Minnesota employers have received a long-awaited decision from the state supreme court on a vacation pay issue that has caused much confusion and has divided employers and employees. In Lee v. Fresenius Medical Care Inc., issued on November 15, 2007, the Minnesota Supreme Court held that an employer's obligation to pay out unused vacation balances upon termination is governed by its policies and contracts. In Lee, a case in which Littler Mendelson represented the employer, the court ruled that the employer's policies lawfully denied an employee's claim for unused vacation benefits when the employee was terminated for misconduct, thereby reversing the 2006 decision of the Minnesota Court of Appeals on that issue. The court also went out of its way to approve vacation policies that require employees either to use allotted vacation time or to lose the potential benefit, as well as those policies that impose caps on vacation accrual.

The Facts

Susan Lee was a dialysis technician who worked at a Fresenius dialysis clinic from 2000 to 2002. Ms. Lee was an at-will employee and subject to Fresenius's policies, as contained in its Employee Handbook and Human Resources Policy Manual. Fresenius's Employee Handbook stated that employees terminated for misconduct were ineligible for pay in lieu of unused paid time off (PTO),¹ unless required by state law. Shortly after Fresenius hired her, Ms. Lee signed an acknowledgment verifying her receipt of the Employee Handbook. Fresenius's Human Resources Policy Manual, which was also available to Ms. Lee, similarly stated that employees who were discharged due to poor performance were ineligible for pay in lieu of unused PTO. As a result of significant performance and misconduct concerns, Ms. Lee's employment was terminated in August 2002. Upon her discharge, Fresenius paid Ms. Lee her accumulated wages, but because her termination was for misconduct, Fresenius did not compensate Ms. Lee for unused PTO.

Approximately two years after her discharge, Ms. Lee brought an action against Fresenius in conciliation court, seeking to recover pay in lieu of accumulated unused vacation time. The conciliation court awarded Ms. Lee $5,053.80, the equivalent of 181.86 hours of vacation pay. Fresenius appealed the case to the district court and moved for summary judgment on Ms. Lee's claims. The district court granted Fresenius's motion, holding that an employer's liability for vacation pay is wholly contractual, and that Fresenius's Employee Handbook, which included its policy regarding vacation pay, satisfied Minnesota's requirements to constitute a binding contract. Under the terms of that contract, Ms. Lee was not, according to the district court, entitled to compensation for unused vacation pay or PTO.

Ms. Lee appealed to the Minnesota Court of Appeals. In Lee v. Fresenius Medical Care, Inc., 719 N.W.2d 222 (Minn. App. 2006), the court of appeals ruled in Ms. Lee's favor. In doing so, the court of appeals looked to Minnesota Statute section 181.13(a), which states that upon discharge, "wages or commissions actually earned and unpaid at the time of the discharge" must be paid immediately upon demand by the employee, or no later than 24 hours after demand. The statute does not define wages, nor does it define the term actually earned. In applying the statute, Minnesota courts, and federal courts sitting in Minnesota, have historically treated section 181.13 as governing only when wages are due. The separate question of whether wages are owed had previously been decided by looking to the terms of the employment agreement.

Nonetheless, the court of appeals determined that the term wages in section 181.13(a) includes compensation for vacation time accrued under the terms of an employment contract, and that pursuant to section 181.13(a), compensation for accrued vacation time actually earned and unpaid at the time of discharge must be paid in the same manner as other wages and commissions. While the court of appeals recognized that an employer's liability for an employee's vacation pay is "generally" wholly contractual, it nonetheless departed from precedent and concluded that Fresenius's policy was contrary to the principle that "[a] party cannot provide by contract what is prohibited by statute."² Applying that reasoning to Ms. Lee's case, the court of appeals refused to give legal effect to the language in Fresenius's handbook, which provided that employees who are terminated for misconduct are not eligible to receive payment for unused PTO, and held that the district court erred in relying on that language.

Fresenius sought and obtained review by the Minnesota Supreme Court.

Can an Employment Agreement Govern Eligibility for Paid Time Off?

The Minnesota Supreme Court first addressed whether eligibility for PTO or vacation can be governed by an employment agreement. Relying on established Minnesota precedent, the court concluded that because vacation is a benefit, and not a right required by Minnesota statutes, an employment agreement can establish the terms under which an employee is eligible for PTO or vacation.

The court next turned to whether an employment agreement existed between Ms. Lee and Fresenius. Minnesota courts have established that the terms in an employee handbook will constitute a contractual offer if those terms are definite in form and are communicated to the employee through dissemination of the handbook. An employee's retention of employment, once she or he has received the handbook, constitutes acceptance of the offer. Finally, by staying on the job, the employee supplies consideration for the offer. In this case, Ms. Lee received the handbook, acknowledged having done so, and remained employed by Fresenius thereafter. Accordingly, the handbook constituted an enforceable employment contract between Fresenius and Ms. Lee.³

Is Paid Time Off Wages for Purposes of Section 181.13(a)?

Even though section 181.13(a) does not define the term wages, Ms. Lee argued that the handbook language disqualifying her from receiving payment for unused PTO was invalid because PTO constituted wages for purposes of section 181.13(a). As a threshold matter, the court agreed that PTO constitutes wages for purposes of section 181.13(a). More important, however, was the court's analysis of the undefined phrase actually earned in section 181.13(a).

Ms. Lee argued that the phrase actually earned in section 181.13(a) created a substantive right to compensation, such that she should be allowed to use the statute as a basis for a wage claim, even though her employment contract specifically denied entitlement to payments for unused PTO. Fresenius argued that section 181.13(a) speaks only to the timing of wage payments when an employer discharges an employee, not what must be paid upon discharge.

