Employment Law and Worker Cooperative Conversions

When converting a business to a worker-owned cooperative, the conventional and legally-recognized employee-employer relationship could blur because of the new distribution of ownership and control. It brings up the question: Will or should the worker-owners remain classified as employees, or be classified as owners? If the worker-owners remain employees, do all employment-related regulations continue to apply?

Generally, having employees comes with a list of obligations and requirements for the employer, including:

1. Paying for overtime work;
2. Ensuring proper work hours and breaks;
3. Withholding and remitting payroll taxes and other withholdings;
4. Maintaining workers compensation insurance;
5. Complying with occupational safety and health laws;
6. Allowing employees to organize and join unions;
7. Verifying eligibility to work in the U.S.;
8. Adhering to standards and practices that protect employee benefit plans;
9. Posting notices and posters related to employee rights; and
10. Adhering to certain recordkeeping requirements.

If the employment relationship ceases to exist upon conversion to a worker cooperative, most or all of the above requirements cease to apply. There are pros and cons to maintaining the employee status of worker-owners. On one hand, the requirements listed above offer protection to worker-owners in cases where the tyranny of some worker-owners would result in exploitation of other workers-owners. If this is the case, however, it is arguable that an employment relationship does exist, and the cooperative could not have sidestepped employment law to begin with.

On the other hand, the above requirements can be expensive, due to the administrative demands of compliance, the cost of workers compensation insurance, and the cost of payroll services. As a result, a recently converted worker cooperative without a conventional employment relationship may show increased profit margins by avoiding the above requirements, and may choose to invest the savings in other types of benefits and protections for non-employee worker-owners.

It is critically important to evaluate the question of employment status carefully. Failure to properly classify someone as an employee could result in an expensive lawsuit or fine when either a labor department or worker decides to call out an actual employment relationship. Below, we provide some of the leading case law on determining the difference between a business owner/partner and an employee. Even with the detail provided below, we strongly suggest seeking the advice of an employment lawyer to ensure that workers are properly classified.

When are Worker-Owners Employees?

It is widely accepted that if you start a sole proprietorship and work for yourself, you are not your own employee. However, how does this principle apply when three people own, manage, and work for their own business in partnership with one another? How about when 100 people own, manage, and work for their own business? And does it matter which kind of business entity is formed?

Employment laws exist primarily to balance the relationship between “master” and “servant,” and generally do not apply when there is truly no master/servant relationship. In 2003, the U.S. Supreme Court, in Clackamas Gastroenterology Associates, P.C. v. Wells, decided whether the Americans with Disabilities Act applied to working shareholders of a small professional corporation. The outcome of the case turned on whether the shareholders were employees of the business. The Court summarized the following guidelines for determining when a master-servant relationship exists:

1. Whether the organization can hire or fire the individual or set the rules and regulations of the individual’s work;
2. Whether and, if so, to what extent the organization supervises the individual’s work;
3. Whether the individual reports to someone higher in the organization;
4. Whether and, if so, to what extent the individual is able to influence the organization;
5. Whether the parties intended that the individual be an employee, as expressed in written agreements or contracts;
6. Whether the individual shares in the profits, losses, and liabilities of the organization.

Note that not every court or labor department will apply the same test, and there are many tests that have been developed for determining who is a partner to an enterprise. Many court opinions acknowledge that, while there are multiple factors to consider, control is often the most important factor. Another case that summarized the factors courts consider is Simpson v. Ernst & Young, decided by the 6th Circuit in 1996. The Court named the following factors as relevant to the determination:

1. The right and duty to participate in management;
2. The right and duty to act as an agent of other partners;
3. Exposure to liability;
4. The fiduciary relationship among partners;
5. Use of the term ‘co-owners’ to indicate each partner’s ‘power of ultimate control;
6. Participation in profits and losses;
7. Investment in the firm;
8. Partial ownership of firm assets;
9. Voting rights;
10. The aggrieved individual’s ability to control and operate the business;
11. The extent to which the aggrieved individual’s compensation was calculated as a percentage of the firm’s profits;
12. The extent of that individual’s employment security; and
13. Other similar indicia of ownership.

