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Published: 2008-03-26

Employer Bonus Plans Following the Ralphs Grocery Co. v. Superior Court Decision



Introduction

In Ralphs Grocery Co. v. Superior Court (Swanson) (“Ralphs Grocery”),1 decided on October 23, 2003, the California Court of Appeal addressed whether the prohibition against deducting cash and inventory shortages from wages prohibits “a large corporate retailer from implementing an incentive compensation plan for managerial, store-level employees in which the amount of the incentive bonus is based on the achievement of store sales and profitability goals.” This decision is an important interpretation of California Labor Code sections 221, and 400 to 410, and is the next in the line of cases beginning with the California Supreme Court’s decision in Kerr’s Catering Service v. Department of Industrial Relations (“Kerr’s Catering”).2 The court also addressed whether bonus plans that make deductions in bonus calculations for worker’s compensation expenses violate Labor Code section 3751. This Insight article discusses the impact of the Ralphs Grocery decision and options for California employers in light of that case.

Summary of the Ralphs Grocery Decision

The decision contains two significant holdings that potentially affect all employee bonus plans in California. They are:

  • As to non-exempt employees only, that “calculation of an incentive bonus based on profitability by taking into account not only revenues but also store expenses in accordance with standard accounting principles” may give rise to a cause of action for violation of Labor Code sections 221, 400 to 410 and the California Wage Orders, specifically Cal. Code of Regulations, title 8, section 11070. The court held that such a bonus plan is permissible as it applies to exempt employees.
  • A plaintiff can state a claim for violation of Labor Code section 3751, which prohibits employers from directly or indirectly holding its employees accountable for workers’ compensation costs, against an employer whose bonus plan includes a “charge for workers’ compensation costs.” The prohibition against deducting workers’ compensation costs from bonus plans applies both to exempt and non-exempt employees.

Because the court took a different approach than the approach taken in earlier cases, including the well-known decisions in Quillian v. Lion Oil Co.sup>3 and Hudgins v. Neiman Marcus Group, Inc.,4 the decision immediately became controversial. The Court of Appeal denied Swanson’s petition for review in November 2003. The parties sought review by the California Supreme Court, but the Court denied the parties’ petitions in February 2004.5

Although the approach taken by the court in Ralphs Grocery offers at least some basis for determining who can be included in a “net profit” bonus plan, the current state of the law is in flux. This article provides some advice to employers on what to do with their bonus plans until the law in this area becomes clearer.

Analysis

The Labor Code and Regulations

California Labor Code section 221 prohibits “rebates” of wages back to an employer:

It shall be unlawful for any employer to collect or receive from an employee any part of wages theretofore paid by said employer to said employee.

Section 402 of the Labor Code prohibits an employer from requiring an employee to post a cash bond except under certain designated circumstances:

No employer shall demand, exact, or accept any cash bond from any employee or applicant unless:

(a) The employee or applicant is entrusted with property of an equivalent value, or

(b) The employer advances regularly to the employee goods, wares, or merchandise to be delivered or sold by the employee, and for which the employer is reimbursed by the employee at regular periodic intervals, and the employer limits the cash bond to an amount sufficient to cover the value of the goods, wares, or merchandise so advanced during the period prior to the payment therefore.

The California Wage Orders, which are promulgated under the authority granted in section 1173 of the Labor Code, prohibit employers from making certain deductions from wages:

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.

Highly significant to the court in Ralphs Grocery, the California Wage Orders, including the provision quoted above, exempt executive, administrative and professional employees if their duties and responsibilities meet specified criteria.6

Finally, Section 3751 of the California Labor Code contains a broad prohibition against recovering any costs associated with workers’ compensation:

3751. (a) No employer shall exact or receive from any employee any contribution, or make or take any deduction from the earnings of any employee, either directly or indirectly, to cover the whole or any part of the cost of compensation under this division. Violation of this subdivision is a misdemeanor.

Cases Interpreting the Statutes

The watershed case on deductions from wages is the California Supreme Court’s 1962 decision in Kerr’s Catering. The plaintiff, an employee who operated a catering truck, objected to a commission plan that deducted “cash shortages” from wages.

On its face, the Court in Kerr’s Catering applied only the provisions of the predecessor to the wage order quoted above: “The narrow question presented, then, is whether the commission has power to prohibit deductions for case shortages from employees’ commission even though the affected employees are earning more than the minimum wage.” In upholding the Labor Commissioner’s authority to make this regulation, however, the Court cited the California Labor Code, including both the non-rebate statute (§ 221) and the employee bond statutes (§§ 400-410). Based in part upon these enunciations of public policy, the Court upheld the position of the Department of Industrial Relations that “cash shortages should be borne as an expense of management.”

