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PROFIT-BASED
INCENTIVE COMPENSATION PLAN DOES NOT VIOLATE
In Prachasaisoradej v. Ralphs Grocery
Company, 2007 Cal. LEXIS 8909 (August 23, 2007), the California Supreme
Court held that an incentive compensation plan based on the employer's net
profits (i.e., subtracting operating expenses from revenues) did not constitute
an unlawful wage deduction under California law. The Prachasaisoradej decision is a significant victory for
The Law
California
Labor Code §221 provides that an employer may not “collect or receive from an
employee any part of wages theretofore paid by said employer to said employee.”
Over the years, California courts have interpreted Labor Code §221 “to prohibit
deductions from an employee's wages for cash shortages, breakage, loss of
equipment, and other business losses that may result from the employee's simple
negligence.” Hudgins v. Nieman Marcus Group, Inc., 34 Cal.App.4th 1109, 1118 (1995). The rationale for this rule is that employees
should not be “insurers of the employer's business losses,” and thus should not
be subjected to unpredictable deductions from their “wages” for losses due to
factors beyond their control. Hudgins, supra, 34 Cal.App.4th at 1123.
Prachasaisoradej v. Ralphs Grocery Company
The plaintiff
in Prachasaisoradej
argued that the “incentive compensation plan” offered by Ralphs
Grocery Company (“Ralphs”) violated Labor Code
§221. Under the Ralphs
plan, certain employees were eligible to receive supplemental compensation
calculated based upon the profitability of particular stores. This incentive compensation was in addition
to the regular pay the employees received.
Ralphs calculated “profits” by subtracting the
store’s expenses from gross revenues.
Store expenses used in the calculation included workers’ compensation
costs, cash shortages, damaged or lost merchandise, and tort claims by
non-employees.
The plaintiff
claimed that reducing an employee’s incentive compensation by such expenses
amounted to an unlawful wage deduction in violation of Labor Code §221. The California Supreme Court rejected the
plaintiff’s argument. In so doing, the
court explained that all of Ralphs’ employees were
paid a predictable amount of compensation - whether an hourly wage or salary –
that was not subject to deduction based on store expenses. All employees who participated in the
incentive compensation plan understood from the outset that any incentive
compensation they might receive depended upon a calculation of profitability
that would include store expenses (workers’ compensation, cash shortages, and
damaged or lost merchandise). It was only
after the calculation of profits under the plan that the employees would know
the amount of their supplemental compensation.
The Supreme
Court distinguished this method of accounting for expenses from earlier cases,
such as Hudgins, supra. In the earlier cases,
employees were expecting to be paid a specific wage, but the wage was “directly
reduced by the full dollar value of merchandise and cash losses, as determined
by the employer, and regardless of employee fault. The employer thus defrayed its merchandise
and cash losses by charging them, dollar for dollar, against its liability for
wages.” In contrast, Ralph’s incentive
compensation plan did not promise any specific wage other than a portion of
profits that could only be determined after expenses were deducted. “Thus, employees suffered neither a
prohibited recapture of compensation already offered, promised, or paid, nor an
uncertain or unanticipated deduction from expected wages. And because they attained no interest or
entitlement in any supplementary compensation other than that finally
calculated under the [incentive compensation plan], they made no forced
‘contribution,’ direct or indirect, from their own resources to reimburse Ralphs for costs the law requires the employer to bear
alone.” In sum, the court found that Ralphs was not shifting its business losses to employees,
but rather used its incentive compensation plan to “determine if there remained
any profit to split with its employees” in addition to their normal wages.
Practical Tips
The Supreme Court’s decision makes it clear that employers can create profit-based compensation plans without running afoul of Labor Code § 221. Employer may still find it difficult, however, to distinguish between valid profit-based compensation plans, on the one hand, and improper deductions from earned wages, on the other hand. Employers are advised to review any profit-based compensation plan with an experienced employment law attorney.