California Supreme Court Upholds Forfeiture Provision In Incentive Compensation Plan
The California Supreme Court issued its decision in Schachter v. Citigroup, Inc. today, upholding the legality of an incentive compensation plan provision providing for forfeiture upon an employee's resignation or termination for cause. The plan at issue allowed employees to elect to receive shares of restricted stock at a reduced price in lieu of a portion of their annual compensation. Title to the shares vested two years after the purchase date. However, the plan provided that if the employee voluntarily resigned or was terminated for cause prior to the two-year vesting date, the employee forfeited his or her stock as well as the portion of annual income designated by the employee to be paid as shares of stock. (If an employee was involuntarily terminated without cause prior to vesting, the employee still forfeited the stock but was paid for the percentage of annual income the employee had directed be used to purchase stock.)
Plaintiff Schachter enrolled in the plan and elected to receive about 5% of his annual compensation in the form of restricted stock. Schachter voluntarily resigned prior to his shares vesting and, as a result, forfeited his shares as well as the amount of annual compensation that had been used to purchase the shares. Schachter filed a class action lawsuit against Citigroup alleging that the forfeiture provisions in the incentive compensation plan violated certain provisions of the California Labor Code prohibiting the forfeiture of earned but unpaid wages. The trial court granted summary judgment in favor of Citigroup and rejected Plaintiff's claims. A California Court of Appeal agreed.
Schachter petitioned for review by the California Supreme Court, which also agreed with the lower court rulings. The Court rejected Schachter's argument that Citigroup should have paid him, upon his resignation, cash for the amount of his annual income he had directed be used to purchase shares of stock. The Court reasoned that an employer and an at-will employee are free to renegotiate the terms of the employee's straight-time compensation at any time during employment. Schachter's election to participate in the incentive compensation plan, understanding its terms and its forfeiture provision, constituted Schachter's agreement to a restructured compensation package. Under the specific terms of the plan, Schachter's interest in the shares he purchased did not vest (and hence was not "earned") unless he remained employed for two years. Because Schachter voluntarily resigned prior to the two-year mark, he had not "earned" and had no right to receive either the shares or the money used to purchase the shares.
The Court also rejected Schachter's argument that at least a portion of his incentive compensation should have vested on a pro rata basis, much like vacation wages. The Court explained that unlike vacation, which is compensation for past services, an incentive compensation plan is inducement for continuing future service. As a result, the Court held that rules prohibiting forfeiture of accrued vacation do not apply to incentive compensation plans.
Although the Schachter case is an employer-friendly decision that allows employers more control and flexibility in structuring incentive compensation plans, employers should note that the California Supreme Court placed some emphasis on the fact that Schachter had voluntarily resigned and, therefore, it was Schachter's own actions that caused him to lose his contingent incentive compensation. Although the Court did not say that a forfeiture provision tied to involuntary terminations would per se violate California law, employers should be mindful that forfeitures in the case of involuntary terminations frequently give rise to a claim that the employer terminated the employee as a pretext to avoid payment of the incentive compensation. Therefore, particular care should be taken in drafting forfeiture provisions tied to involuntary terminations.