In concluding that the statute speaks only to the timing of pay and that it does not provide a substantive right to payments, the court relied on the rule that statutes which provide for penalties should be strictly construed. The court explained that Minnesota law supports strict construction of the statute, in that it does not provide for employee vacation time or pay as of right, but instead gives employers the discretion to choose whether, and under what circumstances, employees will be granted vacation benefits. Construing the statute narrowly, the court found that section 181.13(a) did not prohibit the specific provision in Fresenius's employment contract with Ms. Lee, which provides that "if your employment is terminated for misconduct, you will not be eligible for pay in lieu of notice or payment of earned but unused PTO unless required by state law." Instead, section 181.13(a) permits an employment contract to determine when wages are actually earned for purposes of the statute, and because the statute does not create a substantive right to vacation pay, it does not prohibit the contractual definition of vacation wages as subject to the conditions expressed in the contract.

Ms. Lee argued unsuccessfully that Fresenius was attempting to enforce a condition subsequent to payment of earned and vested benefits. The court rejected this argument, explaining that Ms. Lee's right to receive payment for unused PTO upon termination was subject to the condition precedent that she provide notice prior to her resignation and that she not be terminated for misconduct.

Ultimately, the court concluded that in Minnesota, employers can offer, and employees can accept, a contract provision that attaches conditions to the right to accrued vacation wages. This can be in the form of actual PTO or payment in lieu of PTO. To the extent that PTO is considered wages, the conditions identified in the contract define those wages. Similarly, to the extent that wages in the form of PTO (or payment in lieu of PTO) have been earned, the conditions identified in the contract define precisely what has been earned.

The court also expressed concern about a contrary holding. The court recognized that if it interpreted section 181.13(a) to mean that an employee earns an absolute right to compensation for PTO as soon as she accrues those hours, the result would be, at best, uncertainty, and at worst, potentially serious consequences for many employers' vacation-benefit policies. Moreover, any other conclusion on the facts of the case would call into question the legality of use-it-or-lose-it policies and caps on vacation accrual policies, both of which are common among employers in their attempts to manage their workforces. The court specifically described such policies as lawful.

What Does This Mean for Employers?

During the fifteen months that passed while waiting for the Minnesota Supreme Court's decision in Lee, many employers, concerned with the possibility of challenges, changed their policies, and others contemplated doing so. Relying on the Lee decision, and in the absence of legislative action, Minnesota employers have the right and ability to impose conditions on payments for unused PTO or vacation upon termination of employment, when the conditions are incorporated into a clear policy. Minnesota employers should review their vacation and time off policies, and consider these practical tips:

• Ensure that vacation and PTO policies contained in employee handbooks are properly acknowledged so that they constitute a binding contract.
• Draft vacation and PTO policies clearly and without ambiguity, directly setting forth what, if anything, is owed at the time of termination and under what circumstances. Take special care with disclaimer language to preserve employment-at-will status while making the rules regarding vacation payout upon termination explicit.
• Although employers can lawfully create policies that do not pay out any unused vacation or PTO benefits at the time of termination ("use it or lose it"), such policies need to be drafted carefully. Ideally, the language used will clearly express the employer's intent that vacation will be a benefit used during employment, not a source of additional "wages" arguably payable at termination. To avoid confusion, the same policy that creates the vacation/PTO benefit should also define its limits. For example, while setting forth the number of vacation days granted in a year, in the same document, the employer should state what happens to any remaining balance upon termination.
• Employers operating in multiple states need to recognize that other states have different rules, and that Lee is a Minnesota decision based on Minnesota law. In drafting policies, be aware that other states might be less deferential to policy language that is acceptable in Minnesota.
• Although Lee gives employers greater flexibility in drafting and implementing vacation/PTO policies, it does not require employers to offer vacation benefits to employees. Neither does the decision prevent employers from paying out unused vacation benefits at the time of termination. The matter is left up to the agreement of the employer and employee.
• If an employer intends to pay out some vacation benefit at the time of termination, but is concerned about the size of its exposure, consider instituting a policy in which vacation or PTO is accrued over time, rather than in a lump allotment at the beginning of the year. Doing so can help an employer limit the amount of unused vacation available to an employee upon discharge.
• To control vacation balances, an employer can also prohibit or limit the carryover of unused vacation or PTO from one year to the next.

¹ Although Fresenius's Handbook refers to "PTO" or paid time off, Fresenius used the terms PTO and vacation interchangeably, and the supreme court did the same in its opinion.

² In articulating this principle, the court relied upon Winnetka Partners Ltd. P'Ship v. County of Hennepin, 538 N.W.2d 912 (Minn. 1995), a case in which the owner of an apartment complex entered into a minimum-assessment agreement with a local housing and redevelopment authority, in exchange for tax-increment financing. When faced with interpreting the agreement several years later, the Minnesota Supreme Court opined that if a particular provision were given effect, it would directly violate a state statute governing assessment agreements. Accordingly, the supreme court concluded that the provision in question could not be given legal effect.

³ Ms. Lee's employment terms, as described in the handbook, did not alter her status as an employee terminable "at will." The handbook set forth the terms that applied during her employment, but because she had no agreement as to the duration of her employment, Ms. Lee remained an at-will employee under Minnesota law. See Cederstrand v. Lutheran Bhd., 117 N.W.2d 213, 221 (Minn. 1962).

Marko Mrkonich is a Littler Shareholder who represented Fresenius Medical Care in this matter. Jacy Rubin Grais is a Knowledge Management Attorney in Littler Mendelson's Minneapolis office. If you would like further information, please contact your Littler attorney at 1.888.Littler, info@littler.com, or Mr. Mrkonich at mmrkonich@littler.com, and Ms. Grais at jgrais@littler.com.