September 03, 2019 Issue: Fall 2019

ERISA Reclassification of Independent Contractors

By: James M. Nelson

ERISA-governed plans define the participants who are eligible to participate in the benefits they provide. Whether a worker is classified as an employee or a contractor is often determinative of eligibility. 

This article will appear in two parts.  In Part I, the author explores the constitutional concerns regarding independent contractor reclassification under ERISA in general.  Part II – to appear in a future issue – will explore the scope of the underlying authority for reclassifying workers on a class-wide basis under Fed. R. Civ. Pro. 23 and the Rules Enabling Act, as applied.

INTRODUCTION

Under the ERISA employee status test, the agreement between the service provider and service recipient is but one factor in determining employee status, and not even the most important one. Nationwide Mutual Insurance Co., v. Darden, 503 U.S. 803 (1992). The same is true under the current version of the IRS employment status test.

More recently in Dynamex Operations West v. Superior Court, 4 Cal.5th 903 (2018), an instructive non-ERISA case, the California Supreme Court examined the issue of employee status and, over the course of an 82-page opinion, developed a new test for determining who is and is not covered by California’s Wage Orders. Nowhere in that decision or the new modified ABC test do the desires of the individual service provider factor into the analysis, nor are they even mentioned. In A.B. 5, the California legislature expanded the Dynamex test across the California Labor Code with some exceptions, but it, like the decision, does not include consideration of the contracting parties’ desires as a factor.

We might rightly ask why the desires of the service provider and the agreement with the service recipient are so unimportant? We know there is a constitutionally recognized individual right to contract and to have one’s contracts enforced. Frisbie v U.S., 157 U.S. 160,166 (1895) (“every citizen has a right freely to contract for the price of his labor, services, or property”). That right is protected by the Fifth Amendment. Of course, liberty and property interests are not unlimited. Nonetheless, it is generally recognized that before even state government (which has fewer restraints than the federal government) can act to defeat that contract right in whole or in part, some interest in public health, safety or welfare justifying setting aside the individual contract right must be evident.  West Coast Hotel Co. v. Parrish, 300 U.S. 379, 392 (1937).  (“Liberty implies the absence of arbitrary restraint, not immunity from reasonable regulations and prohibitions imposed in the interests of the community.”).  Due process suggests that the individuals who are parties to the contract are the ones who possess this liberty/property interest right. See, Frisbie, supra.

The first part of this article explores a constitutional concern with judicial disregard of the wishes of the contracting parties regarding worker classification for purposes of ERISA-governed benefits.

There is, however, another layer that surfaces when the procedural context is that of a class action under federal law, in which one party seeks to re-define not only his or her own relationship with the service recipient, but the relationships of dozens or thousands of others whose desires or circumstances may or may not truly be the same as the class representative’s. The second part of the article explores whether the prohibition on impinging “substantive rights” under the Rules Enabling Act, (see 28 U.S.C. §2071-2074) is triggered when Rule 23 is used to re-classify independent contractors as employees under ERISA. The Federal Rules of Civil Procedure, including Rule 23, do not arise directly from Article III of the Constitution, but rather are derived indirectly from Congress and the Court.  Congress enacted the original “Rules Enabling Act” (Pub.L. 73-415 (1934)) to authorize the Court to create its own procedural rules, and made some minor adjustments to that act in 1988.  The Supreme Court’s authority was, however, limited as follows:

Such rules shall not abridge, enlarge or modify any substantive right. All laws in conflict with such rules shall be of no further force or effect after such rules have taken effect.

28 U.S.C. §2072(b).  Once crafted by the Rules Advisory Committee, the Federal Rules of Civil Procedure and any amendments are transmitted by the Supreme Court to Congress with little to no review.  Rules of procedure become effective unless Congress acts to block them.  28 U.S.C. §2074.  Thus, Rule 23, like the other procedural rules adopted by federal courts, did not go through a conventional legislative process.

This article explores whether reclassifying independent contractors as employees in an ERISA case abridges the non-complaining class member rights in a manner inconsistent with the Constitution and the Rules Enabling Act. This analytical journey requires going back to first principles.

OVERVIEW

Regardless of our other conflicting views, we can probably agree that the Declaration of Independence identifies inalienable rights to life, liberty and the pursuit of happiness that we are each endowed with not by man-made law but by virtue of being a free people.  That concept became imbedded in the Constitution with the adoption of the Ninth and Tenth Amendments. The Fifth Amendment protects against federal government denial of the liberty or property interest without due process. We can also agree that neither historical document directly or indirectly mentions employee benefits, or class actions.

That acknowledgement is foundational in examining the liberty interests of class members in employee misclassification cases under ERISA and other employee benefit settings. We can use a hypothetical scenario to set the intellectual table:

  • Andrea, a single mom, went out on her own after the divorce and built a small package delivery and courier business in San Francisco. She needed the independence and income but wanted some control over her own hours. Her and her child’s health care coverage are part of a Qualified Medical Child Support Order and a spousal support award. She has a profit-sharing plan. Her goal was to develop a transportation business with other drivers who like herself were building new lives. All 65 or so of the drivers are DOT/FMCSA regulated, signed written leases agreeing among other thing to be owner-operator independent contractors, own or lease their own trucks, net of operating expenses most gross more than $85,000 per year, and many but not all have their own retirement plans. Some sub-contract further and some have their own employees. Two drivers bring a class case asserting they were denied employer-provided health coverage and seek to re-classify all the drivers as employees of Andrea.

