Time To Reevaluate Employee Bonus and Incentive Plans?
April 2004
In a February 2004 refusal to review Ralphs Grocery Co. v Superior Court, the California
Supreme Court lets stand a ruling which holds that compensation plans based
on store sales and profitability goals violate California law.
by Paul
J. Siegel, Esq.
Jackson Lewis
LLP
California employers now have one more thing to worry about: the validity
of their bonus and incentive plans. On October 23, 2003, the Second District
Court of Appeal issued its decision in Ralphs Grocery
Co. v Superior Court. In that case, the court found a company's incentive
compensation plan based in part on the achievement of store sales and profitability
goals would violate California law. Any hope for a reversal of the decision
was eviscerated on February 18, 2004, when the California Supreme Court denied
review of the appellate court's ruling.
Factual Background
Plaintiff and former Ralphs manager David Swanson filed a class action lawsuit
against Ralphs on behalf of current and former Ralphs managers, and all other
Ralphs employees who were paid a profit-based bonus. The lawsuit alleged Ralphs
violated the California Labor Code and California wage orders and engaged in
unlawful business practices by basing its incentive program for store managers
and other employees on the net earnings
of a store. In other words, Swanson claimed the calculation of employee bonuses
was unlawfully based on a formula that considered a store's profits and certain
losses, including cash and merchandise shortages, "shrinkage" (product stolen
or damaged, for instance) and workers compensation costs.
Ralphs argued its bonus plan was not unlawful because it paid the bonus in addition to employees' regular wages.
Ralphs also contended there were no "deductions" from wages, because the expense
items were simply part of the formula to calculate the bonus, not impermissible
deductions from or offsets against wages already earned or paid.
Court of Appeal's Basis for Finding Ralphs' Bonus Plan Unlawful
In ruling for Swanson, the court of appeal held employee wages, which the
court defined to include compensation under bonus and incentive plans, cannot
be reduced by employer costs, such as workers compensation premiums, despite
the method of calculation. In reaching its decision, the court relied on three
prior rulings in similar cases.
In 1962 the California Supreme Court decided Kerr's
Catering Service v Department of Industrial Relations. In Kerr's Catering, saleswomen were employed to
drive lunch trucks. They were paid a base salary, plus 15 percent monthly commission
on sales exceeding $475 per week. The sales commission was subject to reduction
for any cash and inventory shortages attributable to sales during the month.
The Department of Industrial Relations challenged the reduction in commissions
under the provision of the Industrial Welfare Commission wage orders prohibiting
deductions from wages for expenses due to cash shortages, breakage or loss of
equipment, unless such expense was due to the dishonest or willful act or gross
negligence of the employee. The California Supreme Court upheld the challenge,
emphasizing the public policy in support of protecting employee wages. The court
concluded employers, rather than employees, must bear the burden of business
losses as expenses of management.
The First District Court of Appeal applied the Kerr's
Catering holding to bonuses in Quillian v Lion
Oil Co., a 1979 decision. In Quillian,
a manager of two self-serve gas stations was paid a base salary, plus a monthly
bonus. The bonus amount was measured as a percentage of sales volume, less merchandise
or cash shortages at the stations during the month. The court followed the reasoning
of Kerr's Catering, and ruled labeling the wage
a "bonus" instead of a commission did not merit a different result because it
still constituted wages under the Labor Code. Based on this analysis, the court
ruled the bonus plan in question violated the labor code because it unlawfully
passed employer losses onto the manager.
More recently, in 1995, the court of appeal ruled in Hudgins v Neiman Marcus Group, Inc., a commission
program with deductions for a pro rata share of commissions previously paid
for "unidentified returns" from all sales associates violated California law.
In the court's view, the commission program was unlawful because the unidentified
returns policy resulted in deductions from earned wages for items that would
otherwise be considered a business loss due to factors beyond the employees'
control.
In attempting to distinguish these cases, Ralphs argued its bonus plan did
not specifically reduce payments based on business losses. Rather, its bonus
calculations were based on net earnings. The court of appeal rejected this analysis,
finding the use of net earnings resulted
in an unlawful reduction in the bonus payments for cash and merchandise shortages,
as well as workers compensation costs, because the applicable wage order and
labor code make no distinction between regular wages and bonuses or commissions.
The Court's Distinction between Exempt and Non-exempt Employees
The California Labor Code specifically prohibits employers from directly
or indirectly holding any employee accountable
for workers compensation costs. The court in Ralphs reasoned the use of net earnings as a method
to calculate the appropriate bonus owed to employees included consideration
of workers' compensation costs, and therefore was unlawful as to both non-exempt
and exempt employees.
With respect to cash and merchandise shortages, however, the court of appeal
drew a distinction between exempt (managerial) and non-exempt employees. The labor code and wage order provisions prohibiting
deductions from wages for expenses due to cash shortages, breakage or loss of
equipment apply only to non-exempt employees. Taking this into account, the
court ruled, contrary to the Quillian decision,
basing a portion of management compensation
on a formula that rewards effective supervision and cost control did not violate
the law.
What Does the Ralphs Decision Mean for Employers?
The California Supreme Court effectively provided a judicial seal of approval
to the Ralphs decision when it denied both parties'
petitions for review, because the case is now binding precedent on lower courts.
Until (and if!) the legislature becomes involved with the issue, employers will
have to deal with the consequences of the decision.
For now, bonus and incentive plans must be drafted to ensure workers compensation
costs are not included in the formula for calculating the bonus. This means
that net profit-based bonus plans technically are illegal. Additionally, bonus
and incentive plans for non-exempt employees must not deduct costs for cash
shortages, breakage or loss of equipment. That means not only that employers
cannot deduct such shortages from wages, but also that bonuses for non-exempt
employees cannot be based on a calculation that includes such shortages. The
following categories of incentive plans should be considered in compliance with
California law in the wake of Ralphs.
- Bonus Plans Based on Gross Sales. Bonuses
not reduced by any cost factor, e.g., based upon a gross sales goal or productivity
in terms of units produced, hours worked, etc., should be acceptable because
such bonuses are not affected by the costs of doing business, such as shrinkage
or workers compensation costs.
- Bonus Plans Based on Certain Margins. Bonuses may be based on some portion of a company's profits, excluding impermissible
expenses discussed above. Thus, for example, a bonus based on a gross margin
or contribution margin will be acceptable.
- Profit Sharing Plans. ERISA authorizes
employers to implement profit sharing plans, and generally does not restrict
how profits are calculated, except that amounts accrued must be determined
under a definite ERISA-compliant pre-determined formula. Such plans should
not be affected by the Ralphs decision.
- Discretionary Bonuses. Truly discretionary
bonuses should not violate the Court's holding in Ralphs. Most bonuses, however, do not qualify
as discretionary. A bonus is discretionary only if: (1) the fact and the amount of the payment are determined
in the sole discretion of management; and (2) the payments are not pursuant
to any contract, agreement, or promise causing the employee to expect such
payments regularly. Furthermore, a "discretionary" bonus regularly paid
each year, e.g., a holiday bonus, may lose its discretionary character after
some period of time if employees come to expect such payments.
All bonus and incentive compensation plans in any way based on profitability
or net earnings should be reviewed to ensure compliance with the Ralphs decision. Employers should consult with
experienced employment counsel if they have any questions or concerns regarding
such plans.
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