Many employers use outside payroll services to perform the important functions of processing payroll-related data and issuing employee paychecks. Recently, in Goonewardene v. ADP, LLC, the California Supreme Court addressed the question of whether an employee can sue an outside payroll service company for errors in the employee’s pay. In that case, an employee who alleged unpaid wages, brought claims for breach of contract, negligence and negligent misrepresentation against his employer’s outside payroll service provider. Although there was no employment relationship between the payroll service and the employee for unpaid wages under the Labor Code, the employee brought his claims based on the third party beneficiary doctrine, under which an individual or entity that is not a party to a contract (i.e., the third party) may bring a breach of contract action against a party to the contract if that individual or entity establishes that it is likely to benefit from the contract, that a motivating purpose of the contracting parties is to provide a benefit to the third party, and that permitting the third party to bring its own breach of contract action against a contracting party is consistent with the objectives of the contract and the reasonable expectations of the contracting parties.
The Court found that the third party beneficiary doctrine does not apply to this situation because the underlying purpose of the contract between the employer and the payroll service is to benefit the employer. In addition, permitting employees to bring claims directly against payroll services in wage and hour lawsuits would result in considerable defense costs for the payroll company, which would ultimately be passed on to the employer through increased costs of the payroll services-- a result that would not be consistent with the objectives of the contract. Accordingly, the employees’ redress in such a situation would lie solely against the employer under applicable Labor Code and Wage Order provisions. Of course, the employer may have a claim against the payroll service provider pursuant to their contract if the provider was negligent or otherwise did not fulfill its obligations under the contract.
Employers who use outside payroll service providers should protect themselves through robust service agreements with the providers that set forth the specific payroll functions to be provided, and shift the burden to the provider to cover damages arising out of its failure to properly perform such services. Employers may also want to confirm that their payroll service providers are adequately insured for such losses. Lastly, it is important to note that this decision does NOT apply to PEO (Professional Employer Organization) or other joint employer situations, in which both parties can be found liable as employers. Employers are urged to have legal counsel review their services contracts with any outside payroll service providers.