January 1996, ESI’s growth qualified its stock to move from the NASDAQ Small Cap Market to the exchange’s National Market. That same month the company had a two-for-one stock split and completed the acquisition of Employee Solutions-East, Inc. and Pokagon Office Services, which was renamed Employee Solutions of Ohio, Inc.

Other major purchases moved the company into a new area, the entertainment industry, and increased its focus on the transportation industry. In March, ESI announced it was buying Aslin Transportation Services, Inc., for which it had been providing risk management/worker’s compensation services. Aslin, an employee leasing company based in Indiana, specialized in serving the transportation industry. The company also purchased Penske Truck Leasing Company’s Leaseway Personnel Corp., with $100 million in revenue and 1,900 leased employees. The new subsidiary, which was renamed Logistics Personnel Corp., provided permanent and temporary truck drivers, warehouse workers, dispatchers, mechanics, and administrative employees. With the purchase of TEAM Services, which had $65 million in revenue and about 3,000 leased employees, ESI began leasing musicians, recording engineers, and other commercial talent to the music and advertising segments of the entertainment industry. ESI also acquired Employer Sources, Inc., a California-based subsidiary of Hazar. The $400,000 transaction added approximately 1,400 more leased employees to ESI.

In August, Bane One Corp. of Arizona and First Chicago NBD Corp. joined in providing a $35 million revolving credit loan for the company. Bane One increased the credit to $45 million in November, when ESI announced the acquisition of the McCleary-Trapp Companies for approximately $10.7 million. Based in Alabama and South Carolina, McCleary-Trapp leased some 2,000 employees to 125 companies in 15 states, primarily in the southeast. Their clients tended to be light industrial, transportation, and service companies.

The year 1996 also saw the company initiate a third area in its growth strategy, that of joint ventures. In January it entered into a partnership with Tri-City Insurance Brokers, Inc. to sell ESI’s stand-alone risk management/workers’ compensation services.

In December, the company announced it had signed a two-year contract with U.S. Xpress Enterprises, Inc., one of the largest transportation companies in the U.S. That contract added another 3,800 leased employees to ESI.

But 1996 was not completely smooth for ESI. Some individuals were concerned that ESI was taking on more financial risk than it could cover. In an April 8, 1996, article in The Wall Street Journal, John Dorfman cited Peter Kamin and Todd Bourell, money managers with Peak Investment L.P., as fearful that the company did not have sufficient reserves for potential workers’ compensation claims, particularly as it took on higher-risk employees such as truck drivers. That article caused ESI’s stock to drop, but when the company’s 1996 year-end audit by Arthur Andersen said the reserves were adequate, the stocks recovered. Merrill Lynch, for example, upgraded its investment rating for the company in a report on May 21st, saying, “We have yet to see written or hard core evidence of any of the wild and not-so-wild accusations thrown about to date. Most issues have been raised by anonymous individuals. As long as short sellers continue to lose money, the stories will likely be getting worse. We believe those with a long-term view will be rewarded for riding through the storm.”

1997 and Beyond

Since the company went public in 1993, ESI had added over 25,000 worksite employees and 1,000 client companies. For ESI itself, success would be dependent on its ability to manage its growth. To increase its revenues in 1997, ESI began offering new services which its leased employees could purchase themselves. These included automobile insurance, prepaid telephone cards, and payroll deduction programs for life, disability, and special health insurance.

Despite the concern reported by The Wall Street Journal and a warning in the December 30, 1996, issue of Business Week that “a growing army of short-sellers maintain the earnings of this staff-leasing company are destined to fall,” the future looked bright for Employee Solutions and the PEO industry. According to the Small Business Administration, 5.2 million businesses had fewer than 500 employees and 98 percent of non-farm companies in the U.S. employed fewer than 100 workers. The National Association of Professional Employer Organizations (NAPEO) estimated that less than 2 percent of small businesses were using PEOs. Although somewhere between 2,300 and 2,500 PEOs operated in the U.S., none had a dominant share of the national market.

Finally, significant regulatory issues, particularly regarding tax matters and liability for employment laws, remained unresolved. For example, the Internal Revenue Service formed a Market Segment Study Group which is examining the tax treatment of benefit plans for leased employees. As stated on its web site, “The Company, and other industry leaders, in concert with and through NAPEO, work with government entities for the establishment of appropriate regulatory frameworks to protect clients and employers and thereby promote the acceptance and further development of the PEO industry.”

Principal Subsidiaries

Employee Solutions II, Inc.; ESI America Inc.; Camelback Insurance Ltd.; The Prescott Group, Inc.; Pro Pay, Inc.; Employee Solutions-Midwest, Inc.; Hazar, Inc.; Employee Solutions-East, Inc.; Aslin Transportation Services, Inc.; ESI Risk Management Agency, Inc.; Logistics Personnel Corp.