Since 1962, the Kerr’s Catering decision has become more or less accepted California law, and has been applied consistently by both courts and the California Department of Labor Standards Enforcement (DLSE).7 In Quillian, decided in 1979, the Court of Appeal took this principle a step further, holding that something the employer called a “bonus plan” could not be calculated by subtracting “shrinkage” and theft losses from a schedule of commissions based on gasoline sales.

Quillian involved a compensation device that was called a “bonus.” However the Quillian court took pains to find that the “bonus” system in that case was an artifice for what was really a commission system incorrectly labeled as a “bonus”:

Appellant herein describes the subject bonus as a calculated amount consisting of the computed sales component less the computed shortage component and argues that no deductions are made from the final computation. It appears to this court that this is merely a clever method of circumventing the statutory definition of wages. The bonus herein described is, in fact, a scheduled payment based on the number of gallons of motor fuel sold plus a 1 percent commission on other sales. Rather than call this incentive payment a commission and then deduct for shortages in contravention to Kerr, appellant deducts shortages from the payment and calls the final result a bonus.

The court in Quillian assumed the plaintiff to be an exempt managerial employee.8 The court’s analysis relied less upon the wage order at issue in Kerr’s Catering and appeared to rely more directly on a gloss of the Labor Code bond law provisions:

In analyzing the problem, the court recognized that the employees, through the company’s policy of deducting losses, were in effect made insurers of the employer's merchandise, and the commissions earned by the employees which were subject to the deduction, served the same [96 Cal.App.3d 162] purpose as an employee's “bond” exacted by the employer to cover shortages. The court then discussed sections 400 through 410 of the Labor Code: “Labor Code sections 400 through 410 set out in detail the employee's bond law, and the manner in which a cash bond may be exacted from an employee to cover merchandise entrusted to him. It provides a criminal penalty for the violation of its provisions. (Lab. Code, § 408.) These deductions from wages due appear to be in contravention of the spirit, if not the letter, of the Employee’s Bond Law.” (Id, at pp. 327-328.)9

Since Quillian, most California employers have assumed that deductions from wages of any California employee for employer expenses would violate state law under Kerr’s Catering and Quillian. In Hudgins v. Neiman Marcus Group, Inc., the Court of Appeal held that Neiman Marcus’s commission program violated Labor Code section 221 because it unlawfully deducted “a pro rata share of commissions previously paid for “unidentified returns” from the wages of all sales associates in the section of the store where the merchandise is returned. Again, relying upon the employee bond statutes and section 221, the court held that commissions could not be calculated and reduced by the “business losses” of the employer.

[T]he California courts have long held that, because of the special consideration accorded to wages, sections 221 and 400 through 410 prohibit deductions from wages for business losses unless the employer can establish that the loss was caused by a dishonest or willful act, or by the culpable negligence of the employee. 10

Wage and Hour Litigation Over Bonus Plans

In the past two or three years, plaintiffs’ attorneys have filed a number of class action lawsuits seeking to apply Kerr’s Catering, Quillian and Hudgins to typical corporate bonus plans. According to the writ petition, class action cases challenging employee bonus plans were pending against Ralphs, Albertsons,Winston Tire,Tandy Corporation (Radio Shack), Lucky Stores, Rite Aid, Safeway, Washington Mutual Bank, Wells Fargo Bank, Pizza Hut, Smart & Final Iris Corp. and Federal Express at the time the writ in Ralphs Grocery was granted. In three cases (involving Winston Tire, Albertsons, and Ralphs Grocery), the trial court had ruled against the employer, holding that bonus plans that included reductions based on various cost items were unlawful under Kerr’s Catering, Quillian and Hudgins.

It was against this background that the Ralphs Grocery case was decided on an interlocutory writ.11 The trial court judge, Mary Ann Murphy, denied a demurrer to the complaint in this case, and in doing so certified the case for interlocutory review, after which the Court of Appeal accepted the writ. The case was hotly contested and widely watched by the employment bar.

