attracting and retaining key employees while protecting...

ATTRACTING AND RETAINING KEY EMPLOYEES

WHILE PROTECTING YOUR BUSINESS

Presented By

Robert M. HaleMarian A. Tse

H. David HenkenJoseph A. PiacquadDavid A. Elchoness

Sarah H. Minifie

Copyright 2000 Labor and Employment Department, ERISA/Employee BenefitsDepartment and the Private Equity Group of Goodwin, Procter & Hoar LLP. All rightsreserved, including the right to reproduce these materials or portions thereof, in any form,except for the inclusion of brief quotations in a review. All inquiries should be addressedto Labor & Employment Law Department, Goodwin, Procter & Hoar LLP, Exchange Place,Boston, MA 02109 or visit our website at www.gph.com to access seminar materialspresented today as well as materials from earlier seminars.

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TABLE OF CONTENTS

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PART I EXECUTIVE COMPENSATION ................................................................... 1I. STOCK-BASED COMPENSATION..................................................................... 1

A. INTRODUCTION ........................................................................................... 1B. INCENTIVE STOCK OPTIONS......................................................................... 1

1. General ........................................................................................... 12. Availability..................................................................................... 13. Tax Consequences to Employee...................................................... 24. Tax Consequences to Employer ...................................................... 2

C. NON-QUALIFIED STOCK OPTIONS ................................................................ 31. Availability..................................................................................... 32. Tax Consequences to Optionee ....................................................... 33. Tax Consequences to Employer ...................................................... 3

D. RESTRICTED STOCK .................................................................................... 31. Availability..................................................................................... 32. Tax Consequences to Recipient ...................................................... 33. Tax Consequences to Employer ...................................................... 4

E. ACCOUNTING TREATMENT OF OPTIONS ....................................................... 41. General ........................................................................................... 42. Fixed Accounting under APB 25 .................................................... 43. Variable Accounting under APB 25................................................ 54. Special Considerations under APB 25............................................. 55. FAS 123 Applies to Options Granted to Consultants....................... 6

F. ACCOUNTING OF RESTRICTED STOCK .......................................................... 61. General ........................................................................................... 62. Fixed Accounting under APB 25 .................................................... 73. Variable Accounting under APB 25................................................ 74. FAS 123 Applies to Restricted Stock Granted to Consultants.......... 7

II. RECENT DEVELOPMENTS IN EXECUTIVE COMPENSATION..................... 7A. VESTING TREND ......................................................................................... 7B. BROADER OPTION PARTICIPATION AND LARGER EQUITY POOLS................... 8

1. Broad-Based Plans.......................................................................... 82. Equity Pools ................................................................................... 8

C. STOCK PURCHASE LOANS............................................................................ 8D. FORFEITABLE STOCK DEFERRAL PREMIUM .................................................. 9E. TRANSFERABLE OPTIONS ............................................................................ 9

1. Overview........................................................................................ 92. Gift Tax Consideration ................................................................. 103. Income Tax Consequences............................................................ 10

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F. REPRICING UNDERWATER OPTIONS ........................................................... 101. Overview...................................................................................... 102. Corporate Governance .................................................................. 113. Designing the Option Repricing Program...................................... 124. Proxy Disclosure .......................................................................... 125. Accounting Considerations ........................................................... 12

III. TREATMENT OF EQUITY UPON SALE OF COMPANY................................ 13A. OVERVIEW................................................................................................ 13B. FULL ACCELERATION VS. PARTIAL ACCELERATION ................................... 13C. BUSINESS CONCERNS ................................................................................ 13D. ACCOUNTING CONSIDERATIONS ................................................................ 13

1. Purchase Accounting .................................................................... 132. Pooling of Interests Accounting .................................................... 14

E. TAX CONSIDERATIONS .............................................................................. 14IV. EMPLOYER PROTECTIVE PROVISIONS IN EQUITY COMPENSATION.... 14

A. LIMITED WINDOW TO EXERCISE POST-TERMINATION ................................ 14B. REPURCHASE RIGHTS ................................................................................ 15C. RIGHT OF FIRST REFUSAL.......................................................................... 15D. DRAG ALONG RIGHTS ............................................................................... 15E. NON-VOTING SECURITIES ......................................................................... 16F. OPTION CLAWBACKS ................................................................................ 16

V. GOLDEN PARACHUTE RULES ....................................................................... 16A. OVERVIEW................................................................................................ 16B. PARACHUTE PAYMENT AND EXCISE TAX ................................................... 17

1. Three-Times Rule ......................................................................... 172. Types of Parachute Payment ......................................................... 17

C. STRATEGIES REGARDING EXCISE TAX ....................................................... 181. General ......................................................................................... 182. Tax Gross-Up ............................................................................... 183. Safe Harbor Cap ........................................................................... 184. Payment of Highest Amount With or Without Cap ....................... 19

VI. COMPENSATION DEDUCTION CAP UNDER CODE SECTION 162(M)....... 19A. GENERAL.................................................................................................. 19

1. Publicly Held Corporation ............................................................ 192. Covered Employees ...................................................................... 193. Exception for Performance-Based Compensation.......................... 20

B. SPECIAL RULE FOR STOCK OPTIONS .......................................................... 231. Performance-Based Compensation................................................ 23

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PART II DOCUMENTING THE EMPLOYMENT RELATIONSHIP .................... 24I. OFFER LETTERS AND TERM SHEETS........................................................... 25II. EMPLOYMENT AGREEMENTS....................................................................... 26

A. ADVANTAGES AND DISADVANTAGES OF EMPLOYMENT AGREEMENTS ........ 261. Advantages................................................................................... 262. Disadvantages and Words of Caution............................................ 30

B. TERMINATION PROVISIONS........................................................................ 321. Standards...................................................................................... 322. Severance Period .......................................................................... 363. Release ......................................................................................... 36

III. RESTRICTIVE COVENANTS ........................................................................... 36A. COVENANTS NOT TO COMPETE.................................................................. 37

1. Goodwill....................................................................................... 372. Trade Secrets and Confidential Information .................................. 383. Reasonableness of Noncompetition Covenant............................... 384. Significant State Differences......................................................... 395. Forfeiture for Competition ............................................................ 41

B. NONSOLICITATION OF CUSTOMERS ............................................................ 43C. NONSOLICITATION OF EMPLOYEES (A/K/A ANTI-RAIDING) ......................... 44

IV. PROTECTION OF CONFIDENTIAL INFORMATION & TRADE SECRETS.. 45A. COMMON LAW AND STATUTORY PROTECTIONS ......................................... 45B CONFIDENTIALITY AGREEMENTS............................................................... 47

V. ASSIGNMENT OF INVENTION RIGHTS ........................................................ 47A. COMMON LAW RIGHTS.............................................................................. 48

