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Your Grand Plan for Incentive Compensation May Yield a Grand Lawsuit

May 1, 1997
Related Topics: Variable Pay, Finance/Taxes, Recognition, Featured Article
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It's no longer a trend: Incentive compensation is now a business fact. In an era that reveres productivity over seniority and results over hours clocked, the use of incentive compensation is crucial to many companies' success. Unfortunately, it's also the cause of many employees' disappointments, gripes—and grievances. That's right, incentive compensation brings with it higher risks for lawsuits, as employees realize what they hope to see in their paychecks isn't always what they get.

Alan L. Sklover maintains his own New York City-based legal practice, concentrating on representing executives in employment, compensation and severance issues. Here, Sklover covers the four primary ways employees become entitled to incentive compensation-which in turn entitles employees to take errant companies to court. He also offers insight into the risks employers face in executing the three most common forms of incentive compensation: discretionary, fixed figure and formula-based.

To begin with, can you explain the law relevant to incentive compensation?
People aren't entitled to a bonus by any certain magic—there has to be a basis for it. Sometimes people say, "But [the company] always gave out bonuses." Well that doesn't mean it always has to. There has to be a reason someone is entitled to something. The primary ways in which a person becomes entitled to incentive compensation are: express agreements, agreements implied by circumstances, discriminatory treatment or gross disparity.

Let's start with express agreements-can you explain their basis?
Express agreements mean: "That's what I was promised. [My boss] expressly said to me this is what I'd get." In almost all areas of life, oral agreements are just as good as written agreements. An oral agreement is an expressed agreement. The only problem with oral agreements is proof—the reason [lawyers] always say "get it in writing" is to have proof. [But] either oral or written, if someone was promised something, the person should get it.

What's the law concerning implied agreements?
Implied agreements are like this: Consider going to a restaurant or getting into a cab. You never say, "Oh, I promise you I'll pay," after eating in a restaurant. But if you don't pay, you'll get arrested because from the circumstances there's an implied promise. Example: The employer says, "We never told you we'd give you the $400,000. We only said you could reasonably expect it." Well that doesn't pass the laugh test. Very few people would go from a job paying $300,000 to one paying $100,000 [unless the employee truly believed he or she would receive a bonus making up the difference].

What's the legal basis for a suit based on discriminatory treatment?

[That] there's treatment based on motivations that are illegal. [Lawyers] tend to see a lot of situations in which all the men got twice the bonuses of all the women, without any other reason to explain it. I've had people say to me, "But men have families to feed." It's the notion that men are breadwinners, and women work for extra clothes money. Or [discrimination is seen in the attitude that] older folks don't seem to need the money as much as younger folks do—as much as this person with two kids in college. [Companies] can't do that. They have to have some acceptable motivation for differences in treatment. That's sometimes the basis for disputing or making a claim on an incentive compensation bonus payment that an [employee] finds to be unacceptable.

And finally—can you explain gross disparity?
Sometimes there are tremendous differences between what was expected [by the employee] and what was given [by the employer]. It's just so out of line when a senior vice president gets a bonus of $1.5 million and everyone else gets $200,000. It just shocks the conscience—there's something wrong.

Let's move into the actual types of plans: discretionary, fixed figure and formula-based. Can you describe what a discretionary incentive plan looks like?
Example: [An employer says,] "We can't tell you what to expect with this particular bonus. Depending on what you do in the company and how happy we are with you, you may get zero bonus or you may get a tremendous amount. It's in our total discretion."

And what's fixed figure?
A fixed figure is [a plan] in which, for example, someone is hired on and told the base salary is $50,000 and they [employee] can rest assured the bonus will either be $10,000 or $15,000. Frequently, depending on the industry, the bonus is far in excess of the salary.

How about formula-based plans, how do they work?
Formula-based plans are increasingly common. Example: If an employee's sales amounts for the year are a certain figure, he or she will get, say 2 percent of that. If [the employee's sales] exceed a certain figure over that previous figure, he or she will get 3 percent of that. There are a variety of formulas. Sometimes they're tied to the stock price; sometimes they're tied to the individual's performance. But they're basically something mathematical.

Let's take discretionary: Why do companies use it, and what are its legal disadvantages?
If I had to give my idea of the motivations involved, I believe that most companies think discretionary carries the biggest carrot—that if people don't know what they're going to get, they'll try real hard all year to make their managers happy. Paradoxically, I think it causes the most anger. People tend to believe what they want to believe. They look around, and the company seems to be doing well, so they think it's going to be a great bonus year.

Do the risks of using a discretionary plan outweigh the benefits?
Employers think it's a big motivator. From my point of view, it's the worst way to go, in that it very much tends to cause disputes and to hurt morale.