This fact pattern raises a few questions. One of them is whether a government imposed re-classification of Andrea and the other non-complaining drivers as employees is in her interest or those like her to whom she provided opportunities?

The notion of employer-provided benefits and government regulation of those benefits is less than one hundred years old. Technology has allowed for many new service models for individuals who seek to earn money independent of a traditional “employer.” Call it a gig economy or an app-based service model, the reality is that on the surface these service providers look self-employed. However, some could also observe that the terms of service and the algorithms that drive the technology can impose a significant level of control over the service providers. 

Many entrepreneurial success stories began as small business. The clear majority of small businesses fail eventually. Some entrepreneurs fail multiple times before coming across something that does succeed. Nonetheless, the pursuit of opportunity and happiness are important freedoms. The right to try arguably carries with it the liberty to fail. Under prior IRS doctrines this was sometimes referred to as the opportunity for profit or loss.

Few publicly oppose the formation and operation of a small business. Nonetheless, a self-employed entrepreneur operating on her own, who has willfully set up her business to maximize her tax and liability advantages under the extant legal structure, will not be affording herself “workers compensation” insurance, guaranteeing herself minimum wage or overtime, enjoying family medical leave or paid sick days. She will be filing her state and federal income taxes as a self-employed person, making quarterly tax estimates, and avoiding payroll withholding.  She may or may not choose to purchase high deductible insurance or choose instead to self-insure. She may or may not choose to adopt a tax advantaged retirement plan available to the self-employed.  

If whomever evaluates the business concludes it was set up correctly, that business is the prototypical small business most would like to encourage. If the evaluator concludes that arrangement fails whatever test is applied, the service recipient and the service provider are then part of a vilified underground economy not paying his or her “fair share” and the service provider is deprived of the opportunity to be self-employed. As applied to ERISA coverage this is the employment law equivalent of the Schrödinger’s cat thought experiment because the business operates the same under either conclusion and it’s the opinion/observation of the evaluator that determines the outcome.

The notion that the risk one is willing to accept has an impact on the return one can expect to achieve has been proven. Indeed, that is the lynchpin of prudent ERISA fiduciary investing.   Thus, the right to pursue happiness arguably entails the right to take risk.

The U.S. Supreme Court long ago acknowledged that being self-employed is as lawful as being an employee of someone else.  See, e.g. U.S. v. Silk, 331 U.S. 704, 713 (1947) (superseded by statute on other grounds).  One could argue that in Dynamex, the California Supreme Court disagreed by making most entrepreneurs fight against a presumption of employee status and limiting the market place in which the contractor model can be used. California’s A.B. 5 further adjusts the limitations and creates exceptions for certain positions and industries.  

What differentiates the present from 1789, 1899, or 1929 is the adoption of laws providing that those who decline to take the risk are entitled to various levels of government created economic protection funded in part by the service recipient and in part by taxes both the worker and the service recipient pay.  These benefits include minimum wage rates, workers compensation, health coverage under the Patient Protection and Affordable Care Act (PPACA), ERISA protection of employee retirement savings, various rights to time off (paid and unpaid) and some income security for those laid-off.  Largely ignored is the question of the legitimate role of the federal government in overruling the contractual choice to accept risk, pursue a different path and be self-employed.

Somewhere in the emotionally and intellectually complex discussion is an intellectual and emotional disharmony. Many people dream of the freedom of being their own boss one day and doing so means acceptance of risk. At the same time, we have a cultural distrust of businesses and particularly big businesses, who if left to their own devices we fear will use dominant economic power to oppress individual service providers who require protection from agreements they may otherwise make.  See West Coast Hotel Co. v. Parrish, 300 U.S. 379, 394 (1937).

It is thus that a paradox sprouts. Assume Andrea from our hypothetical (and before she was sued) through good service and good marketing lands a contract with a property management company that desires to offer concierge courier service to tenants in several of its San Francisco buildings. The arrangement will increase Andrea’s package flow by thirty percent but she needs to guarantee independent contractor status and that packages received before noon will be delivered in San Francisco that day. It is true that Andrea just landed a big account. It is also true that the property management company probably has disproportionate economic power due to the number of other delivery businesses that compete with Andrea, and the same day guarantee creates a fair amount of control over the owner-operator drivers. So, is this Andrea’s decision to make on her own or do the risks she (and the other drivers with whom she contracts) are taking on include one that she and the management company’s contract may one day be overruled by a federal court in a case in which she and the clear majority of the drivers who contracted with her will not be the complaining party?  

Courts engaged in re-classifying non-complaining contractors as employees deny the individual contractor the right to operate as he or she once contractually agreed to do.  Accepting that both employment as the servant in a master-servant relationship and self-employment are equally legitimate states, the question then becomes whether the judiciary has a legitimate role in forcing groups of non-complaining service providers into a structure inconsistent with their agreement? Assessing that legitimacy requires some historical and constitutional context.

The reason this article goes back so far in time (and addresses some laws many of us have not looked at since our constitutional law class) is that as benefits lawyers, we spend a lot of time on very technical concepts. Rarely do we go back to first principles. For example, in the earlier days of PPACA, various federal agencies generated a fair amount of material in a variety of forms including FAQs, proposed regulations, bulletins and other guidance. We may not agree on what a FAQ is but we should be able to agree (1) FAQs do not come from Congress and are not signed by the President so they are not legislation; (2) there is no FAQ section of the Administrative Procedure Act so they are not regulations. Eventually, some of this material became known as “sub-regulatory guidance.” But what is “sub-regulatory guidance” in our hierarchy of that which is law? The point for purposes of this article is we may well be taking things for granted in re-classification of independent contractors under ERISA that are worth a more careful review.

