Analyzing, Negotiating, and Drafting Severance Agreements on Behalf of Employee Clients

By Howard Reben and Adrienne Hansen
Reben Benjamin and March 1
© 2004

Ellie Elderberry is a Senior Editor at Teen Scene Magazine. Ellie started with the magazine 35 years ago, back when it was known as Etiquette Magazine, and she has built her career in the magazine industry. On Ellie's 60 th birthday, her boss, Yolanda Young, summoned Ellie to her office. Yolanda made a joke about Ellie being "the grandmother of the teen magazine industry" and asked her how much longer she planned to stay before she retired to that "gorgeous beach house in Florida." Surprised by her boss's remark, Ellie mumbled something about feeling like she was 25 and excused herself. After a few weeks, Ellie began to notice that her projects were increasingly being assigned to a newer, younger editor, Tina Trendsetter. When Ellie asked Yolanda about this, she responded, "Let's face it, Tina can relate better to the teen scene. She's more hip."

Ellie is very upset as she feels that she has always done a good job for the magazine. She loves her work and would have kept at it for a few more years, but with all of her projects going to Tina, she fears that she will be demoted or worse. Ellie's goal is to get as good a severance as possible and enjoy her retirement. A brief interview reveals that Ellie earns $125,000 per year. She has no contract. She did sign a covenant not to compete. The covenant prevents her from working for any of Teen Scene's competitors anywhere in the U.S. for a period of five years. Ellie has a lawyer-friend who told her that the covenant was not enforceable as it was given during her employment and without consideration.

Your inquiry with Teen Scene's counsel reveals that sales were lagging in the past year and it was believed that Ellie was the problem. Ellie is flabbergasted when she hears this. She feels that she has given the best years of her life to the magazine and in return they have tarnished her professional reputation. Ellie is also bitter about the fact that she broke her ankle a few years ago when she slipped on ice in the entry way of the building and she only received a few weeks' workers' compensation payments and medical reimbursements. Teen Scene is self-insured, so Ellie felt awkward pursuing a claim. Lastly, Ellie is a diabetic and she wants to know if she can remain on Teen Scene's comprehensive health plan.

Where do you begin with providing legal services to accomplish Ellie's goals? This article is intended to help plaintiffs' employment lawyers in analyzing, negotiating and drafting severance packages for employee clients like Ellie. Effective representation in this area requires careful analysis of all potential claims because a severance contract is essentially a settlement agreement. Simply analyzing whether the severance contract meets the legal formalities is insufficient. The following is a step-by-step outline of the analysis which should be undertaken whenever you are asked to analyze, negotiate, or draft a severance agreement for an employee client.

Confer with your Client to Clarify the Goals of Severance Negotiations

Begin by clarifying your client's goals. Your client is a unique individual with distinct priorities and goals. While your top priority may be obtaining the most money for your client, your client's goal may be to facilitate a transition into a new position. It is often possible to devise a creative solution that softens the harsh economic and psychological effects of a termination. In Ellie's case, it may be possible to secure for her a role as consultant, advisor, or even corporate officer in order to facilitate her transition into new employment or retirement while at the same time serving her ego needs.

Evaluate the Appropriateness of Settlement

Consider whether your client has a cause of action under federal or state law for discrimination on the basis of a protected trait (age, disability, national origin, race, sex) or has some other non-discrimination claim (breach of contract, failure to pay wages, defamation, invasion of privacy, e.g.). In Ellie's case, the comments made by her boss in conjunction with her replacement by a much younger woman may provide a cause of action for age discrimination or they may be considered "stray remarks." Also consider whether your client is willing and able to endure litigation and whether the employer is willing to settle. Lastly, consider the effects of withdrawing any administrative charges that have been filed. The employer's counsel will almost certainly insist on making settlement contingent upon the withdrawal of any charges. If settlement is reached before a charge is filed, the employer's counsel may insist on a provision that forbids your client from filing an administrative charge. 2

Advise your Client as to the "Resign or Be Fired" Dilemma

Assess the effect your client's resignation has on eligibility for unemployment compensation benefits or ability to pursue a discrimination claim. You may be able to persuade the employer not to contest your client's eligibility for unemployment benefits even if she resigns. Resignation may be acceptable to both parties, as it allows your client to save face in her industry at no cost to the employer. If the employer insists on termination, you may be able to negotiate the reasons for termination for purposes of your client's marketability to future employers. There are several reasons for termination which are more beneficial to your client, such as "corporate reorganization/RIF," "employee wishes to pursue other opportunities," or even "reasons to be kept confidential."