The Ralphs Grocery decision didn’t really make anyone happy. Even the Court of Appeal appeared to regret the need to regulate a popular means of employee compensation:

Ralphs and the amici curiae that have filed briefs on its behalf present persuasive arguments, supported by substantial academic literature, that profit-based compensation plans benefit both employers and employees. Notwithstanding the contrary holding in Quillian, supra, 96 Cal. App. 3d 156, Ralphs also forcefully demonstrates that, as a matter of economics, calculation of an incentive bonus based on profitability by taking into account not only revenues but also store expenses in accordance with standard accounting principles differs markedly from reducing (or recapturing) wages through prohibited deductions. Nonetheless, to the extent the Legislature or, as applied to non-exempt employees, the Commission in its authorized wage orders has prohibited the use of certain expenses in determining wages due an employee, economic reality must yield to regulatory imperative.

Although the court did not halt wage litigation from expanding into bonus plans, it drew a distinction drawn between exempt and nonexempt employees. It drew this distinction from the fact that the Kerr’s Catering decision was based upon an IWC order applicable only to non-exempt employees, and not upon the statutes generally applicable to all employees.

Thus, according to the Ralphs Grocery court, executive, professional and administrative employees may continue to be paid under bonuses calculated using cost items like theft or breakage. No bonus deductions would be permitted for non-exempt employees, those typically working at lower paying jobs usually paid by the hour. The court made no real attempt to distinguish Quillian, and given that case’s facts, it would be difficult to do so.

If Ralphs Grocery remains the law, it arguably justifies a major retooling of the rules for charging costs to management and other exempt employees. For example, there is no reason why other kinds of deductions from wages for exempt employees, such as for cash shortages, would not also be permissible. Because of the significance of this distinction, employers should be extremely conservative in relying on the holding in Ralphs Grocery.

However, even for exempt employees, the Ralphs Grocery court held that deductions for costs associated with workers’ compensation were unlawful. It based this prohibition on Labor Code section 3751, which contains broad prohibitions against deductions from wages “directly or indirectly” for the “cost of [worker’s] compensation.” The court held that this statute, unlike the wage orders, applied directly to all employees.

Recommendations

It is fair to say that the law on bonuses in California is in a state of acute uncertainty. Unfortunately, given this uncertainty, it is impossible to give advice as to the precise kind of bonus that will be vulnerable to an expensive class action challenge. The best that can be done at this point is to identify the options below, each with its associated costs and risks.

It is also fair to say that a large proportion of bonus plans of every California employer are now unlawful under Ralphs Grocery, at least if the plan applies to non-exempt employees. Moreover, even plans that apply only to managers are at risk to the extent that Ralphs Grocery is regarded as inconsistent with Quillian. Any bonus plan that takes workers’ compensation premiums into account are at risk. For these reasons, courts are likely to provide some further word on this issue.

Employers may not wish to take drastic action in the face of this level of uncertainty. However, not acting clearly entails the assumption of some litigation risk.

The most conservative approach is to assume that the “safe harbor” for exempt employees in Ralphs Grocery will not survive, and that either the California Supreme Court will adopt the reasoning in Quillian, or no definitive decision will exist, leaving employers open to litigation in the absence of a clear standard. In that event, there is no real case guidance as to what kind of a bonus would survive an attack. Although it is not yet possible to design a “bullet proof” approach, below are some various approaches to employee bonuses and how they might be impacted by Kerr’s Catering/Quillian.

Bonuses Based On Gross Sales or Revenue

A bonus that is not reduced by any cost factor will not implicate the policies in Kerr’s Catering/ Quillian. Accordingly, a plan that rewards staff for meeting specified sales targets should be acceptable. However, any deductions from sales numbers, like the subtractions from commissions in Hudgins for unidentified returns, might lead to a claim that the bonus is unlawful because it takes away wages for reasons beyond the employee’s control. We are aware of no lawsuit that has made such a claim involving a bonus based on sales. In this environment, it is not impossible.

Bonuses Based On Behavioral Criteria Set by Management

A bonus, for example, that rewards behavioral metrics or observations on a manager’s actual job performance would appear not to be implicated in Ralphs Grocery. However, a bonus that “punishes” managers for unusual or protected costs might be questioned. Most risky would be, for example, a bonus that rewards managers for low accident or workers’ compensation claims. Such a program might be attacked under both Labor Code sections 3751 and 132a, which make it unlawful to retaliate or discriminate against employees who are injured or who make claims for workers’ compensation. Another example of such a claim would be a suit by an insured that an insurance company evaluated its employees and increased their compensation in exchange for achieving unlawful ends (such as making improperly low settlements in insurance claims).12

That said, this kind of “subjective” bonus would appear least likely to implicate the principles at play in Ralphs Grocery.