Before embarking on the analysis, a brief discussion about individual liberty may be useful.  For all the publicity and recent activity on the “independent contractor issue,” discussion of the individual liberty interests of the contracting parties rarely, if ever, surfaces.  As the expectation of routine enforcement of private contracts is, perhaps non-coincidentally, also a necessary feature of modern free market economies, these often glossed over questions are overdue for serious consideration.

FROM THOREAU AND ARENDT TO WEST COAST HOTELS

Our discussion begins in 19th Century Massachusetts with a probably apocryphal exchange that may nonetheless resonate with those who live in or near state capitols.  The narrator is Henry David Thoreau and the passage comes from his journal: 

“I went to the store the other day to buy a bolt for our front door, for as I told the storekeeper, the governor was coming here.
‘Aye,’ said he, ‘and the Legislature too.’
‘Then I will take two bolts,” said I.
He said that there had been a steady demand for bolts and locks of late, for our protectors were coming.

The passage reminds us that the founders of the United States (and many of the generations that followed) retained a healthy respect for preserving all aspects of individual liberty and a degree of suspicion of government officials proposing to chip away at it. More than one hundred years after Thoreau wrote his journal, Hannah Arendt put it this way ". . . it is the freedom (and in some instances so-called freedom) of society which requires and justifies the restraint of political authority. Freedom is located in the realm of the social, and force or violence becomes the monopoly of government." Thoreau, Arendt, and many others understood that the individual’s defense against the majority is often the assertion of fundamental individual rights that override the desires of the many and particularly the power of government.  In Stanley v. Georgia, 394 U.S. 557 (1969), the Court restated the concept as follows:

"The makers of our Constitution undertook to secure conditions favorable to the pursuit of happiness. They recognized the significance of man's spiritual nature, of his feelings and of his intellect. They knew that only a part of the pain, pleasure and satisfactions of life are to be found in material things. They sought to protect Americans in their beliefs, their thoughts, their emotions and their sensations. They conferred, as against the Government, the right to be let alone -- the most comprehensive of rights and the right most valued by civilized man. "Olmstead v. United States, 277 U. S. 438. 478 (1928) (Brandeis, J., dissenting). See Griswold v. Connecticut, supra; cf. NAACP v. Alabama, 357 U. S. 449, 462 (1958).

Stanley at 664. Liberty interests were not simply created by the Constitution but pre-existed it and were recognized and preserved there. E.g. Griswold v. Connecticut, 381 U.S. 479, 481-484 (1965); U.S. Const., amend. IX, X.

The Constitutional Components to the ERISA Employee Status Question

Two components of the Constitution which were vigorously debated at their inception, but are now somewhat obscure, are of importance here and they are the Ninth and Tenth Amendments.  ERISA, though it may be a "comprehensive and reticulated statute," is nonetheless legislation that is constrained by the balance of powers set forth in the Constitution, in particular by the Fifth Amendment.

As we may vaguely recall, the Ninth and Tenth Amendments were part of the accommodations that eventually became known as the Bill of Rights. As the lower numbered Amendments began dealing with items of specific individual liberty (speech, press, religion, jury trial, etc.) a separate concern arose. 

Those who viewed the Constitution, by definition, as a very limited document specifically describing narrow and specific areas of power ceded to the new federal government, argued that no Bill of Rights was needed or desired.   Alexander Hamilton, who was originally opposed to a Bill of Rights, was the voice of that viewpoint and posited the question in Federalist 84: "Why declare that things shall not be done which there is no power to do?" That line did not make it into the musical but it is of some importance here. It voiced a concern about the impact of creating lists of rights. Many of the founders were concerned that the act of listing rights suggested that anything not on the list was not a “right.”  Others were most uncomfortable that freedoms guaranteed in their own state Bills of Rights were not acknowledged at the federal level.

The effort to extricate Founders from the tyranny of words in a ratifiable document fell to James Madison. His solution became the Ninth and Tenth Amendments.  These two amendments were less about specific guarantees than about the limitations of federal power granted by the Constitution itself and the expansiveness of human rights not to be abridged by any government.  Appreciating the significance of these two amendments is, at least arguably, best accomplished in reverse order.

The Tenth Amendment made explicit that which had been implied previously.  It provides:

“The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.”

The Tenth Amendment is typically interpreted as a rule of construction acknowledging that the federal government’s authority is limited to the powers conveyed to it in the Constitution.  Powers that were not granted to the federal government by the Constitution nor prohibited by the Constitution to the states are reserved either to the states or to the people themselves as individuals.  The most frequent source of authority for exerting federal power otherwise rendered problematic by the Tenth Amendment is the Commerce Clause, Article 1, Section 8, Clause 3 discussed below. 

The Ninth Amendment states, somewhat translucently:

“The enumeration in the Constitution, of certain rights, shall not be construed to deny or disparage others retained by the people.”

Thus, the Constitution not only enumerated the limited powers of the federal government and specific authority of the states, but also articulated the existence of a universe of unenumerated rights possessed by the people without attempting to list them all or how potential infringements on individual rights might exist or later occur.

This principal was conceptually very important to the founders’ protection of individual liberty.  It is one thing to know, as an individual, that freedom exists to do anything not expressly and legitimately prohibited.  It is quite another to need to find some source of authority that the government permits an action the individual contemplates before taking it. As society becomes increasingly complex, analysis by lawyers (and particularly employee benefits lawyers) may feel as though it is closer to the later scenario than the former. 

