Countering the risk of misclassification with proactive planning
By: Larry Steinberg and William Miller, Guest Contributors
In early 2021, a client of the Buchalter law firm received a notice from California’s Employment Development Department (EDD) that the EDD was conducting an audit to determine whether the client’s independent distributors were properly classified as independent contractors, instead of employees.
Though, over the years, the firm has handled scores of such audits on behalf of its clients, this was the first time the firm handled an audit which targeted a client that used a multilevel-marketing model. What also contributed to the unusual nature of this particular notice is that this client is based outside of the State of California.
While the client has no employees in California, and only a handful of non-distributor independent contractors, it does have thousands of independent distributors based in California.
The ostensible purpose of the EDD audit was to determine whether the client was properly paying all of its state payroll taxes, but the company and its counsel immediately understood that if the EDD decided the company’s distributors were misclassified employees, such a finding could have broad-ranging implications—including the possibility of a flurry of tagalong litigation, such as class actions and representative claims under California’s Private Attorney General Act
Unique Dangers That Come with a Government Challenge
At the outset, it should be said that having a government agency allege that your independent distributors are misclassified is daunting, and can be even more of a threat than a private lawsuit. When a misclassification allegation is made in a lawsuit, it is often made in tandem with other claims, and there is an opportunity to settle the lawsuit on favorable terms without needing to directly address or resolve the independent contractor issue.
By contrast, an EDD audit that addresses the client’s (and the industry’s) entire business model would present a very limited opportunity (if any) to settle the misclassification issue. As a result, a government inquiry into whether a company is misclassifying distributors as independent contractors can present an all-or-nothing proposition.
What follows is a brief description of the steps that Buchalter and its client took to successfully defend the audit, which, happily, resulted in the EDD closing its file without further action.
This particular EDD audit, like all that the law firm has been involved with in the past, began with a broad set of EDD document requests that needed to be responded to. It is important during this process to be as cooperative and transparent as possible. In the stated case, these requests included: copies of all IRS Form 1099s issued by the client during the past three years, the client’s detailed general ledger, licenses, check registers, and other related items, copies of distributor agreements, and policies and procedures. Depending on the auditor, some of the requests can be negotiated and narrowed with respect to time and scope. That being said, the burden is on the company to provide a clear and consistent accounting of how it is paying its distributors as independent contractors. As a result, keeping and maintaining these records in an easily accessible format is important.
After documents are produced, the auditor will set up an interview with the company and its attorneys. This interview, and the discussions leading up to it, are crucial. This is the company’s opportunity to educate the auditor not only on the specific facts regarding the company’s decision to classify its distributors as independent contractors, but also to educate the auditor on the direct sales model, and the relationship between the company and its distributors.
Educating Auditors About Unique Aspects of Network Marketing
In the case at hand, it was explained to the auditors that the client is a network marketing company with a multilevel compensation plan, and the auditor was educated on the MLM business model. The auditor was also provided with the client’s policies and procedures and independent distributor agreement.
It was important to show the auditor that the relationship between the company and its distributors was governed by a contract, and the business itself operated under policies and procedures that also defined the relationship.
As this matter was in California, it was necessary to discuss with the auditor the inapplicability of California’s current AB5 legislation, now California Labor Code § 2750.3, (which changed the general independent contractor test to the “ABC Test”) and to discuss the “direct seller” exemption that, in the client’s view, clearly applied to the client’s distributors. (See Cal. Labor Code § 2750.3(b)(5))
As a result, the client and counsel successfully argued that the inquiry into whether the client’s distributors qualified as independent contractors in California is governed not by the stringent ABC Test contained in AB5, but by the multi-factor test first enunciated in S.G Borello & Sons v. Dept. of Industrial Relations, 48 Cal.3d 342 (1989)—commonly referred to as the Borello Test.
Preparing for the Client Interview
In preparation for the EDD audit interview, it is important to work with the client to prepare a detailed outline describing why the client’s independent distributors met all of the factors to be considered independent contractors in California. The outline that the law firm typically used for other EDD Audits needed to be substantially modified to address the specifics of the relationship between the network marketing company and its MLM distributors. This outline was then provided to the auditor as a reference during the client interview.
The audit interview is generally conducted over the phone and will include the company’s representative (in this case, the client’s chief operating officer), in-house counsel, and outside counsel.
During the interview, the auditor asks a host of very specific questions regarding the company’s practices. (In some cases, if asked, some auditors will supply, in advance of the interview, a list of the questions the auditor intends to ask the client. In the stated case, to the client’s pleasant surprise, the auditor provided a comprehensive list of questions, which was of inestimable value in preparing the client for the EDD interview).
In the case at hand, less than a month after the interview concluded, the client was informed that the EDD had agreed with the client’s position that its distributors were properly classified as independent contractors, and closed its audit without making any change or reclassification. Predictably, counsel and the client were very pleased with the result. Had the EDD auditor concluded differently, the client was looking at the specter of years of appeals and collateral litigation, at great cost and risk.
The potential for state and federal audits regarding the misclassification of distributors and employees is a threat that exists, to varying degrees, in every state. To see the potential impact of these allegations, one need look no further than the adverse decision in litigation between the state of Oregon and the multilevel-marketing company ACN. In that case, the Oregon Supreme Court found that ACN’s distributors were misclassified employees.
A Balancing Act Between Robust Compliance and Too Much Control
As every network marketing legal department is well aware, there is a constant balancing act between exercising necessary and vigorous compliance oversight over distributors, on the one hand, and avoiding the exercise of what may be deemed to be the “control” that could cause a government agency, judge, or arbitrator to determine that a company’s distributors are misclassified employees.
To combat these threats, it is essential to have policies and procedures that detail the role of a distributor as an independent contractor, clear and consistent accounting for all of the distributors that are classified as independent contractors, and to be able to access all of that information easily.
A company should work with its legal counsel to develop a detailed fact-based outline describing, under the relevant state and federal factors, why it believes each of its distributors are independent contractors. This process will allow the company to identify and address any factors that may present challenges during a government audit or lawsuit, and to make any necessary adjustments to the contractual relationship between it and its distributors.
These steps will hopefully help any company achieve a positive outcome if its classification of its distributors as independent contractors is ever challenged.