Profit-Based Bonuses are Lawful

In a rare pro-business, pro-employer opinion, the California Supreme Court makes the easy call, holding that profit-based bonuses are lawful

View original document | Send to colleague | Print

McKenna Long & Aldridge

Ross Hyslop

USA
September 18 2007

Outside of California, relatively few employers may have noticed when, on August 23, 2007, the California Supreme Court confronted what it called “a significant question of California wage law.” Why was this event so “significant” in California wage law such a non-issue elsewhere? By confirming it’s okay to pay managers a profit-based bonus derived from subtracting operating expenses from revenues, the court simply validated what most of us had considered not only acceptable for decades, but highly effective in motivating employees.   

Article Submitted By: Attorney Shannon M. Jenkins

Lately, employers have found little comfort and much distress in recent opinions issued by the California Supreme Court. Among the recent decisions imposing additional, burdensome obligations on employers and businesses were Murphy v. Kenneth Cole (2007) 40 Cal.4th 1094 (holding that the meal period remedy under California Labor Code § 226.7 is a wage, and thus effectively subject to a four year statute of limitations instead of a one year statute of limitations for penalties), Gentry v. Superior Court ___ Cal.4th ___, 2007 WL 2445122 (Aug. 30, 2007) (holding that class arbitration waivers in employment agreements could not be enforced if the trial court determines that class arbitration would be a significantly more effective way of vindicating rights, and finding that arbitration agreement at issue was not free from procedural unconscionability), Pioneer Electronics (USA), Inc. v. Superior Court (2007) 40 Cal.4th 360 (in consumer class action, holding that California's constitutional right to privacy did not trump precertification discovery requiring defendant to provide identifying information about product purchasers in order to facilitate communication with potential class members), and Sav-On Drug Stores Inc v. Superior Court (2004) 34 Cal.4th 319 (holding that action filed by drug store chain's operating managers and assistant managers seeking overtime wages could proceed as a class action because common issues predominated over questions affecting individual members).

But in Prachasaisoradej v. Ralphs Grocery Co., Inc. (2007) 42 Cal.4th 217, California’s highest court has thrown employers a proverbial bone. Joining the pro-employer, pro-business case of Reynolds v. Bement (2005) 36 Cal.4th 1075 (employer’s officers, directors, and shareholders cannot be individually liable in tort for alleged wage and hour violations), Ralphs reversed an intermediate appellate court and held that a written incentive compensation plan based on the achievement of preset profitability targets was permissible where profits were determined by subtracting store operating expenses from store revenues. No brainer? Not exactly. At least, not according to Plaintiff’s counsel.

Plaintiff had claimed that the formula for calculating the profit-sharing payments violated California statutes, rules, and decisions that prohibit 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 complaint alleged that the bonuses were calculated on the basis of the net earnings of the store where Plaintiff worked, and that the earnings figures were illegally reduced because they netted out expenses for cash shortages, damaged or lost merchandise, workers' compensation, tort claims by non-employees, and other business expenses beyond the employee’s control.

Plaintiff complained that this formula violated wage-protection rules set forth in Labor Code sections 221, 400 through 410, and 3751, Industrial Welfare Commission Regulation 11070, and associated cases. Plaintiff also asserted this was an unfair business practice prohibited by California Business and Professions Code section 17200. The complaint sought injunctive relief, restoration of lost wages, interest, and attorneys fees.

The Supreme Court first analyzed several historical cases relied upon by Plaintiff, then distinguished them by concluding that, in each case, the employee's compensation was “directly reduced by the full dollar value of merchandise and cash losses, as determined by the employer, and regardless of employee fault.” This action, the court reasoned, allowed the employer to defray its “merchandise and cash losses by charging them, dollar for dollar, against its liability for wages,” thereby assessing individual employees the entire unliquidated value of such losses.

The court found that, in contrast to those other cases, Plaintiff Prachasaisoradej and the putative class members were not “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 was then subject to deductions to cover employer costs.” Rather, Ralph’s incentive compensation was premised entirely on store profitability, a factor that necessarily considered the employer's expenses as well as its income.

