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Executives: 10 Legal Areas You Need to Know if You Work With, For or Against Them

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Executives: 10 Legal Areas You Need to Know if You Work With, For or Against Them

Prepared and Presented by: Jeffrey B. Oberman

ONE:  EXECUTIVE EMPLOYMENT AGREEMENTS

I. INTRODUCTION. Many executives are not willing to accept employment without contractual commitments.  Also, employment agreements can offer incentives to executives, direct energies toward desired goals, protect the employer’s confidential information and relationships with customers or other employees who might follow departing executives and simplify future negotiations.

II. COMMENTS REGARDING COMMON TERMS.

A. General Terms and Conditions. Among other general items, address expectations regarding the exclusivity of the position, and whether other board memberships, professional commitments, consulting, etc. are allowed.

B. Term of Agreement.

1. Specific Period of Time. Anticipate and specify expectations regarding the expiration. If the employment continues without a new agreement, and if some of the provisions in the agreement continue forward, there is room for misunderstandings and disagreements.

2. Initial Term With Anticipated Renewals. Clarify whether the agreement automatically renews at the end of each term, absent adequate notice by one party to the other not to renew (commonly referred to as an “evergreen” agreement), or whether the parties must renegotiate a new agreement at the end of its term, and, absent that, the agreement will terminate.

3. No Term At All; “At-will” Relationship. The point of this agreement is to clearly set forth the parties’ expectations, rights and obligations – both during the course of employment and upon termination. The parties may change the obligations, depending on who decides to terminate the relationship, why and/or when.

C. Title; Duties. Circumstances may change. Although it is helpful to describe initial title and duties, be clear whether they are flexible; and who has the authority to make changes.

D. Compensation, Reimbursements and Benefits. In addition to base salaries and basic benefits, this may include bonus plans, incentive compensation plans, separation or severance plans, stock options, etc.  If unique compensation arrangements are made, address issues which they may create. For example, if stock is involved, be clear in the Employment Agreement and in a separate Stock Purchase Agreement what will happen if the employment relationship ends. Also, be sensitive to excess taxes and tax penalties that may be triggered, and who will pay them.

E. Bonus and Other Incentive Packages. Employment agreements may indicate that an annual discretionary bonus will be considered or set up an objective or combined objective/subjective bonus plan (or might refer to other bonus or incentive programs, subject to their terms and conditions). Be clear whether the employer maintains the right to interpret, amend, or cancel the bonus/incentive program and what happens after a mid-year departure.

F. Business Expenses. Clearly state the expectation to abide by the employer’s required practices and IRS rules, and address any unique expense arrangements.

G. Benefits. Avoid inadvertently overriding benefits plans, and preserve the right to change them as circumstances may require.

H. Protection of Trade Secrets, Non-Competition, Intellectual Property and Related Matters. This is the best time for an employer to protect its trade secrets and intellectual property, prevent unfair competition, and prohibit the solicitation of its customers and/or employees in the event the executive departs.

I. Termination/Post-Termination Payments. An employment agreement should anticipate all likely reasons for termination. The parties may have a very different view about post-termination packages, depending on the reason for the departure. For example:

1. Death of Executive. Post-termination payments (beyond life insurance) are rare in this situation.

2. Disability of Executive. Again, post-termination payments (beyond insurance) are rare.

3. Termination by Company “For Cause.” Generally, post-termination payments are not paid in this situation.  Carefully define “cause” to avoid later misunderstandings.  Misconduct, illegal activities, intentional breaches of the duty of loyalty, etc., are often included in the definition. Decide if you want a performance-based threshold.

4. Voluntary Termination by Executive. Generally, post-termination payments are not paid in this situation.

5. Termination by Company Without Cause. It is common to provide post-termination payments to executives who are terminated “without cause.” The amount of post-termination payments might be a flat amount (e.g., one year), a formula (e.g. for each year of service), a diminishing amount (e.g., one year if the termination takes place within the first year, six months if it takes place in the second year, etc.), or some other formula.

6. Termination as a Result of Other Reasons. Employment agreements often discuss terminations as a result of divestitures, acquisitions, mergers, or other changes in control. This type of separation often triggers the same – or greater – payments than a termination without cause.

7. Resignation for Good Reason. Some executives insist on allowing a “resignation for good reason.”  The post-termination pay is usually comparable to a termination “without cause” by the Company.  This might address the right to resign in situations such as divestitures, material changes in the executive’s job title or duties, material changes to the executive’s compensation or benefits packages, or illegal or improper behavior by the employer.

8. Suggested Conditions for Employers. If an employer agrees to pay post-termination payments, it should make them contingent on the executive’s compliance with post-termination obligations (non-compete and non-solicitation agreements, trade secret and confidentiality agreements, etc.), and a signed release of claims.

9. Additional Pay/Benefits. The agreement should state whether bonuses and fringe benefits (cars, club dues, profit sharing, etc.) will result from post-termination severance pay.

J. Mediation/Arbitration Clause. The parties might opt to have disputes decided in an arbitration forum in lieu of traditional litigation, and/or require mediation before litigation.

III. SEPARATION AGREEMENTS.

A. The more the employment agreement anticipates, the more likely later separations will be amicable and smooth.  To the extent separation agreements with executives are needed or desired, they should address, among other things, the following:

1.         Release of claims.

2.         Determine which prior contractual obligations will continue and which will be superseded.

3.         The executive’s future obligations to the employer and visa versa.

4.         Stock redemption and buy/sell issues.

5.         Trade secrets, competition issues, anti-solicitation issues, inventions.

6.         Future communications, such as anti-disparagement clauses.

7.         What to tell the media.

8.         Cooperation with respect to claims.

9.         Future defense and indemnification issues.

10.       Tax ramifications and obligations.

TWO:  NON-COMPETE, CONFIDENTIALITY AND NON-SOLICITATION AGREEMENTS.

I. INTRODUCTION. More employers than ever are using non-competition, confidentiality and non-solicitation agreements to prevent unfair competition and solicitation of their employees, and to protect their trade secrets and confidential information.  This section summarizes goals and strategies relating to such agreements, from all three perspectives.

II. OLDCO’S GOALS IN DRAFTING AND USING AGREEMENTS:  DETERRENCE, DAMAGE CONTROL AND RECOVERY.

A. Do Not Overuse Non-Compete Agreements. Notwithstanding their economic appeal to employers, covenants not to compete are partial restraints of trade, are disfavored by courts and will be narrowly construed.  Bennett v. Storz Broad. Co., 134 N.W.2d 892 (Minn. 1965); Lemon v. Gressman, 2001 WL 290512 at *1 (Minn. App. 2001).  In Minnesota, an enforceable non-compete agreement must be both necessary to safeguard the employer’s protectable interests and reasonable as between the parties.  See Bennett, 134 N.W.2d at 898; Medtronic, Inc. v. Sun, 1997 WL 729168, at *3 (Minn.  App. 1997).  The agreement must not impose any greater restriction on the employee than is necessary to protect the employer’s business.  Bennett, 134 N.W.2d at 899.

