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The next wave of California wage-and-hour class action litigation is here. Profit-based bonus and other compensation plans have come under attack in more than 15 pending class action lawsuits. The charge? Plaintiffs argue that when employers calculate profits under these plans by deducting business losses (breakage, missing merchandise, cash shortages and other forms of “shrinkage”) and workers’ compensation expenses, they are violating California law on loss-deductions from “earned wages.” These suits and the potentially scores more to come have just received a huge boost from the Second District Court of Appeal as a result of its Oct. 23 decision in Ralphs Grocery Co. v. Superior Court, 03 C.D.O.S. 9311. In Ralphs, the court held that with respect to non-exempt employee bonuses, employers may not first deduct merchandise and cash shortages to calculate profitability. Because the court based its ruling on a wage order applicable only to non-exempt employees, the court did not make its ruling applicable to exempt employees. However, the court also held that under Cal. Lab. Code � 3751, employers may not deduct workers’ compensation expenses to calculate the profits on which bonuses are paid for both exempt and non-exempt employees. Because the Ralphs case presents issues of first impression, the California Supreme Court may grant review. But for now, given how widely profit-sharing plans are used in California — some estimate that thousands of profit-sharing plans are currently operating in the state applicable to exempt and non-exempt employees — Ralphs will spawn scores of copycat suits. The ruling in Ralphs came after the trial court overruled a demurrer to a complaint challenging a profit-based bonus plan in which workers’ compensation expenses and certain business losses, including cash and merchandise shortages, were deducted to calculate profits before bonuses are paid. With respect to workers’ compensation expenses, the Court of Appeal found dispositive Cal. Lab. Code � 3751, which states, “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 [workers'] compensation�” The court held that a deduction for workers’ compensation expenses taken in the process of calculating profits from which bonuses was the same as a direct or indirect “deduction from the earnings of the employee,” and disallowed the deduction for both exempt and non-exempt employees. In barring deductions for cash and merchandise losses, the court relied on Industrial Wage Order 7-2001 (Mercantile Industry), which prohibits deductions from wages 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.” In Kerr’s Catering Service v. Department of Industrial Relations, 57 Cal. 2d 319 (1962), the California Supreme Court upheld the power of the Industrial Welfare Commission (IWC) to enact a similar regulation. Although the compensation at issue in Kerr’s was a straight sales commission and not a profit-based bonus, the court in Ralphs found Kerr’s controlling. The employer in Kerr’s paid its drivers, who sold food items from trucks, a base salary plus a 15 percent commission on all sales in excess of $475 per week. Each month, however, the employer reduced the commission payments to each driver by the amount of his or her individual cash shortages even if they were not responsible for them. The California Supreme Court upheld the IWC regulation outlawing the practice. The court cited a variety of statutes protecting the “special status” of wages in California, including Cal. Lab. Code � 221, which makes it unlawful for “any employer to collect or receive from an employee any part of wages theretofore paid by said employer to said employee”; and Cal. Lab. Code � 400-410, which limit the circumstances in which an employee may be required to give a security bond. The Supreme Court ruled that the shortages were a kind of regular expense that should be borne by management, and that to allow the deduction improperly would make the driver the employer’s insurer for cash losses. The Ralphs court also cited Quillian v. Lion Oil Co., 96 Cal. App. 3d 156 (1979). The employer in Quillian paid its service-station managers a base salary and a monthly bonus. The employer calculated the bonus as a fixed dollar amount (based on the amount of gasoline sold each month), plus one percent of other sales, less any cash or merchandise shortages regardless of the manager’s responsibility for the shortages. To get around Kerr’s, the employer argued that shortages were not deducted from the manager’s bonus, but instead were just one of three factors (along with gasoline sales and other sales) used to calculate the bonus. The court rejected that argument as sophistry, calling it a “clever method of circumventing the statutory definition of wages.” The court ruled that the bonus plan, in essence, was a sales commission plan, and the deduction for shortages was nothing more than a deduction for losses from earned commissions, just as in Kerr’s. Finally, the Ralphs court cited Hudgins v. Neiman Marcus Group, Inc., 34 Cal. App. 4th 1109 (1995). That case arose from Nieman Marcus’ practice of deducting, on a pro rata basis from all salespersons’ commissions, merchandise returns that could not be attributed to a specific sales person. Citing Quillian, the court rejected Neiman Marcus’ argument that the deduction of unattributed returns was only a step in the process of calculating sales commissions. It held that the unidentified returns policy “calls for deductions from earned commission wages � representing what would otherwise be business losses. � The deduction is unpredictable, and is taken without regard to whether the losses were due to factors beyond the employee’s control.” In light of these cases, the Court of Appeal in Ralphs court held that Wage Order 7-2001 disallowed loss deductions taken under a profit-based bonus plan. The court ruled there was no difference between the commission plan in Kerr’s and the profit-based bonus plan in Ralphs. In both, the deduction of losses