Worker Misclassification – The Next Big Legal Concern?

Originally published June 22, 2007

Clients frequently ask their counsel: What is the next legal issue that should concern me because of its effect on the way my company conducts business? Worker classification is an answer to that question, and it could soon become a very big issue.

On June 9, 2007, in an article published in the New York Times by Steven Greenhouse, New York Governor Eliot Spitzer announced his intention to "step up enforcement against companies that illegally misclassify workers as independent contractors" rather than employees. The focus on this issue is not new. Rather, Governor Spitzer is joining what appears to be a growing "worker misclassification" movement. Federal and state agencies are auditing, examining and/or litigating against companies — across a variety of industries — claiming that their classification of workers as independent contractors is erroneous. The scrutiny on the classification issue has even reached congressional levels.

On May, 8, 2007, the House Committee on Ways and Means held a hearing on the effects of misclassifying workers as independent contractors. This hearing partially focused on a report from the Government Accountability Office that noted the Department of Labor (DOL) is failing to track the instances in which it refers worker misclassification cases to other agencies and is missing opportunities to address other instances of potential misclassification. Part of the solution to the misclassification problem discussed at the hearing was intensifying oversight responsibilities by DOL. The increased focus on misclassification by federal and state agencies should be a concern for any client who uses independent contractors as part of its workforce.

Attacks on the contractor model (i.e., the reliance on an independent workforce to conduct business) focus on indicia of control over the manner and means of a contractor’s performance of his or her services. Independent contractors are supposed to be skilled individuals who perform services for companies without being subject to control over the manner and means in which their services are performed. Employees, on the other hand, often lack specific skills and are

told specifically how their work is to be performed (including the hours, pace, place and nature of their work). Problems arise when the lines distinguishing "control" over desired results, which is generally acceptable in a contractual relationship, and "control" over the manner and means of performance, which is unacceptable, become blurred. When companies blur these lines, their contractual relationships become susceptible to attack. In recent years, the contractor model has been attacked by:

• The National Labor Relations Board;
• State agencies that administer workers compensation or unemployment compensation;

• The Internal Revenue Service;
• Disgruntled contractors;
• Plaintiffs’ lawyers; and
• Labor unions.

These agencies, groups and individuals are attacking the contractual relationship and seeking reclassification of contractors as employees based on allegations that companies are exerting control over:

• Contractors’ time and schedule (i.e., the time contractors start their work day, finish their work day, take their lunch and even take their breaks);
• The person(s) or client(s) with whom contractors will be working or are allowed to use to assist the contractors in the completion of their work; and
• Contractors’ methods for performing their work (i.e., how the contractor will service a client or complete a task).

In addition to identifying issues of control over the manner and means of performance, attacks on the contractor model focus on whether contractors: are provided training (or familiarization), work solely for one company, have incorporated their businesses, supply their own tools or equipment, wear uniforms, are given paid leave, have a limited term of relationship or can be terminated at will, and/or have an opportunity to increase their profits or incur losses. Depending on the answers to these issues, it is possible that a regulatory agency or a court may conclude that an employer-employee rather than an independent contractor relationship exists.

Misclassifying workers leaves companies exposed to increased government scrutiny, significant liability and a reduction in productivity. Federal and state agencies’ and private litigants’ attacks on the contractor model increase companies’ exposure by making them susceptible to:

• Claims for back taxes such as federal payroll taxes (i.e., social security and Medicare) and state taxes;

• Claims for back benefits (like health insurance) that the previously classified contractor paid himself or herself;

• Claims for back pension contribution or profit sharing that the previously classified contractor did not receive;

• Potential large fines from federal and state agencies;

• Increased tort liability under the theory of respondeat superior (a legal doctrine holding employers responsible for the actions of their employees), which typically does not apply to independent contractors;

• Increased liability arising from suits alleging intentional misclassification in which punitive or treble damages are available; and

• Increased or new organizational efforts from unions.

The result of this increased exposure is a loss of the competitive advantage gained from using an independent workforce if contractors are reclassified as employees (meaning a company will have higher fixed costs which translates into lower profits). The increased exposure and potential reclassification also would cause a diversion of resources (monetary and human capital) to address problems associated with the misclassification rather than growing the business.

