How to design an incentive compensation program and avoid a lawsuit.
Employers large and small need to consider practical strategies when designing effective incentive compensation programs for today’s highly fluid business environment. There are also key legal considerations they need to address proactively to protect the business in the event of employee disputes.
Your Game Plan
An effective incentive compensation program should attract, motivate and retain key employees in a cost-effective manner to serve the company’s long-term best interests. To achieve these goals, companies need to focus on three key plan design principles.
- Identify the strategic individual and organizational performance metrics that will deliver strong and reliable results over the company’s business plan time horizon.
- Align incentive pay with the company’s desired business results, with appropriate upside opportunities for outperforming expectations and corresponding downsides for inappropriate risk-taking or underperformance.
- Provide a balanced focus on short-, medium- and long-term results that, together, support healthy and sustainable future growth.
Companies should tailor incentive compensation programs to their specific interests, and the programs need to make sense to employees. Simply copying another program or relying solely on market data is a recipe for failure.
Stress testing the program design in advance under a wide range of performance scenarios—from worst-case scenarios to hitting the ball out of the park—can help ensure payouts are justifiable and appropriate to both owners and participants compared with peer organizations’ programs. External guidance from compensation consultants can help ensure incentive programs are competitive and promote the company’s aims. It’s also important to take income tax rules regarding deferred pay into account to ensure participants are not subject to unfavourable tax treatment.
Show Us the Money
In recent years, incentive compensation arrangements have become fertile ground for litigation—particularly with departing employees. Though these awards are granted with mutual success in mind, it has become increasingly important for employers to carefully think through the intended treatment of incentive awards over the life of the employment relationship: upon hiring, during active employment, in the event of disability or death in service, and upon termination of employment (whether due to resignation, retirement, termination for cause or termination without cause). Committing a plan to writing and clearly communicating its terms can appease skeptical employees, enhance buy-in and lower the risk that important terms may be vulnerable to legal challenge down the road.
Vesting provisions are one aspect of incentive compensation arrangements that have been subject to legal challenge. These provisions are designed to ensure a participant’s right to a payment or benefit does not crystallize until a period of time has passed or specified performance objectives are achieved, or both.
Although they are a common feature of most incentive arrangements, vesting provisions resulting in the loss of unvested awards upon termination of employment have been—and will likely continue to be—challenged in the courts as unenforceable.
Two other types of provisions ripe for forfeiting awards due to violation of restrictive covenants (i.e., noncompetition, non-solicitation or confidentiality clauses) and clawback provisions in which employees need to repay all or part of a past award if they are found to have engaged in misconduct, or if it becomes necessary for the company to materially restate its financials.
Here are three common challenges to vesting provisions and restrictive covenants employers should keep in mind.
Doctrine of restraint of trade – The most common claim from plaintiff employees argues plan provisions causing the loss of entitlements if the employee resigns and/or engages in post-employment competitive activities should not be enforced. Courts in Canada and in England have refused to enforce cancellation/forfeiture provisions causing an employee to lose vested entitlements following employment due to post-employment competitive activities. However, at this point, no Canadian court has refused to enforce a forfeiture provision applying on resignation, on the basis that it would be an unlawful restraint of trade to cause an employee to lose an unvested benefit if he or she resigns or engages in post-employment competition. Courts are inclined to review each case to ensure the loss of vested or unvested benefits does not amount to a monetary disincentive constituting a barrier to employee mobility.
Doctrine of unconscionability – Employees argue the cancellation or forfeiture of incentive awards upon resignation or for engaging in competitive activities is unconscionable. A court can refuse to enforce a contract if it resulted from the unfair imposition by one party of superior bargaining power. The courts consider the actual loss to the employer as a result of the post-employment competitive activity or conduct affecting the employer’s reputation. If the loss of unvested or vested incentive awards significantly outweighs the employer’s actual loss, the court may hold the employer can’t enforce the forfeiture provisions on the basis
Constructive dismissal – Employees argue an employer has no right to implement or amend executive compensation plans during the employment relationship. Plaintiff employees claim such changes amount to a fundamental and unlawful change to the relationship, or constructive dismissal. The risk of constructive dismissal claims is real, but employers can manage the problem of amending plans by giving adequate notice of the change, seeking employee consent or implementing the changes unilaterally, and, if the employee remains employed, taking the position that the employee has agreed to the new terms.
Once the design elements are decided, put the arrangement in writing. It’s important to articulate the plan’s aims because the enforceability of vesting and cancellation/forfeiture provisions, restrictive covenants and clawback clauses will be judged with a view on whether the provision being challenged is rationally connected to those aims and furthers the company’s legitimate business interests. Before implementing a new or revised incentive program with such provisions, ask if those provisions are reasonably required to incent the behaviours giving rise to the pay provided.
A carefully drafted plan should give the employer some scope to avoid absurd outcomes that may result from rote application of a payment formula. Employers should engage legal counsel to draft or review plan texts to minimize the risk of unintended outcomes and ensure compliance with tax, securities, employment standards and other legal requirements.
Once the terms and conditions are put in writing, communicate them clearly. Provide a summary of key plan terms to participants, and either offer a copy of the official plan text or make it available upon request. Communications should encourage employees to contact the appropriate person in the company with any questions and seek independent legal advice where appropriate.
When possible, incentive grants should be subject to employee sign-off on an award agreement incorporating the incentive plan’s terms and highlighting key terms, such as forfeiture and clawback provisions and restrictive covenants. This way, an employer can mitigate the risk of an employee challenging those provisions later on the basis that he or she did not have proper notice.
With effective design, drafting and communication, an incentive compensation arrangement can give key employees the skin in the game they need to take appropriate risk and deliver sustainable performance.
Stephen F. Gleave is a partner with Hicks Morley; Robert Levasseur is a senior consultant and principal with McDowall Associates; Ray Murrill is a senior consultant with McDowall Associates; and John Prezioso is a partner with Hicks Morley.
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