Tips for Drafting Executive Employment Agreements

Executives and other high-level employees often negotiate a contractual provision requiring the payment of severance if terminated without “Cause” prior to the expiration of a term agreement. While the definition of “Cause” often depends on the parties' respective bargaining powers (highly sought talent typically has considerable leverage), the employer should attempt to negotiate as broad a definition of Cause as possible. Too often, employers limit the definition of Cause to intentional misconduct that harms the company, criminal behavior, or the executive's death. Such a narrow definition ties the employer's hands when an executive is not making a good-faith effort to perform well or is performing very poorly despite reasonable efforts. Under these circumstances, the employer's options are limited to continuing to employ the underperforming executive or terminating the executive and paying out severance.

It is also fairly common for Cause definitions to include a cure period in the event of a breach by the executive ' e.g., “a material breach by the Employee of any of the terms of this Agreement and failure to correct such breach within twenty (20) days after notice from the Company”). By providing the executive the right to breach the Agreement and then cure the breach (if the Company learns of the breach, which it may not), the Company is limiting its options and ability to hold the executive accountable for his/her performance. Moreover, depending on the nature of the breach and its impact on the Company's operations, an extended cure period may negatively impact the Company even if the breach is ultimately cured. This is not to suggest that an employer should never agree to a cure period (many executives will insist on such a provision and, as noted above, they are fairly common), but the employer should weigh the pros and cons of the cure provision in the context of the overall negotiations with the executive.

The Cause definition also should include the executive's disability that prevents the executive from performing his/her responsibilities for an extended period of time. However, the definition must comply with the Americans With Disabilities Act (ADA), the Family & Medical Leave Act (FMLA), and applicable state and local laws addressing disabilities and employee leave rights. In other words, an executive's employment agreement does not trump his/her rights under the law. For example, it would be illegal to include in the definition of Cause a disability that prevents the executive from performing any of his/her job responsibilities. This is because the ADA protects employees so long as they are capable of performing the “essential functions” (i.e., not necessarily all duties) of the position “with or without a reasonable accommodation.” Likewise, depending on the size of the employer and the length of the executive's tenure (among other eligibility factors), the executive may have the right to take up to 12 weeks of leave under the FMLA without the threat of termination. Thus, Cause definitions must be carefully drafted to avoid running afoul of applicable law.

In short, the executive is entitled to be treated fairly and to not be terminated prior to the end of a term agreement for a false reason, an illegal reason, or an unfair reason. But the Company has the right to demand good-faith effort and an acceptable level of performance from the executive. Accordingly, the Agreement should contain a provision requiring the executive to use his/her “best efforts” in the performance of his/her duties under the agreement, and the definition of Cause should provide the Company with the flexibility to terminate an executive without a severance pay obligation for legitimate, non-discriminatory business reasons (assuming it has the leverage to negotiate such terms).

Tip No. 2: Condition Severance on the Execution of a General Release and Compliance with Other Contractual Provisions

If the Company is going to include the payment of severance in an executive's employment agreement, it should always require the executive to execute a general release of all claims against the Company as a condition of receiving severance. By failing to include this condition, an executive could be terminated, collect severance, and turn around and sue the Company for breach of the agreement, discrimination, etc.

The Company also should condition payment of the severance on compliance with other contractual provisions of the agreement, such as provisions relating to the return of Company documents and property, non-disparagement, noncompetition,
nondisclosure of confidential information, and nonsolicitation of customers and employees. Not only does this approach incentivize the executive to honor his/her post-employment contractual obligations, but it permits the Company to engage in “self-help” by simply discontinuing the severance payments in the event of a breach by the executive, rather than having to file suit against the executive and incur substantial attorneys' fees and costs in the process.

