New California Law Imposes Costly Risks to Companies Using Independent Contractors Supplied by Staffing and Recruiting Firms – But Risks Can Be Minimized

Pepper Hamilton LLP

On September 28, 2014, Governor Jerry Brown of California signed a bill that puts a potentially enormous liability risk on companies that use workers supplied by “labor contractors” that fail to pay all wages due the workers. Assembly Bill 1897 requires client employers to “share with a labor contractor all civil legal responsibility and civil liability for all workers supplied by that labor contractor for . . . the payment of wages and failure to secure workers’ compensation coverage . . . .”

There are three important exclusions: First, the new law covers “workers provided to perform labor within [the client company’s] usual course of business from a labor contractor.” Businesses with a workforce of less than 25 workers (including the number of workers provided by labor contractors) and businesses with five or fewer workers supplied by labor contractors are not covered.

Second, the law defines “worker” to exclude those who are exempt from payment of overtime as executive, administrative, or professional employees.

Third, the statute also specifically excludes bona fide “independent contractors” supplied by a labor contractor. However, non-exempt employees who are found to have been misclassified by the labor contractor as independent contractors are covered by the new law when provided to a client company.

The new law raises a number of questions, which we will answer below.

What does this mean for client companies in California that use staffing, recruiting, and other firms to supply them with more than five contract workers that are being paid on a 1099 basis?

Client companies that are prudent will now need to ask whether the labor contractor is treating the workers as independent contractors or employees (i.e., paying them on a 1099 or a W-2 basis) and then determine, for all workers who are being 1099’d, whether the labor contractor has properly classified them as independent contractors. This new law, therefore, is likely to propel client companies to insist that any labor contractors that provide them with contract labor have properly classified as independent contractors any workers who are being treated as 1099ers. This blog post discusses in the “Takeaways” (below) how client companies can do so effectively.

What does this mean for staffing, recruiting and other companies that provide contract labor to clients in California?

This new law puts a premium on labor contractors (i.e., firms that supply individuals to perform work for client companies) to make sure that all workers who are being paid on a 1099 basis are genuine independent contractors under California law. Otherwise, their clients will likely begin to choose competitors of theirs who are more independent contractor compliant. We discuss below in the “Takeaways” an effective means for companies, which supply 1099ers to client companies, to enhance their level of independent contractor compliance.

Does the new law include any definitions of independent contractor?

No. The law expressly notes that it does not change the definition of independent contractor under state law. As noted in a prior blog post on October 12, 2011, California enacted an independent contractor misclassification law prohibiting willful misclassification, but that law likewise does not provide a definition of who is an employee and who is an independent contractor.  California, like many states, uses a modified form of the general common law definition of “employee.”  California’s test is sometimes referred to as the “economic realities” standard, which is similar (but not identical) to the “economic realities” test used in cases arising under the Fair Labor Standards Act (the federal wage and hour law).  Although the economic realities test under California law has a similar starting point as the classic common law test  (“the principal test of an employment relationship [in California] is whether the person to whom service is rendered has the right to control the manner and means of accomplishing the result desired . . . ”), the courts in California and the California Labor and Workforce Development Agency give different weight to certain factors than do courts applying the classic common law test for independent contractor status.

While both the economic realities and classic common law tests have a number of factors to be taken into account in determining whether a worker is an employee or independent contractor – for example, the IRS maintained for years its oft-quoted “20 factor test” and the California Labor and Workforce Development Agency lists 11 factors on its website describing the “economic realities” standard – the courts applying these tests have almost universally held that no one factor is determinative under these definitions of “employee.”  Thus, because these tests are fact-specific, they can be subject to some confusion, which can result in a number of workers falling into the proverbial “gray area” between employee and independent contractor.

What workers are treated as exempt from overtime and are therefore excluded from this law?

The new law defines “worker” as excluding an “employee who is exempt from the payment of an overtime rate of compensation for executive, administrative, and professional employees pursuant to wage orders by the [California] Industrial Welfare Commission described in Section 515 [of the California Labor Code].”  Thus, the new law appears to impose shared liability for wages and workers’ compensation obligations on client companies only with respect to non-exempt employees provided by labor contractors.  Notably, one of the wage orders described in Section 515 includes, under the “Professional Exemption,” an employee in the computer software field who is paid on an hourly basis if a number of specific criteria are met; such computer software workers therefore appear to be outside the coverage of this new law.  This is important in a state such as California, where there is a heightened need for systems analysts, software designers and engineers, computer programmers, and the like. Our recent call with a government official knowledgeable about the new law indicates that it likely excludes such workers.

Are all companies that supply a client with workers considered “labor contractors” under this new law?

No. The term “labor contractor” is defined as an individual or entity that supplies a “client employer” with workers to perform labor “within the client employer’s usual course of business.” The term “usual course of business” means the regular and customary work of a business, performed at the premises or worksite of the client employer.

