As expected, California's governor has signed off on AB 5, a law making it harder for most employers to classify workers as independent contractors. The legislation will have sweeping ramifications for California employers and affect the use of independent contractors for businesses in many other states. While the law will become effective on January 1, 2020, its impact on businesses using independent contractors in California will be immediate. Employers using independent contractors in California should take steps now to understand and comply with AB 5's requirements and also consider how best to mitigate the risks it has created.
AB 5's Adoption of the Dynamex Standard for Classifying Independent Contractors
AB 5, in effect, codifies the independent contractor classification standard set forth by the California Supreme Court last year in Dynamex Operations West, Inc. v. Superior Court.1 In Dynamex, the court adopted a broad definition applicable to determining when a worker is an employee under California's Industrial Welfare Commission (IWC) wage orders. The court's decision established that in wage order disputes, the hiring entity (i.e., the company) has the burden of proving the worker is an independent contractor and not an employee.2 The court further explained that a worker can only be an independent contractor if it passes the so-called "ABC" test, and establishes that all three of the following conditions are met: (a) the worker is free from the control and direction of the hiring entity in connection with the performance of the work; (b) the worker performs work that is outside the usual course of the hiring entity's business; and (c) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.3
Significantly, AB 5 not only adopts the holding in Dynamex, but expands its applicability beyond California's wage orders to the provisions of California's Labor Code and its Unemployment Insurance Code. It makes clear that its amendment to the Labor Code "does not constitute a change in, but is declaratory of, existing law with regard to [IWC] wage orders and violations of the Labor Code relating to wage orders." In prefatory language, and no doubt in an attempt to intimidate employers into compliance, the legislation's language states that the Labor Code already makes it a crime for an employer to violate certain provisions of law with regard to an employee, and that the Unemployment Insurance Code also makes it a crime to violate specified provisions of law with regard to benefits and payments made. The law provides that California's Attorney General can prosecute employers for illegally misclassifying workers and permits the city or county attorneys of larger cities and counties to prosecute violations of AB 5.
Significantly, AB 5 exempts certain occupations from Dynamex's application, and instead provides that these occupations are governed by the independent contractor Borello test familiar to many employers and practitioners but which was not adopted in Dynamex. The occupations exempted include, among others: licensed insurance agents, certain licensed health care professionals, registered securities broker-dealers or investment advisers, direct sales salespersons, graphic designers, real estate licensees, commercial fishermen, workers providing licensed barber or cosmetology services, and others performing work under a contract for certain types of professional services with another business entity, or pursuant to a subcontract in the construction industry.
What Now? How Should California Employers Respond to AB 5's Passage?
Because of the ever-increasing frequency of use of independent contractors in many segments of the economy (including in most technology companies and start-ups), AB 5 is one of the most important employment laws passed in recent years. In signing AB 5, California's governor stated that the law "will help reduce worker misclassification—workers being wrongly classified as 'independent contractors,' rather than employees, which erodes basic worker protections like the minimum wage, paid sick days and health insurance benefits." The law itself notes the legislature's intent to restore "important protections to potentially several million workers [emphasis added] who have been denied these basic workplace rights that all employees are entitled to under the law."
In light of AB 5's ambitious goal of dramatically reducing worker misclassification, California employers should consider doing the following:
- Recognize that AB 5 applies to all California employers, not just to "gig" companies such as ride sharing or food delivery companies.
- Conduct an audit to determine the number of current contractors the employer engages in California.
- Evaluate carefully whether existing independent contractors or consultants meet the classification standard set forth in AB 5, including whether one of the law's exceptions applies. Recognize, however, that even if AB 5's more strict requirements don't apply, the Borello test may determine whether the individual is an employee or independent contractor, and the employer will have the burden of establishing that the individual is not an employee.
- Consider the costs associated with hiring the worker as an employee, including employment taxes, unemployment insurance taxes, workers' compensation considerations, benefits, vacation pay, sick leave obligations, etc. Some estimate that employing a worker may cost the employer 20 to 30 percent more than if the individual is retained as an independent contractor. Out-of-state companies will also want to consider morale and other issues associated with classifying a worker as an employee in California but not doing so for workers providing similar services outside of California.
- Appreciate the risks associated with not hiring the worker as an employee, including exposure to individual, class, and/or California Private Attorneys General Act (PAGA) wage and hour lawsuits over employee status, back pay, overtime, meal and rest period violations, paystub violations, interest, penalties, etc. In addition, employers should consider potential liabilities associated with the failure to withhold or pay state or federal employment-related taxes.
- Establish controls or procedures to ensure that before the company engages a contractor it has considered whether the worker can be safely classified as an independent contractor. Also, educate hiring managers as to the requirements of establishing independent contractor status.
- Review existing consulting or contractor agreements to ensure that they help advance the employer's position that the worker is indeed an independent contractor.
- When considering reclassifying independent contractors as employees, assess the litigation and retention risks associated with doing so.
- Consider the use of a professional employer organization (PEO) to supply workers that the company previously engaged as contractors, or that it now wishes to furnish services as as non-employees of the company, temporarily or for longer periods, but recognize the joint employment risks that accompany such a decision. Pay close attention to how responsibilities are allocated as between the company and PEO, and ensure that the company is properly indemnified.
- Where permitted (especially given the current legal and workplace environment regarding arbitration), consider adding mandatory arbitration and class action waiver provisions in employment and contractor agreements. Where an arbitration agreement already exists, but does not include a class waiver, consider adding such a waiver. An arbitration clause that includes a class waiver may decrease the likelihood of having to defend against such a class action as recent decisions suggest that employers will be able to enforce such waivers.4 Notwithstanding, California employers should note that agreements waiving the right to bring representative claims under PAGA are unenforceable under existing California law.
- Recognize that classification issues will become more significant in M&A and financing transactions. Employers with many independent contractors (or who rely on such contractors as part of their business model) should anticipate scrutiny by potential acquirers or investors, and acquiring companies should pay close attention to independent contractor issues in due diligence, and secure appropriate reps, warranties, and indemnities as part of the transaction.
- Take disputes with contractors seriously. Where risk of misclassification is high, employers should consider resolving the dispute early and securing a properly drafted release. Similarly, employers should not take agency claims or inquiries for granted as these may escalate into full-blown audits, PAGA lawsuits, or class action matters. Again, where the risk of misclassification exists, consider an early amicable resolution.
In taking these steps, employers should consult with counsel to ensure proper consideration of the relevant legal requirements and risks.
