New Guidance from the California Supreme Court on Incentive Compensation Plans and Authorized Deductions

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1 October 2007 New Guidance from the California Supreme Court on Incentive Compensation Plans and Authorized Deductions By George W. Abele, Holly R. Lake, and M. Kirby C. Wilcox In Prachasaisoradej v. Ralphs Grocery Company, Inc. (Ralphs), the California Supreme Court examined the validity of Ralphs Incentive Compensation Plan. According to the Plan, eligible employees were entitled to additional compensation, above and beyond their promised base wage, according to a formula that defined store profits as revenue less certain business costs, including workers compensation insurance, store shortages and other business expenses. In conducting its analysis and reviewing prior case law, the Supreme Court answered a question with which employers often struggle: What calculations and adjustments are permitted in determining commissions and bonus payments? The answer will depend on how the employer structures the commission or bonus plans, and will require an analysis of the following questions: (1) Do the plans affect regular wages or supplemental wages, and what promises do they make about those wages? (2) Do the plans reward collective contributions or penalize an individual for business losses? (3) When are the amounts payable under the plans calculated, and what conditions must occur first? Given the subtle distinctions inherent in this analysis, employers should consult with their attorneys as they develop or review incentive compensation, bonus and commission plans, in order to best take advantage of the helpful guidance offered by this decision. THE ISSUE California Labor Code section provides that, except for deductions expressly authorized by state or federal law, an employer may not collect or receive from an employee any part of wages theretofore paid. Section 3751, subdivision (a) prohibits an employer from exact[ing] or receiv[ing]... any employee... contribution, or tak[ing] any deduction from [employee] earnings... either directly or indirectly, to cover the whole or any part of the cost of [workers ] compensation. Case law has interpreted various provisions of the Labor Code, and regulations issued thereunder, as prohibiting deductions from an employee s stated wage to cover certain of the employer s business costs, such as cash and merchandise losses not caused by the employee s dishonesty, or his willful or grossly negligent act. In addition, the Industrial Welfare Commission ( IWC ) expressly forbids such deductions and charges against the wages of nonexempt employees in the mercantile industry: No employer shall make any deduction from the wage or require any reimbursement from an employee for any cash shortage, breakage, or loss of equipment, unless it can be shown that the shortage, breakage, or loss is caused by a dishonest or willful act, or by the gross negligence of the employee. 2 In Ralphs, plaintiff alleged that the company s Incentive Compensation Plan violated wage deduction laws because the calculations of employees bonus payments were affected by workers compensation costs, cash shortages and other business expenses. The trial court sustained Ralphs demurrer. Relying on a prior case, Ralphs Grocery Co. v. Superior Court (Ralphs Grocery), 3 which had considered the same Plan and found it invalid, the court of appeal reversed. The Supreme Court reversed the court of appeal, finding the Plan lawful and not subject to challenge. 18 Offices Worldwide Paul, Hastings, Janofsky & Walker LLP

2 The Ralphs decision not only impacts employers across California that have incentive compensation plans, but, in the 4 3 majority opinion penned by Justice Baxter, the Supreme Court also validates an employer s ability to make adjustments to advances on wages, commonly referred to as chargebacks. THE RALPHS DECISION Background Certain employees at each of Defendant s stores participated in an Incentive Compensation Plan whereby they were eligible to receive, over and above their regular wages, supplementary payments based upon how the store s actual Plan defined profits compared with preset profitability targets. The Plan did not create an expectation or entitlement in a specified wage, from which deductions were taken to reimburse Ralphs for its business costs. Rather, participants in the Plan separately received a regular wage, and they understood that they were eligible to receive additional payments based on their collective and cooperative effort, consistent with the Plan defined formula. The Plan formula defined both target and actual profit by subtracting store operating expenses from store revenues: [P]ursuant to normal concepts of profitability, ordinary business expenses, such as storewide workers compensation costs, and storewide cash and merchandise losses, were figured in, along with such other store expenses as the electric bill and the cost of goods sold, to determine the store s profit, upon which the supplementary incentive compensation payments were calculated. 4 Plaintiff claimed the Plan violated California law, which prohibits an employer from shifting certain of its costs to employees by withholding, deducting or recouping them from wages or earnings, or otherwise obliging employees to contribute to them. The Supreme Court granted review on the following issue: whether an employee bonus plan based on a net profit figure that included deductions for a store s expenses, including the cost of workers compensation insurance and cash and inventory losses, violates (a) Business and Professions Code section 17200, (b) Labor Code sections 221, 400 through 410, or 3751, or (c) Wage Order No. 7, 8 Cal. Code Reg Analysis Plaintiff asserted that, contrary to the California Labor Code and the IWC orders, the Plan reduces an employee s stated and expected wage by an unexpected contribution, deduction, withholding and/or reimbursement to the employer for items such as the employer s workers compensation expenses, or cash shortages, the costs of merchandise damage or loss, or third party tort claims not attributable to the eligible employee s own dishonesty, willfulness or gross negligence. Hence, Plaintiff argued that the Plan effectively shifts the costs of doing business to the employee. Citing Ralphs Grocery, Kerr s Catering Service v. Department of Industrial Relations, 5 Quillian v. Lion Oil Company, 6 and Hudgins v. Nieman Marcus Group, Inc., 7 the court of appeal found that the Ralphs Plan was subject to challenge. Specifically, the court of appeal held that, by including workers compensation costs in the formula for calculating the store s net earnings, Ralphs arguably was taking a deduction from employee wages to cover such costs, in direct violation of section Moreover, the court concluded that, insofar as the net earnings calculation took into account cash shortages, breakage and loss of equipment not caused by the compensated employee s dishonesty, willful act or gross negligence, the Plan might violate Regulation 11070, applicable to nonexempt employees. This formula, as the Ralphs Grocery court had held, forced such workers to assume business costs that the law places exclusively upon the employer, and to face the special hardship of uncertain and unanticipated wage deductions. The Supreme Court did not agree. The Supreme Court distinguished Kerr s Catering, Quillian and Hudgins on the grounds that, in each of those cases, the employee s compensation, whether regular or supplementary, was set, in essence, as a sales commission, i.e., a specified and promised share of the revenues attributable to that employee s personal sales or managerial efforts. The set commission then was directly reduced by the full dollar value of merchandise and cash losses, as determined by the employer and regardless of employee fault. The employer thus defrayed its merchandise and cash losses by charging them, dollar for dollar, against its liability 2

