United States: California Changes The Rules For Profit-Based Employee Incentive Benefits

On February 18, 2004, the California Supreme Court let stand a lower-court decision that calls into question the lawfulness of many profit-based employee bonus plans. Under the decision in Ralphs Grocery Co. v. Superior Court, 112 Cal. App. 4th 1090 (2003), any plan that is based on net profits is unlawful to the extent that such profits are calculated after accounting for routine costs of doing business such as workers' compensation costs, cash shortages, inventory shrink, or equipment breakage. While the decision turns on an overly rigid interpretation of California law, makes no economic sense, and will increase the cost of doing business in California, the Supreme Court's (in)action means that Ralphs is at present the law in California.

While Ralphs remains good law, any form of compensation tied even indirectly to profitability may result in back pay litigation. Companies that have California-based employees and offer one of these popular programs to its employees should carefully consider the implications of Ralphs and review their bonus, commission, or incentive plans for compliance.

In Ralphs, the Court of Appeals held that any type of business expense that the California Legislature or Industrial Welfare Commission expressly prohibited from being charged to an employee may not be deducted from gross revenue when calculating a net profit-based bonus for employees. These business expenses include deductions for any part of the cost of workers' compensation claims, and most deductions for cash shortages, breakage or loss, of equipment for nonexempt employees. Id. at 1094.

The Ralphs bonus program based employee bonuses on the net earnings of a store. David Swanson, a former Ralphs store manager, alleged that the formula used to calculate the bonuses was prohibited because the formula for calculating net earnings included deductions for (1) workers' compensation, and (2) losses related to cash and merchandise shortages. Id. at 1094 n.1.

While Ralphs agreed that such deductions taken directly from an employee's earnings were prohibited, it argued that calculating the amount of a wage and deducting from the amount of a wage were two different actions. Relying on economic and practical considerations, it argued that using standard accounting principles to calculate net profits was fundamentally different from reducing employee wages by directly deducting business expenses from wages. Id. at 1101.

Although the court found that Ralphs’ arguments were "persuasive," "supported by substantial academic literature," "forcefully" demonstrated, and based on "economic sense," id. at 1101, 1104, it reluctantly concluded that "economic reality must yield to regulatory imperative." Id. at 1104. The court focused on two sets of imperatives.

First, the court held, the plain language of California Labor Code § 3751 prohibits employers from taking any deduction from employees' earnings to cover the costs of workers' compensation. 112 Cal. App. 4th at 1102. Since the incentive bonus plan at issue was a form of employee earnings, by factoring workers' compensation costs into its calculation of profits, Ralphs was effectively charging its employees for those costs. Id.

The second imperative was based on statutes, regulations, and court opinions that bar deductions from employee wages for cash shortages, breakage, or loss of equipment. The Industrial Welfare Commission's Wage Order 7-2001, Cal. Code Regs. tit. 8., § 11070, subd. 8, prohibits such deductions from the wages of nonexempt employees unless the losses are caused by a dishonest, willful, or grossly negligent act of the employee affected. 112 Cal. App. 4^th at 1103.

Ralphs attempted — unsuccessfully — to draw a distinction between deducting expenses from gross revenues to calculate net profit, a percentage of which would then be paid as a bonus to employees, and deducting expenses from the final bonus amount. It did not dispute that its bonus plan failed to distinguish between losses caused by dishonest, willful, or grossly negligent acts and losses that were inadvertent. 112 Cal. App. 4th at 1103. Instead, Ralphs argued that because its bonuses were paid in addition to regular wages, and because nothing was deducted from the amount of the bonuses once the amount was calculated, employee earnings were never reduced. Id. at 1103-04.

The opinion rejected the distinction drawn by Ralphs. Instead, it simply rehashed the analyses made of dissimilar bonus plans in Kerr's Catering Service v. Department of Industrial Relations, 57 Cal.2d 319 (1962), and Quillian v. Lion Oil Co., 96 Cal. App. 3d 156 (1979). Ralphs, 112 Cal. App. 4th at 1104-05.

