Executive Compensation – The Importance of Being Clear (Being Earnest May Not Be Relevant)

Most executive compensation arrangements are in the form of contractual documents. Even a form deferred compensation plan (or “top hat” plan) providing deferred compensation for a select group of management or highly compensated employees, while in legal terms is still an employee benefit plan for purposes of the Employee Retirement Income Security Act of 1974, as amended (ERISA), is still, in a very essential way, a contract or agreement between an employer and those employees designated as eligible for participation.

“Wiggle room” for the administrator of a plan to interpret the meaning of the plan, and discretion retained by an employer to modify unilaterally the terms of a contractual document with an executive, may be helpful but may not go as far to protect the employer as the employer might like. The well-established concept that the administrator of an ERISA plan should be permitted to interpret the terms of the plan and be subject to a deferential standard of review (so that the administrator’s determinations would be second guessed by a court only if those determinations are arbitrary and capricious) may not actually apply to a “top hat” plan. Similarly, it is unlikely that an employer’s right to interpret an executive compensation agreement or contract would be given that level of deference by a court in the event of a dispute (which would typically be a subject of state law, including case law, regarding contracts).

By way of example, a reservation of an employer’s right to terminate a “top hat” plan may well give the employer the right to do so, but it will not necessarily mean that the employer has discretion to do whatever the employer deems appropriate in connection with the process of plan termination.

What this all really means sounds rather trivial when stated. The words in the contract actually matter, and any discretionary rights an employer wants to retain should also spell out as clearly as possible exactly what that would involve. To illustrate with an example, a fairly typical provision in a “top hat” plan might permit any amendments from time to time, and a right to terminate the plan at any time, but with a limitation that any such changes would not be valid as to a participant if the change reduces the participant’s benefit under the plan or would cause a violation of the requirements of Section 409A of the Internal Revenue Code (dealing with nonqualified deferred compensation and imposing significant tax penalties on participants if the statutory and regulatory requirements are not satisfied). While this may permit the plan to be terminated, it does not permit the employer to take any actions that would reduce a participant’s benefit.

Is the benefit the right to be paid at some future date (and not to be taxed until that later date)? Or is it just the right not to have the “value” of the benefit reduced? And what is the value of the benefit if the form of benefit is a life-annuity? Absent clear guidance on what happens to a participant’s benefit on termination of such a plan, the outcome may be decided by a court that takes a different view from the employer’s view, and may not give any deference to the employer’s views notwithstanding the employer’s role as an ERISA plan administrator. 

This does not mean that an employer that establishes such a plan must have its hands tied in how it deals with the plan if circumstances create a need to modify or terminate the plan. An employer should be able to modify a plan and should be able to terminate the plan and provide for a payment of each participant’s account balance (or the present value of their plan benefit) as long as the plan document spells that out with sufficient clarity that the employer cannot be characterized as breaching the terms of the contract (that is to say, acting contrary to the terms of the plan, as the plan is the contract).

The take-away for employers is to ensure that high stakes executive agreements and compensation plans have appropriate and detailed language as to what the employer can do in various circumstances. It is not that certain actions are inherently prohibited, but if attention is not paid to the detailed language of these documents, the contractual language may have the effect of prohibiting an action that otherwise would be permissible and may well be necessary. Review of existing plan documents and review of template executive employment agreements with attention to the details relating to actions the employer may need or want to take in the future may not seem like an urgent matter, but if it becomes urgent, it may also be too late.