3 for wages. The Supreme Court held that the employers in Kerr s Catering Quillian and Hudgins, without following the rules for cash bonds, assessed individual employees the entire unliquidated value of such losses, and did so by withholding amounts from earned and promised commissions until those commissions fell to zero. In Ralphs, unlike in Kerr s Catering, Quillian and Hudgins, no employee was offered or promised a specified bonus or commission that was based upon, and immediately measurable by, his or her individual sales or managerial efforts, but which was then subject to deductions to cover employer costs. Instead, under the Plan, all eligible employees supplementary incentive compensation was equally and collectively premised, at the outset, on store profits, a factor that necessarily considered the employer s expenses as well as its income. Holding The Supreme Court held that nothing in the statutes, regulation, or cases cited by plaintiff prohibited Ralphs from offering its employees, over and above their guaranteed base wages, supplementary incentive compensation on the basis of store profits that remain after legitimate store expenses, including the costs of workers compensation, have been subtracted from store revenues. Therefore, Ralphs profit based supplementary Plan, designed to reward employees beyond their normal pay for their collective contribution to store profits, did not violate the wage protection policies of Labor Code sections 221, 400 through 410, or 3751, or Wage Order No. 7, 8 Cal. Code Reg WHAT RALPHS MEANS FOR CALIFORNIA EMPLOYERS The Ralphs holding permits employers to impose conditions precedent in the form of deductions upon (1) supplemental wages that (2) reward collective behavior. Separately, the Court gives tacit approval to an employer s adjustment of wage advances by endorsing several California court of appeal cases. Each of these three issues will impact employers as they draft or review incentive compensation, bonus or commission plans. Supplemental Wages May Be Subject to Conditions Precedent The Ralphs opinion makes a clear and important distinction between regular and supplemental wages, thus providing guidance on permissible calculations and adjustments in defining incentive compensation, bonus or commission payments. To do so, it relies on the ordinary and usual meaning of the words wages, earnings, deduct and contribution : A wage is [any] amount [paid] for [an employee s] labor, however that amount is calculated. ( 200.) Earnings are [t]he salary or wages of a person. (American Heritage Dict. (2d college ed. 1985), p. 434.) To deduct is to take away [one amount] from another ; to subtract. (Id., at p. 373.) Deduction is the act of deducting, or [a]n amount that is... deducted. (Ibid.) A contribution is something contributed ; while to contribute is [t]o give... in common with others [or] to a common fund or for a common purpose. (Id., at p. 318.) 8 Using these common definitions, the Court concludes that an employee s wages or earnings are the amount the employer has offered or promised to pay, or has paid pursuant to such an offer or promise, as compensation for that employee s labor. 9 The employer takes a deduction or contribution from an employee s wages or earnings when it subtracts, withholds, sets off or requires the employee to return, a portion of the compensation offered, promised or paid as offered or promised, so that the employee, having performed the labor, actually receives or retains less than the paid, offered or promised compensation, and effectively makes a forced contribution of the difference. 10 With this understanding, the Court concludes that Ralphs Plan payments are wages; however, they are supplemental wages. These supplemental wages are not offered or promised until after application of the Plan defined formula. Such supplemental wages do not run afoul of wage deduction law, because no amount is deducted from the promised wage. The Supreme Court thus recognized the legitimacy of conditions precedent to the offer or promise of a wage. The Court cited with approval Neisendorf v. Levi Strauss & Co, 11 in which the court of appeal held that the employer did not run afoul of Labor Code 3