B. Do Aggressively Use Trade Secret and Non-Confidentiality Agreements. Even if the situation does not warrant competition restrictions, employers should use trade secret and confidentiality agreements.  In addition to providing protections vis-à-vis that employee, this helps establish that the employer considers its information confidential.  An entity seeking protection of a trade secret must make a “reasonable effort under the circumstances” to maintain secrecy.  See Electro-Craft v. Controlled Motion, Inc., 332 N.W.2d 890, 901 (Minn. 1983).   One example of measures that signal that an employer intends to keep information confidential is to require every employee to sign non-disclosure agreements.  Surgidev Corp. v. Eye Tech., Inc., 648 F. Supp. 661, 693-94.

C. Time Periods. Covenants restricting competition must be reasonable from a temporal standpoint. To the extent they are not, such covenants are not enforced. Courts consider a variety of factors in determining whether a restrictive covenant is reasonable from a temporal standpoint, including the following: (1) nature of the work; (2) time necessary to train new employees to replace exiting employees; (3) time necessary to allow customers to become familiar with new employees; and (4) time necessary to obliterate the identification between the employer and the employee in the minds of the employer’s customers. Dean Van Horn Consulting Associates v. Wold, 395 N.W.2d 405 (Minn. App. 1986); Klick v. Crosstown State Bank of Ham Lake, Inc., 372 N.W.2d 85 (Minn. App. 1985); See also West Publishing Corporation v. Stanley, 2004 WL 73590 (D. Minn. 2004); Head, DVM v. Morris Vet. Center, Inc., 2005 WL 1620328 (Minn. App. 2005).

D. Geographic Limits. Covenants restricting competition must be reasonable from a geographic standpoint as well. To the extent they are not, such covenants are not enforced. Courts have considered a variety of factors in determining whether a restrictive covenant is reasonable from a geographic standpoint, including the following: (1) a “reasonable” trade area; (2) area where employee actually performed duties; (3) employer’s actual business area; and (4) location of employer’s customers.  Overholt Crop Ins. Serv. Co. Inc. v. Bredeson, 437 N.W.2d 698 (Minn. App. 1989); Satellite Indus. Inc. v. Keeling, 396 N.W.2d 635 (Minn. App. 1986); Metro Networks Comm. v. Zavodnick, 2004 WL 73591 (D. Minn. 2004); Universal Hosp. Serv., Inc. v. Hennessy, 2002 WL 192564, (D. Minn. 2002).

E. Customer Restrictions Becoming Common. A customer restriction may substitute for, or complement, a geographic restriction.  Minnesota courts have upheld non-solicitation agreements even where they contain no territorial limits, because the restriction to former clients is sufficiently narrow.  See Dynamic Air, Inc. v. Bloch, 502 N.W.2d 796, 800 (Minn. App. 1993); IDS Life Ins. Co. v. SunAmerica, Inc., 958 F. Supp. 1258, 1273 (N.D. Ill. 1997) rev’d on other grounds, 136 F.3d 537 (7th Cir. 1998) (applying Minnesota law); see also Madsen v. Spectro Alloys Corp., 1998 WL 373067, at *3 (Minn. App. 1998); Farm Credit Services v. Wysocki, 627 N.W.2d 444 (Wis. 2001); Commodities Specialists, Co. v. Brummet, 2002 WL 31898166 (D. Minn. 2002).

F. Workforce Protection (Anti-Raiding). The Eighth Circuit has ruled on a matter that included an employee non-solicitation clause as part of a settlement agreement between two competing companies.  The court was not asked to rule on the validity of the employee non-solicitation agreement, but its decision assumed its enforceability.  See Frank B. Hall & Co., Inc. v. Alexander & Alexander, Inc., 974 F.2d 1020 (8th Cir. 1992).

III. COMMON DRAFTING AND IMPLEMENTATION MISTAKES.

A. Non-Compete Agreements Must Be Supported By Consideration. Signing a covenant not to compete at the inception of the employment relationship provides sufficient consideration to support the covenant.  See, e.g., Overholt, 437 N.W.2d at 702.  Employers should provide job applicants who they wish to hire with written, conditional offers of employment and a copy of the non-compete agreement prior to the new employee’s first day of work.

B. “Midstream Agreements” Must Be Supported By Separate, Independent Consideration. Where a non-compete agreement is executed after an employee has commenced employment, the agreement must be supported by “independent consideration” to be enforceable. National Recruiters. Inc. v. Cashman, 323 N.W.2d 736 (Minn. 1982).  A non-compete agreement following the original offer of employment cannot be enforced absent independent consideration.  Sanborn Mfg. Co. v. Currie, 500 N.W.2d 161 (Minn. App. 1993); see also TestQuest, Inc. v. La France, 2002 WL 196287 (Minn. App. 2002); Midwest Sports Mktg., Inc. v. Hillerich & Bradsby of Can., Ltd., 552 N.W.2d 254, 265 (Minn. App. 1996); review denied (Sep. 20, 1998); Tonna Heating Cooling, Inc., v. Waraxa, 2002 WL 31687601 (Minn. App. 2002);  FSI Int’l, Inc. v. Shumway, 2002 WL 334409, (D. Minn. 2002);  J. K. Harris & Co., LLC v. Dye and ABC Co., 2001 WL 1464728, (D. Minn. 2001).  However, if the employee signed a non-compete after starting working, but knew of the implementation of the non-compete agreement, continued working, and continued to receive monthly “draws” (or advance payments on unearned commissions), this could constitute sufficient consideration.  See Progressive Tech. Inc., v. Shupe, 2005 WL 832059 (Minn. App. 2005).

C. Protect The Continuing Viability Of Your Non-Competition Agreements. Non-compete obligations must expressly survive termination of employee’s employment or expiration of the employment agreement.  The employer should draft the non-compete clause and related agreement(s) so that it is clear that the non-compete obligations survive termination of the underlying employment.  See Burke v. Fine, 608 N.W.2d 909, (Minn. App. 2000) review denied (June 13, 2000).  The employer should also include a clause allowing the employer to assign the non-competition agreement, and ensure that merger clauses in subsequent agreements – for example, a separation agreement or release of claims – do not by their terms supersede and, thus, render unenforceable, an employee’s continuing non-competition obligations.