What is important, however, is that the starting point is freedom of action and that the search should be for a legitimate basis for a government prohibition. As Justice Powell wrote speaking for the majority in Moore v. City of East Cleveland:

[T]he full scope of the liberty guaranteed by the Due Process Clause cannot be found in or limited by the precise terms of the specific guarantees elsewhere provided in the Constitution. This `liberty' is not a series of isolated points pricked out in terms of the taking of property; the freedom of speech, press, and religion; the right to keep and bear arms; the freedom from unreasonable searches and seizures; and so on. It is a rational continuum which, broadly speaking, includes a freedom from all substantial arbitrary impositions and purposeless restraints, . . . and which also recognizes, what a reasonable and sensitive judgment must, that certain interests require particularly careful scrutiny of the state needs asserted to justify their abridgment." Poe v. Ullman, supra, at 542-543 (dissenting opinion).

Id. Moore was a Fourteenth Amendment case; however, states have more due process flexibility than the federal government has. Under either due process clause, the starting point is individual freedom of action as opposed to presuming the existence and legitimacy of government restraint.

This brings us to the Commerce Clause.  The Commerce Clause requires some brief examination because it is the justification for ERISA being a lawful exercise of federal power.  In Depression era cases, the Court viewed Congress’ power under the Commerce Clause quite broadly. The expansive treatment given to Congress’ authority under the Commerce Clause in the years following 1937 was eventually constrained by the Court.  Beginning with U.S. v. Lopez, 514 U.S. 549 (1995) and clarified in U.S. v. Morrison, 529 U.S. 598 (2000) and Gonzales v. Raich, 545 U.S. 1 (2005), Congress’ power to regulate commerce was limited to (a) the channels of commerce; (b) the instrumentalities of commerce; and (c) actions that substantially affect interstate commerce.  Intuitively, one can grasp what a channel of commerce is and can appreciate that instrumentalities of commerce encompasses regulation of vehicles, railroads and aircraft.  The analytical focus in most cases now is on the third criteria, the substantiality of the impact on interstate commerce .

ERISA, generally, fits well within the “substantially affect interstate commerce” construct if one remains within the bounds of the text. See 29 U.S.C. §1001 (1974). A unified and nationwide regulatory system was both necessary by 1974 and desirable. However, the expansive nature of the Act has led some to express concerns as to whether it can be construed in ways that exceed Commerce Clause authority. In Gobeille v. Liberty Mutual. Ins. Co., 577 U.S. ___, 136 S.Ct. 936 (2016) Justice Thomas was concerned enough about whether the Court’s preemption jurisprudence had transcended Congressional authority under the Commerce Clause to offer the following observation in a concurring opinion:

Read according to its plain terms, §1144 raises constitutional concerns. “[T]he Supremacy Clause gives ‘supreme’ status only to those [federal laws] that are ‘made in Pursuance’” of the Constitution. Wyeth v. Levine, 555 U. S. 555, 585 (2009) (Thomas, J., concurring in judgment) (quoting Art. VI, cl. 2). . . . Just because Congress can regulate some aspects of ERISA plans pursuant to the Commerce Clause does not mean that Congress can exempt ERISA plans from state regulations that have nothing to do with interstate commerce. See Gonzales v. Raich, 545 U. S. 1, 59–60 (2005) (Thomas, J., dissenting).

One can as easily question whether the Commerce Clause supports an interpretation of ERISA that allows federal courts to reform a contract calling for an arrangement to be beyond ERISA’s regulatory scope to bring a person who contracted to be an independent contractor into the status of employee, notwithstanding the liberty interest of the individual.

Post-1865 Constitutional Construction and Contracts

The Thirteenth Amendment straightforwardly abolished slavery, ending the notion that people could be property under state law.  The Fourteenth Amendment, Section 1 contained the following operative language:

No State shall make or enforce any law which shall abridge the privileges or immunities of citizens of the United States; nor shall any State deprive any person of life, liberty, or property, without due process of law; nor deny to any person within its jurisdiction the equal protection of the laws.

In The Slaughterhouse Cases, 83 U.S. 36 (1872), the Court found that the “privileges or immunities” protected under the first portion of the Amendment were limited to those which were guaranteed by virtue of being a citizen of the United States under the Constitution and Fifth Amendment as opposed to those rights guaranteed only as citizens of a particular state.  The Court has recognized that, Article 1 Section 10, Clause One protects the obligations of contract and hence the right to contract is a privilege protected by the federal Constitution by virtue of U.S. citizenship.  As noted above, among the unenumerated rights the Supreme Court has recognized as a portion of liberty is the right to contract. The general right to have the contract enforced is protected by the Fifth Amendment. See Frisbie, supra.  As noted the Fourteenth Amendment provides similar protection from state action arbitrarily impinging on the liberty interest in freely contracting. West Coast Hotels Co., supra.

From Lochner to West Coast Hotels and Beyond.

The degree of protection afforded to the parties’ liberty interest in entering private contracts without governmental intrusion requires exploring an area of constitutional scholarship that is contentious: substantive due process.  The Supreme Court has not retreated from finding that generally the due process clause of the Fifth Amendment protects the right to contract as a liberty interest from federal government intrusion. Frisbie v. United States, 157 U.S. at 165.

