Special Labor and Employment eReport: Contract Modification or Cancellation and Breach of Contract Defenses in Times of Economic Crisis

Special Labor and Employment eReport:

Contract Modification or Cancellation and Breach of
Contract Defenses in Times of Economic Crisis

November 2008

Dear Clients and Friends,

The current economic crisis is unprecedented in recent history. For many companies, adapting to these difficult economic times entails making the hard decision to reduce the size of their workforce. All too often, however, layoffs are as legally complex as they are emotionally trying.

The list of employment laws that may be implicated in a reduction-in-force is indeed long. Moreover, some relatively newer laws, such as the Older Workers Benefit Protection Act (OWBPA), are complicated and sorely in need of greater judicial clarification. Other, even more recent laws, including the New York mini-WARN Act, which goes into effect on February 1, 2009 (and is discussed here), are destined to present covered employers with a host of compliance problems.

We offer for your consideration our most recent "white paper," titled "Contract Modification or Cancellation and Breach of Contract Defenses in Times of Economic Crisis" click here to view White Paper. The paper explores a number of out-of-the-box strategies that may assist employers in analyzing employment and other business relationships that must be adapted to fit the current, unique business environment.

Complementing the white paper, the following article discusses some of the critical legal and practical issues employers should assess when considering or planning a workforce reduction, such as Sarbanes Oxley mandates and IRS deferred compensation rules, and underscores the importance of thoughtful planning as far in advance of the actual reduction-in-force as is practical.

Finally, I would like to remind you that we are holding a briefing on downsizing in New York on December 3, titled "Economic Reality Bites: Handling Major Employment Law Challenges Sparked by the Economic Downturn." The briefing will provide a comprehensive review of legal and practical downsizing issues, including OWBPA and the WARN Act, noted above. Registration information is available here.

As always, we at EBG remain at your service to discuss the issues presented in these articles as well as any specific concerns you may have during these difficult times.

Best Regards,

Ronald M. Green


The Global Economic Crisis — Preparing for a
Tsunami Landfall in the Employment Arena

Allen B. Roberts

In ordinary times, employment contracts and relationships capture the parties' intentions and expectations, moderated by the overlay of construction by courts, arbitrators or administrative agencies engaged by one side or the other when disputes incapable of direct resolution arise. For many, these are not ordinary times.

Whatever the industry, wherever it is located, and irrespective of the parties' sophistication and thoughtfulness, too many employers have been thrust into the vortex of a worldwide economic crisis certain to destabilize employment relations and upset the order of normal intentions and expectations. Before rushing to batten down the hatches, some panic control should accompany, if not precede, damage control; employment risks need to be assessed rationally, just as other business and economic risks. This article assesses some of the challenges, analyses and approaches available to employers as a complement to Epstein Becker Green's White Paper, entitled "Contract Modification or Cancellation and Breach of Contract Defenses in Times of Economic Crisis," click here to view White Paper.

We are seeing that "right-sizing" of workforces is underway across industry lines and geographic bounds, as well as vertically — top to bottom. For many, the process cuts deep with unprecedented rupture of loyalties and relationships; there may be institutional trauma and personal hardship. In such a climate, objectivity and rational decision-making are necessary, even while they may be criticized and devalued as cold, calculating and unsympathetic. More than in any recent time, businesses are focused on concerns for their own immediate wellbeing and for longer term institutional survival and success, while trying to avoid shortsighted reactions that could compromise the value of corporate mission, culture and reputation.

A. Taking Stock of Human Capital and Legal Obligations

For businesses facing economic crisis, accurate assessment of human capital is essential to realizing intended objectives and efficiencies without incurring unwanted, undesirable risks and costs. This entails comprehensive, reliable appraisal of individual employee contributions to the business.