1. Implied Assignment -- Hired to Invent.......................................... 482. Implied Assignment -- Fiduciary Duties........................................ 483. Shop Rights .................................................................................. 48

B. ASSIGNMENT AGREEMENTS....................................................................... 491. Limits on Agreements................................................................... 492. Disclosure of Limits ..................................................................... 49

VI. RECENT LEGAL CHANGES WITH RESPECT TOEMPLOYMENT-RELATED VISAS................................................................... 49

ATTRACTING AND RETAINING KEY EMPLOYEESWHILE PROTECTING YOUR BUSINESS

PART I

EXECUTIVE COMPENSATION

I. STOCK-BASED COMPENSATION

A. Introduction

Companies often use stock-based compensation to incentivize their executives.The types of stock-based compensation most frequently used include stock options (bothincentive and non-qualified) and restricted stock. In the case of public companies, the useof stock-based compensation must take into account a myriad of laws and requirements,including securities law considerations (registration, Section 16, proxy disclosure), taxconsiderations (tax deductibility), accounting considerations (expense charges, dilution,etc.), stock exchange and NASDAQ requirements (shareholder approval), corporate lawconsiderations (fiduciary duty, conflict-of-interest) and shareholder relations (dilution,excessive compensation, option repricing). In order to satisfy the foregoing requirements,equity grants to executive employees of public companies are typically made under ashareholder-approved plan by a compensation committee comprised of independentdirectors.

B. Incentive Stock Options

1. General

A stock option is a right to buy stock in the future, generally at a fixedprice. There are two kinds of options, incentive stock options (“ISOs”) and non-qualified stock options (“NQOs”). ISOs are a creation of the tax code. If all thestatutory requirements are met the optionee will receive favorable tax treatment.NQOs do not provide any special tax treatment to the recipient.

2. Availability

ISOs may be granted only to employees. ISOs must be granted at fairmarket value or higher, and the maximum option term is ten years. In the case ofISOs granted to any 10 percent or greater shareholder, the exercise price must be atleast 110 percent of fair market value and the maximum option term is five years.The maximum amount of ISOs that can vest in the same calendar year for any

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individual is limited to $100,000. This is determined by multiplying the fair marketvalue of the stock against the number of shares that are scheduled to vest in a year.Any option granted in excess of the $100,000 limitation, regardless of howdenominated, will be non-qualified.

3. Tax Consequences to Employee

There is no tax effect on the employee at the time of grant or vesting. Uponexercise of an ISO, there is no ordinary income to the employee, but the optionspread is taken into account in calculating the employee's alternative minimum tax.

(a) When the employee sells the underlying stock, if the sale ofthe underlying stock occurs more than two years from thedate of grant and more than one year from date of exercise,then the employee has long-term capital gains equal to thedifference between sale price and exercise price.

(b) When the employee sells the underlying stock, if the saleoccurs within two years from the date of grant or within oneyear from the date of exercise, the employee has(A) ordinary income equal to the spread (i.e., fair marketvalue less exercise price) that existed at exercise, plus (B)capital gains (long or short term depending on the holdingperiod of the underlying stock) equal to the differencebetween the sale price and fair market value of the stock atexercise. If the amount of sale is less than fair market valueof the stock at exercise, then the amount of ordinary incomeis limited to the difference between the sale price and theexercise price.

4. Tax Consequences to Employer

Subject to Section 162(m) of the Internal Revenue Code of 1986, asamended (the "Code"), the employer has a compensation deduction upon the sale ofthe underlying stock equal to the amount of ordinary income (if any) recognized bythe optionee if the holding period set forth in Section 3(a) above is not met. Theemployer has no compensation deduction if the holding period is met.

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C. Non-Qualified Stock Options

1. Availability

NQOs can be granted to employees, outside directors and consultants.NQOs can be granted at or below fair market value. NQOs can be transferable tofamily members of the optionee.

2. Tax Consequences to Optionee

There is no tax consequence to optionee at the time of grant or vestingexcept in very unusual circumstances. At the time of exercise, the optionee hasordinary income equal to the excess of fair market value of the stock over theexercise price. This amount is also subject to Social Security taxes. Upon sale ofthe stock, the optionee receives capital gain or loss treatment, which may be longterm or short term, depending on the holding period of the stock. The optionee'sbasis is the exercise price plus the amount included in income upon exercise.


Subject to Code Section 162(m), the employer has a compensationdeduction upon option exercise equal to the amount of ordinary income recognizedby the optionee.

D. Restricted Stock

1. Availability

Restricted stock can be granted to employees, outside directors andconsultants. Except for payment of par value (a requirement of most statecorporate laws), the employer may grant the stock outright or require a purchaseprice at less than fair market value. To earn true ownership of the stock, therecipient is usually required to fulfill vesting conditions that may be based oncontinuing employment over a period of years and/or achievement of pre-established performance goals. Restricted stock can deliver more value to therecipient and therefore is less dilutive to stockholders. During the vesting period,the stock is considered outstanding, and the recipient can receive dividends andexercise voting rights.

2. Tax Consequences to Recipient

The recipient is taxed at ordinary income tax rates on the value of the stockat the time of vesting. Alternatively, the recipient may make a Section 83(b)

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election within 30 days of grant to include in income the entire value of therestricted stock at the time of grant. Upon sale of stock, the recipient receivescapital gain or loss treatment, which may be long term or short term, depending onthe holding period.

Any dividends paid while the stock is unvested are taxed as compensationincome subject to withholding. Dividends paid with respect to vested stock aretaxed as dividends and no tax withholding is required.


Subject to Section 162(m) of the Code, the employer generally has acompensation deduction equal to the amount of ordinary income recognized by therecipient. The employer also has a compensation deduction equal to the amount ofdividends paid with respect to non-vested restricted stock.

E. Accounting Treatment of Options

1. General

Options are accounted for under either (i) APB 25, which applies to optionsgranted to employees and non-employee directors in their capacity as such or (ii)FAS 123, which applies to options granted to consultants and third parties otherthan employees and directors. Under APB 25, options receive fixed or variableaccounting, with variable accounting based on the intrinsic value of the option,which essentially means the spread. Under FAS 123, options are accounted forusing variable accounting based on fair value, which is determined using Black-Scholes or other valuation methodology.

2. Fixed Accounting under APB 25

(a) Generally, there is no compensation expense either at time ofgrant or upon vesting if the option grant is at fair marketvalue and vesting is time-based (i.e., fixed).

(b) If the option grant is below fair market value, the discount isa compensation expense; the discount amount is fixed anddetermined at grant date and amortized over the fixed vestingperiod.

(c) Options with performance-based vesting will still be subjectto fixed accounting if vesting will occur (even if theperformance hurdles are not met) at the end of a fixedperiod, typically five to seven years.