However, three years later in Holden v. Hardy, 169 U.S. 366 (1898), the Court upheld a Utah law setting an eight-hour work day for miners notwithstanding a Fourteenth Amendment Due Process challenge. In Holden, the Court noted that although "the police power cannot be put forward as an excuse for oppressive and unjust legislation, it may be lawfully resorted to for the purpose of preserving the public health, safety, or morals." That phraseology, expressed in slightly different ways in a variety of cases, moved the analysis into a world where the distinction between legislation that is “oppressive and unjust” in disrupting a contractual arrangement or a preservation of “public health, safety and welfare” acquired a degree of subjectivity. Holden is not a close case on this factual point because fatigue in the inherently dangerous activity of mining is close to self-evidently a safety issue.  Holden also arose under the Fourteenth Amendment and the state’s power is not constrained by the Ninth and Tenth Amendments.

What was at issue then, as now, was the proper relationship between the right to freely contract on the one hand and the scope of the government power to order society.  The issue surfaced more often in the context of the Due Process Clause of the Fourteenth Amendment largely because police powers tend to be exercised locally, and the Fourteenth Amendment was aimed at curbing abuses of individual liberty by the states. Analytically, the discussion is a little different when applied to federal law under the Fifth Amendment because of the Ninth and Tenth Amendments limitations on the scope of federal power may make the need to find specific justification for disrupting the contract arguably more imperative.

The issue facing the Supreme Court in Lochner v. New York 98 U.S. 45 (1905) was whether the New York Bakeshop Act (limiting hours of bakers) represented a reasonable exercise of the state's police power.  The much-maligned decision found the contract right was fundamental and, by a narrow margin, that the statute in question was invalid.   Lochner remains widely condemned but it has not been over-ruled and the actual text is nonetheless instructive:

The general right to make a contract in relation to his business is part of the liberty of the individual protected by the Fourteenth Amendment of the Federal Constitution. Allgeyer v. Louisiana, 165 U.S. 578 (1897). Under that provision, no State can deprive any person of life, liberty or property without due process of law. The right to purchase or to sell labor is part of the liberty protected by this amendment unless there are circumstances which exclude the right. There are, however, certain powers, existing in the sovereignty of each State in the Union, somewhat vaguely termed police powers, the exact description and limitation of which have not been attempted by the courts. Those powers broadly stated and without, at present, any attempt at a more specific limitation, relate to the safety, health, morals and general welfare of the public. Both property and liberty are held on such reasonable conditions as may be imposed by the governing power of the State in the exercise of those powers, and with such conditions the Fourteenth Amendment was not designed to interfere. [cites omitted]
The State therefore has power to prevent the individual from making certain kinds of contracts, and, in regard to them, the Federal Constitution offers no protection. If the contract be one which the State, in the legitimate exercise of its police power, has the right to prohibit, it is not prevented from prohibiting it by the Fourteenth Amendment. Contracts in violation of a statute, either of the Federal or state government, or a contract to let one's property for immoral purposes, or to do any other unlawful act, could obtain no protection from the Federal Constitution as coming under the liberty of person or of free contract. Therefore, when the State, by its legislature, in the assumed exercise of its police powers, has passed an act which seriously limits the right to labor or the right of contract in regard to their means of livelihood between persons who are sui juris (both employer and employee), it becomes of great importance to determine which shall prevail -- the right of the individual to labor for such time as he may choose or the right of the State to prevent the individual from laboring or from entering into any contract to labor beyond a certain time prescribed by the State.

Id. at 53-54.  Phrased thusly, this portion of Lochner is arguably benign regardless of one’s ideology.  In 1905, the Court found that the New York statute limiting the hours of bakers was not a legitimate exercise of the states’ police powers. What Justice Peckham wrote was:

There is no contention that bakers as a class are not equal in intelligence and capacity to men in other trades or manual occupations, or that they are unable to assert their rights and care for themselves without the protecting arm of the State, interfering with their independence of judgment and of action. They are in no sense wards of the State. Viewed in the light of a purely labor law, with no reference whatever to the question of health, we think that a law like the one before us involves neither the safety, the morals, nor the welfare of the public, and that the interest of the public is not in the slightest degree affected by such an act. The law must be upheld, if at all, as a law pertaining to the health of the individual engaged in the occupation of a baker. It does not affect any other portion of the public than those who are engaged in that occupation. Clean and wholesome bread does not depend upon whether the baker works but ten hours per day or only sixty hours a week. The limitation of the hours of labor does not come within the police power on that ground. Id. at 57.

One could perhaps substitute a gig economy service provider for the bakers and the issue begins to come into focus.

By the 1930s the Court’s position had shifted.  In Nebbia v. New York, 291 U.S. 502 (1934) the Court considered whether the state could invalidate contracts to regulate milk prices.  In another 5-4 decision, the Court again noted the tension between police powers and the right to contract:

Under our form of government, the use of property and the making of contracts are normally matters of private and not of public concern. The general rule is that both shall be free of governmental interference. But neither property rights nor contract rights are absolute; for government cannot exist if the citizen may at will use his property to the detriment of his fellows, or exercise his freedom of contract to work them harm. Equally fundamental with the private right is that of the public to regulate it in the common interest. As Chief Justice Marshall said, speaking specifically of inspection laws, such laws form 'a portion of that immense mass of legislation which embraces everything within the territory of a state ... all which can be most advantageously exercised by the states themselves. Inspection laws, quarantine laws, health laws of every description, as well as laws for regulating the internal commerce of a state, ... are component parts of this mass.' (cites omitted)

Id.  at 523.  The regulation was upheld despite a Fourteenth Amendment challenge.  The basic principles described in Nebbia and Lochner are similar, even though the state labor regulation was stricken in Lochner and the milk regulation upheld in Nebbia.

