US Employment Agreements – the Duel Between Good Reason and Cause

Like any contract, an employment agreement should grant specific rights to both parties – the employer and the employee. The primary goal for the employee is to secure protection against the employer breaching its obligations or promises. Conversely, the employer aims to obtain commitments from the employee, such as restrictive covenants, that may not be enforceable without a formal contract.

An employee secures protection through an agreement that provides severance benefits if the employer fails to meet its obligations. Ideally, if an employee’s employment is terminated involuntarily, the employee would be entitled to severance benefits that align with the amounts the employee would receive under the agreement for the remainder of its term. This presumes that the agreement includes a specified term. However, most employers will ensure that agreements either do not set a term or specify severance benefits the employee would receive upon an involuntary termination of employment which are less than the employee would otherwise receive during the term.

Even if an agreement provides sufficient severance benefits, the employee should consider the implications if the employer breaches the terms of the agreement. While the employee could pursue legal action to enforce the agreement, courts rarely grant specific performance for breaches of employment contracts. From a practical perspective, an employer’s breach likely signals that the employer no longer values the employee and may be trying to pressure the employee into voluntarily resigning. However, unless an explicit contractual provision addresses a forced resignation, an employee who voluntarily resigns under such circumstances is typically not entitled to severance benefits. On the other hand, an employer seeks a mechanism that entitles it to terminate the employee’s employment for reasons that will allow it to avoid paying severance benefits.

An employee obtains the desired contractual protection if he or she is entitled to voluntarily resign for or with “Good Reason”. An employer obtains its contractual protection if it is entitled to terminate the employee’s employment for or with “Cause”.

Because each party’s right to exercise its rights depends on the meaning of “Good Reason” and “Cause”, the importance of each term cannot be overstated. Both an employee and an employer must negotiate and analyse the terms of an agreement through the lens of those definitions.

Good Reason and Cause

From an employee’s perspective, a definition of Good Reason should be a contractual mechanism to treat the employee’s voluntary resignation following any employer breach as if it were the same as an involuntary termination of employment without Cause. While the definitions of Good Reason and Cause are not equivalencies, an employer will counter an employee’s demand that any employer breach constitutes Good Reason with the demand that any breach by the employee constitutes Cause.

Good Reason

A typical definition of Good Reason includes one or more components that, alone or in combination with another condition, will trigger the employee’s right to voluntarily resign and receive severance benefits. Typical components of Good Reason include:

• a diminution in the employee’s base salary;
• a diminution in the employee’s authority, duties or responsibilities;
• a diminution in the authority, duties or responsibilities of the supervisor to whom the employee reports;
• a requirement that the employee report to anyone other than reporting directly to the employer’s CEO or governing board;
• relocation of the employee’s principal place of employment more than a specified number of miles from its current location; or
• a breach of the terms of the agreement.

All or most of the components of Good Reason will generally be subject to a standard of “materiality” or a similar qualifier to prevent minor transgressions from giving rise to the employee’s right to voluntarily resign and receive severance benefits.

Specific components versus general

Anecdotally, courts tend to enforce an employee’s right to resign for Good Reason if the employee relies on a component that specifically addresses the conditions that the employee claims constitute Good Reason. In contrast, absent egregious circumstances, courts generally do not find that conditions constitute Good Reason if the employee relies solely on a reference to a breach, or material breach, of an agreement. Accordingly, while agreements customarily include a breach or material breach as a component of Good Reason, an employee should not rely on such a provision for “catch-all” protection. Instead, an employee should aim to address any employment term that he or she considers critical through specific reference in the definition of Good Reason.

Section 409A

Section 409A of the Internal Revenue Code of 1986, as amended, might also affect a definition of Good Reason. In general, Section 409A provides that compensation deferred by an employee must be included in income when deferred or, if later, when it is no longer subject to a substantial risk of forfeiture, unless the arrangement complies with Section 409A’s various requirements. Severance benefits that are payable to an employee upon a resignation for Good Reason will be subject to Section 409A if the definition of Good Reason applicable to the employee does not constitute a substantial risk of forfeiture for the purposes of Section 409A.

While Section 409A restricts the parties’ ability to restructure how and when severance benefits are paid, compliance with Section 409A is generally not complicated or burdensome to either party. However, to avoid Section 409A or simply use it as a negotiation tactic, an employer might refer to Section 409A as a reason to narrow the circumstances that give rise to Good Reason. In particular, employers commonly assert that Good Reason should mirror a safe harbour definition of Good Reason that is included in the regulations issued under Section 409A. Pursuant to Treasury Regulation Section 1.409A-1(n)(2), Good Reason will be deemed to be a substantial risk of forfeiture if it consists of one or more of the following conditions, each of which incorporates a materiality standard:

• a material diminution in the employee’s base compensation;
• a material diminution in the employee’s authority, duties or responsibilities;
• a material diminution in the authority, duties or responsibilities of the supervisor to whom the employee is required to report, including a requirement that an employee report to a corporate officer or employee instead of reporting directly to the board of directors of a corporation (or similar governing body with respect to an entity other than a corporation);
• a material diminution in the budget over which the employee retains authority;
• a material change in the geographic location at which the employee must perform the services; or
• any other action or inaction that constitutes a material breach by the employer of the agreement under which the employee provides services.

