A recent decision by the Supreme Court of California last November reminds us again of the importance of the contract in compensation and incentive policies of an employer. The California courts and legislature are traditionally known for being very strict in protecting an employee's right to be paid for all compensation that he earns. However, in its highly anticipated decision in Schachter v. Citigroup, Inc., 47 Cal.4th 610 (Cal. 2009) the California Supreme Court rejected claims that an incentive plan that conditioned the earning of restricted stock based on continued service was unlawful where the employee voluntarily elected to participate in the plan, and the employee quit before the date on which the incentive was earned. The plan was lawful even though the incentive plan was funded from wages that the employee would have otherwise received in cash.

With this decision, the California Supreme Court joined the courts of numerous other jurisdictions that had concluded the Citigroup Capital Accumulation Plan complied with each state’s respective wage payment laws. See Weems v. Citigroup, Inc., 900 N.E.2d 89 (Mass. 2009) (under Massachusetts law); Gilmore v. Citigroup Inc. (In re Citigroup Inc. Capital Accumulation Plan), 535 F.3d 45 (1st Cir. 2008) (under Florida and Georgia law); Mewhinney v. Citigroup Inc. (In re Citigroup Inc. Capital Accumulation Plan Litigation, 2008 WL 3982065 (D. Mass. 2008) (under Texas law); Weems v. Citigroup, Inc., 961 A.2d 349 (Conn. 2008) (under Connecticut law); Rosen v. Smith Barney, Inc., 925 A.2d 32 (N.J. Super. 2007) (under New Jersey law); Kim v. Citigroup, Inc., 856 N.E.2d 639 (Ill. App. 1st 2006) (under Illinois law).

Background

David B. Schachter was employed as a stockbroker by Smith Barney, Inc., now a subsidiary of Citigroup, Inc. from April 28, 1992 to March 29, 1996. Schachter was part of a group of key individuals who had the opportunity to participate in the Capital Accumulation Plan (the "Plan"), which provided employees the option to elect awards of restricted stock “in lieu of cash payment of a percentage of the employee’s annual compensation. Participating employees could elect to receive between 5 and 25 percent of their total compensation in the form of restricted stock that did not fully vest for a two year period after the election. If a participating employee remained in Citigroup’s employ for the full two years following the purchase of the restricted stock, title to the shares vested fully with the employee, free of any restrictions. However, the Plan further provided that if the employee voluntarily left the company or was terminated for cause before the two year period expired, the employee forfeited his right to the stock entirely as well as the compensation that the employee directed be paid in the form of the stock. If such employee was terminated without cause, however, that employee would receive a cash payment equal to the portion of the annual compensation paid for the forfeited stock.

Schachter elected to participate in the Plan, but prior to completing the two-year vesting period, he voluntarily terminated his employment. Despite the clear language in the Plan and election form, Schachter filed a putative class action alleging: (1) the Plan's forfeiture provision violated Labor Code sections 201 and 202, requiring prompt payment of all earned wages at the time of separation of employment; (2) it violated Labor Code section 221, prohibiting an employee from returning wages to an employer; and (3) it constituted the unlawful conversion of wages by forfeiting the percentage of annual compensation received in the form of restricted stock. The trial court concluded that the provisions did not violate the California Labor Code and granted Citigroup’s motion for summary judgment. On appeal, Schachter argued that the forfeiture provision violated the Labor Code because an employee’s resignation or termination for cause resulted in the employee’s forfeiture of “not only the shares of the restricted [company] stock they had purchased,” which Schachter conceded was lawful, “but also the ‘earned but unpaid compensation’ used to purchase those shares.”

The Contractual Basis of Incentive Compensation

The California Supreme Court resolved the matter by emphasizing the contractual nature of an employee’s compensation. When Schachter voluntarily elected to participate in the Plan, he elected to divide his wages into two components. One component was wages that would be paid in cash. The other component was wages that would be paid as restricted stock. First, the court acknowledged, and Citigroup conceded, that both the cash compensation and restricted stock – including the conditional present rights (voting and dividend rights), as well as the contingent future rights of full ownership in that restricted stock (awarded but never transformed into noncontingent, fully vested rights) – constituted wages.