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3. Variable Accounting under APB 25

(a) Variable accounting applies if the award is not fixed in somemanner; for example, if the price is not fixed or vesting isperformance-based (e.g., only vests if revenue targets areachieved and not on a date certain).

(b) Compensation expense is based on intrinsic value as opposedto FAS 123 fair value.

(c) Variable accounting always results in compensation expense.This is determined by marking to market every quarter untiloption is exercised, or in some instances, when awardbecomes fixed.

4. Special Considerations under APB 25

(a) Option repricing will result in variable accounting untiloption is exercised under APB 25.

(b) Any cancellation/regrant within six months will be deemedrepricing.

(c) Use of promissory note with below market interest rate topay exercise price will be deemed option repricing.

(d) Use of promissory note without full recourse to pay exerciseprice may raise similar issues and may be deemed repricing.

(e) Any modification to option terms (e.g., change in vesting,extension of post-termination exercise period, extension ofterm) can be considered a new grant for accounting purposesand will result in a new "measurement date." If on the newmeasurement date the exercise price is less than fair marketvalue of the stock, the discount will be a charge to earningsunder APB 25 fixed accounting.

(f) Business Combinations.

i. In a purchase accounting transaction when optionsare exchanged for options issued by the acquiringcompany:

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(A) The fair value (i.e., Black-Scholes value) ofvested options (including options that vest onthe change in control) is included as part ofthe purchase price of the target.

(B) Unvested options also become part of thepurchase price in an amount equal to their fairvalue. However, if continued service isrequired for vesting after the date of theacquisition, then the "intrinsic value" of theunvested options, i.e., the spread at theacquisition date, is allocated to unearnedcompensation cost and expenses over theremaining vesting period. Any compensationcost determined by its intrinsic value isdeducted from the fair value of the unvestedoptions in determining the allocation to thepurchase price.

ii. In a pooling of interests transaction, if the exchangeof options does not increase the intrinsic value or theratio of exercise price to market value, then no newmeasurement date will be required.

5. FAS 123 Applies to Options Granted to Consultants

Fair value of options (determined on each vesting date) with respectto those options vesting as of such date will result in a charge to earnings.

(a) Fair value is determined using Black-Scholes or otherbinomial valuation method.

(b) Directors' grants can be subject to FAS 123 if granted forconsulting services.

F. Accounting of Restricted Stock

1. General

As with options, APB 25 applies only to restricted stock granted toemployees and non-employee directors.

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2. Fixed Accounting under APB 25

If vesting is time-based and grantee pays full value, there is nocompensation charge.

(a) If vesting is time-based, but grantee pays less than full value,the discount is a compensation expense; this amount is fixedand amortized over vesting period.

(b) Restricted stock with performance-based vesting will besubject to fixed accounting if vesting will occur at the end ofa fixed period, typically five to seven years, even ifperformance goals are not met. This form of restricted stockis commonly known as TARSAPs.

3. Variable Accounting under APB 25

If vesting is performance-based, fair market value of stock at time ofvesting, less purchase price, must be charged to earnings; interim estimateswill likely be required.

4. FAS 123 Applies to Restricted Stock Granted to Consultants

(a) The fair market value of the stock, at each vesting date, lesspurchase price, will be a charge to earnings.

(b) Directors' grants can be subject to FAS 123 if granted forconsulting service.

II. RECENT DEVELOPMENTS IN EXECUTIVE COMPENSATION

A. Vesting Trend

The trend is towards faster vesting, over a period of three to four years, withvesting occurring initially at the end of 12 months from the date of grant, and then pro ratavesting on a monthly or quarterly basis thereafter.

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B. Broader Option Participation and Larger Equity Pools

1. Broad-Based Plans

Increasingly, option plans are no longer reserved just for executives.In a recent survey prepared by Wordatwork, 80 percent of the companiesthat reported having a stock-based compensation plan offer stock options toa broad-based group of employees. Options are becoming the currency ofchoice and a large majority of employees in new economy companiesexpect equity grants to be part of the compensation package. In someinstances, companies grant options to every employee, including contractand part-time employees.

2. Equity Pools

The rate at which companies grant stock continues to increase. Thiscan be attributed to the cash-to-equity shift prevalent among new economycompanies, as well as the increased use of equity grants as a keyrecruitment and retention tool across a wide variety of industries for bothexecutives and professionals. According to a 1999 study of equity plans inthe 200 largest U.S. corporations prepared by Pearl Meyer & Partners Inc.,while the average equity pool for executive and employee incentive poolsstabilized at 13.2 percent in 1998, a number of companies have equity poolswell in excess of the average. In fact, 15 companies set aside more than 25percent of their outstanding shares for their employee stock plans. Of these,nine have allocations exceeding 30 percent, with five companies higher than40 percent and two of these higher than 50 percent. The diversifiedfinancial/brokerage sector, with an average equity pool of 32.91 percent,was by far the leader, followed by the technology sector at 20.68 percent.With new economy and start-up companies, which tend to be cash-poor,one should expect an even higher level of equity reserved in employee stockoption pools.

C. Stock Purchase Loans

Another trend is the increased use of stock purchase loans. Both old economycompanies, such as Kodak and Monsanto, and new economy companies, such as eBay andExcite@Home, have extended loans to key employees for use towards stock purchases. Insome instances, the underlying stock may be subject to risk of forfeiture. To encourageretention, sometimes these loans are forgiven if the employee remains employed for acertain period of time. By owning stock outright instead of just options, the key employeesenjoy both voting and dividend rights and are more aligned with the interest ofstockholders. There is also the added and not insignificant benefit of receiving capital

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gains treatment on the stock price appreciation upon subsequent sale of the stock. Thedifferences in tax rates are quite significant (39.6 percent vs. 20 percent for federal taxes).In instances where the underlying stock is restricted, executives often file a Section 83(b)election to avoid recognition of income upon vesting of the restricted stock. Where therestricted stock is purchased for fair market value, albeit with the proceeds of a stockpurchase loan, no income would be recognized by the executives upon making the Section83(b) election.

Stock purchase loans should be structured very carefully to avoid tax andaccounting concerns. State corporate law and the Company's by-laws must also beexamined to ensure that stock purchase loans are properly authorized. In some instances,stock purchase loans that are secured by the stock may result in filings with the FederalReserve Bank.

D. Forfeitable Stock Deferral Premium

Another way that companies may encourage stock retention by executives is byoffering a deferred compensation program pursuant to which an executive could defer aportion of his cash bonus into deferred stock units that are credited to his account with apremium. This premium is forfeitable if the employee terminates employment prior to thevesting date for the premium. To illustrate this approach, assume an employee deferred$10,000 of cash bonuses into deferred stock units at a time when the stock price was $10and the company credited a 15 percent stock deferral premium. The employee would becredited with 1,000 units ($10,000/$10) plus 150 units (1,000 x 15%) for the premium. Ifthe employee subsequently terminates before the vesting date, the 1,000 units would bedistributed in shares and the 150 premium units would be forfeited. Such a programenables executives to acquire more stock on a tax-deferred basis.