Cause

While a definition of Cause covering a senior executive will ordinarily be limited to the employee’s “bad acts” or intentional failure to perform their material duties, other employees might be subject to a definition of Cause that includes elements of poor performance. Examples of Cause might include the employee’s:

• unsatisfactory performance, wilful or negligent performance, or gross negligence or wilful misconduct in connection with performing employer-related responsibilities;
• wilful failure or refusal to perform his or her duties or responsibilities for the employer, failure to execute or follow the directions of a supervisor, or other insubordination;
• misappropriation (or attempted misappropriation) by the employee of any assets or business opportunities of the employer or any of its affiliates;
• embezzlement or fraud committed (or attempted) by the employee in connection with performing his or her responsibilities for the employer;
• conviction of or pleading “guilty” or “no contest” to a felony or other crime (often a crime involving “moral turpitude”);
• violation of the employer’s policies, including policies regarding sexual harassment and business conduct;
• breach of his or her restrictive covenants;
• breach of the agreement; or
• failure to remain licensed (to the extent required by applicable law) to perform the duties of his or her employment, or failure to obtain all relevant licences to perform such duties.

Ultimately, any definition of Good Reason or Cause will – or should – depend on what is important to the employee and the employer, respectively, and their relative leverage during the negotiation process.

Materiality standards in Good Reason and Cause

Regardless of how an agreement defines Good Reason and Cause, it ordinarily includes safeguards to ensure that the definitions will not be triggered unintentionally or will not provide a party with an open-ended option to exercise the rights derived from the definition.

Ordinarily, all or many of the components of Good Reason and Cause will be subject to a “materiality” standard or a similar term to prevent minor transgressions from triggering the rights of the other party (and, in the case of Good Reason, to avoid Section 409A). In addition, agreements generally require a party to notify the breaching party of one or more conditions triggering Good Reason or Cause shortly after the initial existence of the condition (which, in the case of Good Reason, must not exceed 90 days for Section 409A purposes). If the condition is curable, the breaching party will ordinarily have the right to cure the condition within a short period (at least 30 days in the case of Good Reason) following receipt of notice from the other party. Moreover, to prevent an employee from holding an open-ended right to resign for Good Reason, an agreement will usually provide that such right will expire at the end of a specified period following the initial existence of the condition constituting Good Reason (such period cannot exceed two years for Section 409A purposes). Finally, in the case of certain components of Cause, a senior executive might be afforded additional procedural safeguards, such as having the right to dispute the allegation before the employer’s governing board.

Role

Position and responsibilities

Whether for personal esteem, reputation or career advancement, the identification of an employee’s position and responsibilities are probably the most important aspect of an agreement to the employee, aside from compensation. Given its importance, a common component of Good Reason addresses a diminution in, or negative change to, the employee’s position and responsibilities. However, although the employee’s title or position is important, an employee will typically want the responsibilities that are most associated with their title to be identified and, if applicable, incorporated into its definition of Good Reason.

However, because an employee’s responsibilities must necessarily be fluid and evolve to meet the employer’s business needs, agreements typically describe an employee’s responsibilities by referencing what would be customarily performed by a similarly situated employee at a similar or comparable employer in addition to any other responsibilities assigned by the employer. However, for the employee’s protection, those assigned duties might be limited to what is reasonable, given the employee’s title, position and experience.

Due to the inherent need for an agreement to provide a general or abstract description of an employee’s duties, an employee should seek to have an employment agreement clearly specify any particular aspect of an employee’s position or responsibilities that is important to the employee. For example, to ensure that a CEO’s role is not undermined by the appointment of an executive chairperson or as a result of the employer’s acquisition by another company, the CEO’s employment agreement could provide that Good Reason will be triggered if he or she is no longer the most senior employee at the employer and possibly its affiliates.

Reporting structure

For reasons similar to those associated with specifying an employee’s position and responsibilities, an employee may require the agreement to identify to whom the employee will report and who will report to the employee, depending on the employee’s position and circumstances. For example, a chief executive officer will generally insist that he or she reports solely to the employer’s governing board. Similarly, an employee who follows another more senior employee to another employer might negotiate for his or her agreement to clearly provide that such employee will continue to report to such senior employee at the new employer. In either case, Good Reason would commonly address a breach of each provision.

Outside activities

Unsurprisingly, an employer will seek to ensure that an employee’s sole focus is on employer-related responsibilities. Of course, such a commitment would be unrealistic and unreasonable and, in a worst-case scenario, could be used as a reason for the termination of the employee’s employment for Cause. To prevent such a result, the employee’s contractual time commitment might be limited to the employee’s “business time” or the equivalent, and the agreement might describe particular activities in which the employee will be permitted to engage, regardless of the employee’s express time commitment. For example, an employee might be expressly permitted to serve on boards of non-competing businesses and charitable organisations, engage in charitable activities and community affairs, and manage the employee’s personal investments. However, such permitted activities are often subject to the consent of the employer or its board.