Profit Sharing Plans

Ralphs Grocery should not affect profit sharing plans constructed under the Employee Retirement Income Security Act (ERISA). ERISA authorizes employers to implement “profit-sharing” plans as pension plans for employees.13 ERISA does not restrict how profits are calculated except that amounts accrued under a profit sharing plan must be determined by a “definite predetermined formula.” 14

However, non-ERISA plans that attempt to “share” profit by assigning a bonus mathematically related to the profit of the company, or portion of the company, will be subject to the Ralphs Grocery issues. Thus, line items of a profit calculation that relate to workers’ compensation will be vulnerable to attack under Labor Code section 3751. With respect to non-exempt employees, a profit sharing plan that deducts a wide range of business costs is vulnerable under the law as it currently stands in California. Accordingly, unless and until the law changes or is clarified, no profit sharing plan can be considered safe in California as it applies to non-exempt employees.

Discretionary Bonuses

In their brief, the lawyers for amicus San Diego-Imperial Counties Labor Council focused on a bonus that is “non-discretionary.” Borrowing from federal regulations, their test would call a bonus “wages” when “there is a definite formula for calculation of the bonus at the end of the period, and that such a formula was conveyed to the employee prior to the bonus measuring period to motivate employee behavior.”15 A “true discretionary bonus” would not be barred by Kerr’s Catering/Quillian. 16

Discretionary bonuses, at least under the federal standard, are sums paid in recognition of services performed in a given period if (a) both the fact and the amount of the payment are determined at the sole discretion of management at the end of the period, and (b) the payments are not pursuant to any prior contract, agreement or promise causing the employee to expect such payments regularly.17 Thus, to evade the Ralphs Grocery issue with a discretionary bonus, the company would have to avoid creating a plan in which payments are stated and determinable at the beginning of the bonus period.

Using a “Line Item” Approach

The plaintiffs in the Ralphs Grocery writ dropped the broad allegations in their complaint, which attempted to challenge “other losses beyond Plaintiff’s control, and/or not caused by the willful negligence, dishonest act(s) or gross negligence of the employee plaintiffs.” Instead, plaintiffs challenged only “deductions for cash shortages, merchandise shortages and workers’ compensation claims.” This is apparently based upon the language of the Wage Order, which prohibits deductions for “cash shortage, breakage, or loss of equipment.” This suggests that an employer might save a bonus plan by simply deleting deductions based upon these kinds of expenses. Deletions of cost items are certainly required for any expenses for workers’ compensation injuries or insurance. At this point, there is no way that an employer can calculate a bonus to take into account costs related to workers’ compensation without accepting a significant risk of a class action lawsuit under Labor Code section 3751.

Another potential “test” that might be applied to individual line items is a policy-based analysis: A deduction from a bonus (wages) is impermissible if the bonus has the effect of transferring a risk from the employer to the employee. This policy is based more upon the rationale behind the employee cash bond statutes, rather than from the rebate provisions. As stated by the California Supreme Court:

Plaintiff contends, however, that the effect of section 8 of the instant order is unfair to the employer since the prohibition of deductions for cash shortages places the burden of these losses upon the employer. But some cash shortages, breakage and loss of equipment are inevitable in almost any business operation. It does not seem unjust to require the employer to bear such losses as expenses of management when it is presently the unchallenged practice to require him to bear, as a business expense, the cost of tools and equipment, protective garments and uniforms furnished to the employee by prohibiting in section 9, subdivisions (a), (b) and (c) of Order 5-57, deductions for these costs.

Furthermore, the employer may, and usually does, either pass these costs on to the consumer in the form of higher prices or lower his employees' wages proportionately, thus distributing the losses among a wide group. In addition, the employer is free to discharge any employee whose carelessness causes the losses, and he is not prohibited from deducting for cash shortages caused by the “dishonest or willful act, or by the culpable negligence of the employee.”18

Ralphs Grocery gives no clear way to draw a line between a cost item that might be permissible and one that is not in a non-exempt employee bonus system. At least one trial court seized upon language in Kerr’s Catering and found unlawful cost items that are beyond the control of the employee.19

Thus, at least pending more definitive guidance by the Supreme Court, an employer might at least reduce its “litigation profile” by excluding from bonus calculations cost items that appear similar to those that California courts have already disapproved. Such a bonus might allow bonuses based on net sales or other line items where the cost is associated with the revenue item. Other cost items, like facility rent, might also be included. However, it would be easy to see how almost any cost item might be converted to an alleged unlawful deduction from wages. For example, a store that shuts down during a storm sells nothing. Its revenue is reduced as the result of a “casualty” factor beyond the employee’s control. Because of this, the employee has become an “insurer” of the employer’s business. Under Ralphs Grocery, such a calculation is at least theoretically unlawful.