What was the critical difference? Employees understood from the beginning that, by the plan's very nature, the bonus compensation for any given period depended on “the extent to which the store's revenues for the relevant period exceeded its operating expenses.” Moreover, since the employer took no unauthorized deductions from the promised wages, any uncertainty in the amount ultimately due arose from the nature of the plan, not from employer charge-backs taken after the basic wages were determined.

The court found that Plaintiff had not suffered a “prohibited recapture of compensation already offered, promised, or paid,” or an “uncertain or unanticipated deduction from his expected wages.” Such a supplementary incentive compensation, said the court, was “intended to promote and reward employee teamwork that produced a net profit for the store as a whole.”

The employee’s “proportionate stake in the successful result” was considered beneficial to both employer and employees because it encouraged and rewarded their participation, and offered them wages over and above their regular wages. Accordingly, the court concluded that Ralph’s incentive compensation plan did not contravene California’s wage-protection policies.

The court’s philosophy was best expressed by this observation:

The wage-protection statutes and rules do not demand that employee compensation be absolutely certain or stable from pay period to pay period, regardless of the employees' contrary understanding. Nor do they forbid a system in which, even though services have already been performed, the final amount of wages cannot be determined until after specified contingencies have come to pass. On the contrary, numerous California cases have held 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 service, and even where he or she has already received advance sums. In such circumstances, the employer may set off, against future payments, any excess amounts previously paid.

The court also downplayed a concern expressed in an early California Supreme Court opinion, Kerr’s Catering Service v. Department of Industrial Relations (1962) 57 Cal.2d 319, that there was a potential for fraud and deceit in a system where unliquidated losses were unilaterally determined by the employer and then charged to an individual employee through deductions from wages. Noting that “this concern, when stretched beyond reasonable limit, proves too much,” the Ralphs court said:

All forms of employee compensation depend to some degree on the honesty and accuracy of the employer's calculations. Certainly this is true of any fluctuating form of earnings, such as commission-, piece-, or task-based compensation, that relies primarily on the employer's recordkeeping. However, this concern alone does not mean those forms of incentive pay are forbidden. … We are not persuaded that Ralphs's plan is illegal, per se, simply because of the theoretical possibility-concededly not presented herethat Ralphs might cheat in applying it.

Following a thorough, common-sense, and pro-business analysis, the court held: “We conclude only that we find nothing in the statutes, regulation, and cases cited by plaintiff to prohibit 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.”

In light of the opinion in Ralp’s, how should employers with California operations ensure their incentive-based profit sharing compensation plans do not run afoul of California wage and hour laws?

First, the profit-based bonus plan should be in writing and specify how the incentive wages are calculated, including by identifying the costs that will be deducted from earnings to calculate the net profit. The plan should specify that it is based on the financial performance of the business (or an operating division of the business, such as an individual store), which by its nature is fluctuating, uncertain, and dependent on the enterprise’s success. The employer should ensure that no specific incentive wages, in concrete dollar amounts, are promised.

Second, the written plan should identify the specific formula used and the applicable time periods for the calculation (e.g., weekly, monthly, quarterly, or yearly), including the specific percentage of net profits that the specified employees will earn. (Importantly, the employer must recognize that such bonuses are not considered discretionary once the plan is put into place, but rather should be considered earned when the performance statistics are in.  Therefore, if an employee produces spectacular results under the incentive bonus plan that would entitle the employee to a huge and unexpected bonus, the employer has no choice but to pay these earned wages.) The expenses chargeable against revenues, thereby yielding the profit amount upon which the formulaic bonus is based, must be legitimate, not concocted. Although not discussed in Ralphs, prudent employers should provide each affected employee with access to the relevant numbers (e.g., by providing profit and loss statements applicable to the individual business unit) upon which the incentive bonus was calculated, once the earnings and expenses are known for the relevant time period. Third, such a profit-based incentive compensation system should only provide supplemental compensation, not base wages. Fourth, employers should avoid implementing a compensation system whereby employee participants become insurers of the employer’s business losses (i.e., dollar for dollar subtractions from promised wages).