Economic Analysis of the Law

Use cost-benefit analysis to resolve employment law problems.

By Jathan Janove Oct 1, 2011
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Many HR professionals approach employment law compliance from a strictly black or white perspective, by focusing on what is the most legally safe and supportable course of action. This often causes friction with executives when the answer carries a substantial business cost.

This friction may be unavoidable in some circumstances when the answer really is black or white. But when the answer instead is in a gray area, as it often is, unnecessary friction can be avoided if HR applies cost-benefit analysis to employment law problems.

Consider the following scenario.

The HR Director and the Chief Executive Officer

Nancy, a company’s director of HR, returned from an employment law seminar having heard a harrowing presentation on the proliferation of class-action wage and hour litigation in the United States. Heeding the presenters’ recommendation to audit the company’s payroll practices "before it’s too late," she reviewed several positions for compliance with the Fair Labor Standards Act (FLSA).

After completing her review, Nancy concluded that one position—senior customer service specialist—would most likely be deemed by a court or government agency to be misclassified. Historically, this position had involved highly trained and experienced employees working closely with major customers while using a great deal of independent thought and decision-making in performing their jobs. Over time, however, the position had become more systematized, the level of discretion and independence substantially reduced. Nevertheless, the company continued to treat these employees as exempt from overtime pay. So despite their often working more than 40 hours in a week, they received only regular salary.

After reviewing computer logins, work schedules and other information, Nancy estimated that if the company followed the U.S. Labor Department’s directive for fixing this problem—immediate reclassification plus two years of overtime back pay—the cost to the company would be at least $230,000.

Nancy envisioned Frank, her CEO, hearing this news: "You’re telling me I need to spend $230,000 when we aren’t being sued, haven’t heard from a lawyer, don’t have a government agency on our back and none of our employees are even aware of the issue? And the money’s not budgeted?"

Nancy’s palms became moist as she imagined Frank’s next comment: "So this is what happens when you go to some conference to listen to a bunch of lawyers—a conference I paid for!"

Not liking this picture, Nancy decided to use a different approach in discussing employment law compliance with her boss. She went to Frank’s office but instead of telling him what had to be done, she said, "Frank, I’ve identified one position—senior customer service specialist—that I believe has been misclassified under applicable law. There are three options for addressing this problem.

"The first would be to immediately reclassify these employees, begin paying them overtime for hours worked over 40 in a week and pay them approximately $230,000 in back pay. This would fix the problem and essentially eliminate the legal risk. However, it would also be very expensive and I know we haven’t budgeted for it this year."

Before Frank could say anything, Nancy went on.

"A second option would be at the other end of the spectrum. We could simply maintain the status quo and hope we never get sued or audited by the government. That approach has the lowest cost but the highest risk. Unfortunately, employers like ours are more likely than ever to be sued these days. Vast numbers of plaintiffs’ attorneys are trawling the waters for wage and hour claims like these. All it takes is one disgruntled employee and we would be faced with a class-action lawsuit.

"If we do get such a claim, it won’t be for $230,000. Our violation would probably be deemed willful, meaning the back pay would be for three years instead of two, and the hourly calculation would probably be a lot more generous to employees than the number I estimated. Employees may be encouraged to be ‘creative’ in their ‘memories’ of overtime hours worked, and we’ll be in an unsympathetic position to rebut their estimates. Plus, whatever amount is calculated will be doubled, and we will be responsible not only for our attorneys’ fees but for the plaintiffs’ attorneys’ fees as well. I estimate that total cost to the company could easily exceed $1.3 million."

Frank looked a little pale but didn’t say anything.

Nancy continued. "You recently mentioned considering a reorganization of the customer service department and that a few of these senior customer service specialists might eventually be let go as a result. Those terminations would be a potential trigger for these wage and hour claims. Thus, you would be faced with a choice of dramatically increasing the likelihood of a claim or of incurring a substantial noncompliance cost—employing people the company no longer needed."

Frank rubbed his chin and asked, "What’s the third option?"

"It’s sort of in between the first two," Nancy replied. "We have about 10 weeks left in the year. We could do nothing for now, wait until year-end and then announce a new pay plan for next year. Senior customer service specialists—‘in recognition of their long, dedicated service’—would henceforth receive additional pay when they worked more than 40 hours in a week. Under Labor Department rules for salaried nonexempt workers, the overtime pay we’d have to pay wouldn’t be enormous. Instead, it would be more like an additional perk for these employees.

"This approach has risks, too, of course. Someone might make a claim in the next 10 weeks. Or someone might get suspicious when we announce the new plan, go to a lawyer and hit us with a claim for back pay.

"Although real, these risks don’t strike me as very likely. Currently, there aren’t any labor problems or even grumblings from this group about pay or anything else. We won’t be taking anything away but instead giving them money they didn’t expect to get. Also, under the statute of limitations, each payroll period that goes by effectively reduces our exposure until eventually the risk goes away."

Nancy paused, took a deep breath and looked at Frank. "So, what do you think our best option is?" she asked.

The company’s CEO sighed and said, "That third option sounds like the best one under the circumstances. I don’t like having that risk dangling over my head, but I also don’t like spending $230,000 we haven’t budgeted for."