One thing the above tests tell us is that if a worker cooperative chooses not to classify worker-owners as employees, it must give substantial management power to those worker-owners, and must adopt clear safeguards to prevent the devolution into a more hierarchical structure. It is also possible that the working relationships could change over time, as a management structure changes. Thus, it is even a good idea to conduct periodic “audits” to ensure that all workers are properly classified. Below, we provide additional guidance on determining how much control each worker-owner must have in order to be classified as a “partner,” rather than employee.

How much control must each cooperative member have in order to be considered a “partner” rather than an employee?

If all members of a small worker cooperative serve on the Board of Directors and take part in collective management processes, then, arguably, each member could be considered a “partner” for the purpose of some employment laws. But where do courts draw the line? How much control do the workers need to have in order to be considered partners?

One case that examined the question of who is a “bona fide partner” is Wheeler v. Hurdman, decided by the 10th Circuit in 1987. In that case, the court actually de-emphasized the need for each partner to have a significant amount of control, noting that the practical needs of the business may result in partners giving up a certain amount of control over the day-to-day, and abdicating such control to managers, teams, or committees. The Court essentially recognized the following practical reality: Any time a group of people voluntarily works together, each individual gives up a certain amount of control to the group or to members of the group. However, what is important is that the individual gives this power voluntarily.

In another case, Fountain v. Metcalf, Zima & Co. (1991), the 11th Circuit focused on certain voting rights as the indicator of partnership control, instead of on the actual realities of management in the firm. There, the Court ignored the argument that a managing partner was running the firm autocratically, and focused instead focused on the fact that the worker “had a right to vote his thirty-one percent ownership on member/shareholders’ amendments to the agreement, on admission of new member/shareholders, on termination of relationship with member/shareholders, on draws, and on distribution of profits and income.” Thus, the Court found that the worker was a partner, and not an employee.

In contrast to Wheeler and Fountain, however, other courts have focused heavily on the issue of control, and found that factor to be a deal-breaker. For example, in 1987, the U.S. District Court of the Southern District of New York in Caruso v. Peat, Marwick, Mitchell & Co. examined the employment status of a partner in a 1350-member accounting firm, and the Court looked at three primary factors:

1. The extent of ability to control and operate the business,
2. The extent to which compensation is calculated as a percentage of the firm’s profits, and
3. The extent of employment security.

On the question of “ability to control and operate the business” in the Caruso case, it was significant that the firm was “managed by a board of directors separated from plaintiff by six levels of hierarchy” and that the plaintiff tended to seek approval of management-level partners in decisions about his own work. The Court held that the plaintiff was, indeed, an employee.

The Court in Clackamas also focused heavily on the question of control and common law definitions of the master-servant relationship. The Court wrote that “[i]f the shareholder-directors operate independently and manage the business, they are proprietors and not employees; if they are subject to the firm’s control, they are employees.”

A case that examined this issue specifically in application to a worker cooperative was Wirtz v. Construction Survey Cooperative, decided by a federal district court in Connecticut in 1964. In that case, the Court emphasized numerous elements in support of a finding that the cooperative members were not employees, even though two members of the cooperative exercised management over the others:

“It is true [that two members] exerted some measure of leadership over the [other members]. But the Court finds this was due to their longer experience, more extensive knowledge, and driving interest rather than due to positions of control or power. What little guidance they supplied was by consent not authority.”

The lesson with all these cases is: there is no clear set of rules to determine when members of a worker cooperative are employees. Some of the cases described above indicate that, even with somewhat hierarchical management structures, working co-owners of a business may still avoid classification as employees. However, if you want to argue that members of your worker cooperative are not employees, then the safest thing to do is to:

1. Have all members serve on the Board of Directors.
2. Make decisions by a consensus process, supermajority voting, or another process that gives each member a strong voice in each decision.
3. Give each member a lot of control over his/her own work, or create many semi-autonomous departments or committees that control their own work, procedures, and hours.
4. Make it somewhat difficult to fire people, by requiring a vote of a large number of members.
5. If you put some people in a position to manage and supervise others, ensure that they can easily be moved out of their supervisory roles by a proposal brought to the cooperative by the people they supervise.

Does it make a difference if you form a partnership, LLC, or cooperative corporation?

In some jurisdictions and under some statutes, courts have leaned toward the assumption that shareholders of corporations should be treated as employees when they work for the corporation they co-own. In other jurisdictions, the fact of incorporation is merely one factor, among many, that a court would consider in determining whether an employment relationship exists. Generally, corporations are required to treat their officers as employees for tax purposes. This does not, however, mean that a corporation must treat its officers as employees for the purpose of wage and hour law, workers’ compensation, and other realms of employment law.