Location

The designation of where an employee will perform his or her responsibilities is often taken for granted. However, like most other aspects of the agreement that need to evolve to reflect the employer’s business needs, an employer will insist on retaining some flexibility to move its offices; that flexibility is often addressed in the definition of Good Reason.

An employer will seek maximum flexibility to relocate its offices and employees while the employee may require greater certainty to avoid longer commutes or possibly disruptive relocation and its effect on the employee’s family or other personal relationships. Accordingly, while an agreement will usually designate a particular city or metropolitan area in which the employee will be assigned, a change in the employee’s work location will not normally give rise to Good Reason unless the relocation of the employee’s principal place of employment exceeds a specified number of miles from its current location, although the specific number of miles typically depends on the office’s geographic location. For example, a relocation by more than 50 miles has been a common element of Good Reason; however, that distance is typically shorter if the office is located in a city, such as New York City, where a relocation of even a few miles might increase the employee’s commute exponentially and require him or her to work in a different state. A similar but less commonly used formulation triggers Good Reason based on a relocation that increases the employee’s commute from his or her existing residence by a specified distance.

Coinciding with the recent acceptance of flexible or remote work arrangements, a Good Reason definition covering an employee who has negotiated for such an arrangement may include a mandate that the employee commence, or recommence, physically working in the employer’s office.

For an employee who will be required to travel on a regular basis, the employer should include a reference to such required travel in the provision. Otherwise, an employee could argue that such required travel entitles the employee to terminate for Good Reason.

Compensation

The components of compensation are understandably a primary focus of both employer and employee. However, the importance of compensation terms is not generally reflected in Good Reason. With respect to base salary, Good Reason may provide that an employee’s base salary cannot be reduced at all. Alternatively, Good Reason may limit reductions of base salary to a specified percentage and provide that base salary can only be reduced in connection with across-the-board reductions to similarly situated employees.

With respect to bonus compensation, the more formulaic the bonus arrangement, the greater the employee’s ability to argue that an employer has breached the agreement by not complying with the specific terms of the arrangement. Employers, however, often require flexibility to respond to changing business needs, and a guaranteed bonus is typically limited to sign-on, retention or initial guaranteed minimum bonuses. Instead, at best, bonus compensation may be prescribed by a “target” expressed as either a dollar amount or a percentage of base salary. To the extent Good Reason references bonus compensation, it is often included in the same component as base salary and similarly refers to a reduction in such target bonus rather than any measure of the actual paid bonus.

Employment Term

While many agreements include a specified employment term, it is rarely the case that an employer will need to pay out all remaining amounts due in respect of the term upon termination of employment. As a result, an employment term generally has little substantive meaning. Instead, if an employee is entitled to severance benefits, the agreement will set forth what severance benefits the employee may receive and the conditions for such severance benefits.

However, where an agreement does include a term, the parties may agree to provide that non-renewal of the term by the employer will be treated as a termination without Cause, and non-renewal of the term by the employee will be treated as a resignation for Good Reason (and properly designed restrictive covenants will be of the same length and of the same application, regardless of the reason for termination).

Severance

An employee should receive the same severance regardless of whether they resign for Good Reason or are involuntarily terminated without Cause. The types of severance an employee may negotiate for include:

• continuation of base salary;
• payment of an unpaid prior year bonus;
• all or a portion of the bonus for the year in which termination occurs;
• employer paid health insurance coverage during the period the employee is receiving severance; and
• full or partial vesting of outstanding equity or equity-based awards.

Where an employee’s Good Reason definition includes a reduction in base salary or target bonus, an agreement will frequently provide that severance is calculated without regard to any reductions that gave rise to Good Reason.

Change in Control

Employees of a company subject to a possible acquisition or merger face uncertainty regarding their future employment if the transaction were to occur. Recruiters often capitalise on that uncertainty and attempt to recruit those employees to other employers. To provide greater protection to employees, many employment agreements include protection specific to employment following a change in control. An employer may agree to include the concept of Good Reason that applies after a change in control or that provides expanded protection after a change in control.

In the past, employment agreements covering senior executives often included a “walk-away right” that entitled the executive to resign for any reason (or no reason) following a change in control and receive severance benefits. Walk-away rights are strongly disfavoured by institutional investors and have become extremely rare, particularly in public companies.

Crime

Any component of Cause involving a crime requires special attention. If Cause is triggered by a conviction or guilty plea, the employer will not be entitled to terminate the employee for Cause until the criminal proceedings are concluded. To address this issue, an employer will ordinarily seek to have Cause triggered by the employee’s indictment for a crime or, alternatively, the employee’s commission of a crime and reserve to itself the discretion to determine whether a crime has been committed. In contrast, although most individuals presumably do not contemplate engaging in crimes, employees generally seek to limit Cause to crimes that materially affect the employer’s business.

Conclusion

Due to the importance of Good Reason and Cause, as each key term of an employment agreement is negotiated by the parties, they should also consider whether it should be reflected or addressed by those definitions.