D. Enhance the Claim for Damages. Employers can contractually enhance their potential damage claims by one or more of the following provisions:  granting the employer express rights to an accounting in the event of a breach; requiring the breaching former employee to repay all profits earned as a result of the breach; granting attorneys’ fees; and requiring the employee to notify the potential future employer, in writing, of any possible re-employment prior to accepting an offer and an authorization for the employer to contact the potential employer and provide it with a copy of the non-compete agreement.

E. Notice to Future Employer. Consider provisions that put future employers on notice of possible liability for any/all of the above.

F. Choice of Law, Forum. It is critical for an employer to include a choice of law provision and a forum/venue selection provision, to minimize forum shopping and races to the courthouse.

G. Injunctive Relief. In addition to providing for money damages in the event of a breach, the agreement should expressly state that injunctive relief would be appropriate in the event of a breach and that irreparable harm would result absent injunctive relief.

IV. NEWCO’S GOALS: HIRE THE EMPLOYEE YOU WANT REGARDLESS OF THE NON-COMPETE.

A. NEWCO’s Exposure to Liability. A new employer who hires an employee who is subject to a non-compete agreement may be liable to the prior employer for tortious interference with contract.  Kallok v. Medtronic, Inc., 573 N.W.2d 356 (Minn. 1998). The new employer may also be required to indemnify the old employer for attorneys’ fees incurred by the old employer in litigation to enforce the valid non-compete agreement.  Id. NEWCO may also have liability to OLDCO for violations of trade secret and other common laws.  See Minn. Stat. § 325C.01, subd. 5 (2006); Electro-Craft, 332 N.W.2d at 899; Widmark, 530 N.W.2d at 588; Surgidev 648 F. Supp. at 693-94.

B. NEWCO’s Pre-Hire Strategies:  Look Before You Leap.

1. Make at-will employment offer letters contingent on applicant’s ability to perform duties; confirm applicant is not hindered by non-compete or other agreement with a previous employer.

2. Make it clear in offer letters that the employee is prohibited from bringing or using OLDCO’s property, trade secrets, confidential information.

3. If you discover a problem (e.g., existing non-compete agreement) up front, evaluate the question of enforceability, and balance the risks before going forward with the hire.  Also, consider limiting the terms of the employment to assure (or at least make a good faith effort to assure) that activities will not conflict with the prior agreement or entail the use of OLDCO’s confidential information, trade secrets, or customer relationships.

4. Determine whether, and on what terms, NEWCO will defend/indemnify the employee.

5. Decide whether NEWCO’s attorney will represent the employee, whether NEWCO will hire separate counsel for the employee, or whether NEWCO will expect the employee to provide for his/her own representation.

6. Have an “exit strategy” (right to end employment, etc.).

C. NEWCO’S Post-Hire Strategies: Say What You Mean; Mean What You Say.

1. Don’t hide from OLDCO.  Consider open, honest and good faith communications (to resolve issues, and/or establish good faith).

2. Provide/offer as many concessions as possible to OLDCO (e.g., employee will not use OLDCO’s property, trade secrets, customer contacts, etc.); and honor your commitments.

3. Consider whether to file a declaratory judgment action.

4. Be prepared to address/discuss creative, multifaceted business solutions so all parties can avoid litigation risks and expenses; and

V. EMPLOYEE’S GOALS:  MOVE ON WITH NO OR CAPPED EXPOSURE.

A. Employee’s Exposure to Liability or Other Loss. An employee who takes a new job in violation of a non-compete agreement risks a direct lawsuit by OLDCO, for numerous legal theories.  In addition, the transitioning employee is at risk of committing to a new position (likely at-will) and then getting fired as a result of a non-compete dispute.  The risk that NEWCO will terminate the at-will relationship increases if NEWCO is surprised by OLDCO’s claims.

B. Employee’s Pre-Hire StrategiesFull Disclosure; Anticipate Potential Problems; Minimize, Eliminate or Protect Yourself Against Such Problems.

1. At the right time, inform NEWCO about the existence of your non-compete agreement or other protective agreement with OLDCO.

2. Have an understanding with NEWCO that you are not required or expected to bring or use OLDCO’s property, trade secrets, confidential information.

3. Try to get the terms of the employment to assure that your activities with NEWCO will not conflict with your prior agreement or until the use of OLDCO’s confidential information, trade secrets or customer relationships.

4. Try to get NEWCO to agree, in writing, that it will defend and indemnify you in the event of a claim by OLDCO.

5. If NEWCO expects you to retain separate counsel, see if NEWCO will pay for that advice and consultation; and make sure you get the counsel before, rather than after, you make new commitments.

6. If your employment with NEWCO is on an “at-will” basis, and if you have made full disclosure of OLDCO’s agreement, seek an agreed severance/transition package, in the event NEWCO decides to terminate the relationship as a result of the OLDCO agreement.

THREE:  INTELLECTUAL PROPERTY ISSUES.

I. introduction. Regardless of contractual rights and obligations, executives virtually always have access to confidential information, trade secrets and other intellectual property. In many cases, they (often inadvertently) take actions that violate their legal obligations in these areas. This section summarizes some of the more common mistakes/violations.

II. TRADE SECRET AND CONFIDENTIALITY ISSUES.

A. Executives’ Common Law Duties to Maintain Confidentiality. Regardless of the existence of a contractual agreement, Minnesota common law provides protection to employers from employees that misuse an employer’s confidential information, or attempt to compete with the employer while still employed.  See Eaton v. Giere, 971 F.2d 136, 141 (8th Cir. 1992) cert. denied, 506 U.S. 1034 (1992).  But the employer-employee relationship creates a common law duty of confidentiality only as to information that the employer treats as secret.  Electro-Craft Corp. v. Controlled Motion, 332 N.W.2d 890, 903 (Minn. 1983).

B. Executive’s Statutory Obligation Not To Misuse Trade Secrets.  The Minnesota Uniform Trade Secrets Act (“MUTSA”), bars misappropriation, which is defined as “improper acquisition, disclosure, or use of a ‘trade secret.’”  M.S.A. §§ 325C.01 to 325C.08; Electro-Craft Corp., 332 N.W.2d at 897 (quoting Minn. Stat. § 325 C.01, subd. 3).  The existence of a proven trade secret and proof of a confidential relationship are prerequisites to an action for misappropriation.  Id.

C. Trade Secret. General knowledge within an industry does not constitute a trade secret.  I.B.M. Corp. v. Seagate Tech., Inc., 941 F. Supp. 98, 100 (D. Minn. 1992); NewLeaf Designs, LLC v. BestBins Corp., 168 F. Supp.2d 1039, 1044-45 (D. Minn. 2001).  The test used to determine whether information constitutes a trade secret is embodied in Minn. Stat. § 325C.01, subd. 5 (1982): “Trade secret” means information, including a formula, pattern, compilation, program, device, method, technique, or process, that: (i) derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use, and (ii) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.”  Electro-Craft, 332 N.W.2d at 899; Widmark v. Northrup King Co., 530 N.W.2d 588 (Minn. App. 1995).  Further, a common law claim of misappropriation of confidential information requires an affirmative showing that the employee intended to misappropriate the employer’s confidential information.  Conus Communications Co. Ltd. P’ship v. Hubbell, 2000 WL 979133, at * 3 (Minn. App. 2000).

