The Advisors' Blog

This FW Cook alert shares more on the executive compensation implications of the California law, effective January 1, restricting certain repayments upon separation. The alert says the contract in the hypothetical below would be illegal under the new law if entered into after the effective date — meaning the contract would be void and the employer in this scenario would be subject to injunctive relief, required to pay a fine and liable for attorneys’ fees and costs in an associated lawsuit. 

Assume a California company hires a new executive (who works in California) and one of the features of the new employment contract is a large cash payment upon commencement of employment, which payment is subject to repayment if the executive leaves within a certain period of time, for example, a $5 million payment subject to complete repayment if the executive leaves within three years. These cash payments can occur, for example, if the executive is forfeiting awards that he or she might have earned if the executive had stayed with the former employer. Alternatively, a large cash upfront payment may be seen as an advantageous way of enticing the executive to switch jobs because it is a one-time payment, whereas enticing the executive with a large salary increase creates a permanent increase in compensation.

The alert points out that the main concern prompting the statute was TRAPs – Training Repayment Agreement Provisions – but the actual statutory text has implications far beyond those provisions – and possibly even beyond executive compensation arrangements that may require repayment.

As Liz shared, there is a limited exception if the repayment obligation follows the law’s prescriptive requirements, including a proration requirement, and that separation was the employee’s choice or, if the employer’s, due to misconduct.

The forced proration provision [. . .] immediately applies rather than having at least some minimum period of employment that must be met to avoid a complete forfeiture. Limiting the retention period to two years, also required by the third condition, could be problematic to some employers if the initial contract is for more than two years.

The fifth condition may be problematic [. . .] Suppose the executive dies or becomes disabled. It’s far from clear that these are separations “at the sole election of the employee.” Perhaps an executive claims he or she is quitting for good reason because of changes in the conditions of employment. Some cases say major deleterious changes in work conditions constitute a “constructive termination.” Previously, the parties could agree on language clarifying whether and how a “good reason” termination would be analyzed. Now it’s up to the courts.

Finally, the statute defines “misconduct” by a cross-reference to the California Unemployment Insurance Code. As you might expect, there is a high bar that must be cleared before an executive’s behavior will amount to misconduct.

The alert also expresses concern that the statute’s separate prohibition on penalties upon termination of employment could be read so broadly as to restrict something as common as restricted stock with three-year cliff vesting that is forfeited when employment terminates.

– Meredith Ervine