However, the court concluded that Schachter did not earn, and thus had no right to receive either the restricted stock of the funds used to purchase it. The California Supreme Court recognized that incentive compensation can act as an inducement for future and productive service, and that incentive compensation is not earned until all of the conditions to receiving such compensation are met. Schachter’s right to receive the stock was, accordingly, subject to the requirement that he complete the two-year period of employment after he was awarded the restricted stock. When Schachter voluntarily terminated his employment prior to the end of the required two-year vesting period, he forfeited his contingent ownership interest in the stock. As a result of the forfeiture, there were no earned and unpaid wages due at Schachter’s termination. Schachter could not, therefore, successfully argue that he had failed to receive all of the compensation due upon the termination of his employment in violation of section 201 of the California Labor Code or that he had returned earned compensation to his employer in violation of section 221. As the incentive had not been earned, there could be no argument that the Company had attempted to contravene the California Labor Code by private agreement or that the Company had converted the employee’s compensation.

It is important to note, however, that the court emphasized the result might have been different had an employee been involuntarily terminated without cause. The California Supreme Court endorsed in dicta that an employee who is terminated when there are no further services to be performed in order to earn a commission, for example, cannot be denied the commission if all of an employee’s expected duties had been accomplished before termination. The Court stated that this finding is consistent with contract law principles prohibiting efforts by one party to a contract to prevent completion by the other party. The contractual underpinning of the decision appears to provide an employer with great flexibility in structuring the compensation of employees, including the forfeiture of such compensation. Under the decision, an at-will employee who is given notice of a change in compensation and then continues to work is deemed to have accepted the change. An employee who is notified that some of his or her compensation that may be earned in the future will be received through cash and some through the opportunity to participate in an incentive plan is likely bound to that arrangement if the employee continues in employment.

Effect of Minnesota Employers

The Minnesota courts have not considered an incentive compensation plan similar to the Citigroup Plan. While the Schachter decision does not have a binding effect on Minnesota employers and it is difficult to predict how such a plan would be treated by the Minnesota courts, the reasoning behind the decision is consistent with the way that entitlement to bonuses and similar compensation are treated in the Minnesota courts.

Over the past several years Minnesota courts have made it clear that in determining whether an employee is entitled to payment of bonuses, commissions and other incentive compensation, they will apply contract principles. See Holman v. CPT Corp., 457 N.W.2d 740, 743 (Minn. Ct. App. 1990), rev. denied (Minn. Sept. 20, 1990) (held that whether compensation is “actually earned” is governed not by the Minnesota Wage Statute, but by the terms of an employee’s contract with his/her employer); see e.g., Lee v. Fresenius Medical Care, Inc., 741 N.W.2d 117 (Minn. 2007) (utilized contract principles in determining whether unused vacation pay, which were deemed to be wages, had been earned by the employee); Kvidera v. Rotation Engineering and Manufacturing Co., 705 N.W.2d 416 (Minn. Ct. App. 2005) (resolved dispute over whether a bonus constituted earned wages by applying traditional contract principles); U.S. Foodservice, Inc. v. Rezac, 2005 WL 1661529 (D. Minn. July 15, 2005) (finding an employee forfeited his points (which had no monetary value) under the terms of the employer’s Points of Focus reward and incentive program by resigning from his employment and dismissing the employee’s Minnesota Wage Statute claim because the collected points did not constitute “wages or commissions earned and unpaid”).

Schachter and the related decisions, as well as the Minnesota cases cited above, suggest that employers have wide flexibility in drafting incentive compensation plans, including bonus, commission, and equity plans. However, these cases re-emphasize to employers the care that must be taken in drafting and disseminating information regarding such compensation plans. The terms and conditions of an incentive program should be in writing with material terms fully disclosed to eligible employees prior to enrollment. Most importantly, all forfeiture provisions, including and any conditions precedent or vesting requirements, should be clearly and unambiguously disclosed and the employer should seek employee acknowledgement and consent to the of the forfeiture provisions. Indeed, it appears Citigroup prevailed principally because the forfeiture provisions of its plan were in writing, carefully drafted, unambiguous, and communicated to affected employees. The failure to reduce such compensation arrangements to writing, or the lack of clear communication to an employee, could easily result in a less favorable outcome. Employers should approach any situation involving a forfeiture of wages with caution and seek advice of counsel to ensure the conditions and analyses set forth by the courts of various jurisdictions and other relevant laws are satisfied.