"OK, Frank," Nancy said. "Your reasoning makes sense, and we’ll implement your choice. I’ll put together a draft policy statement and message from you to employees that we will give them in mid-December."

And the HR director and the CEO lived happily ever after.

Costs and Benefits

Although the story is based on a real event, this scenario might not always play out as simply as outlined above. If Nancy believed that the situation was black and white, and confirmed it with labor and employment counsel, the options presented to Frank would have been different.

That said, when she does discuss the matter with the CEO, it’s important for her to identify and present all the options, including—if there are gray areas—more than one option for how to comply. In this example, the switch to overtime pay on a prospective basis only might be the best the HR professional can do for employees and the organization, particularly if Nancy’s hunch is right that the CEO would not agree to back pay absent an actual lawsuit.

Ethics and Cost-Benefit Analysis

With one exception, the story of Nancy and Frank has been well-received at HR conferences. HR professionals seem eager to acquire tools that will improve their relationship with management.

The exception occurred when an audience member became angry and accused me of “encouraging HR to promote illegal behavior. The law is the law—those employees were entitled to the money and should get it!”

After my “uh oh” alarm quieted, I explained that the law is not as black and white as many people think. The tendency is to construe dark gray as black and light gray as white, with the result that executives are given one option only. Although Nancy’s analysis appeared sound, no court had yet adjudicated the issue. Light or dark, there was still enough gray to create space for C = LM.

Employing cost-benefit analysis doesn’t mean abandoning the law or ethics. It means addressing compliance issues in the broader context of organizational goals and needs. This approach increases the likelihood of C-suite support of compliance action—just as Nancy experienced in guiding her company toward full Fair Labor Standards Act compliance. Moreover, enhanced executive trust will enable HR to create better working conditions for employees since there’s plenty of evidence that good working environments help keep employers out of court and improve the bottom line.

Is C = LM always appropriate? No. I’m not suggesting you do a cost-benefit analysis of whether to discourage employees from reporting on-the-job injuries. That’s pounding in a nail with a Phillips screwdriver. Instead, add the economic analysis tool to your toolbox and look for opportunities to use it. There will be plenty.

A senior executive once said to me, HR professionals “may have a seat at the table, but that doesn’t mean we’re going to listen to them.” Well, those executive will listen to C = LM and the three options if you develop and articulate them. As you weave together legal compliance and human capital return on investment, your ability to influence your organization will grow, persuading it to do the economically smart thing and the right thing.

When I attended the University of Chicago Law School, I got a crash course in the "Chicago School of Law and Economics." As a mathematically challenged English major, I resisted the lessons. Yet years later, I learned the utility of applying cost-benefit analysis to challenging HR legal issues.

Two lessons stand out. The first involves a method some judges have used in assessing liability. Here’s an example. Assume you and I are neighbors. In your backyard, there’s a prizewinning garden you’ve lovingly and expensively cultivated; in my backyard, there’s a goat. One day my goat wanders into your yard and devours your garden. You sue me for negligently failing to prevent this disaster, seeking damages for the lost time and money, plus emotional distress at the sight of your chewed-up gardenias.

Using economic analysis, the judge would consider three variables: the cost of preventing harm, such as by my having put up a fence; the likelihood that my goat would wander off and make a meal of your prized creation; and the magnitude of the harm—your lost time, money and emotional investment. If the cost of putting up a fence is less than the likelihood times the magnitude of harm, I should be liable to you for not taking reasonable precautions to prevent my goat from wandering over to your yard. Here’s the equation: C (cost) < L (likelihood) × M (magnitude).

The second lesson has to do with the fact that people have different levels of risk tolerance and aren’t necessarily rational. Some are "risk-averse," meaning they’ll pay a higher cost than likelihood multiplied by magnitude would seem to justify (i.e., C > LM). At the other end of the spectrum are "risk preferrers," meaning they won’t spend C even when it exceeds LM ("I’ve got a lucky feeling and ain’t leaving the table until I win back my $500!"). Finally, there are the "risk-neutral" people—the rational ones who carefully compare C to LM.

Returning to Nancy, we see that she assessed C (cost of FLSA compliance) and compared it to LM (likelihood and magnitude of a wage and hour claim). She articulated three options. The first was risk-averse—immediate compliance plus $230,000 in back pay to employees who didn’t know there was a problem. The second was risk-preferrer—a $1.3 million exposure that would continue unabated in highly litigious times and could be triggered anytime by a disgruntled employee. The third was risk-neutral. By employing economic analysis, Nancy performed her job as HR director in a manner that got her CEO’s support.

Accordingly, if you’re faced with a challenging HR issue, whether a compliance problem like Nancy’s or a "crossroads" decision such as whether to fire a problematic but high-risk employee, use the C = LM equation and identify three options. If you do, resistance from management likely will go down while trust and confidence in you goes up.

The author is a shareholder with Ogletree Deakins in Portland, Ore., and author of The Star Profile: A Management Tool to Unleash Employee Potential (Davies-Black Publishing, 2008). Write him at jathan.janove@ogletreedeakins.com.

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