California's Supreme Court has issued a decision making it harder for companies to classify California workers as independent contractors. In Dynamex Operations West, Inc. v. Superior Court,¹ the court adopted a broad definition applicable to determining when a worker is an employee under California's wage orders. The court's decision establishes that the hiring entity (i.e., the company) has the burden of proving the worker is a contractor² and not an employee. The court further explained that a worker can only be a contractor if: (a) the worker is free from the control and direction of the hiring entity in connection with the performance of the work; and (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.

Given that the number of U.S. workers working as contractors is estimated to be in the tens of millions, the court's expansive definition of employee status will likely call into question the current classification of many contractors, and as a result increase the number of lawsuits in which workers allege that a putative employer has misclassified the worker as an independent contractor. Government audits may also increase, especially at the state level. Dynamex is part of a trend, in California and nationwide, challenging companies' purported overuse of independent contractors.

While by no means alone, start-ups and technology companies are particularly fond of using independent contractors. Because of the perceived administrative burdens and higher costs associated with hiring employees, as well as the desire to maintain flexibility, such companies often make extensive use of independent contractors. For these companies in particular, Dynamex should serve as a wake-up call and a reminder that in California and elsewhere, there are substantial risks associated with misclassifying workers as independent contractors instead of employees.

The Issue Presented in Dynamex: What Standard Applies Under California's Wage Orders to Determine Whether a Worker Is an Employee or an Independent Contractor?

In Dynamex, two individual drivers filed a class action against a nationwide package and document delivery company, Dynamex Operations West (Dynamex). The drivers claimed Dynamex misclassified its delivery drivers as independent contractors instead of employees, and that as a result, Dynamex engaged in unfair competition and violated various sections of California's Labor Code. Although Dynamex had previously classified the drivers as employees, it later re-classified them as contractors pursuant to a new company policy and entered into agreements with the workers that stated that each was a contractor, not an employee.

The plaintiff drivers in Dynamex alleged that after their reclassification, they performed essentially the same tasks in the same manner as when Dynamex initially classified them as employees. They also claimed that as a result of their misclassification as independent contractors, Dynamex failed to comply with requirements imposed by the California Labor Code and the California wage order that applied to their industry.

The central issue in Dynamex was whether in deciding to let the case proceed as a class action, the lower court used the correct definitions of the terms "employ" and "employer" to decide whether a worker is properly classified as an independent contractor under California Wage Order # 9, the wage order in question. As generally used in California's industry and occupational wage orders, the term "[e]mploy" means "to engage, suffer, or permit to work," while the term "employee" means "any person employed by an employer."³ The wage orders set forth significant obligations on employers of employees (as opposed to independent contractors), including but not limited to, requirements regarding minimum wage, overtime, pay records, and meal and rest periods.

Dynamex argued that the lower court was obligated to use the more familiar multi-factor test for determining employee status outlined by the California Supreme Court's nearly 30 years ago in S.G. Borello & Sons, Inc. v. Department of Industrial Relations.⁴ Unfortunately for many companies, the Dynamex court disagreed.

The Court's Decision

In a unanimous decision, the court rejected Dynamex's argument that in deciding whether a worker is an employee or an independent contractor, the lower court erred in using the "suffer or permit to work" part of the wage order's definition of "employ." It specifically rejected the contention that the court was obligated to follow the multi-factored control test set forth in Borello. The court explained "that the wage order's suffer or permit to work definition must be interpreted broadly to treat as 'employees,' and thereby provide the wage order's protection to, all workers who would ordinarily be viewed as working in the hiring business."⁵ It noted that its decision was consistent with its 2010 decision in Martinez v. Combs.^6,7

The court concluded that the "suffer or permit to work" standard was both relevant and significant in assessing who should properly be treated as an employee, rather than an independent contractor, under the wage order in question. It noted that the federal law Fair Labor Standards Act had long used a broader standard of employment in the wage and hour context and that such an expansive definition of the employment relationship was consistent with the salutary purposes of such legislation (e.g., protecting employees with less bargaining power, ensuring the payment of minimum wages, and advancing the health and safety of workers). The court also expressed its belief that adopting the broader standard would help ensure that responsible companies (those the court characterized as law-abiding businesses that comply with their wage order obligations) are "not hurt by unfair competition from competitor businesses that utilize substandard employment practices."