Tip No. 3: Check Applicable Law Before Drafting Restrictive Covenants

Executives often are provided with access to high-level client contacts and highly confidential, proprietary, and competitively valuable information. While state law typically provides some protection against the disclosure of trade secret information in the absence of contractual commitments, including restrictive covenants in an executive employment agreement can provide additional and, in most cases, much more effective, protection. Employers must keep in mind, however, that the law differs considerably from state to state, and it is imperative that the employer consult applicable state law (typically, where the executive is employed, but some states will recognize the law of the state where the employer is headquartered), when drafting restrictive covenant provisions.

For example, Oregon has a statute that provides that a noncompetition provision is voidable and unenforceable in certain circumstances unless the “employer informs the employee in a written employment offer received by the employee at least two weeks before the first day of the employee's employment that a noncompetition agreement is required as a condition of employment.” Or. Rev. Stat. Section 653.295.

Even in states that do not have a statute that addresses restrictive covenants, all states have case law on the topic that provides guidance regarding the circumstances in which courts have enforced and refused to enforce restrictive covenants. Some states are very employee-friendly (e.g., California, which typically will not enforce a straight noncompetition provision), while others are employer-friendly (e.g., Florida and Missouri). Key factors include the temporal and geographic scope of the restrictions, the types of activities sought to be restricted, and the types and competitive value of the confidential information sought to be protected.

Moreover, many states will permit the court to modify an otherwise overly broad restriction to make it enforceable under the law, provided the agreement contains a provision granting the court the power to do so. Depending on the type and extent of the permissible modification, this doctrine is referred to as either “reformation” or “blue-penciling.” Thus, including such a provision in an executive employment agreement typically increases the likelihood of the court enforcing the restrictive covenant.

Tip No. 4: Beware of 409A

When drafting executive employment agreements, it is imperative to consider the potential implications of Section 409A of the Internal Revenue Code of 1986, as amended (“Section 409A”). Section 409A is a U.S. tax law that governs the payment of deferred compensation (i.e., compensation earned in one year that is payable in another year). This law generally regulates the time, form and manner in which deferred compensation is paid, and imposes severe penalties on the executive for a failure to comply. These penalties generally include payment of income tax on any amounts deferred under the agreement retroactive to the first year the agreement violated Section 409A, interest on the unpaid taxes and an excise tax equal to 20% of the income recognized. Although it is the executive, and not the employer, who is penalized under Section 409A, the executive's counsel typically will raise the issue. Thus, even if the employer does not believe that its duty of good faith and fair dealing requires bringing this issue to the attention of the executive, it is typically more efficient to draft the employment agreement to comply Section 409A in the first instance so that the negotiations can focus on the terms in dispute.

While a detailed discussion of Section 409A's triggers and loopholes is beyond the scope of this article, employers should keep in mind for issue-spotting purposes the following potential triggers for Section 409A liability:

• Not including a six-month delay in payments made on account of termination of employment if the executive is a “specified employee” of a public company (Note, while this provision only applies to public companies, Section 409A applies to both private and public companies);
• Including a non-compliant definition of “good reason” (when the intent is to rely on the “involuntary termination” exemption from 409A); and
• Making payments contingent on receipt of notice or evidence of the executive's death.

Legal counsel experienced with drafting Section 409A-compliant executive employment agreements can avoid potential liability in a number of ways (e.g., including “safe harbor” provisions, restructuring the agreement). Accordingly, employers should always consult counsel with Section 409A expertise when an executive employment agreement provides for any form of deferred compensation.

William (Bill) Wortel, a member of this newsletter's Board of Editors and a partner at Bryan Cave LLP, has represented management in a variety of litigation at the administrative level, in state and federal courts and in the U.S. Court of Appeals. Carrie E. Byrnes is an associate at the firm; both are resident in the Chicago office.

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For every well-drafted executive employment agreement in the business world, there seem to be multiple poorly drafted agreements. Too often, employers simply copy and paste from older agreements without knowing anything about the identity or qualifications of the author of the original agreement, or the jurisdiction or circumstances in which the agreement was intended to be used. Moreover, employers sometimes borrow terms from an agreement that was heavily negotiated by an executive with considerable leverage. Under such circumstances, the agreement likely will contain terms that are less favorable to the employer than those that can be negotiated with another executive.