Even while businesses strategize concerning workforce size, talents and cost, their employees who hold publicly traded securities in investment or pension accounts may be reconsidering planned retirement dates and assessing their recourse in the face of depleted portfolios that are no longer synchronized to personal and actuarial assumptions because of current corporate fortunes and prospects. On a positive note, companies that had anticipated announced or unannounced departures for retirement may now find that they enjoy the continuing resource of talented individuals who will remain in the workforce. Conversely, employees who failed to measure up but whose presence was tolerated because business was robust and retirement was drawing near may not be so welcome for an indeterminate extended period. In any event, if normal attrition is disrupted by elections not to retire, the employee complement may exceed a desired level, even as budgeted for normal times, and paring may become more critical.

Outside of the arena of employees with employment agreements and those represented in collective bargaining by labor organizations, the prevailing American view tends to be that individuals are employed "at will," meaning that changes in employment status — up to termination — may occur for a good reason, a bad reason or no reason at all, provided there has been no impermissible discrimination or retaliation by the employer. Taking inventory of the employment relationship entails identifying the commitments by the employer that may modify employment at will with respect to continuing employment, total compensation, eligibility under benefit plans and programs and separation entitlements.

In the realm of employment agreements, most are structured to identify core items of job title and duties, compensation and benefits entitlements and incentives, bases for voluntary and involuntary employment termination and separation entitlements and conditions for receipt of separation payments and benefits. Some of these items have become subject to contingency, restraint, deferral, elimination or claw-back by such legislation as the Sarbanes-Oxley Act, the Internal Revenue Code, the Bankruptcy Code and the recently enacted Emergency Economic Stabilization Act of 2008. Relying on those statutes or other bases, administrative agency regulators, state attorneys general and shareholders have elevated their scrutiny of executive compensation and severance arrangements.

B. Management of Downsizing Risks

A starting point for any downsizing is taking account of the talents and compensation packages appropriate to retain the most valuable employees who will contribute positively to an economically viable enterprise in a period marked by wrenching workforce reductions and contraction. Absolute reductions in cost or "headcount" may be the unavoidable mandate, but they must be accomplished with appropriate regard for legal obligations and business pragmatics. Vital needs, properly assessed, must trump convenient or mechanistic formulaic guides.

Ideally, documented performance evaluations would provide a reliable, objective measure of employee strengths, shortcomings, productivity, goal attainment and accomplishments. Experience — and litigation results — caution that such consistent and dependable documentation may be more aspirational than actual; adequate documentation may be lacking. In a time of involuntary workforce reductions, and with recent guidance from a relatively conservative Supreme Court, employers are likely to be put through their paces when personnel records do not support individual decisions or analysis shows disparate impact on certain individuals or protected employee groups.

When cuts in staffing or compensation are on the table, assessment of external legal obligations by way of equal employment opportunity and other employee-protective laws proscribing discrimination and retaliation as factors in decision-making and directing advance notice of workforce reductions that meet certain numeric thresholds have to be considered. Commitments unique to the business or to certain key individuals come into play, as well. For example, there may be written or oral agreements or assurances given during employment or at the inception of the recruitment or hiring process.

Where employment agreements exist, it is customary to see undertakings and covenants by the employee, variously articulated but generally calling for the individual to devote full work time and effort faithfully to the business, to follow appropriate directives and to not engage in activities harmful to the business or inconsistent with its codes of ethics, codes of conduct or compliance codes. For companies with publicly traded securities that are subject to Sarbanes-Oxley and for some other organizations having or creating an obligation or protocol modeled on Sarbanes-Oxley, there may be employee certifications (or sub-certifications) to such items as the truth of material facts reported, the fair representation in material respects of the financial condition and results of operations, the establishment, maintenance and effectiveness of internal controls, the disclosure of significant control deficiencies and the existence of any fraud — even if immaterial — that involves management or other employees having a significant role in the organization's internal controls.1 Particularly in certain industries, businesses should be confirming that employees charged with such corporate responsibilities and legal obligations have performed their duties as required. Depending upon the severity, those who have not lived up to their responsibilities may be subject to employment termination or lesser adjustments in employment status or compensation or disqualification from receipt of incentive awards or bonuses.