E. Transferable Options

1. Overview

Transferring stock options to family members is a valuable estate-planning device for high net worth executives. Only non-qualified stockoptions can be transferred since incentive stock options are not transferableunder the tax laws. If the executive makes a completed gift of a stockoption to a family member, the gift will be subject to federal gift taxes at thetime of the gift based on the fair market value of the option at that time,subject to the potential availability of the $10,000 annual exclusion and/orthe unified credit. Since the value of the option could be less than the valueof the shares at the time of exercise, the individual could have transferredthe future increase in value to family members free of estate and gift taxes.

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2. Gift Tax Consideration

In order to achieve the desirable tax consequences, it is importantthat the executive makes a completed gift of the stock options. For sometime, there had been some uncertainty as to whether a completed gift couldbe made with an option that was not currently exercisable. The InternalRevenue Service, in a recent revenue ruling, concluded that one cannotmake a competed gift of a stock option until it becomes exercisable. In theevent the option were to become exercisable in stages, each portion of theoption that becomes exercisable can be gifted on a separate basis. Rev. Rul.98-21.

In a recent revenue procedure, the Service also provided guidanceon the valuation of stock options for gift tax purposes. In Rev. Proc. 98-34,the Service stated that stock options must be valued by using a generallyrecognized option pricing model, such as the Black-Scholes method, thattakes into account the following factors: the option exercise price; theexpected life of the option; the current market price of the stock; theexpected volatility of the stock; the expected dividends on the stock; and therisk-free interest rate over the remaining option term. Further, a taxpayerthat wishes to rely on Rev. Proc. 98-34 may not apply a discount to thevaluation produced by the option pricing model to take into account factorssuch as the lack of transferability and risk of early termination of the optionupon termination of employment. It should be noted, however, that themethodology provided by a revenue procedure is simply a safe harbor.

3. Income Tax Consequences

At the time of option exercise by the family member, the executive(not the family member) will recognize ordinary income in an amount equalto the excess of the fair market value of the stock over the exercise price ofthe option (i.e., the option spread). The family member neverthelessreceives a basis in the shares received upon exercise equal to the exerciseprice paid plus the amount of income recognized by the executive. Theincome tax consequences of option exercises again result in transfer ofwealth to family members without the payment of gift or estate taxes.

F. Repricing Underwater Options

1. Overview

When a company's stock price drops below the exercise prices ofoptions, the options become "underwater" and have no perceived currentvalue to the employees. Many companies try to address employees'

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dissatisfaction with "underwater" options by repricing the stock options.Repricing of stock options often results in increased scrutiny and criticismby institutional shareholders of a company's compensation program andpolicies. Shareholders may question whether repricing defeats the purposesof providing long-term incentive to employees by removing the risk to suchemployees of downward price movements in the company's stock. Somecritics compare repricing to changing the scoreboard or moving the goalposts halfway through a game. Institutional Shareholder Services, a proxyadvisory service in Bethesda, Maryland, that advises institutional investors,proclaims a zero tolerance for option repricing. Institutional ShareholderServices advises its institutional clients to vote against stock plan proposalsfor any company that has repriced stock options without shareholderapproval. Recently, the State of Wisconsin Investment Board has takensteps to persuade a number of companies in which it has a stake to seekshareholder approval of all option repricings, although such approval is nottypically required under state laws or stock exchanges rules. These policiesmay ignore the business realities faced by many companies; namely thatunderwater options do not have retention value to employees. SinceDecember 1998 when FASB announced that stock option repricing wouldresult in variable accounting, the use of option repricing has slowed downsignificantly. Instead of re-pricing when stock price drops below the optionstrike price, some companies, like Microsoft, who have a large pool ofreserved shares in their option plans, have made additional option grants toemployees to address morale and retention issues.

2. Corporate Governance

Shareholder approval is typically not required for option repricing,so long as the stock plan document gives the board, or the compensationcommittee, discretion to determine the option price, and there is noprohibition in the company's by-laws or the stock plan itself. Nevertheless,repricing of stock options has been the subject of shareholder litigation.Grounds for such lawsuits have included corporate waste, conflict ofinterest and breach of fiduciary duty. To avoid shareholder litigation overthis issue, compensation committees asked to approve repricing shouldcarefully deliberate and consider any proposed option program in order toavail themselves of the business judgment rule. In particular, compensationcommittees should consult legal, accounting and other professional adviceand should demonstrate their careful consideration of the issues throughwell-documented minutes, including well-reasoned justification for therepricing program, such as the need to keep the company's compensationprograms competitive and to avoid cherry picking by competitors. Tomitigate the risks of shareholder litigation, the compensation committeeshould also consider prohibiting outside directors and executives from

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participating in the program and requiring additional consideration from theoption holders, such as restarting the vesting period over again.

3. Designing the Option Repricing Program

One way to reprice options is to simply amend the existing stockoptions to reduce the exercise price. Another method is through an optionexchange program. Under this method, employees are given an opportunityto surrender underwater options for new options at a lower exercise price,but for fewer shares. Very often, the exchange is made on a true economicbasis, by valuing the old and new options under an option-pricing model.Some companies require additional consideration such as extending thevesting period and/or imposing a "black-out" on option exercises for areasonable period following the repricing.

4. Proxy Disclosure

If option repricing benefits any of the named executive officers, thenthe company is required to disclose additional information in its proxystatement for the fiscal year in which the repricing occurs. This includes anexplanation by the compensation committee of the repricing program andthe basis therefor, as well as a repricing table that shows all option repricing(as well as exchanges) with respect to options held by executive officers(not just the named executive officers) in the last ten years.

5. Accounting Considerations

(a) Expense Charge. Companies that reprice options will besubject to variable accounting under APB 25 and arerequired to recognize as a compensation expense an amountequal to the difference between the new lower exercise priceand any future increase in stock price through the date theoption is exercised. This applies to both vested and unvestedoptions. Any option cancellation and re-grant within sixmonths is deemed to be option repricing for this purpose.

(b) Pooling of Interest Accounting. Option repricing within twoyears of a business combination could adversely affect theparties' ability to use the pooling of interest method toaccount for the combination.

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III. TREATMENT OF EQUITY UPON SALE OF COMPANY

A. Overview

In designing stock option plans, it is important to consider whether the vesting ofunvested options will be accelerated upon a sale of the company. There is no one correctapproach that serves the needs of every company.