In Kerr's Catering, the California Supreme Court held that cash shortages could not be deducted directly from a sales "commission" that catering truck operators received on all sales. Even though the truck operators received a base salary that was not subject to deductions, the Court held that the terms of the wage orders, as well as the public policy against permitting employers to shift routine business losses to employees, invalidated the commission scheme. The fact that the deductions were taken only from the commission, but not the base wage, did not make a difference to the Court.

In Quillian, the California Court of Appeals invalidated a similar bonus plan for service station managers. In addition to their base salary, the station managers received a "bonus" based on the volume of fuel sales plus a percentage of other sales. However, merchandise and cash shortages were directly deducted from the bonus before it was paid. The Ralphs court found no distinction between Quillian's "bonus" plan, Kerr's Catering's "commission" plan, and Ralphs' practice of deducting certain routine operating expenses to calculate net profit, where a percentage of profit was to be paid to employees.

The Ralphs court emphasized that its decision was mandated by "legislative and administrative policies protecting employee wages and the Supreme Court's implementation of those polices." Id. at 1104. At the same time, it hinted that in the absence of such policies, the "economic sense" of Ralphs’ position might have brought about a different result. Id.

The opinion did adopt a distinction offered by Ralphs between managers who are exempt from overtime requirements, and the nonexempt clerks and cashiers who work under their supervision. Although the Ralphs court did not perceive a distinction when deducting workers' compensation losses, it found nothing in the California Labor Code (or the wage orders) prohibiting deductions for shortages from exempt employees' wages. Id. at 1105. Freed from the "regulatory imperatives" that tied its hands when it comes to cash shortages, breakage, and loss of equipment, the court followed its policy inclinations and held that the bonus plan was lawful when applied to managers in this respect. Id. at 1102, 1106. Thus, the Court concluded that this profit-based bonus plan does not threaten unexpected deductions from an exempt manager's wages as the Court concluded it did for the nonexempt worker. The Court added that, in their management role, exempt employees have control over business operations that most directly affect revenue and expenses, and profit-based bonuses would encourage them to manage in both to the benefit of themselves and the employer. Id. at 1106.

Employers trying to sort out the implications of the Ralphs decision are faced with a number of important open questions:

Will Ralphs Be Overruled? We are not sure whether Ralphs will remain good law. Although the California Supreme Court denied review, two justices voted in favor of taking up the issue. Moreover, at least two cases currently pending before the Court of Appeals raise the same issues as Ralphs: Prachasaisoradej v. Ralphs Grocery Co. (Case No. B165498) and Gordon v. Pacific Component Xchange, et al. (Case No. G032177). While Prachasaisoradej is pending before the Second District of the Court — the same district that issued the first Ralphs decision — Gordon is pending before the Fourth District. Different districts of the Court of Appeals sometimes disagree, requiring Supreme Court review to settle the issue. Indeed, the Supreme Court was aware of the pendency of Prachasaisoradej and Gordon when it denied review in Ralphs, and the Court might be waiting to see whether a consensus — or a conflict — arises among different districts of the Court of Appeals.

How Far Will Ralphs Go? The rationale of Ralphs does not seem to be confined to the workers' compensation costs, cash shortages, breakage, and inventory losses at issue. Rather, it extends to a great number of business expenses that go into the calculation of net profit and that cannot lawfully be imposed on employees. Thus, if its reasoning is adopted by other courts, then deducting a host of other expenses to arrive at net profit also violates the law.

The California wage orders, for instance, require employers to provide to employees any uniforms, tools, and equipment required to perform the job (and maintain them at the employer’s expense). Certainly, the Ralphs reasoning applies to these categories of expenses as well.

Employees will likely push the Ralphs decision even farther. Ultimately, the Supreme Court decisions upon which Ralphs is based — Kerr’s Catering and Quillian — are based on the principle that employees should not be required to bear the risk of business losses outside of their control. Almost any business expense subtracted from gross receipts in the routine calculation of net profit can be so characterized.