Because employment relations are not typically commoditized and treated like other contractual obligations, concepts ingrained in contract law do not typically transport to employment law. The familiar commercial law concepts of force majeure, unforeseeable economic hardship, impossibility of performance, impracticability and commercial frustration of purpose — excusing performance of acknowledged contractual obligations when certain extraordinary crises strike, have not been widely invoked or accepted in the construction of employment agreements or arrangements. Nevertheless, unexpected chronic circumstances of the current environment that may threaten the viability of a business may invite analysis of those concepts as companies survey the agreements, policies, programs, codes and procedures that govern employment relationships and the bases of continuing employment, along with existing levels of compensation, incentives and benefits, and entitlement to severance pay and benefits after employment has terminated.

C. Statutory Redefinition of Compensation Arrangements

Legislative directives can alter executive compensation or severance arrangements in several meaningful respects.

  • Some businesses have policies resembling the Sarbanes-Oxley mandate for publicly traded companies that the chief executive and chief financial officers must reimburse the company for any bonus or other incentive-based or equity-based compensation received, as well as any profits realized from the sale of company securities, during a period of 12 months from the issuance or filing of an accounting report that must be restated because of the company's material noncompliance with reporting requirements as a result of misconduct. 2
  • Section 409A of the Internal Revenue Code, enacted in 2004 and occasioned by abuses at companies such as Enron and WorldCom, is a complex law having a legislative purpose of averting withdrawal by executives of large amounts of nonqualified deferred compensation owed to them by companies that may be distressed. It provides an expansive and complex set of rules governing nonqualified deferred compensation, which is broadly defined to mean compensation that is payable in a taxable year after the year in which a legal right to the payment arises, but excluding deferrals under an employer's tax-qualified retirement plan (e.g., a Section 401(k) plan). In general terms, nonqualified deferred compensation includes all types of payments and benefits under employment agreements and arrangements, including equity-based compensation, severance payments and welfare and fringe benefits provided after termination, as well as more traditional forms of deferred compensation such as supplemental executive retirement plans. For certain key employees of publicly traded companies (generally the 50 highest paid employees on a controlled group basis), payments of nonqualified deferred compensation payable upon termination must be delayed six months following the executive's termination, thus putting the executive at risk as a general unsecured creditor in the event of the company's bankruptcy or insolvency. If the Section 409A rules are not strictly followed, the executive entitled to the compensation is subject to a 20% excise tax, plus interest at the IRS underpayment rate plus 1%, on the non-compliant payments. 3
  • For companies in bankruptcy proceedings, employment contracts where performance remains due on both sides are considered executory. Subject to court approval and certain limitations, debtor employers may be allowed to either assume or reject them. 4 Section 502(b)(7) of the Bankruptcy Code places a cap on the amount an employee may recover on a claim arising from an employer's rejection of an employment agreement. 5

Since it was amended in 2005, the Bankruptcy Code has reduced historic discretion and introduced new restrictions on bonus compensation and severance payments under key employee retention programs designed to encourage key employees to stay with the business. 6 Section 503(c)(1) 7 restricts commitments and inducements to such insider employees as officers and directors by requiring proof acceptable to a bankruptcy court that the insider has a bona fide job offer from another business for the same or greater compensation, the insider's services are essential to the business, and the transfer or obligation does not exceed 10 times any similar benefits given to non-management employees in the same year or, if there are no such similar transfers or obligations in respect of non-management employees, the transfer or obligation is not more than 25% of similar transfers or obligations for the benefit of the insider in the prior year. Additionally, Section 503(c)(2) 8 limits the amount of severance payments to insiders, disallowing them unless (1) the payment is part of a program applicable to all full-time employees; and (2) the amount of the payment is not greater than 10 times the mean severance pay given to non-management employees in the same year. Finally, Section 503(c)(3) 9 exposes to challenge and bankruptcy court review any transfers or obligations for the benefit of officers, managers or consultants hired post-petition that are outside the ordinary course of business and are not justified by the facts and circumstances.

