'Catastrophically Huge': New Labor Laws Aimed at Independent Contractors Could Be a Huge Drag on Uber and Lyft Stock

Since July, shares of both Uber and Lyft have been skidding downward: down 37% and 27% respectively from midsummer highs. One of the reasons is regulation, particularly in the form of employment laws.

A new measure in California—AB-5—and related bills in New Jersey and New York would put more pressure on the major names in the rideshare industry to treat drivers as employees instead of independent contractors. The impact would be significant: higher costs, most of which consumers would ultimately pay, and a reduction in people willing to use the services, according to a September client note from Loop Capital Markets.

The issue is also one that investors haven’t completely come to grips with. “I think the share prices to some degree are assuming somewhat of a benign outcome in 2020,” says Rohit Kulkarni, Internet and capital markets analyst at MKM Partners. “If a year from now we’re starting at a crossroads where Uber and Lyft are looking to hire tens of thousands of drivers as employees, that scenario I think is not priced into the stock.”

Business model bomb

Uber and Lyft are prototypical gig-economy employers that depend on hiring drivers who are self-employed independent contractors rather than employees. Lyft and Uber pay by the completed ride. Drivers work when they want and pay for their car expenses and taxes, with the remaining money being what they take home.

The arrangement has meant abundant availability of drivers looking for flexibility and significant savings to the companies in the lack of payroll taxes and regulatory compliance costs.

The cost of treating the drivers as employees would be “catastrophically huge,” according to Kate Gold, a labor and employment partner at Proskauer Rose in California, where the new AB-5 law that could recategorize many drivers as employees will take force on Jan. 1, 2020.

“Depending on whether the drivers are designated as exempt or non-exempt [from overtime requirements], [Uber and Lyft] have to make sure they have the proper rest and meal breaks,” says Angela Reddock-Wright, an employment attorney and managing partners of Reddock Law Group. “They have to make sure they are at a minimum paid the minimum wage per hour they’re on the clock. They’re subject to reimburse them for mileage, for gas.” There are requirements for sick days and vacation days. “In California, there is a minimum of three sick days, even for part-time employees,” Reddock-Wright says.

New Jersey and New York have their own requirements. New Jersey unemployment taxes alone range from 0.4% to 5.4% of the first $34,000 of an employee, according to the office of state Senate president Steve Sweeney, depending on various factors. The costs mount quickly, which would reduce earnings the companies have in three major states, should the measures in New York and New Jersey also pass into law.

Not only are there costs for benefits and additional taxes, but for administration and compliance, which could be the most expensive items in the long run. “I can’t quantify it, but it’s many layers of cost that don’t exist right now,” Gold says. Uber and Lyft would need mechanisms and procedures to manage people as employees under a combination of state and federal laws that have different requirements. “You may be looking at one test [of employee status] for a given state, another test for federal taxes, and another test for Employee Retirement Income Security Act—or ERISA—for purposes of looking at your benefits plans like 401(k) plans,” she says. It’s the sort of work that keeps highly paid lawyers and HR consultants in business.

Business fallout

Responding to a question from Fortune, Uber pointed to a blog statement from Tony West, the company’s chief legal officer, which said in part, “AB5 does not automatically reclassify any rideshare drivers from independent contractors to employees.” Instead, West wrote, the law codifies the so-called ABC test that is already required in the state since the California Supreme Court decision in the Dynamex Operations West, Inc. v. Superior Court of Los Angeles case.

The ABC test has three parts, all of which must be satisfied:

that the worker is free from control and direction over performance of the work, both under the contract and in fact;
that the work provided is outside the usual course of the business for which the work is performed; and
that the worker is customarily engaged in an independently established trade, occupation or business.

The rideshare companies have tried arguing that they are platforms and aren’t in the business of providing rides, to pass the B part. But that may not fly—or drive. “I don’t think the B part of the ABC test is prone to that type of argument,” Gold says. “It’s hard to say that they’re not in the business of providing drivers.”

If the companies do face employer status, they might have to significantly change how they do business. A statement that Lyft sent to Fortune reads, “If drivers are reclassified as employees, Lyft would have no choice but to act like every other business with employees, with set schedules, flat wages and a limit on the number of people who earn simultaneously on the platform.

The issue, as Lyft representatives explained, is control of business and pay. The concern is that too many drivers could decide to turn on their apps, driving up labor costs. The company says that passengers would face higher prices and longer wait times for a ride.

Loop Capital Markets expects that in California, at least, that the companies and government will reach a compromise. Uber and Lyft have backed a ballot initiative to get exemptions from the state’s new laws while promising more for drivers in guaranteed earnings, healthcare stipends, liability and accident insurance, and protection against discrimination and sexual harassment. It’s too soon to tell whether this might work.

But, at best, that would cover California and require duplicate efforts in New Jersey, New York, and another other state that decided to take up similar measures. The future could be a lot of hard slugging for the companies, and make the past few years look like an easy ride.