D. Prima Facie Case for Trade Secret Protection. To make out a claim for trade secret protection, a plaintiff must prove the following elements:  plaintiff is the owner of a trade secret; plaintiff disclosed the trade secret to defendant; or defendant wrongfully took the trade secret from plaintiff without plaintiff’s authorization; defendant was in a relationship with plaintiff as a result of which defendant’s use or disclosure of trade secrets to plaintiff’s detriment is wrongful; and defendant has used or disclosed (or will disclose) the trade secret to plaintiff’s detriment; or, defendant who knew or should have known of plaintiff’s rights in the trade secret, used such secret to plaintiff’s detriment.  Surgidev, 648 F. Supp. at 680.  The fourth and final factor requires “proof that there is an intention on the part of the defendants to use or disclose the putative trade secrets, or alternatively, that under the circumstances of the case, there is a high degree of probability of inevitable disclosure.”  Id. at 695.

E. Inevitable Disclosure Doctrine. The doctrine by which some courts presume, that, regardless of the intention to disclose, wrongful disclosure will take place is known as the “inevitable disclosure” doctrine.  See PepsiCo, Inc. v. Redmond, 54 F.3d 1262, 1269-71 (7th Cir.1995); cf. Lumex, Inc. v. Highsmith, 919 F. Supp. 624, (E.D.N.Y.1996); but see Hoskins Mfg. Co. v. PMC Corp., 47 F. Supp. 2d 852 (E.D. Mich. 1999); Schlage Lock Co. v. Whyte, 101 Cal.App.4th 1443, 125 Cal.Rptr.2d 277 (Cal. App. 2002).  In Minnesota, generally a court may issue an injunction only where there is misappropriation or threatened misappropriation of trade secrets.  Seagate, 941 F. Supp. at 101; Minn. Stat. § 325C.02(a); see also NewLeaf Designs, 168 F. Supp. 2d at 1044-45.

III. Invention and Patent Rights.

A. General Rule. The general rule is that “an individual owns the patent rights to the subject matter of which he is an inventor, even though he conceived it or reduced it to practice in the course of his employment.”  E.g., Banks v. Unisys Corp., 228 F.3d 1357, 1359 (Fed. Cir. 2000).

B. Exceptions. There are two widely recognized exceptions to the general rule:  “first, an employer owns an employee’s invention if the employee is a party to an express contract to that effect; second, when an employee is hired to invent something or solve a particular problem, the property of the invention related to this effort may belong to the employer.”  Banks, 228 F.3d at 1359.

C. Use Agreements. In the absence of an express contractual agreement defining ownership rights in inventions, the employer’s right to claim ownership in discoveries made by an employee can be an expensive and risky battle.  An employer can, and should, require an employee to assign ownership rights in past and future inventions.  At the time such an agreement is made, the employer must provide the employee with written notice that the agreement “does not apply to an invention for which no equipment, supplies, facility or trade secret information of the employer was used and which was developed entirely on the employee’s own time, and (1) which does not relate (a) directly to the business of the employer or (b) to the employer’s actual or demonstrably anticipated research or development, or (2) which does not result from any work performed by the employee for the employer.”  Minn. Stat. § 181.76.  It is best to get these agreements up front, as a condition of employment.  Existing employees should be provided independent consideration to support such agreements.  See Eaton Corp., 971 F.2d at 139-40.

FOUR:  FIDUCIARY DUTIES.

I. INTRODUCTION. All employees owe a duty of loyalty to their employer.  See, e.g., Eaton Corp., 971 F.2d 136; Sanitary Farm Dairies, Inc. v. Wolf, 112 N.W.2d 42 (Minn. 1961); Rehabilitation Specialists, Inc. v. Koerning, 404 N.W.2d 301.  In addition to the duty of loyalty, executives often have additional fiduciary duties.

A “fiduciary” is a person or legal entity who has the power and obligation to act for another under circumstances which require total trust, good faith and honesty.  Characteristically, the fiduciary has greater knowledge and expertise about the matters in question.   A fiduciary is held to a standard of conduct and trust above that of a stranger or a casual business person. A fiduciary relationship “exists when confidence is reposed on one side and there is resulting superiority and influence on the other.”  I-Systems, Inc. v. Softwares, Inc., 2004 WL 742082 (D. Minn. 2004) (quoting H. Enterprises Int’l Inc. v. General Elec. Capital Corp., 833 F.Supp. 1405, 1421 (D. Minn. 1993).  Because of the fiduciary’s duties, he or she must avoid “self-dealing” or “conflicts of interest” in which the potential benefit to the fiduciary is in conflict with what is best for the person who trusts him or her.  Id.

II. PARTNERS. Partners have a fiduciary duty to each other and the partnership.  Minnesota law imposes the highest duty of integrity and good faith on partners in their dealings with each other.  Triple Five of Minnesota, Inc. v. Simon, 404 F.3d 1088, 1095 (8th Cir. 2005) (citing Venier v. Forbes, 25 N.W.2d 704, 708 (Minn. 1946)).  Under Minnesota law, a breach of duty by a managing partner (entity) of a partnership can be imputed to officers of the managing partner, through their positions with the managing partner and their holding themselves out as having authority to act for the partnership.  Triple Five of Minnesota, Inc. v. Simon, 280 F.Supp.2d 895, 901 (D. Minn. 2003) clarified in part 2003 WL 22989059, amended 2003 WL 23018825.

III. SHAREHOLDERS IN CLOSE CORPORATIONS. The Minnesota Supreme Court has compared closely held corporations to a “partnership in corporate guise.”  Westland Capitol Corp. v. Lucht Eng’g Inc., 308 N.W.2d 709, 712 (Minn. 1981).  Thus, shareholders in closely held corporations have a fiduciary duty to each other.  Pedro v. Pedro, 489 N.W.2d 798, 801 (Minn. App. 1992) (“Pedro II”); Pedro v. Pedro, 463 N.W.2d 285, 288 (Minn. App. 1990) (“Pedro I”).  The fiduciary relationship imposes upon shareholders the “highest standards of integrity and good faith in their dealings with each other.”  Pedro II, 489 N.W.2d at 801 (quoting Prince v. Sonnesyn, 25 N.W.2d 468, 472 (Minn. 1946)).