Uncertainty about whether incorporation automatically creates an employment relationship has caused stress for some worker cooperatives, which are often formed as some type of Cooperative Corporation. As a result, some worker cooperatives have chosen instead to form as partnerships or limited liability companies (LLCs), entities where a court is less likely to find that managing partners and managing members are employees.

The U.S. Supreme Court, in the Clackamas case, and other courts have found that a “partnership,” rather than employment, relationship exists even when the entity is a corporation. In 2009, the court in Godoy v. Rest. Opportunity Ctr. of New York, Inc. also held that the members of a worker-owned cooperative were “partners,” in spite of the fact that they were working under a corporation. Many courts may ultimately consider the incorporation status of an entity as relevant, but only as one factor among many in determining whether an employment relationship exists.

The lesson here is: If you are planning to form a cooperative corporation, as opposed to a partnership or LLC, be extra attentive to the question of whether there is an employment relationship, and talk to a lawyer.

Workers Compensation Insurance and Cooperative Conversion

In some cases of worker cooperative conversion, even if the worker-owners continue to treat themselves as employees, they may become exempt from certain legal requirements, such as the requirement to provide workers compensation insurance. For example, Section 3351 of the California Labor Code contains exceptions to the requirement that all employees be covered by workers’ compensation insurance, such as “where the officers and directors of the private corporation are the sole shareholders thereof,” or where the “working members of the partnership or limited liability company are general partners or managers.”

Thus, in the case of a cooperative corporation operating in California, if the directors are the only members (meaning they are the only “shareholders”) of the cooperative, then they may not need to be covered by workers’ compensation. Most worker cooperatives that are managed collectively meet this requirement. However, if there are cooperative members who do not serve on the Board of Directors, then it’s possible that workers compensation will be required for everyone. Note that a worker cooperative that hires non-member employees will definitely need to carry workers compensation for those employees. Note also that a worker cooperative that chooses to form as a partnership or LLC will also be exempt from carrying workers compensation if the working partners/members all participate in management.

At least one business that we know of converted to worker-ownership, brought all new worker-owners onto the Board, cancelled workers’ compensation insurance for those worker-owners, and spent the savings on health benefits and long-term disability insurance.

Could conversion affect union status of workers?

If employees take over ownership of the business they work for, they may still elect to form a union or remain part of a union, so long as a specific union’s policy allows them to remain members. However, the worker-owners might lose their protected right to organize, meaning that if managers or a group of workers seeks to block organizing, the worker-owners may have no recourse. The National Labor Relations Act (NLRA) protects the right of employees to organize unions and collectively bargain with employers, and it prevents employers from intervening in and backlashing against such organizing.

Conversion of a business to a worker cooperative could move the worker-owners outside of the protection of the NLRA if the worker owners have an “effective voice” in the operation and policies of the business. In any cooperative where the worker-owners elect the Board and can serve on the Board (which is most worker cooperatives), it is quite possible that the NLRA would not protect the right of workers to organize. In addition, the worker-owners might not have a protected right to organize if there is a conflict of interest between the worker-owners and the non-owner workers of the business.

Whether members of a worker cooperative have a protected right to form or join unions is addressed in great depth by attorney Neil A. Helfman in his 1992 article “The Application of Labor Laws to Workers’ Cooperatives,” and by Deborah G. Olson in her 1982 article “Union Experiences with Worker Ownership: Legal and Practical Issues Raised by ESOPs, TRASOPs, Stock Purchases and Cooperatives,” Wisconsin Law Review.

The application of the NLRA to worker-owned businesses has also been examined in the following cases:

• NLRB v. Union Furniture Company, 67 NLRB 1307 (1946) (holding that employee-stockholders who chose the Board of Directors from amongst themselves had substantial control over corporate policy and divergent interests from non-proprietary employees).
• Brookings Plywood Corp., 98 NLRB 794 (1952) (holding that employee-shareholders who could collectively influence company policy had sufficient control over corporate decision-making to fall outside of the protection of the NLRA).
• Everett Plywood and Door Corp., 105 NLRB 17 (1953) (holding that employee-stockholders in a cooperative were protected by the NLRA).