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Vizcaino v. Microsoft Corp.: The Exception Which Proves the Rule that Employers May Exclude Temps and Freelancers from Benefit Plans, But Only If They Do It Right

December 31, 2000

Introduction

Many managers choose to avoid the impact of head count limitations on short-term, labor-intensive projects by hiring independent contractors to help get the job done. Later, they may overlook their initial intent to dismiss the temps at the conclusion of the original assignment, with the result that many temps stay on indefinitely, working side-by-side with regular employees, but compensated differently, with few or none of the benefits that regular employees enjoy. Many employers, appreciating the flexibility that freelance employees provide in enabling them to fine-tune the size of the workforce to meet the needs of the business, utilize a freelance or temporary employee program as a matter of ongoing policy, taking freelancers on and dismissing them as the needs of the business require, wholly apart from the quality of any individual's job performance.

These situations -- all of them quite common -- carry potentially expensive legal implications for employers. The highly publicized Vizcaino v. Microsoft Corp., 120 F.3d 1006 (9th Cir. 1997), cert. denied, 522 U.S. 1098 (1998), involved a class of freelancers who worked for Microsoft, sued for participation in the various Microsoft benefit plans (including its stock option plan) during their tenure as freelancers, and recently garnered a settlement that is going to cost Microsoft $96.9 million. Microsoft has placed a sharp focus on the question of whether freelance and temporary employees are entitled to participate in an employer's benefit plans, and if so, under what circumstances. That case made many employers acutely aware that an extensive freelance program can result in unexpected and very substantial liability for employee benefits to people the employers believe are independent contractors. And in the wake of Microsoft, many plaintiffs' lawyers look for ways to assert claims for benefits for their freelance clients.

Properly understood, however, Microsoft is the exception that proves the rule. And that rule is this: ERISA accords employers broad sway in determining who will be entitled to participate in their benefit plans. The only provisions contained in the Employee Retirement Income Security Act ("ERISA") that pertain to who is entitled to participate in an employer's benefit plans are that (a) the person must be an "employee" and (b) the employee may not be excluded from participation because of age or length of service (unless his or her age is less than 21 and he or she has been employed for less than a year). Within these limitations, an employee's eligibility to participate in a benefits plan is determined solely in accordance with the eligibility provisions set forth in the relevant benefit plan's "Plan document" or in its Summary Plan Description ("SPD"). Notwithstanding the decision in Microsoft, therefore, an employer may exclude or include temps, freelancers, and independent contractors from its benefit plans as it deems most advantageous to its organization -- if the employer decides what it wants to do as a matter of policy, if the Plan documents for benefits that are governed by ERISA are consistent with those policy choices, and if the employer tells those who are affected (which, in the case of ERISA plans, is done in an SPD).

How the Microsoft Case Arose

By the 1980's, when Microsoft was growing by leaps and bounds, it had augmented its regular workforce with thousands of "freelance" workers. Those workers were engaged pursuant to agreements by which they acknowledged that they were independent contractors who were not entitled to participate in any of Microsoft's employee benefits, including vacation pay, sick leave, holiday pay, health and life insurance, the 401(k) plan, and the Employee Stock Purchase Plan (the "ESPP") (under which employees were permitted to purchase stock at a 15% discount from the market price in certain quantities and at certain times). The agreements also provided that since the freelancers were not employees of Microsoft, neither income tax withholdings nor FICA (social security) contributions would be deducted from their paychecks. Microsoft paid them out of its accounts payable department on the basis of invoices they submitted. Many of these freelance workers were paid more than Microsoft employees who did similar work, in part to compensate for the fact that they did not receive benefits. Generally, they worked shoulder-to-shoulder with regular employees, performing the same functions, often supervised by the same supervisors.

In 1988 and 1989, the IRS conducted an audit. It concluded that Microsoft's freelance workers were, in fact, common law employees within the meaning of the Internal Revenue Code, and that Microsoft should have deducted income tax withholdings and FICA contributions from their paychecks. (The fact that they performed the same work as regular employees, under the same conditions and often under the same supervision, was the most significant factor in its analysis.)

Soon thereafter, the freelancers filed a class action lawsuit, in which they claimed that since they were employees, they were entitled to the benefits that were available to regular employees. The district court granted Microsoft's motion for summary judgment, largely on the strength of the independent contractor agreements which explicitly provided that freelance workers were not entitled to benefits. On appeal, the workers did not attack the dismissal of their claims for vacation pay, sick leave and the like. Instead, they focused on their exclusion from Microsoft's 401(k) plan and the ESPP plan. While there were multiple appeals, including one to the full court of the Ninth Circuit Court of Appeals (the "en banc" court), which vacated an earlier ruling by a three-judge panel of that court, this article will focus only on the ultimate holdings, and only on those issues that pertain to the design of 401(k), stock purchase and stock option plans.

The 401(k) Plan

The Microsoft 401(k) plan provided that common law employees who were "on the United States payroll of the employer" were eligible to participate in the 401(k) plan, pursuant to which Microsoft matched a portion of employees' contributions to the plan. The first question presented to the Ninth Circuit was whether it was an abuse of discretion for Microsoft's Plan Administrator to determine that the freelancers were ineligible to participate in the 401(k) plan because they had waived such participation by signing Microsoft's independent contractor agreement.

