California Appellate Court Establishes Guidelines For Unlimited Vacation/PTO Policies

I. Key Takeaways

Many employers have established “unlimited vacation” policies in recent years. Under such policies, an employee may take time off for vacation as their job requirements permit, but the employee does not accrue vacation days. The flexibility of such policies, which reflect the reality of today’s work culture in many companies, inures to the benefit of employees and employers. In Teresa McPherson et al. v. EF Intercultural Foundation, Inc., No. BC609090, the first published opinion to address the legality of such policies, the California Court of Appeal for the Second Appellate District confirmed that unlimited vacation policies, if communicated and implemented properly, can be lawful.

Specifically, the Court set forth the following guidelines for an unlimited, non-accruing vacation policy to be valid:

• Communicate the policy in writing;
• Clearly state that employees’ ability to take PTO is not a form of additional wages for services performed, but part of a promise to provide a flexible work schedule, including employees’ ability to decide when and how much time to take off;
• Spell out the rights and obligations of the employer and employees, as well as the consequences of failing to schedule PTO;
• Allow sufficient opportunity for employees to take time off or work fewer hours in lieu of taking time off; and
• Fairly administer the policy so that it does not become a “use it or lose it policy” in practice or result in inequities—for instance, where one employee works many hours and takes minimal PTO, and another works fewer hours and takes more PTO.

Under the facts in McPherson, however, the Court concluded that the employer failed to establish a valid unlimited vacation policy and, thus, found the employer was required to compensate the terminated employees for unused vacation time. In light of McPherson, all employers utilizing unlimited vacation policies should evaluate such policies for compliance and proceed cautiously if seeking to implement such a policy.

II. Details of Decision

The McPherson court considered two key questions: (1) whether an employer’s practice of providing certain employees unaccrued PTO was subject to § 227.3 and (2) whether § 227.3 continues to apply to an employee who voluntarily leaves California to live and work in another state for the same employer.

A. Legal Background

In California, employers are not required to provide employees with paid vacation. But if an employer offers paid vacation for its employees, § 227.3 requires the employer to pay as wages any “vested” but unused vacation time upon an employee’s termination.

In Suastez v. Plastic Dress Up Company, 31 Cal. 3d 774 (1982), the California Supreme Court addressed when the right to vacation vests under § 227.3. The Court held that vacation vests as the labor is rendered and that vacation pay is a form of deferred compensation. Once vested, the right to vacation pay is protected from forfeiture by § 227.3. Upon termination, an employee must be paid in wages for a pro rata share of their vacation pay. Employers can legitimately limit the amount of vacation pay that an employee accrues by establishing a maximum amount of accrued vacation time.

B. The Decision Below

EF Intercultural Foundation, Inc. (EF) is a foreign nonprofit corporation that runs educational and cultural exchange programs between the United States and other countries. EF Educational Homestay Program (EHP) is a division of EF. EHP employs full-time area managers on the East and West coasts to run seasonal homestay programs for international students. Plaintiffs Teresa McPherson, Donna Heimann, and Linda Brenden were full-time, exempt, salaried EF employees who worked in the EHP division as area managers.

During plaintiffs’ employment, EF had a vacation policy in its employee handbook that provided certain salaried employees with a fixed number of vacation days per month based on their length of service. That policy did not apply to plaintiffs. Instead, plaintiffs could take an unspecified amount of paid time off, subject to approval. Although they were discouraged from taking time off during EHP’s peak season, some time off during the peak season was approved in certain instances. Plaintiffs did not accrue vacation days, and unlike employees who were subject to the written vacation policy, did not use EF’s online system to request or keep track of paid time off. They were only required to notify their supervisors before taking time off.

Plaintiffs sued EF in February 2016, alleging that EF had failed to pay them for accrued but unused vacation. The complaint asserted causes of action for violation of Labor Code § 227.3 (denial of vacation wages), breach of contract, breach of the implied covenant of good faith and fair dealing, violation of Labor Code §§ 201 and 203 (unpaid wages at discharge and waiting time penalties), and violation of Business and Professions Code § 17200 (unfair competition).