Ensure Confidentiality

Insist on an agreement that the terms of your client's severance remain confidential due to the negative effect that disclosure may have on her marketability to future employers. However, retain your client's right to disclose the terms of the severance to her spouse, accountant, and investment advisor. The confidentiality provision should also prohibit the employer from disclosing the fact that the employee retained counsel, asserted claims, or filed an EEOC or state administrative charge. Liquidated damage provisions should be rejected unless they are nominal.

Obtain a Positive Letter of Reference

A positive letter of reference is one example of a non-economic item that may be very important to your client and costs the employer nothing. Such a letter also protects your client in the face of state laws that immunize malevolent employers from liability for "good faith" disclosures regarding a former employee's job performance to prospective employers. 3 Typically, you draft this letter. Relying on prior favorable evaluations may facilitate agreement by the employer on the content of the letter. Once a letter is negotiated, the parties should designate a specific individual who will field all inquiries from prospective employers regarding your client and who may not say anything inconsistent with the letter or the spirit of the letter or otherwise disparage your client's job performance. Non-disparagement agreements in public sector employment require special care. One law firm recently claimed that a non-disparagement clause in a severance agreement meant that a town employee had forever forfeited all First Amendment rights to speak critically of town officials, even in matters wholly unrelated to the employment.

Sanitize Your Client's Personnel File

Negotiate for the removal of all adverse references or the placement of all sensitive information in corporate counsel's files, with the right to review the file to ensure compliance. It is very difficult to get an employer to agree to destroy personnel files. However, once the sensitive material is buried in counsel's files, it is rarely, if ever, unearthed.

Ensure that any Non-Competition Agreement is Reasonable

If your client signed a non-competition agreement during her employment, negotiate for a release from that agreement as part of the severance package. 4 If your client did not sign a non-competition agreement, the employer's counsel will often demand that she sign one as part of the severance. In that case, ensure that the agreement is precisely and narrowly drawn. The agreement must be reasonable in scope, time, and geographic area. Watch for language that prohibits your client from "indirectly" competing. Ellie's non-competition agreement prohibited her from working in the magazine industry anywhere in the U.S. for five years. While Ellie's non-compete is arguably unreasonable, do not rely on the court to strike it. A trend is emerging whereby courts are now willing to revise a covenant to make it reasonable. 5

Ensure Timely Payment of all Wages, Commissions, and Accrued Vacation Pay

Be aware of federal and state laws regarding timely payment of wages. For example, Maine law classifies commissions and vacation pay as wages and penalizes employers who fail to pay on time by requiring them to pay liquidated damages equal to three times the actual amount withheld, in addition to reasonable attorneys' fees. 6 Accordingly, in Maine, earned commissions and accrued vacation pay are statutory entitlements, regardless of the strength of your client's job performance or any alleged misconduct on her part. Familiarize yourself with the employer's policy or practice regarding payment and carryover of accrued vacation pay, as it may vary from the written policy. Also analyze whether your client has been wrongfully denied overtime wages. Maine law penalizes employers who fail to pay overtime wages by requiring them to pay liquidated damages equal to twice the actual amount withheld, plus attorneys' fees. 7

Negotiate for Accrued Sick Leave

Familiarize yourself with the company's policy or practice regarding payment and carryover of accrued sick leave. While there may be no legal entitlement for this benefit upon termination, it may be a useful bargaining chip.