A shareholder’s claim for breach of common law fiduciary duty can be brought in addition to claims for minority shareholder relief pursuant to Minn. Stat. § 302A.751.  Berreman v. West Publishing Co., 615 N.W.2d 362, 369 (Minn. App. 2000), rev. denied (Minn. Sept. 26, 2000).

Generally, Minnesota courts require one who stands in a fiduciary relationship to disclose “material facts.”  Klein v. First Edina Nat’l Bank, 196 N.W.2d 619, 622 (Minn. 1972).  The fiduciary duty of shareholders in a close corporation includes the duty to disclose material information about the corporation.  Berreman, 615 N.W.2d at 371.  A shareholder in a close corporation has a duty not to make decisions based on personal and private interests to the detriment of the corporation.  Gunderson v. Alliance of Computer Professionals, 628 N.W.2d 173, 186 (Minn. App. 2001).

Although Minnesota courts have long agreed that shareholders in a closely held corporation owe a fiduciary duty to one another, the actual scope of the duty has not been well defined.  Berreman, 615 N.W.2d at 370.  Courts have “carefully refrained from defining the particular instances of fiduciary relations in such a manner that other and perhaps new cases might be excluded.”  Parkhill v. Minnesota Mutual Ins. Co., 995 F. Supp., 983, 991 (D. Minn. 1998.)

However, Minnesota courts have addressed several actions, which the courts have held or commented to be violations of fiduciary duties.  For examples:  “Freeze-out” situations (Berreman, 615 N.W.2d at 370); preferential financial treatment (Gunderson, 628 N.W.2d at 185); material misrepresentations leading to sale of stock for less than their value (Fewell v. Tappan, 27 N.W.2d 648, 654 (Minn. 1947)); interfering with the fellow shareholder’s ability to perform his job, and defaming and threatening the fellow shareholder (Pedro II, 489 N.W.2d at 801-802); and obtaining a resignation in an abrasive and intimidating manner (Evans v. Blesi, 345 N.W.2d 775, 779 (Minn. App. 1984)).

However, shareholders and partners are not excused from contractual provisions. For example, there was no breach of fiduciary duties where a partner was terminated in compliance with the terms of a partnership agreement. Rothmeier v. Investment Advisers, Inc., 556 N.W.2d 590, 595 (Minn. App. 1996), rev. denied (Minn. Feb. 26, 1997). Similarly, there was no breach of fiduciary duty for terminating the former CEO and one of the founding shareholders where: the buy-sell agreement, the company employee manual and an acknowledgement form all evidenced an at-will relationship; and the plaintiff admitted that he had always understood that he was an at-will employee who could be terminated with or without cause, and he, himself, had terminated the employment of other shareholders, and understood that all shareholders were at-will employees.  Regan v. Natural Resources Group, Inc., 345 F.Supp.2d 1000, 1012 (D. Minn. 2004).

IV. DIRECTORS AND OFFICERS. Directors and officers owe their employers fiduciary duties.  These duties include the duties of good faith and fair dealing.  In Minnesota, the fiduciary duties of officers and directors of corporations have developed statutorily and through common-law.  See Minn. Stat. § 302A.251 and Minn. Stat. § 302A.361 (imposing a duty of good faith on officers of a corporation); Minn. Stat. § 302A.751 (close corporations); Minn. Stat. § 322B.833 (limited liability companies); Minn. Stat. § 323A.0404 (partnerships); and Minn. Stat. § 321.0408 (limited liability partnerships).  It is a well-recognized common-law principle in Minnesota that directors and officers hold a fiduciary relationship to the corporation, imposing upon them the duty to exercise their powers solely for the benefit of the corporation and its stockholders.  Diedrick v. Helm, 14 N.W.2d 913, 919 (Minn. 1944).  Officers must not exercise their powers as directors to serve their own personal interests at the expense of the corporation and its stockholders.  Id. An officer cannot divert corporate opportunities to his or her own use, but he or she is not bound to act for the benefit of the corporation in non-corporate matters.  Id.

FIVE:  SHAREHOLDER EXECUTIVES AND WORKING PARTNERS.

I. INTRODUCTION. In addition to traditional employment claims, minority shareholder executives and working partners may assert additional claims against their employer/partnership, and their fellow shareholders/partners.

II. STATUTORY PROTECTIONS. Regardless of the form of the business, there may be a statute which provides for protections to minority shareholders/partners, fiduciary obligations and equitable rights and remedies.  Minn. Stat. § 302A.751 (close corporations); Minn. Stat. § 322B.833 (limited liability companies); Minn. Stat. § 323A.0404 (partnerships); and Minn. Stat. § 321.0408 (limited liability partnerships).

III. MINORITY SHAREHOLDERS’ RIGHTS.

A. Forced Buyouts and Other Remedies. Minn. Stat. § 302A.751 provides forced buyouts and other equitable remedies to minority shareholders in closely held corporations when the majority shareholders have acted “fraudulently or illegally” or have otherwise acted “in a manner unfairly prejudicial,” toward them.  Gunderson, 628 N.W.2d at 184.  This is because, due to the lack of a ready market for the shares, minority shareholders require enhanced protections.  Id.  “Unfairly prejudicial” means conduct that frustrates the reasonable expectations of all shareholders in their capacity as shareholders or directors of a corporation that is not publicly held or as officers or employees of a closely held corporation.”  Id., at 184 (citing Berreman, N.W.2d at 374).

In determining whether to order a buyout or other equitable relief, a court must consider “the duty which all shareholders in a closely held corporation owe one another to act in an honest, fair, and reasonable manner in the operation of the corporation and the reasonable expectations of all shareholders as they exist at the inception and develop during the course of the shareholder’s relationship with the corporation and with each other.” Minn. Stat. § 302A.751, subd. 3a.

When such buyouts are ordered, the court is required to set the price at “fair value” (rather than a discounted “fair market value”) unless prior documents provide otherwise.

B. Statutory Presumption Favoring Agreements. If the bylaws or some other agreement provide otherwise, then the court generally must follow their designated price and terms – unless the court determines that they are “unreasonable under all of the circumstances of the case.”  Minn. Stat. § 302A.751, subd.2.  If a buy-sell agreement (or other agreement or bylaws) requires a discount for lack of marketability, minority shares and other related factors, the discount will usually be applied as long as it is reasonable.  Regan, 345 F.Supp.2d at 1009 (D. Minn. 2004) (citing Gunderson, 628 N.W.2d at 187, and Minn. Stat. § 302A.751, subd. 2).