B. Full Acceleration vs. Partial Acceleration

Some stock option plans provide for full acceleration of unvested stock optionsupon a sale of the company. This is particularly prevalent among large public companies.Other stock option plans provide that if the options will be assumed by the acquiringcompany, the vesting of 50 percent of the unvested options will be accelerated upon thesale of the company. The remaining 50 percent will vest in their normal course, but in theevent the optionee is terminated by the acquiring company without "cause" within a periodof time after closing (typically varies from 12 to 18 months), the vesting of the remainingunvested options will be accelerated as well. A third approach provides for no accelerationupon sale, but full or partial acceleration of vesting if the optionee is terminated without"cause" within a certain period after closing. The second and third approaches aresometimes referred to as "double-trigger" approaches.

C. Business Concerns

Investors are generally not in favor of full acceleration because of concerns that itmight lower the value of their investment. Further, there is the added concern that theemployees who receive a "windfall" upon the sale of the company will have no incentiveto stay with the acquiring company post-acquisition. This could increase the cost of theacquisition as the acquiring company may be required to put in place additional incentivesto retain the key employees. The double-trigger approaches discussed above are viewed bysome investors as a more balanced approach which also provides protection for employeeswho are terminated without "cause" before the end of the vesting period. Employees, onthe other hand, for obvious reasons prefer full acceleration of stock options upon the saleof the company. Some companies may permit full acceleration in specific grants in orderto attract and retain high quality employees in a competitive market.

D. Accounting Considerations

1. Purchase Accounting

In a purchase accounting transaction when options are exchangedfor options issued by the acquiring company, vested options (includingoptions that vest on the sale of company) are treated as they have been inthe past. The "fair value" (i.e., Black-Scholes) of the substitute options is

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included as part of the purchase price of the target. Unvested options alsobecome part of the purchase price in an amount equal to their "fair value."However, if continued service is required for vesting after the date of theacquisition, then the "intrinsic value" of the unvested options, i.e., thespread at the acquisition date, is allocated to unearned compensation costand expenses over the remaining vesting period. Any compensation costdetermined by its "intrinsic value" is deducted from the "fair value" of theunvested options in determining the allocation to the purchase price.

2. Pooling of Interests Accounting

If the exchange of options does not increase the intrinsic value or theratio of exercise price to market value, then the exchange of options will notresult in compensation expenses. In a transaction that is accounted for as apooling of interests, it is impermissible to change the vesting of options atthe time the transaction is negotiated or contemplated as that would beconsidered a change in equity position that would disqualify the use ofpooling.

E. Tax Considerations

Stock options or stock grants that vest upon a sale of the company are consideredparachute payments potentially subject to the golden parachute tax. In the case of a privatecompany, the golden parachute tax concerns can be avoided completely if the shareholders,upon full disclosure, approve the acceleration in vesting in connection with the saletransaction. See Section V.

IV. EMPLOYER PROTECTIVE PROVISIONS IN EQUITY COMPENSATION

There are a number of protection provisions that a properly represented employershould seek to have in their employee equity documentation. As indicated below, not allof these provisions are appropriate for public employers.

A. Limited Window to Exercise Post-Termination

If the employment is terminated with cause, stock options should provide that theoption held by an executive terminates immediately, and is no longer exercisable.Similarly, with respect to restricted stock, vesting should cease and a repurchase rightshould arise (See IVB). In all other cases, the option agreement should specify the post-termination exercise period. Typically, post-termination periods are 12 months in the caseof death or disability, and 90 days in the case of termination without cause. Someexecutives will try to negotiate extended post-termination exercise periods as long as theremaining exercise period in the original ten-year term.

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B. Repurchase Rights

With respect to restricted stock, private companies should always consider havingrepurchase rights for unvested as well as vested stock. Unvested stock should always besubject to repurchase either at cost or fair market value, or the lower of cost or fair marketvalue. With respect to vested stock and stock issued upon exercise of vested options, someemployers retain a repurchase right at fair market value upon termination under allcircumstances until the employer goes public; other employers only retain a repurchaseright under limited circumstances, such as termination without cause or bankruptcy.

In general, public companies should only retain the repurchase right with respect tounvested stock, as the need to ensure that an employer’s securities remain only in a limitednumber of friendly hands is no longer present.

C. Right of First Refusal

As another means to ensure that securities remain only in relatively few friendlyhands, private company employers often have a right of first refusal or first offer withrespect to any proposed transfers by an executive. Generally, these provide that prior totransferring equity securities to an unaffiliated third party, an executive must first offer thesecurities for sale to the employer-issuer and/or perhaps other shareholders of the employeron the same terms as offered to the unaffiliated third party. Only after the executive hascomplied with the right of first refusal can the executive sell the securities to such a thirdparty. Even if an employer was not contemplating a right of first refusal, outside venturecapital investors are likely to insist on these types of provisions.1 Rights of first refusal(and co-sale rights) typically terminate once the employer has successfully completed anIPO.

D. Drag Along Rights

Private companies should also consider having a so-called “drag-along” or “take-along” right, which generally provides that a holder of the employer’s equity securities willbe contractually required to go along with major corporate transactions such as a sale ofthe company, regardless of the structure thereof, so long as the holders of a statedpercentage of the employer’s equity securities is in favor of the deal. This will preventindividual employee shareholders from interfering with a major corporate transaction by,for example, voting against the deal or exercising dissenters’ rights. Again, venture capitalinvestors typically insist on this type of provision.

1It would not be unusual for venture capital investors to insist on a co-sale right as well.

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E. Non-Voting Securities

Another technique private employers should consider is issuing non-votingcommon stock to their employees. Generally, except as required by law, holders of non-voting common stock have very limited voting rights and, hence, will be less likely tointerfere with a major corporate transaction that has the backing of a stated percentage ofsecurity holders.

F. Option Clawbacks

To protect themselves from an employee who seeks to engage in post-terminationcompetition, employers may consider a “claw back” provision under which an employeewho violates a noncompetition agreement (see Section II.B. below) forfeits not only his orher stock and stock options but also any profit derived therefrom. At least one FederalCircuit court has recognized such a provision. International Business Machines Corp. v.Bajorek, 191 F.3d 1033 (9th Cir. 1999) (option agreement enforces where it included apromise that employee would return any profit (here, $928, 538.74) made from his or herstock option if he worked for a competitor within six months of their exercise). But seeLucente v. International Business Machines Corp., 99 Civ. 3987 (CM) (S.D.N.Y.October 19, 2000) (stock forfeiture provision invoked when former executive joinedcompetitor two years after his retirement was unreasonable as a matter of law).

V. GOLDEN PARACHUTE RULES

A. Overview

Sections 280G and 4999 of the Internal Revenue Service Code disallow a federalincome tax deduction to the employer corporation of an "excess parachute payment" andimpose a non-deductible excise tax equal to 20 percent of the "excess parachute payment"on the recipient of the payment.