Negotiate Form and Amount of Severance Pay

Consider whether to categorize your client's severance pay as wages or salary for tax treatment purposes, and whether your client would prefer to be paid one lump sum or periodic payments. Spreading payments over two tax years may be beneficial to both employer and employee. Payment of a portion of the settlement directly to employee's counsel may or may not affect taxation to your client, but it avoids a paper trail which might otherwise be adverse to your client's interests. With regard to retention of benefits, it is often easier for the employer to continue your client's health insurance and other benefits and to delay the COBRA start date if payments are made periodically. Where relevant, inquire as to whether the employer has a written severance pay plan and what other similarly situated employees received. Also ensure that the employer is solvent and be aware of any risk of default that might require a personal guarantee, and include an acceleration clause or a liquidated damages provision in the event of default.

Negotiate for Continuation of Health Insurance/COBRA and Other Benefits

Employers can often provide continuation of health insurance and other medical benefits during a salary continuation period on the same terms as during active employment at either the employer's or employee's expense. This might be an attractive option in Ellie's case, where she expressed concern about losing the magazine's comprehensive health insurance. COBRA provides a discharged employee with the right to continue group health insurance or medical coverage at the existing benefit level and rates for up to 18 months after the off-payroll date. In the severance context, COBRA provides that an employer may agree to pay the cost of continuing the benefit after an employee is off payroll as part of a severance package. 8 Note that employers with fewer than 20 employees have no COBRA obligation; however, you may be able to negotiate with the employer to pick up the cost of "substantially equal" coverage. The employer can also continue to provide other benefits during a salary continuation period, such as life insurance, disability insurance, and other privileges (car leasing, country club memberships). Conversely, if your client has outstanding loans to the employer, you may want to negotiate for a release of all debts as part of the severance package.

Negotiate Pension/401K Options

If the employer has a pension plan, determine what type (defined benefit, defined contribution, simplified employee pension, or employee stock ownership plan). For a lump sum distribution, check rollover and withholding rules. For high level employees, there may be a supplemental retirement plan (sometimes called a "top hat plan") that would have an effect on ERISA's vesting rules. If your client is close, but has not yet vested, negotiate for an agreement to extend the employment status until vesting or, alternatively, negotiate for an acceleration of vesting rights. One creative solution is for the employer to place the employee on a leave of absence, with pay, to maintain active status.

Negotiate Exercise of Stock Options

Determine whether your client was a participant in a qualified or unqualified stock option plan and when the option is exercisable. Where your client has acquired a small percentage of stock as part of compensation, majority shareholders may owe a fiduciary duty to disclose material information. Also consider whether the company has the right to purchase the options back or whether your client can force the company to do so.

Secure Eligibility for Unemployment Compensation

Attempt to persuade the employer to convert a termination into a layoff or otherwise agree not to contest unemployment benefits, regardless of the reason for termination. Typically, unemployment benefits are payable despite a lump sum severance payment and during periodic payments, but not while the employee remains on the active payroll.

Consider a Consulting Agreement

A consulting agreement is a contract, the non-performance of which gives rise to a claim for breach by the employer. A consulting agreement may be beneficial to both parties, as the employer may have a continuing need for your client's knowledge and expertise and your client may find some relief from the harsh economic and psychological effects of termination. Due to the contractual nature of the agreement, careful drafting is vital. Do not assign your client any significant or mandatory duties, the non-performance of which might give rise to a claim against your client and justify non-payment of severance. Use language such as "the employee may , in her sole and unreviewable discretion, do A, B, C..." In Ellie's case, she could be paid simply for being available for telephone consultations, and if the agreement is carefully worded, she could draw additional income while seeking new employment. The advantage from the employer's perspective is that a consulting agreement does not cost anything above what the employer is already paying, but it can provide substantial psychological benefit to your client. As the adage goes, "It's easier to find a job when you have a job."

