Employers Net A Victory: The California Supreme Court Allows Deductions for Operating Losses from Profits Which Form the Basis of Incentive Compensation/Bonus Plans
08/28/2007

On August 23, 2007, the California Supreme Court in Prachasaisoradej v. Ralphs Grocery Company, Inc. held that an incentive compensation plan that allows employees to share in profits, as calculated by subtracting operating expenses from revenues, does not violate Labor Code provisions or Wage Order regulations that prohibit an employer from taking wage deductions to cover operating losses.

The Claims
The plaintiff, a produce manager in a Ralphs Grocery store, participated in a bonus program based on a store’s net earnings less expenses for cash shortages, damaged or lost merchandise, workers’ compensation and tort claims, and other business expenses. He sued Ralphs in a class action, alleging that the bonus calculation violated wage protection rules contained in Labor Code sections 221, 400 through 410, and 3751, as well as Business & Professions Code section 17200.

Decisions by the Lower Courts
Ralphs defended its bonus plan as an addition to regular wages that varies with store profitability and that therefore did not entail any deductions that would violate the Labor Code. The Court of Appeal disagreed. Relying on Ralphs Grocery Co. v. Superior Court, 112 Cal. App. 4th 1090 (2003), which also addressed the same incentive compensation plan, the court concluded that the terms of the plan violated the Labor Code’s prohibitions on deductions from employee pay to account for workers’ compensation costs.

The Supreme Court’s Decision
The Supreme Court granted review on the issue of the permissibility of a bonus plan that paid bonuses based on a company’s net profits. Of particular significance on review were the following:

(1) Labor Code section 221, which provides that an employer may not “collect or receive from an employee any part of wages theretofore paid by said employer to said employee,” where “wages” are defined to include “all amounts for labor performed by employees . . . whether the amount is fixed or ascertained by the standard of time, task, piece, commission basis, or other method of calculation.” Cal. Labor Code § 200(a).

(2) Labor Code section 3751, which provides that an employer may not “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 [workers’] compensation.”

(3) Section 8 of the Wage Orders, which provides that an employer may not, with regard to nonexempt employees, “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.”

The Supreme Court first noted that while the bonus plan itself did not define “profit,” profit was, by “usual accounting principles,” derived by deducting regular operating and overhead expenses, as well as expenses for workers’ compensation, merchandise losses, and the like. Of particular import were the plan terms that required calculation of “profit” after a particular period of operation. Therefore, the amount “offered or promised as compensation for labor performed”—which may not be reduced—already had accounted for the deductions about which the plaintiff complained. Nevertheless, the plaintiff contended that this method of determining the profit in which employees were eligible to share was itself a violation of the Labor Code.

Prior cases had invalidated commission and bonus plans on the ground that they imposed “prohibited deduction[s], setoff[s], or recapture[s] of expected wages for the purpose of saddling employees with prohibited employer costs.” See Kerr’s Catering Service v. Department of Industrial Relations, 57 Cal. 2d 319 (1962); Hudgins v. Nieman Marcus Group, Inc., 34 Cal. App. 4th 1109 (1995); Quillian v. Lion Oil Co., 96 Cal. App. 3d 156 (1979). The Supreme Court distinguished these cases based on the fact that the plans at issue in those cases promised employees a set commission or bonus and then reduced it on a dollar for dollar basis to cover losses attributable to the employee or to the store generally.

In the case at hand, by contrast, the plan (1) promised only store profits to eligible employees, which as noted above already reflected expenses, and, as a necessary corollary, (2) did not include any deductions against what employees would receive. The Supreme Court concluded that incentive compensation plans “such as Ralphs’s start from the fundamentally different premise that the basic measure of the compensation due is the overall profitability of the enterprise. By its inherent nature, such a plan does not promise, or even create, incentive compensation unless and until profitability occurs and is determined.”

Beyond the fact that the bonus plan complied with the Labor Code, regulations, and the anti-deduction provisions of the IWC Wage Orders, the Supreme Court noted that it could be argued that the bonus plan, in including workers’ compensation costs in the profit calculation, promoted public policy “by encouraging employees to maintain a safe workplace, and by discouraging claim abuse.”

What Ralphs Means for You
The Ralphs decision is unquestionably a victory for employers. Because the decision was split 4-3, however, it is important not to read the decision too broadly. A business clearly has the right to have a bonus plan that distributes sums based on the level of the company’s net profits, but it is difficult to say how the courts will treat factual scenarios that depart from that basic point.

That being said, several pronouncements in the case may help employers in other litigation. For example, there is a suggestion that compensation consisting of “a scheduled amount based on sales volume and revenue” constitutes a “commission.” That definition is broader than what the Supreme Court had suggested in earlier cases, such as Ramirez v. Yosemite Water Co., 20 Cal. 4th 785 (1999). This looser standard of “commission” would afford more employers the opportunity to classify employees as “inside” sales people, thereby rendering them exempt under section 3(D) of Wage Order 4.

Additionally, the Supreme Court approvingly cites two earlier cases that benefit employers. First, the Court cites Neisendorf v. Levi Strauss & Co., 143 Cal. App. 4th 509 (2006), for the point that Labor Code section 221 is consistent with a bonus plan that, though based on profits for a particular year, renders an employee who worked during that year ineligible for the bonus if the employee does not continue to be employed on a later date when the bonuses are distributed. Second, the Court cites Koehl v. Verio, Inc., 142 Cal. App. 4th 1313 (2006), for the proposition that it is permissible to “charge back” sums advanced against sales commissions, which are not deemed earned until all conditions to earning the commissions have been satisfied.

If you have any questions concerning this Management Alert, please contact the Seyfarth Shaw LLP attorney with whom you work or any labor and employment attorney on our website.

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