Analyzing Specific Cost Items Under Ralphs Grocery and Similar Legal Theories

In addition to workers’ compensation premiums, there are other expense items that appear to be most likely to come under scrutiny by plaintiffs’ class action lawyers. Following is a list, which should not be regarded as exclusive, including cost items that most likely would result in challenges to bonus calculations under a Ralphs Grocery rationale:

1. Breakage, theft, or “shrinkage” losses

These are the most frequently attacked categories, and would appear to fall squarely within the category of “cash shortage, breakage, or loss of equipment.”

2. Casualty losses

These also would probably fall into the category of “breakage.”

3. Third party tort claims

These are one step removed from the above, and arguably not within the strict language of the wage order. Of course, if the particular third party tort claim was the result of breakage or loss of equipment, then a plaintiff could argue that the cost of the loss was being charged to the employee indirectly. More worrisome, these kinds of expenses are precisely the kinds of “contingent” costs that the Kerr’s Catering court opined that an employer is expected to assume “as an expense of management,” and to insure against.

4. Employee expenses and overtime costs

Costs for employee overtime would not appear to be cash shortage, breakage, or loss of equipment. One could argue that overtime is an expense that ought to be borne as a cost of management. There is no case that has yet held that such expenses could not be figured into a “net profit” bonus. Such bonus criteria might also be dangerous for an entirely separate reason. Monetary rewards for limiting employee overtime have been used by class action plaintiffs’ lawyers as an argument in class action litigation based upon unpaid overtime, unpaid meal periods, and untaken “break time.” The argument is that managers were given bonuses for limiting overtime, creating a policy that forced employees to work “off the clock.”

5. Safety rewards and bonuses

Costs and compensation associated with workplace injuries are dangerous for two separate reasons. First, Labor Code section 3751 has such broad prohibitions on deducting costs “directly or indirectly” from an employee’s pay. Second, employees who are injured or make claims for injury under the workers’ compensation laws are protected from discrimination under Labor Code section 132a. Thus, for example, an employer that grants a bonus to a manager for lowering the number of workers’ compensation claims in his unit may find itself accused of pressuring its work force to underreport or minimize claims in violation of section 132a.

Accordingly, employers who grant bonuses to employees for any statistical measure of success related to workplace injury are at special risk. It would appear that the safest way to avoid this problem but still grant incentives through the compensation system to improve workplace safety would be to grant bonuses to employees who meet specified metrics for safety compliance, e.g., scores on safety audits. Given the huge significance of workers’ compensation costs for California employers, this must seem a highly unsatisfactory and illogical limitation. However, under the law, to create compensation incentives tied to a reduction in workers’ compensation costs—directly or indirectly—is an extraordinarily high risk venture.

Many employers offer bonuses such as cash, prizes, or raffle tickets as a result of successful periods without reportable injuries. One court has held in a case for discrimination under Labor Code section 132a that a safety bonus is not a “deduction” at all.20 Likewise, it does not appear likely that the bonus is designed to cover the costs of workers’ compensation injuries. Finally, the rationale for such bonuses is to comply with an employer’s statutory duty to maintain a safe workplace as codified in Labor Code § 6401. At least in some cases decided under Labor Code section 132a, this policy has been held to carry weight in setting a limit on how an employer can compensate employees.21 Thus, a reward system that provides an incentive to employees for limiting injuries may be permissible. To reduce risk, such a reward should not “revert” unused bonus money to the employer if the injuries do occur. Such a system could arguably be challenged as a means of having employees assume the costs (“directly or indirectly”) of workers’ compensation injuries or insurance.22

Conclusion

This appellate decision brilliantly exemplifies the chaos that has overtaken California compensation law. Our hope is that cases which set standards apparently so out of step with current business reality are addressed either by senior courts or by the legislature. However, this will undoubtedly take some time. In the meantime, employers are faced with the decision to either: (a) radically modify bonus plans that seem completely unremarkable to management; or (b) wait in the hopes that the litigation firestorm passes them by.

No clear-cut advice can accurately balance the administrative burden with the litigation risk avoidance without evaluating the particular bonus plan that a company has in place. However, an employer may be able at least make informed choices using an analysis like the one above until the law is further clarified.

The complete article with citations in printable PDF format is available at http://www.littler.com/nwsltr/Insight_Ralphs_8.04.pdf

You can find the other Insights at http://www.littler.com/nwsltr/index_insight.html.

J. Kevin Lilly is a shareholder with Littler Mendelson and can be reached at (310) 553-0308; klilly@littler.com