In the end, the Dynamex court concluded that the hiring entity has the burden to establish that a worker is an independent contractor and not an employee covered by a wage order. Even more important, the court emphasized that in order for the hiring entity to meet this burden, it had to establish each of the three factors embodied in the so-called ABC test—specifically:

1. that the worker is free from the control and direction of the hiring entity in connectionwith the performance of the work, both under the contract for the performance of the work and in fact; and
2. that the worker performs work that is outside the usual course of the hiring entity's business; and
3. that the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.⁸

If a hiring entity fails to establish each of the three requirements, this establishes that the worker is an employee under the wage orders and not an independent contractor.⁹

Practical Impact of Dynamex: What Should Employers Do Now?

As a result of Dynamex, California companies making use of independent contractors must take steps to minimize the risks associated with misclassifying workers as independent contractors. Moreover, employers everywhere should appreciate that Dynamex will likely have nationwide ramifications. In particular, Dynamex is part of a trend (especially in the states), and it serves to shine a light on the independent contractor misclassification issue. For example, in taking steps to ensure compliance with applicable California law, a New York or Washington company will likely want to evaluate the extent to which it is properly classifying its workers as independent contractors under applicable state and federal law. Employers would be well advised to remember that a single claim with a state agency can trigger a full-scale audit of service providers classified as independent contractors in the past several years. (Often such audits are triggered when an independent contractor applies for unemployment insurance, or files a wage claim, following the conclusion of the contractor relationship.)

To minimize the risk of employee misclassification and potentially expensive individual, representative, or class actions brought by workers misclassified as contractors, employers should, at a minimum:

1. Understand the legal risks associated with the misclassification of contractors. In addition to the potential tax liability for failing to pay various state and federal employment-related taxes, misclassification often results in numerous wage and hour violations (e.g., minimum wage, overtime, meal and rest period, failure to pay final wages on a timely basis). In addition, Labor Code Section 226.8 makes it unlawful to willfully misclassify an individual as an independent contractor. Stiff penalties attach to such violations, including pattern and practice violation civil penalties of not less than $10,000, and not more than $25,000 for each violation, in addition to any other penalties or fines the law permits. Finally, in certain circumstances, misclassification mistakes can form the basis of individual liability claims—especially in the distressed company setting. (This means in certain situations, officers and directors of a company may be found personally liable for misclassification claims.)
2. Ensure that HR and other managers, decision-makers, and personnel involved in the process of engaging contractors sufficiently understand, through training or otherwise, how to properly classify workers, including the legal standards applicable to the analysis. After Dynamex, and especially for California workers, sole reliance on guidelines such as the IRS "20-factor" test will likely result in classification problems. Similarly, managers should understand that reclassifying a contractor as an employee may raise questions as to whether the worker was properly classified in the first instance, and in some instances result in legal action.
3. Take steps to ensure that those workers the company has retained as contractors (as well as those it will retain in the future) are correctly classified. Where the new, more stringent, Dynamex test suggests that a current contractor is misclassified, take immediate steps to reclassify the worker. Consult with counsel to minimize the risks associated with doing so.
4. Review form contracts used with contractors. While a contract's language will not ultimately determine independent contractor status (as Dynamex makes clear), it may nevertheless be relevant to the analysis and helpful in establishing a contractor relationship. Companies should review any such form agreements with counsel.
5. While the U.S. Supreme Court shortly will address this issue, employers should consider adding mandatory arbitration and class action waiver provisions in employment and consulting 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 getting hit with such a class action as recent decisions suggest that employers will be able to enforce such waivers. Notwithstanding, California employers should note that agreements waiving the right to bring representative claims under the California Private Attorney General Act (PAGA) are unenforceable under existing California law.
6. 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 for granted as these may mushroom into full-blown audits, PAGA lawsuits, or class action matters. Again, where the risk of misclassification exists, consider an early amicable resolution.