Most employers do not realize their mistakes until they are consulting an employment attorney regarding their rights and obligations with respect to an executive who has engaged in misconduct or is simply performing poorly. The purpose of this article is to provide tips for drafting executive employment agreements and to highlight the importance of consulting counsel before tendering an agreement to an executive for consideration.

Tip No. 1: Define 'Cause' Broadly

Executives and other high-level employees often negotiate a contractual provision requiring the payment of severance if terminated without “Cause” prior to the expiration of a term agreement. While the definition of “Cause” often depends on the parties' respective bargaining powers (highly sought talent typically has considerable leverage), the employer should attempt to negotiate as broad a definition of Cause as possible. Too often, employers limit the definition of Cause to intentional misconduct that harms the company, criminal behavior, or the executive's death. Such a narrow definition ties the employer's hands when an executive is not making a good-faith effort to perform well or is performing very poorly despite reasonable efforts. Under these circumstances, the employer's options are limited to continuing to employ the underperforming executive or terminating the executive and paying out severance.

It is also fairly common for Cause definitions to include a cure period in the event of a breach by the executive ' e.g., “a material breach by the Employee of any of the terms of this Agreement and failure to correct such breach within twenty (20) days after notice from the Company”). By providing the executive the right to breach the Agreement and then cure the breach (if the Company learns of the breach, which it may not), the Company is limiting its options and ability to hold the executive accountable for his/her performance. Moreover, depending on the nature of the breach and its impact on the Company's operations, an extended cure period may negatively impact the Company even if the breach is ultimately cured. This is not to suggest that an employer should never agree to a cure period (many executives will insist on such a provision and, as noted above, they are fairly common), but the employer should weigh the pros and cons of the cure provision in the context of the overall negotiations with the executive.

The Cause definition also should include the executive's disability that prevents the executive from performing his/her responsibilities for an extended period of time. However, the definition must comply with the Americans With Disabilities Act (ADA), the Family & Medical Leave Act (FMLA), and applicable state and local laws addressing disabilities and employee leave rights. In other words, an executive's employment agreement does not trump his/her rights under the law. For example, it would be illegal to include in the definition of Cause a disability that prevents the executive from performing any of his/her job responsibilities. This is because the ADA protects employees so long as they are capable of performing the “essential functions” (i.e., not necessarily all duties) of the position “with or without a reasonable accommodation.” Likewise, depending on the size of the employer and the length of the executive's tenure (among other eligibility factors), the executive may have the right to take up to 12 weeks of leave under the FMLA without the threat of termination. Thus, Cause definitions must be carefully drafted to avoid running afoul of applicable law.

In short, the executive is entitled to be treated fairly and to not be terminated prior to the end of a term agreement for a false reason, an illegal reason, or an unfair reason. But the Company has the right to demand good-faith effort and an acceptable level of performance from the executive. Accordingly, the Agreement should contain a provision requiring the executive to use his/her “best efforts” in the performance of his/her duties under the agreement, and the definition of Cause should provide the Company with the flexibility to terminate an executive without a severance pay obligation for legitimate, non-discriminatory business reasons (assuming it has the leverage to negotiate such terms).

Tip No. 2: Condition Severance on the Execution of a General Release and Compliance with Other Contractual Provisions

If the Company is going to include the payment of severance in an executive's employment agreement, it should always require the executive to execute a general release of all claims against the Company as a condition of receiving severance. By failing to include this condition, an executive could be terminated, collect severance, and turn around and sue the Company for breach of the agreement, discrimination, etc.

The Company also should condition payment of the severance on compliance with other contractual provisions of the agreement, such as provisions relating to the return of Company documents and property, non-disparagement, noncompetition,
nondisclosure of confidential information, and nonsolicitation of customers and employees. Not only does this approach incentivize the executive to honor his/her post-employment contractual obligations, but it permits the Company to engage in “self-help” by simply discontinuing the severance payments in the event of a breach by the executive, rather than having to file suit against the executive and incur substantial attorneys' fees and costs in the process.