The other event of some import here is the Rules Enabling Act with its “substantive rights” limitations referenced earlier. It was originally enacted in the same year as the Nebbia decision and amended decades later, after ERISA was enacted. A long-recognized problem is that the scope of the limitation and the Court’s jurisprudence have not been clear. A complicating factor is that human nature suggests that having submitted the Federal Rules of Civil Procedure to Congress, it seems unlikely that the Supreme Court would find it violated the “substantive rights” limitation in doing so. See Ortiz v. Fibreboard Corp., 527 U.S. 815, 842, 845 (1999). What is more likely is that the Court would decline to adopt an interpretation of something protected or prohibited by the Federal Rules that crossed over into an area impacting substantive rights. See, Amchem Products, Inc. v. Windsor, 521 U.S. 591, 628-629 (1997); Cooter & Gell v Hartmarx, 496 U.S. 384,391(1990) (superseded by statute on other grounds). This issue is addressed further in part two of this article.

Returning to the labor context, three years after Nebbia, the court decided West Coast Hotel Co. v. Parrish, 300 U.S. 379 (1937).  In substance, the case addressed Washington state’s authorization of an administrative agency to fix a minimum wage for women and minors.  In the course of the decision, the Court again noted the continuing viability of the freedom to contract as part of the right to liberty.  Id. at 391.  The Court noted:

Liberty in each of its phases has its history and connotation. But the liberty safeguarded is liberty in a social organization which requires the protection of law against the evils which menace the health, safety, morals, and welfare of the people.  Liberty under the Constitution is thus necessarily subject to the restraints of due process, and regulation which is reasonable in relation to its subject and is adopted in the interests of the community is due process.
This essential limitation of liberty in general governs freedom of contract in particular. . . .'But it was recognized in the cases cited, as in many others, that freedom of contract is a qualified, and not an absolute, right. There is no absolute freedom to do as one wills or to contract as one chooses. The guaranty of liberty does not withdraw from legislative supervision that wide department of activity which consists of the making of contracts, or deny to government the power to provide restrictive safeguards. Liberty implies the absence of arbitrary restraint, not immunity from reasonable regulations and prohibitions imposed in the interests of the community.'(Cite omitted) Id at 391-392

Up to this point, Lochner and West Coast Hotel are reconcilable.

The point of true ideological demarcation occurred in dicta, when the Court also noted and rejected a claim that adult employees should be free from restriction in making their own employment contracts.  The Court in West Coast Hotel noted that there were situations where the disparity of economic interests is wide enough that free choice no longer prevails:

[T]hat both parties are of full age, and competent to contract, does not necessarily deprive the state of the power to interfere, where the parties do not stand upon an equality, or where the public health demands that one party to the contract shall be protected against himself.' 'The state still retains an interest in his welfare, however reckless he may be. The whole is no greater than the sum of all the parts, and when the individual health, safety, and welfare are sacrificed or neglected, the state must suffer.'

Id. at 394 (emphasis added).  Although the Fourteenth Amendment right to contract as an element of liberty did not die with West Coast Hotel, it did become subject to arguably more broad health, safety and public welfare exceptions enabling regulation of employment relationships.

The author comes neither to praise nor bury Lochner or West Coast Hotel. As Fourteenth Amendment cases, neither is fully authoritative on the ERISA issue under the Fifth Amendment.  These decisions do not directly answer the question posed at the outset and raise others.  Both addressed acts of a state legislature not an act of Congress.  That context is somewhat different than an administrative agency or court interceding in a contract to change the agreement from one legitimate structure (independent contractor) to another (employment). An exercised police power to regulate the health and welfare of employees as a state legislature with approval of the executive is one thing.  A government agency or federal court moving multiple parties to a number of contracts into a zone of regulation they contractually agreed to refrain from entering is quite another. Another variant arises when the branch of government with the least democratic authority, the federal courts, chooses to disregard the contract to re-write multiple agreements in the context of a class action in which a very small minority are deemed to represent a very large group of separately contracting parties.

Federal Government Interdiction into the Contracting Parties’ choice to operate as Employees or Independent Contractors.

Analysis of government interest in the employee status question need reach back no earlier than the ratification of the Sixteenth Amendment in 1913, which permitted income taxation and, later, the adoption of the Social Security Act in 1935.  The self-employed did not become covered under the Social Security Act until the 1950 Amendments.  Thus, the funding of Social Security through payroll tax and the unavailability of Social Security eligibility to the self-employed along with the Fair Labor Standards Act, 29 U.S.C. §201 and the National Labor Relations Act, 29 U.S.C. §151, arguably became the catalyst for federal government interest in differentiating workers as employees or independent contractors. See U.S. v. Silk, 331 U.S. 704, 711 (1947). The Court did not differentiate between the lawfulness or the desirability of one status over another nor did it find that choosing to be an independent contractor was such a bad deal that the public health, safety or welfare justified abolishing independent contractor status or limiting it.

U.S. v. Silk and Darden v Nationwide

 The Supreme Court’s first foray into this area was U.S. v. Silk, 331 U.S. 704 (1947).  At issue were two groups of service providers, owner-operator truck drivers and coal loaders.  The specific concern was their coverage under the Social Security Act (SSA).  The SSA applied solely to specific employees, but it did not define “employee.” It did, however, define a variety of exclusions from coverage.  Noting a sense that the definition of employee should be broadly construed to achieve the purposes of the SSA, the Court also appreciated some of the limitations. 