The parachute tax rules generally apply to compensation payments to a disqualifiedindividual if the payments are contingent on a change in the ownership or effective controlof the employer corporation or in the change in ownership of a substantial portion of theassets of the employer corporation. The parachute tax rules do not apply to payments by Scorporations, or payments by closely-held corporations, if the shareholder approvalrequirements have been satisfied.

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B. Parachute Payment and Excise Tax

1. Three-Times Rule

Code Section 280G(b)(2)(A) defines a "parachute payment" as any paymentin the nature of compensation that is made to a "disqualified individual" (i.e.,officer, shareholder or highly compensated employee), is contingent on a change incontrol of the employer corporation, and, together with all other payments, has apresent value that equals or exceeds three times the individual's "base amount" (i.e.,the average annual taxable compensation received by the disqualified individualover the most recent five years ending before the change in control). Compensationpaid pursuant to agreements entered into one year before a change in control ispresumed to be contingent on the change. If the present value of the parachutepayment equals or exceeds three times the individual's base amount, then theindividual must pay an excise tax equal to 20 percent of the excess of parachutepayment over the base amount. (Note, not three times the base amount.) Forexample, if an individual's base amount is $300,000 and the individual is entitled toreceive parachute payments with a present value of $1,000,000, he is liable for anexcise tax of $140,000 [.2 x ($1,000,000 - $300,000)]. The corporation's taxdeduction is limited to $300,000.

2. Types of Parachute Payment

(a) Severance payments which become payable because of atermination of employment in connection with a change incontrol are generally considered parachute payments.

(b) Stock grants that vest or stock options that becomeexercisable as a result of a change in control are alsoconsidered parachute payments. However, if the payment iscertain (i.e., would have been paid sometime in the future ifthe individual had remained employed) but the timing ofreceipt is accelerated due to the change in control, only aportion of the payment is treated as contingent on thechange. The proposed regulations include a formula fordetermining the value of the portion to be treated ascontingent. Prop. Reg. § 1.280G, Q/A - 24(c).

(c) If a disqualified individual receives benefits continuationfollowing a termination of employment in connection with achange in control, the value of the benefits continuation arelikely to be considered parachute payments.

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(d) Any amount that one can establish as reasonablecompensation for personal services to be rendered on or afterthe change in control is not considered a parachute payment.Payments to a disqualified person for not competing againstthe employer corporation after the change in control maycome under this exception if the amounts are reasonable.

(e) Payments from tax-qualified plans are not consideredparachute payments.

C. Strategies Regarding Excise Tax

1. General

There are three approaches that corporations generally take with regard tothe golden parachute tax: (a) tax gross-up; (b) safe harbor cap; and (c) payment ofhighest amount with or without cap.

2. Tax Gross-Up

In order to protect the executive from the punitive nature of the excise tax,many corporations provide the executive with a "gross-up" payment to ensure thatthe executive receives the after-tax benefits he or she would have received had thepayments not been subject to the excise tax. In particular, the gross-up paymentwould be equal to the sum of (a) the excise tax on the parachute payments, and (b)the federal, state, local, employment tax and excise tax on the gross-up payment.The gross-up payment can be very costly to the employer. At today's tax rates, thegross-up payment can be close to three times the amount of the excise tax. Inaddition, the corporation would not be entitled to a tax deduction with respect to theexcess of the parachute payments, including the gross-up payment, over theexecutive's base amount.

3. Safe Harbor Cap

Under this approach, the corporation and executive agree in advance thatthe parachute payments (including severance payments) payable upon a change incontrol would be limited to three times the executive's base amount less $1.00. Forexample, assume that the executive's base amount is $200,000, and that theparachute value of the executive's options that accelerated upon the change incontrol is $150,000. Under the safe harbor cap approach, the maximum severancepayments cannot exceed $449,999 [(3 x $200,000 -- $150,000 - $1)]. This safeharbor cap could lead to disappointment to the executive because in manyinstances, given the magnitude of today's equity grants for executives, the

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acceleration of vesting may cause all or a substantial portion of the executive's safeharbor to be used up prior to the payment of any severance benefits.

4. Payment of Highest Amount With or Without Cap

Another approach that some corporations take is to impose the safe harborcap only if the executive's net after-tax benefit is greater by applying the cap than ifthe cap is not applied. A variation of this approach is to impose the cap only if theamount to be eliminated as a result of the cap is less than a certain percentage (e.g.,110 percent) of the present value of all taxes imposed on the eliminated amount.These approaches are less costly to the corporation than the gross-up approach andwill provide for larger after-tax dollars to the executive. For example, assume thatthe executive's safe harbor is $900,000 and that the contractual payments wouldhave been $1,500,000 prior to any cutback. Further assume a maximum combinedtax bracket of 65 percent (including the excise tax) and 45 percent (excluding theexcise tax). With the cap, the executive would have received $495,000 on an after-tax basis ($900,000 x .55). Without the cap, the executive would have received$585,000 on an after-tax basis ($1,200,000 (i.e., the amount of the payment inexcess of the base amount) x .35 + $300,000 (i.e., the base amount) x .55). In thisinstance, the executive would be better off without the cap than if the cap hadapplied.

VI. COMPENSATION DEDUCTION CAP UNDER CODE SECTION 162(m)

A. General

Under Code Section 162(m), subject to certain exceptions, a "publicly heldcorporation" is denied a deduction for remuneration paid to a "covered employee" forservices performed by such employee to the extent the remuneration exceeds $1 million forthe taxable year.

1. Publicly Held Corporation

A "publicly held corporation" is defined as "any corporation issuingany class of common equity securities required to be registered underSection 12 of the Securities Exchange Act of 1934." Code § 162(m)(2).

2. Covered Employees

Under Code Section 162(m), an individual is a "covered employee"if the individual is employed on the last day of the company's tax year andhe or she is either the chief executive officer or any other individual whosecompensation must be reported to shareholders under the Securities

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Exchange Act of 1934 Act by reason of being among the four highest paidofficers.

3. Exception for Performance-Based Compensation

Code Section 162(m) excludes performance-based compensationfrom the $1 million deduction limit. Such compensation must satisfy thefollowing four requirements:

(a) Performance Goals. The compensation is paid solely onaccount of the attainment of one or more pre-establishedobjective performance goals. See Treas. Reg. § 1.162-27(e)(2)(i)-(ii).

i. The goal must be established by the compensationcommittee not later than 90 days after thecommencement of the performance period (or withinthe first 25 percent of the period if the period is lessthan one year).

ii. The performance goal must be objective such that athird party having knowledge of the relevant factscould determine whether the goal is met.

iii. The compensation committee does not have thediscretion to increase the compensation due uponattainment of the goal, but may retain negativediscretion to reduce the compensation.

iv. The performance goal can be based on one or morebusiness criteria that apply to the business unit, orcorporation as a whole. Examples of business criteriainclude stock price, earnings per share, return onequity, market share, sales, etc.

v. If the executive would receive part or all of thecompensation even if the performance goal is notattained, the compensation does not qualify for theperformance-based exception.