Despite the statutory presumption that buy-sell agreements reflect the parties’ reasonable expectations (Minn. Stat. § 302A.751, subd. 3a), written agreements are not dispositive of shareholder expectations in all circumstances.  Often, shareholder expectations arise from understandings that are not expressly stated in the corporation’s documents.  Gunderson, 628 N.W.2d at 186 (citing Berreman, 615 N.W.2d at 374); see also Powell v. Anderson, 2000 WL 943842 *3 (Minn. App. 2000).  Depending on the facts of a case, courts have the equitable power to apply a fair value analysis, even if it conflicts with a written agreement of the parties.  See Pedro v. Pedro, 489 N.W.2d 798, 802 (Minn. App. 1992), rev. denied (Minn. Oct. 20, 1992) (“Pedro II”). 

SIXPEDRO DOCTRINE.

A. Expectation of Continuing Employment. In addition to a potential claim for a court-mandated buyout at fair value and other equitable remedies under Minn. Stat. § 302A.751, Minnesota courts have held that, under the right circumstances, an employee/shareholder may have an additional and separate claim for wrongful termination based on a reasonable expectation that his or her employment was not terminable at will, or even that there was an agreement to provide lifetime employment.  Pedro v. Pedro, 463 N.W.2d 285 (Minn. App. 1990), rev. denied (Minn. Jan. 24, 1991) (“Pedro I”);  Pedro v. Pedro, 489 N.W.2d 798 (Minn. App. 1992), rev. denied (Minn. Oct. 20, 1992) (“Pedro II”).  In the Pedro cases, the Court made it clear that the plaintiff had a reasonable expectation as a shareholder in a closely held corporation “that his employment was not terminable at will.”  Pedro I, 463 N.W.2d at 289.

The Pedro cases have often been cited by plaintiffs, authors and even courts for the proposition that a minority shareholder in a closely held corporation, particularly if he or she was one of the founding shareholders, has a reasonable expectation of continued employment.  See, e.g., Gunderson, 628 N.W.2d at 189 (stating that close-corporation shareholders commonly have an expectation of continuing employment: “[I]n fact, because of the unique characteristics of close corporations, employment is often a vital component of a close-corporation shareholder’s return on investment and a principal source of income”; “[T]he discharge of a shareholder-employee may thus be grounds for equitable relief” (citations omitted)).  Id.

B. Pedro Applied Sparingly. Minn. Stat. § 302A.751 has been amended since the Pedro cases, and recent post-Pedro cases have applied the expectation of continuing employment doctrine sparingly.

The 1994 Amendments to Minn. Stat. § 302A.751 added, “For purposes of this section, any written agreements, including employment agreements and buy-sell agreements . . . are presumed to reflect the parties’ reasonable expectations . . .”

To determine whether a minority shareholder has a reasonable expectation of continued employment, a court must look at more than the fact that the individual was a minority shareholder in a close corporation. Factors include whether: [1] the shareholder made a capital investment in the company; [2] continued employment could be considered part of the shareholder’s investment; [3] the shareholder’s salary could be considered a de facto dividend; and [4] continued employment was a significant reason for making the investment.  Haley v. Forcelle, 669 N.W.2d 48, 59 (citing Gunderson, 628 N.W.2d at 190).

“Reasonable expectations” can be weighed by assessing: written agreements, normal understandings expected to result from associative bargaining, and the standard of conduct associated with the fiduciary duty to act in an honest, fair, and reasonable manner.  Gunderson, 628 N.W.2d at 185. Further, a shareholder’s expectation of continued employment is only reasonable if that expectation is known and accepted by other shareholders and properly balanced against the majority or controlling shareholders’ need for flexibility in running the business.  Haley, 669 N.W.2d at 59-60 (citing Gunderson, 628 N.W.2d at 190).

A shareholder’s expectation of continued employment is not reasonable when the employee/shareholder understood that the employment contract provided for termination without cause; and can point to no oral or written agreements to contradict the plain language of the contract.  Kelley v. Rudd, C7-91-1142, at p. *5 (Minn. App. 1992) (unpublished opinion); see also House v. C.K. Baxter, 371 N.W.2d 26, 30 (Minn. App. 1985).  Even if a plaintiff was a co-founder of the company, had been one of the its two largest shareholders, had been its CEO and Board Chair, and had guaranteed significant portions of the company’s debts, there was no reasonable expectation of continued employment where: the buy-sell agreement, the company employee manual and an acknowledgement form all evidenced an at-will relationship; the plaintiff admitted that he had always understood that he was an at-will employee who could be terminated with or without cause; and the plaintiff himself had terminated the employment of other shareholders, and understood that all shareholders were at-will employees.  Regan, 345 F.Supp.2d at 1012. 

SEVEN: SARBANES-OXLEY ACT.

I. INTRODUCTION. The Sarbanes-Oxley Act of 2002 was passed after top executives at Enron Corp., WorldCom Inc. and other companies which had securities and public relations problems, said they were unfamiliar with the details of their company’s accounting practices that resulted in devastating losses by investors.  15 U.S.C. 7201 et. seq., Pub. L. No. 107-204, 116 Stat. 745 (July 30, 2002).  Sarbanes-Oxley is wide-ranging; it requires extensive financial reporting and disclosure systems, and places restrictions on how public companies and their auditors operate.  Unlike prior securities laws and regulations, which prohibited fraudulent and other misconduct, Sarbanes-Oxley affirmatively mandates duties of certain executives and board members.  Moreover, it requires chief executive officers and chief financial officers to certify financial reports, and creates both criminal and civil penalties for violations of these and other securities law obligations.  Executives need to play a far more active role in assuring that their companies are in full compliance with the SEC laws and regulations, and that financial representations are accurate.

II. PROVISIONS REGARDING EXECUTIVES. The Sarbanes-Oxley Act’s provisions include, among other things, the following:

A. Certification by chief executive officers and chief financial officers of financial reports.  Section 302 of the Act requires a set of internal procedures designed to assure accurate and complete financial disclosures.  The signing officers must certify that they are “responsible for establishing and maintaining internal controls” and “have designed such internal controls to insure that material information relating to the company and its consolidated subsidiaries is made known to such officers by others within those entities, particularly during the period in which the periodic reports are being prepared.”  15 U.S.C. § 7241(a)(4).  The officers must “have evaluated the effectiveness of the company’s internal controls as of a date within 90 days prior to the report” and “have presented in the report their conclusions about the effectiveness of their internal controls based on their evaluation as of that date.”  Id. Moreover, under section 404 of the Act, management is required to produce an “internal control report” as part of each annual Exchange Act report.  See 15 U.S.C. § 7262.  Among other things, this report must affirm “the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting.”  15 U.S.C. § 7262(a).

B. Ban on personal loans to any executive officer or director. Under § 402 of the Act, corporations are barred from making personal loans to officers or directors.  15 U.S.C. § 78m.

C. Accelerated reporting of trades by insiders. Under § 403, accelerated disclosures regarding transactions involving management and principle stockholders are required. 15 U.S.C. 78p.

