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Employment Law Update: California Supreme Court OK’s Forfeiture of Employee Incentive Compensation Plan
By Teresa R. Tracy
On November 2, 2009, in Schachter v. Citigroup, Inc., the California Supreme Court resolved an issue that spawned years of litigation particularly in the technology and financial sectors: can an employer offer a voluntary employee incentive compensation plan that provides shares of restricted company stock at a reduced price in lieu of a portion of that employee’s annual cash compensation be subject to forfeiture if the employee resigns or is terminated prior to vesting? The Court unanimously answered: Yes.
The Terms of the Incentive Plan
Under the plan, an eligible employee could elect to receive an award of discounted restricted company stock in lieu of cash payment of a percentage of the employee’s annual compensation. The restricted stock could not be sold, transferred, pledged, or assigned for two years commencing on the date of the award, although the employee could direct the vote and receive any regular dividends on restricted stock shares during the restricted period.
If the employee remained employed with the company for two years following the purchase of the restricted stock, title to the shares vested fully in the employee. However, if the employee voluntarily terminated employment or was terminated for cause before the end of the two-year period, the employee forfeited not only the stock but also the percentage of annual income that the employee had designated be paid as the shares of restricted stock. If an employee was involuntarily terminated without cause, the employee forfeited the restricted stock but was paid, without interest, a cash payment equal to the portion of the employee’s annual compensation that had been paid in the form of the forfeited restricted stock.
The plaintiff elected to receive various percentages of his annual compensation in restricted stock, but voluntarily resigned before any stock vested. Thus, he forfeited all of his shares of the stock as well as the percentage of this annual compensation that he had elected to be paid in the form of restricted stock.
The Court’s Analysis of California Law
At issue were the interpretation and application of the following state laws:
- Section 201, that provides in pertinent part that if an employer discharges an employee, the wages earned and unpaid at the time of discharge are due and payable immediately
- Section 202, that provides in pertinent part that if an employee quits employment, the wages are due and payable not later than 72 hours thereafter.
- Section 221, that provides that it is unlawful for an employer to collect or receive from an employee any part of wages theretofore paid by the employer to the employee.
- Section 219, that provides that wage payment statutes, among others, cannot “be contravened or set aside by private agreement.”
The Supreme Court started its analysis by addressing whether the plaintiff (or any class member in his class action) would be owed – and therefore required to forfeit – any “earned and unpaid” wages upon resigning or being terminated for cause. The Court noted that “wages” is broadly construed and include those benefits to which an employee is entitled as part of the employee’s compensation, and that it includes incentive compensation such as bonuses and profit-sharing plans.
The plaintiff did not allege that he did not receive all cash compensation due to him, or that the employer failed to pay him the compensation he elected to receive as cash or the shares of restricted stock upon his termination. Instead, he argued that the portion of his cash compensation that he had directed to be paid to him in the form of restricted stock should have been paid to him in cash upon his resignation.
The Court observed that it could not be questioned that employers and employees are free to prospectively and bilaterally alter the terms of employment, and that straight time wages (above the minimum wage) are a matter of private contract between the employer and employee. According to the Court, when the employee executed the forms electing the incentive plan, he essentially renegotiated the terms of his compensation with the company and elected to be compensated with a mixture of cash and restricted stock. He understood that the restricted stock would have limited and conditional present value and would not fully vest until two years following the date he received it, provided he remained employed by the company. The employee elected not to remain employed with the company for the designated period and thus did not earn – and had no right to receive – either the restricted stock or the funds used to purchase it.
Thus, the Court acknowledged that incentive compensation is generally understood as an inducement to employees to procure “efficient and faithful service” and eligibility is properly determined by the plan’s specific terms and general contract principles. The Court resoundingly confirmed that only when a employee satisfies the conditions precedent to receiving incentive compensation (which often includes remaining employed for a particular period of time) can the employee be said to have earned the incentive compensation, thereby necessitating payment upon resignation or termination.
The Court also noted that had the employee been involuntarily terminated without cause, he would have forfeited his shares of restricted stock in exchange for a cash payment equal to the portion of his annual compensation that had been paid in the form of the stock “without interest.” It observed that this provision was consistent with contract law principles prohibiting efforts by one party to a contract to prevent completion by the other party.
The Court concluded that the incentive plan’s forfeiture provision did not violate sections 201 or 202 because no earned wages remained unpaid upon termination for cause or resignation. Therefore, there was also no violation of section 219.
The Court rejected the argument that, like vacation, the incentive compensation should vest in a pro rata manner. It thus limited its earlier ruling on this pro rata vesting of vacation – which is compensation for past services, rather than an inducement for future services.
Implications for Employers
Employers can rest easier as the result of this decision on the following issues:
- An incentive plan can provide for certain forfeitures if the employee is terminated for cause or voluntarily resigns.
- Incentive plans, unlike vacation, do not vest in a pro rata manner.
However, the Court’s discussion suggests that it would have reached a contrary conclusion had the employer terminated the employee without cause or if the employee could otherwise show that the resignation was not voluntary. Furthermore, the Court may well have been influenced by the provision of the plan that the portion of cash compensation that had been diverted to stock would be repaid, albeit without interest, so that there was not a complete forfeiture of that portion of the employee’s compensation.
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©2009 Gladstone Michel Weisberg Willner & Sloane, ALC. All Rights Reserved.