(b) Goals Must Be Determined by Compensation Committee.The performance goals must be established by acompensation committee comprised solely of two or more"outside directors." See Treas. Reg. § 1.162-27(e)(3).

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i. To qualify as an "outside director," a director

(A) must not be a current employee of the publiccompany;

(B) must not be a former employee of the publiccompany who receives compensation for priorservices (other than benefits under a tax-qualified retirement plan);

(C) must not have served as an officer of thepublic company; and

(D) must not receive remuneration from thepublic company, directly or indirectly, in anycapacity other than as a director. For thispurpose, "remuneration" includes:

i) any amount paid to an entity in whichthe director has more than a 50 percentbeneficial interest;

ii) amounts, other than de minimisremuneration, paid by the publiccompany to an entity in which thedirector has more than 5 percentbeneficial interest; and

iii) amounts, other than de minimisremuneration, paid by the publiccompany to an entity by which thedirector is employed or self-employed.

To qualify under the de minimis exception,the remuneration must be $60,000 or less ifpaid for personal services and may not exceed5 percent of the gross revenues of the entityfor the taxable year ending with or within thepreceding taxable year of the public company.

ii. Although the regulations provide that thecompensation committee must be comprised solely oftwo or more outside directors, the Service has ruled

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that a compensation committee with directors who donot so qualify as outside directors can still qualify asa committee of outside directors under Code Section162(m) so long as all the directors who do not soqualify abstain or recuse themselves, and there are atleast two remaining directors who qualify as outsidedirectors. PLR 9811029.

(c) Shareholder Approval Required. The material terms of theperformance goal under which the compensation is to bepaid must be disclosed to and approved by the shareholdersbefore the compensation is paid. Treas. Reg. § 1.162-27(e)(4).

i. The shareholders must be made aware of the materialterms of the compensation, including the class ofeligible employees, the description of the businesscriteria on which the performance goal is based andeither the maximum amount of the compensation thatwould be paid or the formula used to calculate theamount.

ii. The specific targets do not have to be disclosed to theshareholders.

iii. If the compensation committee has authority tochange the targets under a performance goal, theshareholders must reapprove the performance goalsevery five years.

iv. The shareholder approval requirement is satisfiedonly if the material terms of the performance goal areapproved by the shareholders, in a separate vote inwhich a majority of the votes cast (includingabstentions, to the extent abstentions are counted asvoting under applicable state laws) on the issue arecast in favor of approval.

(d) Certification. Prior to payment, the compensation committeemust certify in writing that the performance goals were infact satisfied. Code Section 162(m)(4)(C)(iii). For thispurpose, the approved minutes of the compensationcommittee are satisfactory.

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B. Special Rule for Stock Options

1. Performance-Based Compensation

Stock options will be considered qualified performance-based compensationif the grant is made by a compensation committee comprised solely of two or moreoutside directors, the plan specifies a limitation on the number of options that maybe granted to any individual during a specified period and the amount ofcompensation attributable to the option is based solely on an increase in the valueof the stock after the date of grant.

(a) The individual limit on the number of options need not bethe same for each employee.

(b) Under the regulations, if an outstanding option is repriced, itis deemed canceled with a new option issued in its place.The canceled option counts against the particular employee'soption share limit under the plan.

(c) If the exercise price of the option is no less than the fairmarket value of the stock on the date of grant, then theoption is considered performance-based under theregulations. In such a case, any compensation attributable tothe option is based solely on an increase in the value of thestock after the date of grant.

(d) Compensation that is tied solely to an increase in stock price,such as options, does not require written certification by thecompensation committee.

(e) Generally, with discounted stock options, the executive mayreceive compensation even if the stock declines in value (i.e.,the exercise price is less than the stock's fair market value atgrant, the stock drops in value but the executive still realizesa gain so long as the stock does not fall below the exerciseprice). Thus, discounted options are not deemedperformance-based compensation because the executive canrealize a gain that is not based solely on an increase in thevalue of the stock after the date of grant. However, if thegrant or the vesting of a discounted stock option is basedsolely on the attainment of an objective performance goalthat has received shareholder approval, then the resultingcompensation is qualified performance-based compensation.

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PART II

DOCUMENTING THE EMPLOYMENT RELATIONSHIP

The extent to which terms and conditions of the employment relationship should bedocumented at the outset of employment is a delicate issue in which a number ofcompeting concerns should be considered.

For example, certain terms and conditions (e.g., noncompetition covenants,assignment of work-related inventions, etc.) must be documented if the employer expectsto have an agreement that is binding upon the employee. Other matters (e.g., stock optionsand restricted stock grants, incentive compensation plans, etc.) should be documented sothat there is no confusion regarding the parties’ respective rights and obligations. Themeans by which these terms are documented vary. For example, restrictive covenantsfrequently are embodied in stand-alone contracts. Likewise, the terms of equity grantsfrequently are (and should be) embodied in stand-alone agreements supplemented by theterms of underlying equity plans.

Other terms and conditions of employment (e.g., base salary, duties and reportingrelationships, frequency of annual reviews, etc.) do not need to be documented in a formalcommunication between the employer and employee, but frequently are. These terms maybe set forth in offer letters, term sheets or employment contracts. These documents alsooften are used, in lieu of standard agreements, to describe other matters, such as the termsof equity grants or the scope of restrictive covenants. Properly worded offer letters, forexample, can and do describe clearly the terms of employment.

Carefully documenting the relationship between employer and employee also mayhelp attract and retain employees. For example, new employees may find security in adocumented relationship. Existing employees with written agreements are more likely tounderstand their rights and obligations and accordingly may be less likely to lookelsewhere for employment.

Problems often arise, however, when employers attempt to document the terms ofemployment. Frequently encountered problems include, but are not limited to: (i) creatingconflicts among documents (e.g., an offer letter that describes terms of an equity grant thatare inconsistent with the terms of the equity plan); (ii) altering the employment relationshipfrom at-will to employment for a term; (iii) creating ambiguous terms (e.g., is an incentivebonus earned ratably?); (iv) promising benefits the employer is not yet ready or able toimplement; and (v) guaranteeing an employee that he or she will have a certain reportingrelationship (e.g., “you will report to the CEO”) or specific responsibilities (e.g., “you willbe responsible for world wide sales and marketing”). In some cases, these problems canlead to legal liability. In other cases, they can lead to significant morale or humanresources problems. In either case, these types of problems can have a detrimental effect

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on the specific employee at issue, other employees in the workforce and, as the use ofemployer-specific chat rooms becomes more prevalent, potential recruits.

The following sections discuss in more detail some of the benefits and commonlyrecurring pitfalls of documenting the employment relationship.