D. Required independence of auditors, Boards and Audit Committees. Executives must assure that there are no conflicts of interest among the ranks.  Under § 201, the Act prohibits audit firms from providing extra services to their clients such as actuarial services, legal services, consulting services, and other services that are not related to their audit work.  15 U.S.C. § 78j-1.  Under §§ 301 and 305, companies are required to have independent, knowledgeable boards and audit committees that will uphold shareholder interests by challenging management and auditors on important issues.  15 U.S.C. §§ 78j-1; 78u.

E. Criminal and civil penalties for violations of securities laws. Under the Act, senior executives can be personally liable for the information being reported.  Such executives, who “willfully” sign off on faulty financial reports, knowing they are incorrect, could be sentenced up to 20 years in prison and fined up to $5 million.  Citing 18 U.S.C. 1350.  Furthermore, Section 802 provides that “Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object, with the intent to impede, obstruct or influence the investigation or proper administration of any matter…shall be fined under this title, imprisoned not more than 20 years, or both.“  Citing 18 U.S.C. 1519.  Also, Section 304 of the Act allows corporate boards of directors to seize the bonuses and stock profits of chief executives and finance chiefs whose companies restate financial results because of “misconduct.”   15 U.S.C.  § 7243.

III. SARBANES-OXLEY IMPACTS NON-PUBLIC BUSINESSES. As written, Sarbanes-Oxley focuses on public companies.  However, many private firms and nonprofit organizations are voluntarily adopting its provisions in order to help assure that their own practices are consistent with what is becoming the new standard for business conduct.  Companies that voluntarily develop compliance programs consistent with Sarbanes-Oxley may enhance their business relationships with bankers, customers and shareholders.  Moreover, if private companies have any thoughts of becoming public in the future, they need to consider the ramifications of not complying with the Act’s principles.

EIGHT:  EXECUTIVE’S RISKS OF INDIVIDUAL LIABILITY FOR CLAIMS.

I. INTRODUCTION. It was not a common practice in the past for plaintiffs’ attorneys to name individuals as defendants in employment law actions, generally focusing on the “deep pocket.”  However, in recent years, for strategic and other reasons, employment law claims against individuals have been far more common – some of which may lead to individual liability.

II. POTENTIAL AREAS FOR INDIVIDUAL CLAIMS.

A. Aiding and Abetting Under Minnesota Human Rights Act. Generally, individual supervisors or managers cannot be sued under the Minnesota Human Rights Act for violations of those acts.  Iyorbo v. Quest International Food Flavors & Food Ingredients Company, ICI, 2003 WL 22999547, *3 (D. Minn. 2003) (citing, Waag v. Thomas Pontiac, Buick, GMC, Inc., 930 F.Supp. 393, 407-08 (D. Minn. 1996); D.W. v. Radisson Plaza Hotel Rochester, 958 F.Supp. 1368, 1375 (D. Minn. 1997).  However, the Minnesota Human Rights Act does provide for individual liability for aiding and abetting discrimination.  Under Minn. Stat. § 363A.14 (2003), it is an unfair discriminatory practice for any person (not necessarily an “employer”) intentionally “to aid, abet, incite, compel or coerce a person to engage in any of the practices” forbidden by the Act, to “intentionally obstruct or prevent any person from complying with” the provisions of the Act or any related orders, or to “resist, prevent, impede or interfere with” related investigations.

However, if the individual is a shareholder in the company (particularly a major or sole shareholder), and the company is also a named defendant, there should not be individual liability.  State by Beaulieu v. RSJ, Inc., 532 N.W.2d 610, 613 (Minn. App. 1995), aff’d as modified, 552 N.W.2d 695 (Minn. 1996); State by McClure v. Sports & Health Club, Inc., 370 N.W.2d 844, 854 (Minn. 1985).

B. Federal Civil Rights Laws. Generally, individuals cannot be held liable for claims under Title VII of the Civil Rights Act, 42 U.S.C. § 2000e.  See Roark v. City of Hazen, 189 F.3d 758, 761 (8th Cir. 1999); Spencer v. Ripley County State Bank, 123 F.3d 690, 691 (8th Cir. 1997); Bonomolo-Hagen v. Clay Central-Everly Community School District, 121 F.3d 446 (8th Cir. 1997); Rueda v. West Side Community Health Services, 2003 WL22508089, *3 (D. Minn. 2003).  Similarly, most courts have held that there is no individual liability in claims under the Age Discrimination in Employment Act, 29 U.S.C. 621, et seq.  See Rothmeier v. Investment Advisors, Inc., 932 F.Supp. 1156, 1161 (D. Minn. 1996), aff’d. 85 F.3d 1328 (8th Cir. 1996).

C. Americans With Disabilities Act. The 8th Circuit has determined that there is no individual liability under the Americans with Disabilities Act, 42 U.S.C. § 12101, et seq.  See Williams v. The Thomson Corporation, 2001 WL1631433 (D. Minn. 2001); Alsbrook v. City of Maumelle, 184 F.3d 994, 1004, n.8 (8th Cir. 1999); Longstetch v. Copple and MCI Telecom. Corp., 101 F.Supp. 2d 776, 780 (N.D. IA 2000); Meara v. Bennett, 27 F.Supp.2d 288 (D. Mass. 1998).

D. Fair Labor Standards Act. The Fair Labor Standards Act does not directly address individual liability.  29 U.S.C. § 201, et seq.  However, it appears that individual liability is a possibility under this statute.  See Rockney v. Blohorn, 877 F.2d 637 (8th Cir. 1989); Trustees of MN State Basic Bldg. Trades v. GibSons Constr., 2003 WL 21058163 (D. Minn. 2003).

E. Family and Medical Leave Act. Again, there may be individual liability here.  See Darby v. Bratch, 287 F.2d 673 (8th Cir. 2002).

F. Statutory or Common Law Breaches of Fiduciary Duties. There can be individual liability for statutory or common law breaches of fiduciary duties.  See discussions in sections Four and Five of this article.

G. Other Common Law Claims. An employer is liable for the intentional torts of its employees committed within the course and scope of employment.  Marston v. Minneapolis Clinic of Psychiatry & Neurology, Ltd., 329 N.W.2d 306, 310 (Minn. 1982); see also Manion v. Jewel Tea Co., 160 N.W. 767, 768 (Minn. 1916) (involving defamation). But the fact that an employer is vicariously liable for the torts of an employee committed within the course and scope of employment does not mean that the employees may not also be sued for these torts. Phillips v. State of Minnesota, 1999 WL 759987, *2 (Minn. App. 1999).  In Minnesota, the liability of master and servant is characterized as joint and several liability.  Id.

NINE:  DEFENSE AND INDEMNIFICATION.

I. INTRODUCTION. Although executives do get named in legal actions individually, in some – not all – cases they often have the right to be defended and indemnified by their employers.

