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Increasingly we are being asked for our views on whether a
company should have employment agreements with one or more of its top
executives and, if so, what practices we would suggest. Often the inquiry is
prompted by a reconsideration of current arrangements. The focus on
corporate governance in recent years is causing many companies and
Compensation Committees to reexamine the rationale for, and terms and
conditions of, executive contracts.
In determining whether and when to use contracts for executives, it is
critical to examine an organization’s specific facts and circumstances and
to understand why employment agreements have been used or are under
consideration. At many companies it is helpful to review the basic
approaches for executive contracts and then consider the pros and cons of
these agreements.
Prevalent Practices
The use of employment agreements for executives can vary considerably among
companies, often depending on the organization’s culture and the views of
the Board of Directors, the Compensation Committee and the Chief Executive
Officer. Four prevalent practices are discussed below.
- Some employers do not use contracts at all, instead relying on
general policies or more limited agreements to address specific issues
such as severance, change in control, confidentiality and
non-competition.
- Other companies limit employment agreements to new hire situations,
especially where a sought-after executive is reluctant to join a new and
largely unfamiliar organization without the protections of a contract.
- Many organizations extend employment agreements to some or all of
the top team of executives. Certain employers may have a contract with
only their CEOs, while others enter into written agreements with a dozen
or so executives. A recent survey found that 82% of responding companies
used employment contracts with their CEOs; this compares to 70% in the
same survey conducted in 2004.
- A few companies use employment agreements to document their
employment relationships with all executives above a certain level,
e.g., vice president.
Rationale for Agreements
An executive contract sets out the key terms and conditions of the
employment relationship. While contracts typically address salary, bonus
compensation, long-term incentives, benefits and perquisites, there is
little need for a contract if the objective simply is to memorialize these
items. We have found that the most important reasons for an employment
agreement generally are to:
- specify and make clear what an executive will receive upon various
events resulting in a termination of employment, e.g., death,
disability, retirement, resignation for good reason, dismissal for
cause;
- address the impact of a change in control of the employer; and
- impose reasonable post-employment restrictions applicable to the
executive, e.g., restrictive covenants addressing such matters as
confidentiality and non-disclosure, non-competition, non-solicitation of
employees and/or customers and non-disparagement.
If properly drafted, employment contracts can help secure the future
services of key executives that are critical to the organization’s success.
These agreements establish the respective rights, duties, obligations and
responsibilities of the parties at a harmonious time; from this perspective
they have much in common with premarital agreements.
Rationale against Agreements
While both the employer and the executive can be well-served by documenting
the employment relationship through a contract, another view is that such
agreements are either unnecessary or overly favor the executive. Arguments
sometimes advanced against executive employment agreements are discussed
below.
Pay for Failure. The focus on executive compensation in recent years
has highlighted instances where an executive dismissed for poor performance
was entitled to large severance pay based on the terms of an employment
agreement. This view maintains that any payments would have been more
reasonable if no contract had been in place and the executive had to
negotiate a severance package in connection with his or her termination.
Performance Equals Security. Others maintain that the protection
provided by an employment agreement is unnecessary for a top executive who
is doing a good job and that an executive should not have this protection if
he or she is not performing well. However, the increased turnover among CEOs
and other senior executives in recent years (a shorter job “life
expectancy”) causes many executives to believe contractual protection is
necessary.
Key Provisions and Usage
Severance and change in control protections generally are the most critical
provisions for executives while employers seek the benefits of restrictive
covenants. Both parties receive certainty of the terms that will apply in
identified circumstances…especially various termination events. From an
employer’s perspective, a contract may discourage a competitor from
recruiting an executive in jurisdictions that provide for tort damages for
interference with the relationship of an executive under contract. An
agreement may enable an employer to determine what state law will apply
where there are contracts in multiple jurisdictions and, if desired, mandate
arbitration of disputes regarding employment matters.
The below checklist can be helpful when considering a new agreement or when
evaluating a current one.
Employment Agreement Checklist
Critical definitions. The definitions of “change in control,”
“cause,” and “good reason” should be particularly scrutinized. In reaction
to some widely publicized severance payments to executives who were
dismissed or resigned after poor performance, the current view is to expand
cause definitions and to constrict good reason definitions.
Renewals. “Evergreen” renewals typically provide for automatic
extension or renewal unless a specified advance notice is given. Procedures
should be implemented to review these agreements before any such extension
becomes effective. An employer’s advance notice not to extend the agreement
term or renew the agreement should not trigger severance pay.
Calculating “pay.” Where any payments are based upon pay, a
determination is needed on what amounts should be included. Most employers
use base salary, some use salary plus bonus, and an even fewer number use
total remuneration for such calculations.
Retirement benefits. Shareholder groups may object to provisions
that provide “deemed service credit” to increase an executive’s retirement
package (often coordinated with SERP benefits). While that approach may be
needed to recruit a mid-career executive to make up for benefits foregone at
a former employer, the cost should be calculated and understood and the
rationale documented.
Severance pay. Any severance payments should be conditioned on the
executive’s agreement to reasonable restrictive covenants. Depending on what
is permitted under the laws of the relevant jurisdiction, covenants relating
to non-competition, non-solicitation, non-disclosure of confidential
information and non-disparagement of the employer may considered.
Change in control. Accelerated vesting would generally be appropriate
where there is a non-cause dismissal of the executive following a change in
control or where the executive would have no continuing equity interest in a
merged entity. In other cases, it may be appropriate to continue the vesting
or provide for discretion of the Board to accelerate vesting schedules.
Costs. The potential costs for all payments directly or indirectly
impacted by an executive’s contract should be determined on a worst case
basis. These costs should be reviewed periodically to make sure the employer
understands how changes in base salary, for instance, may affect these
payments.
Trigger event. Any chance in control severance benefits should
require a “double trigger” for payment rather than simply the change in
control event (“single trigger”).
IRS Section 409A. The potential application of Internal Revenue Code
section 409A (regarding nonqualified deferred compensation arrangements)
should be considered when determining payment provisions. Since there are
various exceptions and alternative approaches for compliance, section 409A
can affect design and not merely legal language.
Document preparation. The employer should have the agreement drafted
by its advisors, not by someone representing the executive’s interests. The
drafting process should be within control of the Board. Also, a general
counsel should not be put in the position of negotiating contract terms with
an executive to whom he or she may have to report.
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