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A PEO Deal Goes Upside Down

February 26, 2008
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It’s the stuff of nightmares.

A week before Christmas 2007, a North Carolina professional employer organization abruptly shut down, leaving 3,000 workers it managed for close to 100 clients wondering if they’d get paid or still had health insurance. Days later, the company, the Castleton Group of Raleigh, North Carolina, filed for bankruptcy protection. Now the state’s Bureau of Investigation is looking into the company’s finances, and the North Carolina Insurance Department alleges, among other things, that the company owes $8 million in back federal payroll taxes.

As the Castleton case makes painfully clear, companies large and small must thoroughly vet the outsourcers they hire or leave themselves open to unexpected disruptions, sometimes with dire consequences.

“Oftentimes when these things happen it’s sad and there are hurt folks,” says Gray McCaskill, president of an insurance company that took over the workers’ compensation contracts of some Castleton clients after the company shut down. “You have to look before you leap.”

Professional employer organizations such as Castleton are often likened to HR outsourcers for smaller companies of up to several hundred employees. But there’s one big difference. Unlike HR outsourcers, PEOs act as co-employers, handling HR functions like payroll, health benefits and workers’ compensation while the client company manages workers’ day-to-day activities.

In the past 20 years, PEOs have mushroomed into a $61 billion industry with more than 400 companies covering 2 million employees, according to Milan Yager, executive vice president of the National Association of Professional Employer Organizations, an Alexandria, Virginia, trade group.

From the outside, Castleton was a pillar of the community. During 2007, the 10-year-old business made it onto Inc. magazine’s list of the 5,000 fastest-growing private companies, was named the year’s top woman-owned business by a local business weekly, and moved into a new 32,000-square-foot office complex near downtown Raleigh.

Castleton owner Suzanne Clifton, 64, held a seat on the state PEO association’s advisory council. According to local news reports, Clifton and her husband owned three homes with a combined tax value of $4.2 million, including one in the Virgin Islands.

But trouble was brewing behind that successful façade. Since 2005, the North Carolina Insurance Department had denied Castleton’s license requests because of concerns about the company’s solvency. In court filings, William Brewer, the Raleigh lawyer representing Castleton in the bankruptcy proceedings, called the company’s financial dealings “voluminous but inscrutable.”

After Castleton shut its doors on December 18, clients scrambled to replace employees’ benefits. Castleton attempted to transfer employees to another PEO without disrupting benefits, but it didn’t work out “for reasons outside of Castleton’s control,” according to Terry Carlton, a former Castleton attorney.

McCaskill, president of insurer Senn Dunn in Greensboro, North Carolina, says he was contacted by several Castleton clients and ultimately took over workers’ comp for a number of businesses.

To avoid catastrophe, anyone who wants to outsource or enter into a PEO arrangement should perform due diligence on prospective vendors, NAPEO’s Yager says. Companies can start by determining whether their state is one of 29 that, like North Carolina, have PEO licensing or registration laws. NAPEO is lobbying other states to follow suit and recommends that regulations include financial audit requirements so that even if PEOs are privately held, customers can find out if they’re fiscally stable. “The truth is many still aren’t [audited], and consumers aren’t asking for it,” Yager says.

As a further sign of their trustworthiness, some PEOs choose to become bonded by passing a financial accreditation process administered by a nonprofit industry group called the Employer Services Assurance Corp. that NAPEO started in 1995. About 25 PEOs representing 30 percent of the industry’s total revenue are bonded, Yager says. While Castleton was an NAPEO member, the company wasn’t bonded.

Yager also suggests that prospective clients check in with a PEO’s existing customers to find out what the company is like to work with, whether they meet contractual obligations, if their benefits package is acceptable, and whether there have been any problems.

To Yager, Castleton’s failure proves that state PEO regulations work. “It’s only because there was a statute with an audit provision that this whole situation came out,” he says. “The state had the company under observation, the public was aware of it, but the clients trusted them so much they didn’t leave.”

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