4 section 221 when it required a condition precedent (employment on the bonus distribution date) prior to determining eligibility for incentive compensation. While the plaintiff in the Ralphs case attempted to rely on the principal of public policy supporting employee wage protection, the Court makes it very clear that supplemental wages subject to conditions precedent are consistent with such policies: the predictability of an employee s regular wages are not impacted. Indeed, Ralphs Plan, and plans of this nature, only impact payments offered above and beyond regular wages, and many California courts have found that, where the parties so understand and agree, final compensation, or at least a portion thereof, may be contingent on events that occur after the employee has performed a service. 12 This distinction between regular wages and supplemental wages, and the focus on what promise was made to employees regarding the payment of wages, will be important considerations in the construction of incentive compensation, bonus and commission plans following Ralphs. The decision provides support for the application of conditions precedent on supplemental wages. Employers must ensure, however, that plan language does not promise to calculate or pay the wages before the application of such conditions. Incentive Compensation Plans That Reward Collective Contribution Are Distinguished From Those That Evaluate Individual Effort or Shift the Cost of Conducting Business to Individual Employees In the process of differentiating regular wages from supplemental wages, the Court necessarily distinguished the Ralphs Plan from commission and bonus plans detailed in a series of cases that had constrained employers. In doing so, the Court specifically highlighted that the Ralphs Plan rewarded the collective and cooperative effort rather than penalizing individual employees, dollar for dollar, for business losses. Thus, according to Ralphs, cases like Kerr s Catering, Quillian and Hudgins shifted the cost of doing business to an individual employee by, for example, calculating commission payments as a percentage of sales, but deducting dollar for dollar losses. This practice, according to Ralphs, reduces the individual employee s wages to increase the employer s retained profits. The impact of this language is significant. Kerr s Catering, Quillian and Hudgins are cases that plaintiffs routinely cite to attack incentive compensation, bonus and commission plans. While Kerr s Catering, Quillian, and Hudgins remain good law, their application will be more limited. As a result, employers should be very careful as they structure incentive compensation, bonus and commission plans to avoid shifting the burden of doing business to individual employees. Ralphs Gives Tacit Approval to Adjustments to Wage Advances In distinguishing Kerr s Catering, Quillian and Hudgins, Ralphs includes powerful dictum endorsing an employer s ability to adjust compensation already advanced. Specifically, the Court approved a line of cases frequently used by employers to support chargebacks and wage adjustments: Neisendorf v. Levi Strauss & Co., 13 Koehl v. Verio, Inc., 14 Steinhebel v. Los Angeles Times Communications, LLC 15 and Prudential Ins. Co. v. Fromberg. 16 Employers often advance a commission payment to employees before the commission is earned. If agreed upon conditions precedent do not occur, the commission is not earned, and the employer charges back the advanced amount by reducing subsequent advance payments. The cases approved by Ralphs permit such a practice for either of two reasons: (1) the subsequent advance payments from which deductions are made to account for unearned commissions are not wages (they are advances on unearned commissions), so deductions from them do not violate Section 221; or (2) even if they are wages, Section 224 permits deductions from those wages if the two conditions in section 224 are met: the deduction (a) is authorized in writing, and (b) does not amount to a rebate or deduction from the employee s standard wage. Although adjustments to wage advancements was not the subject of Ralphs, the inclusion of this language is noteworthy and offers significant support to long standing arguments employers have made. CONCLUSION The Supreme Court s decision in Ralphs is a victory for employers in many respects. However, employers 4

5 should consult with their attorneys to ensure that the logic and reasoning of Ralphs applies to their incentive compensation, bonus or commission plans. Please contact any of the following Paul Hastings employment lawyers or any other Paul Hastings employment lawyer should you have any questions: Los Angeles George W. Abele Leslie L. Abbott Holly R. Lake Orange County Stephen L. Berry Palo Alto Bradford K. Newman San Diego Mary C. Dollarhide San Francisco M. Kirby C. Wilcox E. Jeffrey Grube Thomas E. Geidt All subsequent unlabeled statutory references are to the Labor Code. 2 CAL. CODE REGS., tit. 8, 11070, subd. 8. Other Wage Orders have identical prohibitions against certain deductions and charges against the wages of nonexempt employees Cal. App. 4th 1090 (2003) Cal. 4th 217, (2007) 5 57 Cal. 2d 319 (1962) Cal. App. 3d 156 (1979) Cal. App. 4th 1109 (1995) Cal. 4th 217, 228 (2007) 9 Id. 10 Id Cal. App. 4th 509 (2006) Cal. 4th 217, 239 (2007) Cal. App. 4th 509 (2006) Cal. App. 4th 1313 (2006) Cal. App. 4th 696 (2005) Cal. App. 2d 185 (1966). 18 Offices Worldwide Paul, Hastings, Janofsky & Walker LLP StayCurrent is published solely for the interests of friends and clients of Paul, Hastings, Janofsky & Walker LLP and should in no way be relied upon or construed as legal advice. For specific information on recent developments or particular factual situations, the opinion of legal counsel should be sought. These materials may be considered ATTORNEY ADVERTIISING in some states. Paul Hastings is a limited liability partnership. Copyright 2007 Paul, Hastings, Janofsky & Walker LLP. IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations governing tax practice, you are hereby advised that any written tax advice contained herein or attached was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code. 5