Later courts seized on the former point choosing to ignore the later.  See S. G. Borello & Sons, Inc. v Dept. of Industrial Relations, 48 Cal.3d 341 (1989). In Silk, the court limited its expansive reading and noted:

Of course, this does not mean that all who render service to an industry are employees. Compare Metcalf & Eddy v. Mitchell, 269 U.S. 514, 520. Obviously, the private contractor who undertakes to build at a fixed price or on cost-plus a new plant on specifications is not an employee of the industry thus served nor are his employees. The distributor who undertakes to market at his own risk the product of another, or the producer who agrees so to manufacture for another ordinarily cannot be said to have the employer-employee relationship. Production and distribution are different segments of business. The purposes of the legislation are not frustrated because the Government collects employment taxes from the distributor instead of the producer or the other way around.

Id. at 713.  Apart from recognizing the existence of the independent contractor exemption,  the passage also notes that the purpose of legislation is not frustrated by the distinction as to who pays the tax supporting the benefit provided.

 In Silk, the Court also noted:

The problem of differentiating between employee and an independent contractor or between an agent and an independent contractor has given difficulty through the years before social legislation multiplied its importance. When the matter arose in the administration of the National Labor Relations Act, 29 U.S.C. §151 et seq., we pointed out that the legal standards to fix responsibility for acts of servants, employees or agents had not been reduced to such certainty that it could be said there was 'some simple, uniform and easily applicable test.' The word 'employee,' we said, was not there used as a word of art, and its content in its context was a federal problem to be construed "in the light of the mischief to be corrected and the end to be attained." We concluded that, since that end was the elimination of labor disputes and industrial strife, 'employees' included workers who were such as a matter of economic reality. The aim of the Act was to remedy the inequality of bargaining power in controversies over wages, hours and working conditions. We rejected the test of the "technical concepts pertinent to an employer's legal responsibility to third persons for the acts of his servants." This is often referred to as power of control, whether exercised or not, over the manner of performing service to the industry. Restatement of the Law, Agency, 220. We approved the statement of the National Labor Relations Board that "the primary consideration in the determination of the applicability of the statutory definition is whether effectuation of the declared policy and purposes of the Act comprehend securing to the individual the rights guaranteed and protection afforded by the Act." (citing N.L.R.B. v. Hearst Publications, 322 U.S. 111 (1944)).

Id. at 713.  Ultimately, the court in Silk found the owner-operator drivers to be independent contractors even though many had but one customer and their contracts provided for termination at will.  It found the loaders whose equipment investment consisted almost exclusively of the picks and shovel they used to load coal to be employees.

That said, the Silk court also agreed that:

Few businesses are so completely integrated that they can themselves produce the raw material, manufacture and distribute the finished product to the ultimate consumer without assistance from independent contractors. The Social Security Act was drawn with this industrial situation as a part of the surroundings in which it was to be enforced. Where a part of an industrial process is in the hands of independent contractors, they are the ones who should pay the social security taxes.

 Id. at 714. What the Court did not do was expressly defer to the contract of the parties.

The Silk Court also set itself on a partial collision course with Congress on the scope of the employee definition.  That divergence of views on what Congress meant when using either the undefined or circularly defined term “employee” would not be fully reconciled for 45 years until Nationwide Mutual Ins. v. Darden, 503 U.S. 318 (1992).

When Congress enacted ERISA, “employee” was unhelpfully defined in that statute as “any individual employed by an employer.” 29 U.S.C. §1002(6). The Court in Nationwide noted that the definition was completely circular and explained nothing. Faced with a need to give meaning to that term in a dispute involving insurance agents treated as independent contractors, the Court reverted to the common law.  The Court abandoned the Silk “economic realities” test in Nationwide noting its lack of Congressional support:

To be sure, Congress did not, strictly speaking, "overrule" our interpretation of those statutes, since the Constitution invests the Judiciary, not the Legislature, with the final power to construe the law. But a principle of statutory construction can endure just so many legislative revisitations, and Reid's presumption that Congress means an agency law definition for "employee" unless it clearly indicates otherwise signaled our abandonment of Silk's emphasis on construing that term “`in the light of the mischief to be corrected and the end to be attained.' " Silk, supra, at 713, quoting Hearst, supra, at 124.

Nationwide at 325.  A portion of Silk that remained undisturbed was the passage that notes that the purpose of legislation is not frustrated by the distinction as to who pays the tax supporting the benefit provided. There are two import features for our purposes. First, Nationwide was not a class action. Second, the court did not decide the employment status question but instead remanded to the court of appeals.

Legitimacy of Re-Ordering of Independent Contractor Relationships under ERISA

Assessing the legitimacy of contractor re-classification under ERISA requires an understanding of how it occurs in the “real world.”  We begin with accepting that, for the most part, intervention does not occur at all. The independent contractor relationship is both as safe and in peril as the cat in Schrödinger’s thought experiment. 

An independent contractor relationship begins with a contract between two parties.  Some are negotiated fully at arm’s length, and others are form agreements with some specific terms to be negotiated.  In heavily regulated industries or occupations, the later are relatively common and do not perforce preclude an independent contractor relationship. U.S. v. Silk, supra; Southwest Research Inst. v. Unemployment Ins. Appeals Bd., 81 Cal. App. 4th 705, 709 (2000).  The party desiring the service has a price it desires to pay that factors in the value of the service, the projected cost of providing it and a zone of profit necessary to entice someone to provide the service, among other factors.  Potential providers have a similar though reciprocal analysis with each side attempting to maximize profit within their zone of what Adam Smith described as enlightened self-interest. When all goes well that is generally the end of the discussion.