impermissibly operated to reduce employee wages. The court in Ralphs, however, declined to extend its ruling to exempt employees. It ruled that the Wage Order did not apply to exempt employees, and nothing in the Labor Code expressly prohibits deductions from wages for cash or merchandise shortages. “Nor does the calculation of an incentive bonus based on profitability resemble, literally or ‘in spirit,’ either the recapture of wages previously paid in violation of [Lab. Code �221] or exacting a cash bond in contravention of [Lab. Code � 400-410],” held the court. The Court of Appeal also reasoned that the policy considerations underlying Kerr’s are not present for exempt employees because a previously disclosed profitability formula does not threaten “special hardship” because of unanticipated or unpredictable deductions from wages. To the court, it was especially significant that as members of management, exempt employees have control over business operations that may directly affect revenue and expenses. “There is nothing unfair,” said the court, “in basing a part of the compensation for such employees on a formula that rewards them for effective supervision that, in turn, controls expenses, including reduced cash and merchandise shortages.” The Court of Appeal’s middle-of-the-road position — prohibiting loss deductions from profit-based compensation plans for non-exempt employees, but not for exempt employees — may be more practical than logical. After all, like Cal. Lab. Code � 221 (which does apply to exempt employees), Wage Order 7-2001 does not specifically address profit-based compensation plans, and both prohibit deductions only from “wages.” Similarly, Cal. Lab. Code � 3751 (which also applies to exempt employees) prohibits deductions for workers’ compensation expenses from “earnings.” As the court correctly held, loss deductions in profit-bonus calculations do not constitute an unlawful deduction from wages under Cal. Lab. Code � 221. It is therefore hard to see why the same deductions are unlawful under the similarly worded Wage Order 7-2001 and Cal. Lab. Code � 3751. Surely the better reasoned view is that deductions may not be taken from already earned wages. In Kerr’s and Hudgins, the wage was called a “commission,” and in Quillian it was called a “bonus.” But the essence of the transaction was the same: Once the employee made the sale, he or she earned the wage (calculated as a percentage of the sale). At that point, the employer’s deductions for business losses were taken from an earned wage, even if (as in Quillian and Hudgins) the employer portrayed the deduction as merely one step in the wage-calculation process. For the Ralphs court to apply these cases to an employer profit-based compensation plan, even just as to non-exempt employees, skips a step in the analysis. The wage promised in a profit-sharing plan is a share of the profits — not a percentage of revenues alone — and the calculation of profits by definition entails an accounting of revenues, expenses and losses. Even those plaintiffs challenging profit-based compensation plans have not gone so far as to challenge the deductions of expenses from revenues. They recognize that without expenses like rent, utilities, payroll, insurance, etc., the revenues would not be generated in the first place. Plaintiffs argue that losses are different from expenses, but both are inevitable in the running of a business. Indeed, under standard accounting rules there often is no bright line between what should be characterized as an “expense” and a “loss.” Unlike the manner in which the “bonus” and commission plans operated in Quillian and Hudgins, the deduction of business losses from revenues under a profit-based compensation plan is not intended to reduce an otherwise promised wage. Rather, it is an essential step in the calculation of whether a business has made any profit in the first place. After all, companies are not always profitable. Sometimes expenses and losses overtake revenues. But under Ralphs, employers would remain stuck paying out “profit-based” bonuses even when profits were consumed by large losses. Ralphs stands in contrast to numerous California judicial and regulatory authorities that have acknowledged or enforced profit-based bonus plans without questioning their legality. See, e.g., Lucian v. All States Trucking Co., 116 Cal. App. 3d 972 (1981) (upholding employee’s forfeiture of interest in profit-based bonus plan upon departure); DLSE 2002 Enforcement Policies and Interpretations Manual, � 35.2 (following Lucian); Division of Labor Law Enforcement v. Safeway Stores, 96 Cal. App. 2d 481 (1950) (recognizing employer’s right to use “any formula it desired” in computing bonus due under profit-based bonus plan). Furthermore, even Kerr’s recognized that an employer could set (i.e., calculate) wages to reflect its overall expenses and losses. If that is so, why should it be lawful to calculate a wage of $10 per hour to reflect an employer’s expense/loss load, yet unlawful to calculate a profit-based bonus that reflects that same expense/loss load? Rather than battle it out under state law, employers could replace their profit-based compensation plans with profit-sharing plans under the Employee Retirement Income Security Act of 1974 (ERISA), which should preempt state law when it comes to how to calculate profits to be shared with employees. But ERISA entails a host of disclosure, reporting and substantive plan structure requirements that may prove undesirable. If ERISA is not an option, employers with profit-based compensation plans must now take Ralphs into account. Absent Supreme Court intervention and reversal, those plans may now need to be substantially restructured. M. Kirby C. Wilcox and Jeffrey D. Wohl are partners in the employment department at Paul, Hastings, Janofsky & Walker. They are based in the firm’s San Francisco office. If you are interested in submitting an article to law.com, please click here for our submission guidelines.

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