How Far Back Will Ralphs Reach? Although employees are already filing lawsuits seeking damages based on bonuses earned and paid in prior years, it is far from clear that Ralphs may be applied retroactively. Another question that will be hotly debated (and litigated) is whether Ralphs applies only to future profit-based incentive plans.

Although the California Supreme Court holds that "[t]he general rule that judicial decision are given retroactive effect is basic, . . . [t]his rule. . . has not been an absolute one." Newman v. Emerson Radio Corp., 48 Cal. 3d 973, 978-79 (1989). Thus, "in instances where a . . . statute has received a given construction by a court of last resort, and contracts have been made or property rights acquired in accordance with the prior decision, neither will the contracts be invalidated nor will vested rights be impaired by applying the new rule retroactively." Moradi-Shalal v. Fireman's Fund Inc. Cos., 46 Cal.. 3d 287, 305 (1988), quoting Peterson v. Superior Court, 31 Cal. 3d 147, 151-52 (1982). Reliance on seemingly settled law will not be upset by retroactive application of a new rule: "[R]esolution of this issue of prospective application turns primarily upon the extent of the public reliance upon the former rule, and upon the ability of litigants to foresee the coming change in law." Neel v. Magana, Olney, Levy, Cathcart & Gelfand, 6 Cal. 3d 176, 193 (1971).

Ralphs represents a new, unforeseeable interpretation of controlling statutes. The concurring opinion in Kerr's Catering — claiming to be speaking for a unanimous court — cautioned that "Our decision today should not be interpreted as encouraging further governmental impairment" of the freedom of the parties to agree to a profit-based component to employee compensation. 57 Cal. 2d at 334. Employers relied on prior law to structure their profit-based incentive plans. Had the result in Ralphs been foreseen, employers could have easily adopted different plan structures to make the same bonus payments without running the risk that their plans would be found to be unlawful.

Although this issue has not yet been resolved, we believe that employers will want to vigorously argue — and may succeed in establishing — that Ralphs cannot be applied retroactively.

What About ERISA? Ralphs may not apply to some bonus programs or plans governed by ERISA. Employers assessing the impact of Ralphs on their employee bonus plans must carefully consider the potential intersection between state and federal law.

Although ERISA does not regulate programs that merely provide for "payments made by an employer to some or all of its employees as bonuses for work performed," it may apply when "such payments are systematically deferred to the termination of covered employment or beyond, or so as to provide retirement income to employees." 29 C.F.R. section 2510.3-2(c). In addition, certain deferred compensation arrangements may permit distributions to begin during employment and still be subject to ERISA regulation. See ERISA Op. Ltr. 83-42A (DOL August 17, 1983); ERISA Op. Ltr. 89-07A (DOL April 27, 1989). If an employee pension benefit plan exists, then state wage payment laws relating to the plan may be preempted. See McMahon v. McDowell, 794 F.2d 100, 106 (3d Cir. 1986 (Pennsylvania wage payment and collection laws preempted); Scotti v. Los Robles Reg'l Ctr., 117 F. Supp. 2d 982, 988 (C.D. Cal. 2000) (California Labor Code section 132(a) preempted). The DOL has issued advisory opinion letters advising that to the extent the state law is interpreted to limit, prohibit, or regulate the funding by wage deduction of ERISA-covered plans, it is preempted by ERISA. ERISA Op. Ltr. 96-01A (DOL Feb. 8, 1996); ERISA Op. Ltr. 94-24A (July 14, 1994); ERISA Op. Ltr. 93-05A (Mar. 9, 1993); ERISA Op. Ltr. 88-17A (Dec. 19, 1988); ERISA Op. Ltr. 84-18A (Apr. 19, 1984).

The Ralphs decision raises more questions than it answers. We recommend that all employers with California-based employees and operations carefully review any profit-based employee incentive plans in effect over the past four years to determine whether changes in light of Ralphs are warranted.