  • More recently, and expressly responsive to concern over a financial services meltdown, the Emergency Economic Stabilization Act of 2008 ("EESA") has several limiting or superseding provisions. Financial institutions participating in the Troubled Asset Relief Program ("TARP") and its Capital Purchase Program instituted under the EESA, authorizing Treasury purchases of preferred securities in certain financial institutions in need of immediate capital, are subject to restrictions that (a) limit incentives for senior executive officers who take "unnecessary and excessive risks that threaten the value of the financial institution;" (b) provide for the recovery by the financial institution of any bonus or incentive compensation paid to a senior executive officer (generally, one of the top 5 highly paid executives) based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (c) require agreement not to deduct compensation in excess of $500,000 for each senior executive officer in accordance with new Section 162(m)(5) of the Internal Revenue Code; and (d) prohibit golden parachute payments by the financial institution payable upon the involuntary termination of a senior executive officer if the amount exceeds three times that individual's base compensation. 10 As a condition to participating in the TARP Capital Purchase Program, the financial institution and each of its senior executive officers must contractually waive all claims against the Treasury as a result of any changes or modifications made to existing employment contracts, employee benefit plans or arrangements for the purpose of complying with these new executive compensation requirements. 11
  • Financial institutions participating in the TARP Capital Purchase Program also have received requests from the New York State Attorney General and Congress for information relating to bonuses and bonus-related payments based on the concern that the additional capital received is being used to provide cash to pay executive compensation in the form of year-end bonuses. The New York State Attorney General is requesting information on expected bonus pools and payouts to financial institution employers as a possible violation of New York State fraudulent conveyances laws. 12 The House Committee on Oversight and Government Reform has requested similar information on compensation and bonuses. 13

* * *

Once employers step outside the comfort of employment at will, there is a potentially complex and complicated set of arrangements likely to be subjected to stress and testing in trying times, with an overlay of legislation and a prospect of litigation where the stakes are large, passions elevated and alternative options of comparable employment reduced. This article, as a companion to Epstein Becker Green's White Paper on the subject, is intended to supply an early orientation and suggest options if forecasted difficulties of a deep and long recession eventuate.


1See Sarbanes-Oxley Act of 2002, 15 U.S.C. § 7241(a).
2See Sarbanes-Oxley Act of 2002, 15 U.S.C. § 7243(a).
3Internal Revenue Code, 26 U.S.C. § 409A.
4Bankruptcy Code, 11 U.S.C. § 365.
5In general terms, the cap applies to the extent the claim exceeds (A) the compensation provided by the contract, without acceleration, for one year following the earlier of (i) the date of filing of the petition or (ii) the date on which performance under the contract was terminated, plus (B) any unpaid compensation under the contract, without acceleration, on the earlier of such dates.
6Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, P.L. No. 109-8.
711 U.S.C. §503(c)(1).
811 U.S.C. §503(c)(2).
911 U.S.C. §503(c)(3).
10Department of the Treasury, Interim Final Rule, TARP Capital Purchase Program, October 14, 2008. For sales of "troubled assets" to the federal government under the EESA, certain executive compensation requirements apply for as long as the equity or debt position is held. Emergency Economic Stabilization Act of 2008, Division A of Public Law 110-343, § 111 and § 302. See also IRS Notice 2008-94.
11TARP Capital Purchase Program, Public Term Sheet, October 14, 2008.
12Letter to Members of the Boards (Financial Institutions) from Andrew M. Cuomo, New York State Office of Attorney General, dated October 29, 2008 regarding Bonus Pools and Board of Directors Oversight Oversight and Government Reform, dated October 28, 2008.
13Letter to Vikram S. Pandit of Citigroup from Henry A. Waxman, Chairman, House Committee on Oversight and Government Reform, dated October 28, 2008.