I teach courses in employment relations, and there's something I call the Three Cs, which is the [fact that] the healthiest employment relations tend to have three things: clarity, commitment and sense of community. Discretionary incentive compensation programs don't have any of those. They don't have clarity—who knows what anyone is going to get? They don't have a commitment—[employers can change their minds about bonuses up to the last minute]. And they don't always have a sense of shared community—[some employees could unfairly receive better bonuses than others]. I look for those three ingredients in any of these plans. They often show you which ones are the best.

So discretionary plans are troublesome for employers who play games with bonuses—or for all employers?
I truly believe they're an overall negative in employment relations. Unquestionably, they bring up the most lawsuits. [An employee] goes to an employer and says, "You think I could get as much as $70,000 this year?" The employer says sure—and that number gets locked in there. [Employees] pick up sometimes even unintended messages—a positive memo about how well the company is doing, for example. Or if they work for a public company, they see the stock price is doing well. All those things tend to encourage employees' beliefs that they're going to be getting what they believe they were told they were going to be getting. If the employees don't, they feel a big breach of trust. I think [discretionary plans] are a big negative in the workplace.

Using discretionary plans is the worst way to go. It very much tends to cause disputes and to hurt morale.

When an employee does bring suit because of a discretionary bonus, what's usually the complaint?
It's usually tried as a breach-of-contract or broken-agreement case. [The employee says:] "I was led to believe... " "I relied on the promises." Employers say, "We never guaranteed it." So what we have is a case of, "You told me ... " "No, I didn't."

What about fixed-figure plans—any legal problems there?
Fixed-figure plans are historically the most common. [The employer tells the employee:] "You can expect a salary of $35,000 and a bonus of between $10,000 and $15,000 come [year-end]." The only real concern with these plans is if there are any conditions associated with them, or if they're not given out as promised. Sometimes companies don't truly make the commitment. They say this job "should" get or things like that. But the fixed figure is the simplest.

What spurs suits in fixed-figure plans?
They tend to yield the smallest number of disputes because they're relatively simple in their approach... If disputes arise, it's because of unknown or unanticipated conditions—like an employee has to be employed on the [bonus] day. When people take jobs, they're like tourists. New people are walking around in a cloud. They may have been told bonuses are given January 15 for all people working that day, but they may not realize that's a big condition.

So what would be your recommendation to employers choosing a fixed-figure plan?
I believe that in the whole [incentive-compensation] area—especially fixed-figure plans—the fairest thing would be pro rata. If an employee was there for 95 percent of the year, the employee should get 95 percent of the bonus. That would show commitment.

Finally, what are the issues surrounding formula-based plans?
The formula-based plans, if they're relatively clear and if they're based on objective criteria, shouldn't have problems... I love formula-based plans. They're intuitively my favorite kind because formulas can be set up that are very much win-win. For example, a very simple one: For every dollar rise in the stock price, employees will receive a $10,000 bonus. That's very easy—employees look at the stock price on January 1. They look at it December 31. Everybody hopes the stock does well, and if the stock goes up, the shareholders are happy, the senior managers are happy and the employees are happy. Everybody's happy.

Are there any pitfalls?
There are some formulas that are so obtuse that I've had arbitrators or judges throw up their hands and say, "I have no idea what [the company] meant by this, maybe we should hire a mathematician." They make you very skeptical. The formulas make [employees] doubt there was ever really an intention to pay a bonus.

What kinds of lawsuits can these plans bring?
In formula-based plans, the disputes tend to come up primarily in miscalculations or miscommunications depending on the formula—when it appears either the data is incorrect or has been incorrectly applied. [Formulas requiring] data in control of the employer that may be confidential or may be subjective will always hurt a formula-based plan.

Is there anything else employers should keep in mind concerning formula-based plans?
There are some negatives. One thing that's sometimes a problem: Even though the formula is applied exactly as it's supposed to be, an unusual circumstance can arise. The formula when applied may give an employee either a far greater bonus than implied or far less, like 3 cents or a million dollars, in which case one side or the other is extremely unhappy. Every once in awhile, a formula will give someone more than the CEO. That's one reason I like to set minimums and maximums on all this so no one's shocked. I encourage that.

But for the most part, formula-based plans are positive plans?
When I see something set up [to reward] a division that shows better profits—and the profits are readily discernible and clearly identifiable—it can be a real team motivator. Everyone there can be encouraged to cut down costs together. People in HR can set these up so they really make a great team. They encourage both good results and good working relationships, and that's the best thing in the world.

Workforce, July 1997, Vol. 76, No. 7, pp. 89-92.

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