The court concluded that the IRS determination that the freelancers were common law employees, coupled with Microsoft's concession that this determination was binding in the freelancers' lawsuit, nullified the agreements. The court reasoned that since Microsoft and the freelancers had assumed that the freelancers were independent contractors when they entered into these agreements, and since the IRS's determination had revealed that this assumption was incorrect, there was a "mutual mistake of fact." It followed, in the court's view, that since the agreements were infected by mutual mistake, the Plan Administrator's determination that the agreements waived participation in the 401(k) plan was erroneous.

Notably, the court did not hold that this meant that the freelancers were entitled to participation in the 401(k) plan. Instead, the court ruled that this was a determination for the Plan Administrator to make in the first instance, not the Court, and it remanded the case to the Plan Administrator to make this decision, subject to judicial review in the event of an appeal.

When the case was returned to the Plan Administrator, the Administrator determined that since the freelancers were paid through the accounts payable department rather than from the payroll, there were not "on the United States payroll of the employer" even though they were common law employees. Therefore, the Plan Administrator concluded once again that the freelancers were ineligible to participate in Microsoft's 401(k) plan.

At the time of this writing, the subsequent settlement agreement in Microsoft was available only in media accounts. However, none of those accounts reveals that the 401(k) plan claims were specifically negotiated, and it appears that the settlement was limited to the ESPP claims. Whether or not this is the case, what we do know is that Microsoft settled before any judicial opinion on the Plan Administrator's action was rendered.

Hence, it appears that notwithstanding the publicity that attended the Microsoft case, that case did not vitiate the principle that a Plan document's exclusion of temporary workers or independent contractors from eligibility to participate in an ERISA-governed pension or welfare benefit will be honored if that exclusion is clearly expressed and if the Plan Administrator properly exercises his or her discretion to construe that exclusion in accordance with the terms of the Plan.

The Stock Purchase Plan

The Microsoft court's analysis and disposition of the freelancers' ESPP claim was a lot less complex than its handling of the 401(k) plan issues, albeit a great deal more troubling. However, in light of the unique circumstances that were presented by Microsoft (e.g., an IRS determination that the freelancers were common law employees, Microsoft's concession that this determination was binding in the court action, and a powerful dissent by three judges), it presents more of a lesson in how other employers can avoid similar results in the future than it does a death knell for the use of freelance labor without the obligation to permit participation in an employee stock purchase or stock option plan.

Briefly, unlike Microsoft's 401(k) plan, which was governed by ERISA, the entitlement of the freelancers to participate in the ESPP, its stock purchase plan, was governed exclusively by state contract law. The majority of the Microsoft court concluded that the "mutual mistake" it had found in the independent contractor agreement between the freelancers and Microsoft nullified that agreement in its entirety, as a matter of Washington state law. Since the freelancers were not actually independent contractors but, rather, common law employees, the court concluded from the fact that the ESPP was available to all "employees" of Microsoft that it was available to those "employees" who happened to have been called freelancers pursuant to a mutual mistake. The court simply did not address the fact that the independent contractor agreements had stated expressly that freelancers were not entitled to any of the benefits available to regular employees.

Since the Microsoft independent contractor agreement was about as explicit as it could be in excluding the freelancers from participation in the ESPP, the question posed is: How does an employer construct a stock purchase or stock option plan without having to worry about claims from temps, freelancers and independent contractors first raised long after they signed agreements that excluded them from participation?

One possibility is to state expressly in the independent contractor agreements and in the stock purchase or stock option plan that if it is later determined in any legal forum that the contractor in fact was a common law employee and/or that the parties' understanding that she was an independent contractor was erroneous, such a ruling would not change the parties' agreement that the contractor is not entitled to participate in the stock purchase or stock option plan. Another approach is to recite in the independent contractor agreement that the contractor will not be entitled to participate in the employer's stock purchase or stock option plan unless the head of the Human Resources Department determines, in writing, that common law employees who have ever been classified by the Human Resources Department as temporary or freelance employees or as independent contractors are ineligible to participate.

Conclusion

Microsoft does not mean that any temp or independent contractor who works long enough and closely enough with regular common law employees to be classified as a common law employee for purposes of the withholding provisions of the Internal Revenue Code automatically is entitled to benefits under the employer's ERISA or other benefit plans. Such entitlement will be determined according to the terms of the Plan documents themselves.

Accordingly, if an employer wishes to make sure that temps, freelancers, and/or independent contractors do not participate in benefit plans that are designed to encourage productivity and longevity of regular employees, there are several steps that should be taken.

First, the employer should identify exactly which workers are supposed to be covered and which workers are supposed to be excluded, and articulate clear criteria that distinguish these groups. Reliable criteria, such as "persons designated by the Human Resources Department as independent contractors are ineligible," are safer than criteria that leave meaning open to construction by courts, such as a generalized exclusion of "independent contractors" or "leased employees," which invite a court to second guess the employer's eligibility determinations by applying common law definitions of these terms.

Second, once these criteria are identified, the employer should have its benefit plans reviewed by counsel to determine whether the definitions set forth in the Plan documents and SPDs conform to the criteria that are so identified.

And third, the Plan Administrator should be carefully attuned to these issues, so that he or she is prepared, when issuing a decision that denies coverage because the applicant for benefits was not a regular employee, to prepare a written decision that sets forth the reasons for denial of benefits in a way that minimizes the likelihood and prospect of success of a claim that the applicant was a common law employee who is therefore entitled to benefits.