II. STATUTORY INDEMNIFICATION.

A. General Employee Indemnification under Minn. Stat. § 181.970. Minn. Stat. § 181.970 obligates employers to defend and indemnify all of their employees for civil damages, penalties or fines claimed or levied against the employee, as long as the employee:  “(1) was acting in the performance of the duties of the employee’s position; (2) was not guilty of intentional misconduct, willful neglect of the duties of the employee’s position, or bad faith; and (3) has not been indemnified by another person for the same damages, penalties, or fines.”  This statute provides exceptions for employees of the state or municipality who receive indemnification through those entities, employees “who are subject to a contract or other agreement governing indemnification rights,” or employees who are governed by specific indemnification sections pertaining to non-profit corporations, limited liability companies, other legal entities.  Minn. Stat. § 181.970, subd. 2.

B. Indemnification for Directors, Officers and Employees of General Corporations under Minn. Stat. § 300.083. Subject to exceptions, Minnesota corporations are required to indemnify “a person made or threatened to be made a party to a proceeding by reason of the former or present official capacity of the person against judgments, penalties, fines, including, without limitation, excise taxes assessed against the person with respect to an employee benefit plan, settlements, and reasonable expenses, including attorneys’ fees and disbursements, incurred by the person in connection with the proceeding, if, with respect to the acts or omissions of the person complained of in the proceeding, the person:  (1) Has not been indemnified by another organization or employee benefit plan for the same judgments, penalties, fines . . . ; (2) Acted in good faith; (3) Received no improper personal benefit; (4) In the case of a criminal proceeding, had no reasonable cause to believe the conduct was unlawful; and (5) In the case of acts or omissions occurring in the official capacity described in subdivision 1, paragraph (c), clause (1) or (2), reasonably believed that the conduct was in the best interests of the corporation, or in the case of acts or omissions occurring in the person’s official capacity described in subdivision 1, paragraph (c), clause (3), reasonably believed that the conduct was not opposed to the best interests of the corporation.  If the person’s acts or omissions complained of in the proceeding relate to conduct as a director, officer, trustee, employee, or agent of an employee benefit plan, the conduct is not considered to be opposed to the best interests of the corporation if the person reasonably believed that the conduct was in the best interests of the participants or beneficiaries of the employee benefit plan.”  Minn. Stat. § 300.083 subd. 2(a).

C. Indemnification for Directors, Officers and Employees of Business Corporations under Minn. Stat. § 302A.521.

Minn. Stat. § 302A.521, which applies to business corporations in Minnesota, provides similar indemnification provisions to directors, officers and employees.

D. Indemnification for Directors, Officers and Employees of Non-Profit Corporations under Minn. Stat. § 317A.521.

Minn. Stat. § 317A.521, which applies to non-profit corporations in Minnesota, provides similar indemnification provisions to directors, officers and employees.

E. Indemnification for Directors, Officers and Employees of Minnesota Limited Liability Companies under Minn. Stat. § 322B.699.

Minn. Stat. § 322B.699, which applies to Minnesota limited Liability companies provides similar indemnification provisions to directors, officers and employees.

III. CORPORATE BYLAWS/ARTICLES OF INCORPORATION AND AGREEMENTS. In addition to the statutory protections, it is common for employers to provide executives with expressed assurances of indemnification – often “to the maximum extent permitted by law” – in bylaws, articles of incorporation and/or agreements.  On the other hand, it should be noted (although this is rare) that the entity may either prohibit indemnification or specify pre-conditions with respect to indemnification in the articles of incorporation or bylaws.  See Minn. Stat. §§ 317A.521, subd. 4; 300.083, subd. 4; 322B.699, subd. 4; and 302A.521, subd. 4.

TEN: tax issues.

I. INTRODUCTION. It is beyond the scope of this article to discuss tax issues in depth, but some unique tax issues that may pertain to executive compensation should be noted.

A. IRC §§ 280G and 4999 Impact Severances Packages. Large severance packages to executives, often in conjunction with early termination of employment or changes in control, have frequently been called “parachutes.”  Parachutes are often part of the negotiations with executives, and may be necessary to recruit them, retain then, or address their concerns about takeovers or other changes in control.  Unfortunately, many companies and executives do not carefully analyze the tax treatment of potential parachute plans, and risk devastating tax results.

Generally, “golden parachutes” are those that exceed the IRS threshold for excessive severance payments, which are payments that equal or exceed three times the recipient’s average salary for the prior five years.  IRC §§ 280G and 4999.  If there is an “excess parachute payment,” IRC § 280G makes it nondeductible to the payor, and IRC § 4999 imposes a 20% nondeductible excise tax on the recipient.  To the extent the company has a “gross-up” provision in the severance agreement (essentially agreeing to pay for the executive’s tax consequences), the company would become obligated to increase the golden parachute by an amount sufficient to offset the excise tax liability as well as the underlying tax liability.  Further, the money paid out for the gross-up itself would be taxed, requiring further payments to cover the “gross-up” on the “gross-up.”  Ultimately, a company can end up spending more than three times the actual benefit that goes to the departing executive, which can be as much as five times more than the actual benefit when analyze on an after-tax basis.  Careful planning with a tax lawyer or an accountant is critical!

B. IRC §§ 280G and 4999 Impact Other Compensation/Benefits. The excise taxes discussed above may apply to compensation and benefits other than severance payments.  For example, the value of any stock options or restricted stock, the value of accelerated SERP accrual investing, agreements to pay post-termination welfare benefits such as health and/or life insurance premiums, agreements to pay other benefits such as automobile or club memberships and other post-termination payments could be subject to the golden parachute taxes.  See 26 C.F.R. § 1.280G-1 (Treas. Reg. § 1.280G) (IRS Regulations pertaining to §§ 280G and 4999).

C. IRC §§ Section 409A May Also Apply. Executive compensation was complicated more by the enactment of Internal Revenue Code § 409A, which was passed in 2004 and imposed sweeping new rules on nonqualified deferred compensation arrangements.  These new rules institute substantial penalties on taxpayers who are not in compliance.

Although § 409A, on its face, deals with “deferred compensation” arrangements, it has become clear that many types of compensation, which were not necessarily considered to be “deferred compensation” may be subject to § 409A. Section 409A might apply to severance agreements, employment agreements, bonus or incentive plans, change in control agreements or other agreements that create an enforceable right to compensation to be paid at a later date.  If § 409A is triggered, the compensation could be deemed taxable to the employee (and possibly trigger a tax gross-up obligation to the employer) prior to the time that the money is actually paid, along with a 20% penalty on the compensation.

CONCLUSION:

Whether you work with, for or against an executive, you should have a working familiarity with the 10 legal areas highlighted above.

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