Time To Reevaluate Employee Bonus and Incentive Plans?

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. 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.