California Supreme Court Upholds IRC §83 Restricted Stock Plans Against Claim That They Cause Unlawful Forfeiture Of Employee Wages Upon A Voluntary Termination

On November 2, 2009, the California Supreme Court, in an opinion authored by Justice Moreno, unanimously rejected a challenge to a form of equity compensation widely used in the technology and financial sectors. In Schachter v. Citigroup, Inc., the Supreme Court affirmed an appellate ruling that the forfeiture provision of a restricted stock plan established by a predecessor company of Citigroup was consistent with California Labor Code sections 219 or 221. Section 221 prohibits an employer from accepting a return of wages paid to an employee, and section 219 bars attempts to circumvent certain provisions of the Labor Code—including section 221—by private agreement.

The Restricted Stock Program And Procedural History

David Schachter, the plaintiff, participated in his employer’s Internal Revenue Code section 83(b) qualified restricted stock plan (the “Plan”). The Plan allowed eligible employees to elect to receive restricted company stock at a reduced price as a portion of their annual compensation. Under the Plan, participating employees’ cash compensation was offset by a corresponding amount designed to keep the total compensation for participating and non-participating employees about the same.

The restricted stock fully vested after two years, at which point the restrictions lapsed. If the participant quit before then, or if the company terminated the participant’s employment for cause, the participant would forfeit any interest in the stock. This forfeiture provision is consistent with Internal Revenue Code section 83(a) and associated Treasury Regulations—because the restricted stock awards carried a “substantial risk of forfeiture” until the date of vesting, the participants could defer income recognition on the restricted stock awards to the date of vesting.

Schachter received restricted stock and then voluntarily resigned his employment before the stock vested. Consistent with the Plan, his unvested restricted stock awards were forfeited. He filed a putative class action lawsuit against the company, alleging that the Plan’s forfeiture provision violated Labor Code section 221, as well as other Labor Code sections (201 and 202) that require prompt payment of earned wages upon termination of employment.

The trial court granted summary judgment in favor of the employer. The Court of Appeal affirmed, concluding that the Plan’s provisions did not violate Labor Code sections 201, 202, 219, or 221 because Schachter was paid all of his earned wages at termination—some in the form of restricted stock, and some in the form of cash compensation.

The California Supreme Court Holds That Unvested Stock Has Not Yet Been Earned—And Found No Labor Code Violations

Construing the term “wages” broadly, the Supreme Court agreed with Schachter that the restricted stock grants constituted wages within the meaning of Labor Code section 200(a) (and therefore also constituted wages under Labor Code sections 201, 202, and 221). But the Court also held that Schachter had received all the wages he had bargained for: “Schachter understood that the restricted stock he opted to receive 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.” Accordingly, the Court held, Schachter “did not earn either the [company] stock or the funds used to purchase it” and therefore had no right to receive unrestricted stock or the funds used to purchase it at his termination. Citigroup argued, and the Court agreed, that Schachter’s “bargained-for wages ha[d] been paid in full.”

As a fall-back position, Schachter argued that his restricted stock award, like vacation payment, should at least have been partially paid, on a theory that “the stock should have vested on a pro rata basis, entitling him to at least some payment on termination.” The Court rejected this argument as well, holding that California’s doctrine on vacation pay being deemed to accrue over the time needed to obtain an award of vacation pay was “limited to vacation pay and could not be extended to voluntary incentive compensation programs.” The distinction, the Court noted, was that vacation pay was intended as compensation for past services, whereas the promise of incentive compensation (such as restricted stock) is intended to induce the employee to perform services in the future.

Forfeiture Of Restricted Stock After A Termination Without Cause

Although the Schachter decision reaches a result favorable to the employer in this case, some of its language provides a basis for caution. The Court noted that under the Plan at issue, “had Schachter been involuntarily terminated by the company without cause, he would have been required to forfeit his shares of restricted stock in exchange for ‘a cash payment equal to the portion of his or her annual compensation that had been paid in the form of such forfeited [r]estricted [s]tock.’” This payment (even prior to vesting), the Court reasoned, would be consistent with contract law principles prohibiting efforts by one party to a contract to prevent completion of contractual performance by the other party.

If the Plan, on the other hand, called for the forfeiture of shares after an involuntary termination without cause, the outcome may have been different. Although it was not at issue in the case, the Court clearly indicated that plans calling for the forfeiture of restricted stock because of an involuntary termination without cause likely would offend California’s wage and hour laws. In support of this position, the Court invoked the colorful analogy of “[h]e who shakes the tree is the one to gather the fruit.”

Meaning For California Employers

 After Schacter, it is an opportune time for employers to review their deferred compensation plans to ensure they comply with the Supreme Court’s guidance on restricted stock plans. As the number of lawsuits in this area continues to rise, there is no better time to take action to evaluate benefits plans and ensure compliance. Also, employers facing pending Labor Code litigation over restricted stock plans should reevaluate their case strategy in light of the Schachter decision.

For more information, please contact the Seyfarth attorney with whom you work or any California Labor & Employment attorney on our website.