The misclassification issue is here to stay, and attacks on the contractor model will likely continue to increase for one reason: money. The desire to raise revenue or obtain damage awards attracts those who attack the contractor model, including government agencies, disgruntled contractors, plaintiff attorneys, and unions. Yet, they are attracted for different reasons.

First, as the Times article notes, federal and state governments are attracted to this issue because they are losing hundreds of million of dollars in lost tax revenue as a result of the erroneous classification of workers. Federal and state governments’ tax, treasury and labor departments are deploying significant resources to develop audit plans and enforcement strategies to collect the taxes to which they believe they would have been entitled but for the misclassification. State governments are also looking to their respective legislatures to clarify the definition of employee and independent contractor.

Second, disgruntled contractors are looking to profit from classification challenges. These contractors, if reclassified as employees, may stand to gain from judgments or settlements for lost overtime pay and the expenses of providing their own benefits (like insurance) and even retirement contributions or lost stock options that might have been provided to the contractor’s employee counterpart. Throw punitive damages into the mix and the contractor has significant reason to challenge the model.

Third, the plaintiffs’ lawyer also sees worker classification as a potential source for a pay day. Because the contractor model is generally applied to all workers in an enterprise who perform the same function, challenges to classification usually involve a group of workers who were similarly classified. The plaintiffs’ lawyer typically challenges the contractor model by class action, hoping to recover substantial attorney fees.

Finally, labor unions also see an opportunity in the classification issue to organize and obtain new members. Increased membership translates into increased dues for unions. In fact, unions sometimes work hand-in-hand with the plaintiffs’ lawyer to find the best client(s) to challenge the models.

In light of the significant opportunity for monetary gains for federal and state governments, employees, plaintiffs’ lawyers and unions, it is likely that scrutiny of worker classification will continue to increase.

Many industries are potential targets for claims of worker misclassification. As the Times article noted, Governor Spitzer previously targeted grocery companies, and the article also noted that construction and package delivery companies are susceptible to classification challenges based on those industries’ heavy reliance on independent contractors. Even Microsoft was involved in a high-profile challenge to its worker classification. Defense companies could face similar challenges given their utilization of contractors for projects; home service industries could face challenges given their reliance on contractors to conduct product installation or repairs; multi-level marketing agencies could face similar challenges based on their utilization of

contractors to sell products; and the list goes on. Simply put, worker misclassification cuts across industries affecting any company using a contractor workforce.

Perhaps the type of business most vulnerable to the misclassification challenge, however, is a financial services company. Financial services companies may be vulnerable because they have regulatory responsibilities that require control over the behavior of their broker-dealers and registered representatives, which in turn cause these companies to exert control over the day-to-day manner and means of the performance of their brokers and registered representatives notwithstanding their classification as independent contractors. In many instances, the regulations do not even distinguish employees from contractors. Websites exist, like http://www.armydiller.com/financial-scam/ic.htm, that identify the independent broker-dealer and registered representative relationship as one steeped in fraud. These same sites solicit workers to join the fight against financial services companies’ alleged classification fraud and may lead to cases similar to the recent case of Havel v. Sun America Securities Inc., 2006 WL 2917591 (N.D. Cal), in which the classification of registered representatives as independent contractors is being challenged.

Worker classification is a multifaceted issue that requires a multifaceted legal response. The issue implicates tax and labor law expertise and litigation specialties. In the financial services sector, the issue also requires the necessary regulatory background. Sutherland Asbill & Brennan’s legal team not only possesses the experience, specialties and background needed to address this dynamic issue, but also has been closely monitoring the trends in this arena and is experienced in identifying the problems associated with worker classification. Perhaps more important, Sutherland has worked with clients to find creative solutions to stymie attacks on their contractor model and take remedial steps to strengthen their contractor model to protect them from pending, potential or future attacks. Defending the contractor model is not impossible (or even difficult for that matter), but taking action before challenges arise places companies in the best position to defend their contractor model when challenges do arise. In this area, an ounce of prevention does equate to a pound of cure.