The term “labor contractor” specifically excludes (a) a bona fide non-profit, community-based organization that provides services to workers; (b) a bona fide labor organization (union) or apprenticeship program or hiring hall operated pursuant to a collective bargaining agreement; (c) a motion picture payroll services company; and (d) a third party to an employee leasing arrangement if the arrangement contractually obligates the client employer to assume all civil legal responsibility and civil liability under this new law.

Does the “payment of wages” for which a client employer may be liable include payroll and unemployment taxes?

Yes. The term “wages” is defined to include all sums payable to an employee or to the state based on the failure to pay wages. It would therefore appear to cover state unemployment taxes and may also cover the withholding of state income taxes in California.

Can a client employer shift its legal duties or liabilities to the labor contractor by contract; if not, can a client employer or labor contractor agree by contract to an indemnification provision?

By law, the shared wage and workers’ compensation responsibilities and obligations imposed on a client employer under the law may not be “shifted” by contract or in any other manner to the labor contractor. In other words, a client company cannot prevent itself from being sued and having a judgment against it.  However, the law expressly permits the parties to enter into contracts with indemnification provisions between them, whereby one party will become liable to reimburse the other party for their respective liabilities under the new law.

May a worker who has been denied payment of all lawful wages file a lawsuit against the client employer?

Yes, but the worker must provide the client employer at least 30 days’ notice prior to filing any such lawsuit.

What other rights does a worker have under this new law?

Like most labor and employment laws, the new law also protects workers from any retaliatory action by a labor contractor or a client employer for filing a lawsuit or giving notice of a violation to the client employer.

Does this new law have any effect on any of the types of claims or theories of liability that workers have asserted for independent contractor misclassification?

No. The law provides that the imposition of shared liability upon a client employer adds another form of relief for misclassified workers.  The law also provides that the rights, remedies, and obligations in the new law “are in addition to, and shall be supplemental of, any other theories of liability or requirements established by statute or common law.”


Staffing, recruiting, and other contract labor firms that provide workers to client companies sometimes pay the workers on a 1099 basis and sometimes on a W-2 basis.  Where the workers are paid on a 1099 basis, they are not typically paid for any overtime, not typically provided with any benefits, and typically are required to pay for their own expenses.  If properly classified as independent contractors, this treatment is permissible.  Likewise, those who retain properly classified independent contractors are not required to withhold taxes, have no payroll tax liability for such workers, and are not obligated to provide unemployment or workers’ compensation coverage.

How do client companies know whether the labor contractor has properly classified  contract workers as independent contractors?  And what can a client company do to best protect itself from this new form of “shared” liability under California law? 

One means for client companies to assure themselves that the labor contractor maintains an enhanced level of independent contractor compliance is through the use of IC Diagnostics™, a proprietary system designed to measure compliance with IC laws and provide tools to minimize IC misclassification liability.  While IC Diagnostics™ is principally designed for use by businesses that retain ICs directly, the same tools can be effective for a client company in measuring a labor contractor’s level of IC compliance.

Oftentimes, even a quick review of a labor contractor’s IC agreement will reveal the general level of its IC compliance, determined in accordance with the applicable state and federal laws.  Labor contractors that use 1099ers to furnish services to client companies should be favored if their IC relationships, both by contract and in actual practice, reflect a heightened level of IC compliance.  Those labor contractors that have a diminished level of IC compliance should be disfavored by client companies, especially in California, given the enactment of the new law.

Almost all IC relationships can be enhanced to a considerable degree.  Therefore, client companies can insist that their labor contractors enhance their level of IC compliance if they wish to continue to do business with the client.  Client companies can also demand indemnification provisions in their agreements with labor contractors; however, indemnification clauses cannot alone minimize the likelihood that the client company will be sued for shared wage and workers’ compensation liability if the labor contractor has been misclassifying its workers as ICs.  The combination of improved IC compliance by the labor contractor and insistence on a suitable indemnification provision is a prudent approach for client companies to avoid exposure to this new liability under California law.

How can labor contractors that provide 1099ers to client companies enhance their level of IC compliance and gain a competitive advantage in California over those firms that are not IC-compliant?

Labor contractors can use IC Diagnostics™ to obtain a competitive edge over other labor contractors if they use that process to heighten their level of IC compliance in comparison to their competitors.  Enhancements in IC compliance can be achieved by the use of informed restructuring, re-documentation, and/or re-implementing of the IC relationships with the labor contractor’s 1099ers, using state-of-the-art tools.

Ideally, such IC enhancements are accomplished before a client company demands them as a condition of continuing its relationship with the labor contractor.  Such firms can also use their heightened level of compliance as a client retention tool with existing client companies, a marketing tool with potential new clients, and of course a means to reduce their own potential for IC misclassification liability.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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