The Judicial/Employment Standards Agency Reclassification Conundrum

The legitimacy issue, when the re-classification arises from court order, is complicated.  It becomes more so if it occurs after class certification.

Most of the early law defining the master/servant and principal/agent relationship was derived from fact specific patterns where a third party to the relationship was injured in some way by acts of the alleged agent or servant. This took the form of unperformed contracts and personal injuries suffered.  The common judicial exercise was thus in determining when the nature of a service arrangement meant that party A was responsible for actions B undertook as to C arising from the service arrangement between A and B.  If B was an agent of A acting in the course and scope of the agency relationship then A was liable to C.  If B was an employee of A and injured C then the doctrine of respondeat superior could make A liable to C for the injury.  It was in this environment that courts became comfortable in piercing the parties’ agreement and looking beyond it to other factors. A large part of that comfort was attributable to the existence of an injured third party who had no role in negotiating the agreement that was instrumental in creating the injury. 

The scenarios in which reclassification is examined here are conceptually different.  The first scenario of interest arises when a disgruntled contractor seeking to reclassify himself and many others pursues employee status at a government agency like the Employee Benefits Security Administration (EBSA).  The second arises in a class action when a combination of lawyers and at least one disaffected contractor seek to reclassify a group of others who are, by definition, too numerous to include in the dispute.

Labor Standards Agency Reclassification

Evaluating the legitimacy of a group reclassification by an agency like EBSA or IRS should begin with the constitutional analysis as applied to the context.  More often the agency will start with its variant on one of the approved tests or lists of factors without critically examining whether the conditions necessary for disregarding the contract have been met and met for all who may be affected. 

For this purpose, the fact patterns the Court described in U.S. v Silk, supra with respect to the owner-operator drivers (transported into the present with a few embellishments) will suffice.  Assume that instead of a Social Security tax audit, the triggering event was an arrival on the scene of an investigator from DOL or Treasury/IRS.  The on-site owner notes that all the company’s drivers are owner-operators signatory to independent contractor agreements and produces one for each driver.  The payment records also reflect that compensation varies from driver to driver and week to week but over the past several years none has been paid, on average, less than $1,500 per week and all comply with applicable DOT hours of service standards and annually verify state and federal income tax filing via an independent auditor.

The question arguably should not be whether the drivers are employees or independent contractors but rather whether the agency has a constitutionally legitimate basis for questioning or second guessing the executed agreements.  Again, it is understood that agencies pole vault over this issue to apply factor-based tests in the real world. That this occurs does not automatically mean it is always constitutionally legitimate.

At this point in the analysis, we know that the individual class members have liberty and property interests in the independent contractor agreements they entered. We know that Congress could have applied ERISA protection to benefits for both employees and independent contractors and did not do so. We know that if Congress has a significant interest in protecting the health, safety or welfare, the Fifth Amendment will not bar the regulation if it is empowered by the Commerce Clause and stays within the limits imposed by the Ninth and Tenth Amendments. We also know that under U.S. v Silk, the status of being an independent contractor is as lawful as being an employee.

It is at this analytical crossroad where mischief detrimental to individual liberty rights can occur.  That Congress, under ERISA, invoked its powers under the Commerce Clause to regulate employee benefits does not mean that the government has the power to void agreements by those who chose to be outside ERISA’s regulatory scope.  First, by limiting ERISA standards to “employees” but not imposing similar standards on the self-employed, Congress has not exercised its powers over the self-employed, presupposing that that such powers exist.  See U.S. Const. Amend. IX, X. Second, while the courts have an obligation to interpret statutes, expansion of statutory coverage by interpretation inconsistent with a written agreement of the parties to a contract is a different issue.   That is precisely because of the liberty interest at stake and the reliance both parties to a contract should be able to afford their agreement.  Third, absent a finding that health, safety or public welfare are impacted, judicial interference in the agreement exceeds the exercise of the powers Congress found appropriate.  Moreover, one could ponder how health, safety or public welfare could be affected if being an independent contractor is as lawful as being an employee? Justice Thomas’ expressed concerns in Gobeille are another consideration as Congress plainly did not intend for ERISA to regulate non-employees. All of those concerns are present when considering ERISA reclassification of a single independent contractor.

Conclusion

It is beyond the scope of this article or the next installment to answer all the questions raised when an ERISA case begins with the premise of reclassifying those with written independent contractor agreements into “employees,” to whom ERISA would apply. Instead, the author’s goal is to shed light on some of the constitutional questions of individual liberty that arise when such claims are brought. The notion that the practical consequence of class certification is the delegation of the absent class member’s liberty interests in the enforcement of their individual contracts to the class representative and his or her counsel is worth reflection. That the transfer is accomplished by a procedural ruling of which the absent service provider has little to no notice until after the certification notice is sent is also worth considering – a topic that will be taken up in part 2 of this article. Finally, it is this author’s opinion that whether the way the courts and government agencies approach independent contractor reclassification even beyond the ERISA context under federal law and whether it meets basic due process requirements for vitiating the contracting parties’ liberty interests is due more consideration than it has received thus far. 

    James M. Nelson

    Greenberg Traurig