Ten Considerations in Drafting Executive Employment Agreements

By: David J. Woolf

Perhaps your company has just acquired a new business and wants to put that entity’s employees under a more structured employment arrangement.  Or maybe you are just looking to roll out new executive-level agreements within your own company.  Whatever the motivation and circumstances, here are ten things to think about in drafting employment agreements that often go overlooked: 

  1. Severance – The most common question is the easiest: Are you going to provide severance and, if so, how much?  Other details merit consideration though.  For example, is death or disability a severance trigger?  As part of the package, do you want to provide things like medical benefit continuation, prorated bonus, equity vesting acceleration, extension of the option exercise period, or other benefits?  Whatever you do, the employer will want to make sure that the executive has to execute a release to receive the severance benefits, other than vested benefits and accrued compensation.
  2. Fixed Term (or Not) – Traditionally, a term contract was like a baseball contract – the executive had a term and, except where the employer had good cause for an early termination, it had to pay the executive out through the end of the term no matter what.  That concept seems to have largely disappeared, in that (a) employers don’t want to be saddled with paying out the full term if they elect to make a change earlier and (b) executives want severance even when the agreement expires naturally and is not renewed by the company.  As a result, except where the employer can secure a true no obligation walk away at the end of the term, or at least establish some difference between an in-term and end-term separation, an employer would be wise to go with an at-will arrangement with no set term.
  3. Restrictive Covenants (or Not) – Restrictive covenants, including covenants not to compete, require clearer, more definitive consideration than most contract terms.  And aside from new employment, there is no better consideration than new or enhanced compensation and benefits memorialized in a formal employment agreement.  So, if you think non-competition, customer non-solicitation, or other restrictive covenants are worthwhile (and you usually should at the executive level), the employment agreement (or a separate, contemporaneously-executed and cross-referenced restrictive covenant agreement) is the place to do it.
  4. Cause – “Cause” means different things to different people.  From an executive’s point of view, Cause is often engaging in particularly serious conduct that is not rectified after notice and an opportunity to cure.  Employers, however, should seek to include things like the executive’s failure to perform his or her duties; violation of material company policies (such as anti-discrimination and harassment policies); commission of a felony or other serious crime; breach of his or her restrictive covenants, fiduciary duty, or other misconduct; and material misrepresentation of experience or education, among other things.
  5. Good Reason Provision (or Not) – A “Good Reason” separation provision allows an executive to resign for certain preapproved reasons – typically the employer’s material breach of the employment agreement, a required relocation, or a material diminution of the executive’s duties, often after the employer has failed to cure – and collect severance as if he or she was fired without Cause.  Most savvy executives have come to expect such a provision, and providing it to the executive can be a relatively easy give if the Good Reason provision is drafted correctly.
  6. Award Equity (or Not) – Many executives, particularly when accepting a role in a new or newly-acquired company, understand that the cash compensation may be limited initially.  What they really want is equity or options so that, if they succeed in developing the company, they can share in that success.  Employers and equity firms often find this arrangement beneficial too in that it limits cash outlays and aligns incentives.   
  7. State Law and Venue Selection – Almost all employment agreements include a choice of law provision, and many, if not most, employers instinctively select the state in which the company operates and the executive will work.  But that may not be the best law for the employer and other options may be available.  For example, most courts will apply another state’s law if there is a nexus to that state, such as it being the employer’s state of incorporation.  Venue is equally important, as requiring an employee to litigate in a certain forum can give the employer litigation location certainly and potentially avoid the executive running to another state where the law (for example, concerning non-competes) is more favorable.
  8.  Assignment – Often forgotten, the assignment provision is critical in that, without it, many states’ laws will not permit assignment, even upon a sale of the employer’s assets.  To avoid this, the employment agreement should state that, although the executive may not assign the agreement, the employer may do so, at least to an affiliate or as part of a transaction.
  9. 409A – When possible, severance, other payments and the agreement generally should be structured so as not to trigger coverage under Section 409A of the Internal Revenue Code.  If the agreement is subject to Section 409A, it should be written to comply with it.  Failure to do so can expose the executive, among other things, to a 20 percent additional tax and the employer to an angry executive.
  10. Miscellaneous – There are of course numerous other things of value that an employer can do.  For example:

●  The salary section can allow for the reduction of the executive’s salary when executive salaries are being cut across the board. 

●  The employer may want to make any bonuses contingent on the executive working through the end of the year.

●  In most states, an employer can provide that accrued, unused vacation and PTO will not be paid out upon termination of employment.

●  Arbitration, subject to a carve out for injunction actions, has its positives and negatives and should be considered.

●  Address what is to happen upon a sale of the employer or other change of control.

●  New executives should represent and warrant that they are not bound by any restrictive covenants that would limit their ability to work for the employer and that they will not use any confidential information from their former employer.

●  Although largely standard now, employers should take care to ensure that the agreement provides that it can be revised only by written document. 

●  Make sure the agreement works with other documents and that the integration clause doesn’t unintentionally overwrite other agreements.

There are always more issues of course, particularly those specific to the particular company and the executive.  But the ten-plus areas above arise frequently and thus typically merit consideration.

The Impact of 409A on Severance Payments

Editor’s Note: The following post by Katrina Veldkamp, Associate in the Los Angeles office, appears in the latest issue of the California HR Newsletter.  To sign-up to receive the California HR Newsletter click here.

The Impact of 409A on Severance Payments

The Issue: An employment agreement conditions severance payments to an executive on her signing a release. Can this create a tax problem for the executive under the non-qualified deferred compensation rules of the Internal Revenue Code?

The Solution: Yes, unless the provisions of the employment agreement are properly drafted and the parties comply with the terms of the agreement.

Analysis: Code Section 409A (409A) governs the terms and operation of “non-qualified deferred compensation plans” and imposes restrictions on the reasons for and timing of deferred payments.  Neither the employee nor the employer may accelerate or defer the receipt of deferred compensation (with some exceptions not applicable here).

Failure to comply with 409A leads to serious tax consequences for the executive, including acceleration of income and a 20% tax penalty.  California imposes its own 5% tax penalty for failure to comply with 409A.

Termination of employment is a permissible payment event.  If the employment agreement provides that severance will be paid within 2-1/2 months after termination with no conditions, the payment isn’t subject to 409A.  If the  agreement provides for a series of payments equal to not more than twice the executive’s pay (or the qualified plan compensation limit, currently $260,000) and they are to be paid within two years after termination, there is no problem.

The concern with conditioning severance pay on an executive signing a release is that if there is no time limit on when the release must be signed, the employee can affect the timing of payment by either signing the release quickly or delaying to a later date.  This violates the strict requirements of 409A.  It is important to recognize that it is not the employee’s action or inaction that is the problem; it is the provision in the employment agreement.

The remedy is simple.  The employment agreement must specify (or be amended to specify) a fixed payment date after termination of employment (either 60 or 90 days) or a specified period no longer than 90 days when the severance payment will be made or commence (with special rules if the payment period can go into another tax
year).  If the executive fails to sign and return the release by the commencement date, the severance must be forfeited.

Employers should tread carefully when dealing with the complicated requirements of 409A.  If an employment agreement provides for any post-termination payment, it should be reviewed for compliance with 409A.