BY:Daniel M. Wasser
From the point of view of an executive, is it good news or bad news when an employment contract is presented for signature? The answer is “it depends.” The degree of freedom and flexibility the executive wishes to retain to change jobs or renegotiate terms must be weighed against the security the employer offers and the restrictions it seeks to impose.
In New York, absent a contract, employment is deemed to be “at will,” which means that the relationship can be terminated by either party at any time, for any reason, without further financial obligation.1 There is a general expectation that a written employment contract will make the employee whole if employment is terminated by the employer without “cause” prior to the end of the term, but this is not necessarily the case. For example, many contracts have no fixed term and, instead, describe the employment relationship as being “at will.” Other contracts may be for a fixed term yet limit the employer’s severance obligation to a much shorter period, exposing the executive to the worst of all worlds: limited financial protection that does not correspond to the term of the agreement and an exclusivity obligation that, for the full duration of the term, makes it impossible for the executive to accept a better position elsewhere.2
The balance of this article describes typical provisions found in employment contracts and highlights some of the issues they present. Once the implications of those provisions are recognized, the executive will be better able to formulate cogent arguments and creative alternatives when contract negotiations ensue.
• Some employment contracts are for a term that continues indefinitely unless and until cancelled by written notice. If the executive must give many months of advance notice of termination, it materially hampers the executive’s ability to secure other employment (since a new employer is unlikely to be willing to wait months for the executive to commence employment). There is no compelling reason why the executive’s and the company’s notice periods should be identical.
• If employment is for a fixed term, does the company have a unilateral right to extend? Such a provision benefits only the employer, but if it must be accepted, consider the date by which the extension right must be exercised (failing which it should be deemed waived) and the financial terms applicable to the extension period.
• Consider the effect of the contract termination date. Will it impact the executive’s bonus entitlement for the final year of the term, especially if company policy requires the bonus recipient to be employed on the payment date? How will it impact the vesting of equity incentives?
• How much protection really is afforded by the term? A three-year agreement is no better than a three-month agreement if the company’s severance obligation is capped at three months.
• Is there a description of the executive’s responsibilities, title and reporting obligations? This can help protect the executive against a diminution of the position.
• Employers often describe the executive’s position and then undermine the benefit of that specificity with broad language such as “and such other responsibilities as shall be assigned.”
• Are there built-in increases? At a minimum there should be provision for periodic review for purposes of increase (although this creates no assurance that there will be an increase).
• If the executive is accepting a position with a new employer, is there a signing bonus to compensate for any bonus or equity incentive left behind with a former employer?
• A signing bonus also can be a useful way to bridge the gap if there is a disagreement over salary.
• If there is bonus plan, has a target award been established (e.g., 40% of annual salary)? To merely states that the executive will be entitled to participate in the company’s bonus plan provides no guidance as to the range of the potential bonus award.
EQUITY INCENTIVE GRANTS
• If possible, extend the contract termination date to capture the immediately following vesting date, particularly if the vesting date is just a few days beyond the termination date. If a valuable equity incentive will be lost if the contract is not extended, the company will have gained considerable leverage when an extension is negotiated.
• Consider what happens to the grants upon termination, particularly if termination is without cause or due to death or disability.
• If options have increased in value, a departing executive will want to realize that benefit. Even a brief post-termination exercise period will be adequate if the company is publicly traded, but different considerations apply in private companies.
• For private companies there is no public market for shares and, therefore, there usually is no way to realize the value of options until a liquidity event occurs. If there is a short window on post-termination exercise, the executive may feel compelled to exercise the options to preserve the potential for value upon a future liquidity event. However, this will require a cash outlay for both the exercise price and the income tax due on the spread. For these reasons, in a private company, the longest possible post-termination exercise right will be desirable, and, as an alternative, a restricted share arrangement involving subordinated equity should be considered.
CAUSE AND GOOD REASON
• Is “cause” tightly defined or does it include broad language such as, “or other comparable conduct as determined by the board of directors”?
• Cause should be restricted to unethical or grossly negligent conduct and should not apply when there has been good faith effort but disappointing results.
• Must the company give the executive notice of conduct alleged to be cause and an opportunity to cure?
• Is there a “good reason” provision that allows the executive to terminate as a consequence of a breach by the company and receive the same severance as would apply had the company terminated the contract without cause?3 If the company requires the executive to relocate, the executive should be able to invoke the right to terminate for good reason.
• If the contract does not give the company the right to terminate absent cause, and if it does not provide for severance, then the executive’s rights are governed by basic contract law. Thus, a termination without cause by the company would constitute a breach of contract, entitling the executive to the benefits of the contract for the balance of the term, subject to a duty to mitigate.
• If the contract contains a severance provision, do not assume that the company’s severance obligation runs for the full balance of the term. This obligation often is capped.
• Is there a minimum period for which severance will be provided (so that if there is a termination without cause with only two months left in the term, severance nevertheless will continue for a longer period)?
• If the term comes to an end and the company declines to extend the executive’s employment, is the executive entitled to severance?
• If there is an established company severance policy for non-contract employees, does the contract provide that in no event is the executive to receive less? An executive with many years of service may have a substantial severance entitlement by virtue of company policy and, therefore, little incentive to enter into an employment agreement.
• Base salary protection is usually provided for, but what about continuing benefits and bonus entitlements? What happens to equity incentives?
• Is there a duty to mitigate (i.e., and obligation for the executive to seek other comparable employment) and a right of offset if the executive secures other employment while severance otherwise is payable?
• Is severance payable over time or in a lump sum? A lump sum payment obviates issues of mitigation and offset.
• Is the executive barred from accepting a competing position for a period of time following the termination of employment even if the contract has run for its full term? Restrictions of this sort are generally disfavored by New York courts, but since a new employer does not want to become enmeshed in a lawsuit, such restrictions can have an in terrorem effect.
• Following a termination without cause, what is the consequence of the executive accepting a competing position? Some severance provisions state that by accepting a competing position, the executive completely relieves the company of its severance obligation without regard to how much the executive will earn in the new position.
1 A termination made for a discriminatory reason can result in liability, however, and severance policies expressed in an employee manual or resulting from a course of dealings may result in an obligation on the part of the employer.
2 Although no one can be forced to work for a particular employer, an executive who is under contract can be prevented from working within the same industry during the term of the employment agreement and, potentially, could be sued for damages should the executive refuse to perform.
3 The executive will, of course, have contractual rights if the company breaches the terms of the employment agreement. Incorporating a “good reason” definition will usually simplify the determination of whether a breach has occurred and clarify the financial consequence of the breach.