The trial court granted summary adjudication to EF on plaintiffs’ claim for breach of the covenant of good faith and dealing, and the case proceeded to a bifurcated bench trial on the remaining claims. The trial court found EF liable for vacation wages, holding that EF’s policy of providing vacation time that did not accrue was an “undefined” vacation policy, not an unlimited one. The trial court based its decision on the three primary facts: (1) plaintiffs’ vacation requests required approval; (2) there was no evidence that plaintiffs requested or received approval for more than a typical amount of vacation; and (3) no one told plaintiffs that they had the right to take a large amount of vacation. Ultimately, the trial court ruled that if a policy provides vacation time, vacation time vests even if the employer does not expressly define the precise amount of vacation in a policy statement to employees. Because EF granted plaintiffs approval for between one and 20 vacation days per year during their employment, the court held that EF’s policy provided at least 20 days of annual vacation and that EF owed plaintiffs for any unused vacation.

The trial court also held that Heimann was covered by California’s wage and hour laws even though she had moved to Virginia, finding that her work was focused on people and activities in California and that EF required her to temporarily reside in California for significant periods.

On appeal, EF challenged the trial court’s ruling, arguing that California law did not prohibit unlimited time off policies, that neither EF’s policies nor plaintiffs’ employment contracts gave plaintiffs vested vacation rights, and that § 227.3 did not apply to Heimann after she moved to Virginia.

C. The Court’s Opinion

Application of § 227.3 to “Unlimited” Vacation Policies

Agreeing with the trial court, the McPherson Court held that § 227.3 applied to EF’s vacation practice because it was unlimited neither in practice nor in how EF explained it to employees. The court dismissed EF’s argument that the second prong of § 227.3—“an employee is terminated without having taken off his vested vacation time”—does not apply to unlimited vacation policies because no vacation time vests if there is no fixed vacation bank. The court explained that once EF chose to provide plaintiffs with paid vacation, that benefit constituted additional wages. Those wages were attributable to plaintiffs’ labor and must have vested as plaintiffs worked. The court added that once an employer offers paid vacation, it must communicate any limits on an employee’s entitlement to that vacation in a clear, written policy. EF did not do so.

The McPherson Court concluded that EF never had an unlimited vacation policy because no written policy existed and it never told plaintiffs that they had unlimited vacation or that their vacation was not part of their compensation. According to the court, EF’s vacation policy had an implied limit and, in practice, EF granted plaintiffs some fixed amount of vacation time. Based on witness testimony and trial exhibits, the Court determined that EF expected plaintiffs to take between two and six weeks of vacation per year, the range typically available to employees governed by EF’s written vacation policy. It also held that plaintiffs’ busy schedules precluded them from taking advantage of an unlimited vacation policy and that plaintiffs reaped no benefits of an unlimited vacation policy (e.g., taking more than four weeks of vacation, significantly reducing hours during the off-peak season, etc.). Citing the trial court, the McPherson Court said that an employer “cannot avoid § 227.3 by leaving the amount of vacation time undefined in its policy while impliedly limiting the time actually available for approval.”

The court also emphasized that EF never told plaintiffs that they could take as much vacation as they wanted. Instead, supervisors informally notified plaintiffs that: (1) they did not accrue vacation but could take paid vacation outside of the busy season; (2) they had to notify their supervisor before taking time off and ensure they could complete their work; and (3) they did not need to track their days off in the online system because they did not accrue vacation. Although an EF representative testified that plaintiffs could take as much or as little time off as they wanted as long as they could still perform their job duties, the court gave great weight to plaintiffs’ statements that they did not understand the vacation policy to be unlimited. Finally, the Court held that EF failed to demonstrate that § 227.3 did not apply to its vacation policy for plaintiffs because EF never “set out its purported unlimited vacation policy—or any limitations it imposed on earning vacation wages—in a clear, express writing (or otherwise).”

The McPherson Court noted that § 227.3 did not necessarily apply to “truly unlimited time off policies” and that there could be circumstances in which unlimited PTO would not need to be paid upon termination of employment. It then articulated guidelines (described above) for an unlimited PTO policy to pass legal scrutiny.

Application of § 227.3 to Nonresident Employees

The McPherson Court reversed the trial court's holding on this issue and held that § 227.3 does not apply to work performed outside of California by a nonresident, even if that work is focused on activities and people actually in California. The court summarized its holding, stating that § 227.3 did not apply where a nonresident, exempt employee of a non-California employer has periodically performed work within California, has received no California wages, and has paid no California income taxes on any wages earned. The extraterritorial application of California’s wage and hour laws is also the subject of two cases pending before the California Supreme Court, Ward v. United Airlines and Oman v. Delta Airlines, which were argued on April 7, 2020.

If you have any questions about the McPherson decision or how it may affect your company’s policies or practices, please contact the authors of this alert or your O’Melveny advisor.