Advise Your Client on Tax Treatment of Funds Received in Settlement of Employment Discrimination Claims and Attorneys' Fees

The Small Business Job Protection Act of 1996 provides that only damages received "on account of personal physical injuries or physical illnesses" are excludable from income. 9 Emotional distress, and its attendant physical manifestations (sleep disturbance, headaches, gastrointestinal disorders) are not physical injuries resulting in excludable damages. In other words, compensatory and punitive damages resulting from any non-physical injury are taxable. Likewise, damages received from employment discrimination claims are taxable. Accordingly, whenever there are sufficient facts to support a claim of physical injury, plead one. For example, in a sexual harassment case, there might be contact causing physical injury or the harassment may be so severe that it has resulted in your client's suffering from severe workplace anxiety. Any settlement funds attributable to a workers' compensation claim are not taxable. However, this presents a negotiating challenge for employee's counsel because state law limits the amount of attorneys' fees allowed in workers' compensation cases. 10 The conflict is often be resolved by entering into a fee agreement with the client that reflects this situation and provides for an enhanced fee for other causes of action. With regard to fees, the IRS's current position is that attorneys' fees are taxable to the client. Request a separate check and 1099 for attorneys' fees and suggest that your client consult with a tax attorney to decide how to handle tax treatment of any award and/or fees. A legislative document resolving this issue favorably to the employee has passed the House and Senate and as of this time is awaiting a promised presidential signature.

Draft an Effective Release

The employer will demand a general release of all claims. In addition, you may want to insist that the employer release your client. In some cases, as when the employer suspects that your client has defrauded the company, the employer will not agree to a mutual release, but may agree to a release of all claims except fraud. Analyze carefully whether there are any claims that you want to preserve for your client (e.g. pension benefits) and remember that workers' compensation claims cannot be waived without Board approval. Also note that release of potential age discrimination claims under the ADEA, like Ellie's, must be knowing and voluntary under the OWBPA. In these cases, the employer will insist on specific language referencing statutory rights and claims under the ADEA, that your client has been advised in writing to consult with counsel, and that your client was given at least 7 days to consider or revoke the agreement.

Select the Forum/Applicable Law to Resolve Disputes over the Agreement

The argument has been made that arbitration favors employers due to a "repeat user" effect. Do not give the employer the right to dictate who the arbitrator will be. Instead, jointly select a neutral arbitrator to limit or eliminate the danger of partiality. In sum, arbitration offers the advantage of a quicker, less costly method of dispute resolution while litigation provides your client with the right to a jury trial and a day in court. The American Arbitration Association provides an objective arbitral selection process which can be incorporated in the settlement agreement.

Provide for Delivery of Settlement Check

Request separate checks - one made payable to your client and one made payable to you. This method is consistent with the above-mentioned request for separate 1099 forms.

Representing an employee client such as Ellie is more work than just a cursory review of the settlement agreement. Counsel should be prepared for a lengthy client interview and a thorough review of all of the applicable laws mentioned above before embarking on settlement negotiations on behalf of the employee client. Educating your client as to the scope of the task is essential to having the resources available to properly evaluate the claim. Whether the fee agreement is hourly or contingent will vary with the circumstances. The bottom line is that you should be prepared to respond when your telephone rings and your client asks for a "quick read" on a settlement agreement.

1 Reben Benjamin and March represents employees exclusively, with a concentration on representation of both administrative and executive employees in severance agreements and all other employment matters.

2 The EEOC's position is that covenants not to file an administrative charge are not enforceable. EEOC v. Astra USA, Inc., 94 F.3d 738 (1 st Cir. 1996).

3 See 26 M.R.S.A. § 598 (Supp. 2002) (employer is presumed to acting in good faith unless the employee can show by clear and convincing evidence that the employer knowingly disclosed false or misleading information with malicious intent).

4 Ellie's lawyer friend was wrong when he said that the non-compete was voidable for lack of consideration. Maintaining employment for an at-will employee has been held to be sufficient consideration to support a covenant not to compete. See Brignull v. Albert, 666 A.2d 82 (Me.1995).

5 See id.

6 26 M.R.S.A. § 626-A (Supp. 2002).

7 26 M.R.S.A. §§ 664, 670 (Supp. 2002).

8 29 U.S.C. § 1611 et seq.

9 Pub. L. No. 104-188 § 1112(a).

10 See e.g. 39-A M.R.S.A. § 325.

Reben, Benjamin & March
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Located in Portland, Maine, Reben, Benjamin & March assist clients in Augusta, Biddeford, Falmouth, Kittery, Lewiston, Portsmouth, Saco, Waterville, and Yarmouth, and in Cumberland County, York County, Sagadahoc County, Androscoggin County, and Lincoln County.