Tip No. 3: Check Applicable Law Before Drafting Restrictive Covenants

Executives often are provided with access to high-level client contacts and highly confidential, proprietary, and competitively valuable information. While state law typically provides some protection against the disclosure of trade secret information in the absence of contractual commitments, including restrictive covenants in an executive employment agreement can provide additional and, in most cases, much more effective, protection. Employers must keep in mind, however, that the law differs considerably from state to state, and it is imperative that the employer consult applicable state law (typically, where the executive is employed, but some states will recognize the law of the state where the employer is headquartered), when drafting restrictive covenant provisions.

For example, Oregon has a statute that provides that a noncompetition provision is voidable and unenforceable in certain circumstances unless the “employer informs the employee in a written employment offer received by the employee at least two weeks before the first day of the employee's employment that a noncompetition agreement is required as a condition of employment.” Or. Rev. Stat. Section 653.295.

Even in states that do not have a statute that addresses restrictive covenants, all states have case law on the topic that provides guidance regarding the circumstances in which courts have enforced and refused to enforce restrictive covenants. Some states are very employee-friendly (e.g., California, which typically will not enforce a straight noncompetition provision), while others are employer-friendly (e.g., Florida and Missouri). Key factors include the temporal and geographic scope of the restrictions, the types of activities sought to be restricted, and the types and competitive value of the confidential information sought to be protected.

Moreover, many states will permit the court to modify an otherwise overly broad restriction to make it enforceable under the law, provided the agreement contains a provision granting the court the power to do so. Depending on the type and extent of the permissible modification, this doctrine is referred to as either “reformation” or “blue-penciling.” Thus, including such a provision in an executive employment agreement typically increases the likelihood of the court enforcing the restrictive covenant.

Tip No. 4: Beware of 409A

When drafting executive employment agreements, it is imperative to consider the potential implications of Section 409A of the Internal Revenue Code of 1986, as amended (“Section 409A”). Section 409A is a U.S. tax law that governs the payment of deferred compensation (i.e., compensation earned in one year that is payable in another year). This law generally regulates the time, form and manner in which deferred compensation is paid, and imposes severe penalties on the executive for a failure to comply. These penalties generally include payment of income tax on any amounts deferred under the agreement retroactive to the first year the agreement violated Section 409A, interest on the unpaid taxes and an excise tax equal to 20% of the income recognized. Although it is the executive, and not the employer, who is penalized under Section 409A, the executive's counsel typically will raise the issue. Thus, even if the employer does not believe that its duty of good faith and fair dealing requires bringing this issue to the attention of the executive, it is typically more efficient to draft the employment agreement to comply Section 409A in the first instance so that the negotiations can focus on the terms in dispute.

While a detailed discussion of Section 409A's triggers and loopholes is beyond the scope of this article, employers should keep in mind for issue-spotting purposes the following potential triggers for Section 409A liability:

• Not including a six-month delay in payments made on account of termination of employment if the executive is a “specified employee” of a public company (Note, while this provision only applies to public companies, Section 409A applies to both private and public companies);
• Including a non-compliant definition of “good reason” (when the intent is to rely on the “involuntary termination” exemption from 409A); and
• Making payments contingent on receipt of notice or evidence of the executive's death.

Legal counsel experienced with drafting Section 409A-compliant executive employment agreements can avoid potential liability in a number of ways (e.g., including “safe harbor” provisions, restructuring the agreement). Accordingly, employers should always consult counsel with Section 409A expertise when an executive employment agreement provides for any form of deferred compensation.

William (Bill) Wortel, a member of this newsletter's Board of Editors and a partner at Bryan Cave LLP, has represented management in a variety of litigation at the administrative level, in state and federal courts and in the U.S. Court of Appeals. Carrie E. Byrnes is an associate at the firm; both are resident in the Chicago office.

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