I. OFFER LETTERS AND TERM SHEETS

At the recruiting stage, employers often use term sheets or offer letters to conveythe offered terms of employment. Frequently, employers ask a potential employee toindicate his or her acceptance of the offer by signing and returning the document. Manyemployers fail to recognize, however, that offer letters and term sheets can constitute or beevidence of contractual commitments that can be accepted expressly (i.e., when thecandidate executes the document) or implicitly through performance (i.e., when thecandidate begins working or leaves his or her other job in reliance on the offered terms).

If documents such as offer letters or term sheets are going to be used at therecruitment stage, an employer either should recognize that it may be creating a contractand draft with the care accorded other contracts or should take steps to avoid creatingcontractual commitments.

The language of offer letters and terms sheets sometimes may result in alteration ofthe employment relationship from at-will to employment for a term. This problem caneasily be avoided by a clear at-will disclaimer. Other steps also can be taken to avoid suchan unintended result. For example, offer letters should describe compensation in monthlyor weekly, rather than annual, terms because references to time may be construed tosupport the claim of a promise for employment of a certain duration. See Venizi v.Mahoney & Wright Insurance Agency, Inc., 40 Mass. App. Ct. 218, 225 (1996). Inaddition, offer letters should avoid representations concerning the timing of salaryincreases or performance reviews, since such representations may give rise to claims thatthe employee has a contract at least until the date of the salary increase or performancereview. See, e.g., Frederich v. Conagra, Inc., 713 F. Supp. 41, 46 (D. Mass. 1989).

When drafting term sheets or offer letters, it is important to keep in mind otherdocuments an employee may be asked to sign, especially documents that are to be signedcontemporaneously with acceptance of the offer of employment. To the extent that offerletters or term sheets refer to terms or conditions of employment that are embodied in otherdocuments, care should be taken to refer to those other documents as controlling. Thisprecaution should avoid creating confusion or, in the worst case, modifying the terms ofthose other documents. For example, an offer letter may promise unconditionally that acandidate will receive stock options upon commencement of employment, but theunderlying stock plan requires execution of a noncompetition agreement as a condition to agrant of options. Not surprisingly, the employee may balk at executing the noncompetitionwhen it is presented to him or her a month later.

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Many of these same concerns arise when an employer engages in a bidding war toretain its own employees who are being recruited by other employer.

The key point for an employer is to treat offer letters with the same care andconsideration as it would in preparing or negotiating any other contract. An employershould not make commitments it is not prepared or able to fulfill.

II. EMPLOYMENT AGREEMENTS

Employment agreements are used to document many critical aspects of theemployment relationship, most frequently with respect to senior executives or other keypersonnel. As with any other contract a company may enter into, precision, accuracy andattention to detail are important in any such effort. A carefully crafted employmentagreement can clearly delineate an employer’s and employee’s respective rights, duties andobligations. Such agreements can anticipate and provide for future occurrences, such asthe consequences of any breach of the agreement and provide for a mutually agreeableforum in which to resolve disputes. A poorly drafted employment agreement, however,may fail to memorialize adequately all aspects of the parties’ agreed upon intentions.Indeed, a poorly drafted employment agreement may result in terms or conditions beingimposed by a court that were not intended by one or both parties to the agreement.

A. Advantages and Disadvantages of Employment Agreements

1. Advantages

The advantages of using an employment agreement todocument the employment relationship are numerous, provided thatsuch agreements are drafted accurately and precisely. Agreementsthat contain omissions, inconsistencies or ambiguities invariablylead to disputes. Of course, such disputes are exactly what theagreement was meant to prevent.

(a) Negotiate at Optimum Time. The start of an employmentrelationship is probably the most opportune time to negotiatean employment agreement. Among other reasons, theparties’ relationship at that time will most likely be amicable.

(b) Nature of the Relationship. In most jurisdictions,employment is presumed to be at-will (i.e., terminable byeither party at any time and for any lawful reason or noreason). If an employer intends to maintain an at-willrelationship, identifying employment as “at-will” in theemployment agreement is advisable. A statement that

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employment is “at-will” signed by the employee may rebut aclaim of employment for a particular term. See Novosel v.Sears, Roebuck, 495 F. Supp. 344 (E.D. Mich. 1980). Onthe other hand, failure to do so may create unintendedguarantees of employment for a certain duration or that isterminable only for “cause.” Goldhor v. Hampshire College,25 Mass. Ct. App. 716, 721 (1988). If employment for adefinite term is intended, including that specific term in awritten contract provides evidence of commitment on thepart of both the employer and the employee.

(c) Compensation. In this tight job market, compensationremains a key method of attracting, incentivizing, andretaining key employees. Defining compensation, such assalary, bonus or other incentive compensation as well as anyequity rights in an employment agreement clearly informsthe employee how performance will be rewarded and mayassist in preventing disputes related to compensationobligations.

(d) Capacity. Spelling out an employee’s duties, responsibilitiesand functions confirms the employee’s understanding of thearrangement he or she is entering into and establishes theemployer’s expectations. Careful drafting is requiredbecause an inadvertent gap in an otherwise comprehensivedescription may become a subject for a dispute. To preventthis possibility, the employer should consider broadlyworded descriptions that reserve the employer’s discretion todefine or alter job duties over time.

(e) Damages. In light of the amicable nature at the start of mostemployment relationships, the issue of damages should bebroached with the employee at that time. Specifically,provisions may be negotiated to establish the rights of eitherparty in the event of a breach by the other. For example, theparties may agree to liquidated damages in the event theemployee breaches obligations to the employer. In the caseof employment for a term, the parties may negotiate damagesif either party terminates employment without cause or goodreason. The parties should be able to reach agreement onthese issues more easily prior to the onset of any dispute.

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(f) Noncompetition, Nonsolicitation and NondisclosureAgreements. In the new economy, employers have becomeincreasingly vigilant about preventing the disclosure ofconfidential information to their competitors. Similarly,employers have an increased interest in keeping a workforceintact. Accordingly, employers should consider includingrestrictive covenants, such as noncompetition agreements,nonsolicitation of customers, nonsolicitation of employees,and nondisclosure provisions in their employmentagreements. Of course, as discussed above, for obviousreasons, these provisions should be negotiated prior to thecommencement of the employment relationship. In additionto practical concerns, some courts hold that restrictivecovenants entered into after the start of employment may notbe enforceable without new consideration. Compare IkonOffice Solutions, Inc. v. Belanger, 1999 WL 508689(D. Mass.) (continued employment insufficient to support anoncompetition agreement) with Zellner v. Stephen D.Conrad, M.D., P.C., 183 A.D.2d 250 (N.Y. 2d Dept. 1992)(enforcing agreement entered into during employmentwithout additional consideration); Reynolds & ReynoldsCo. v. Tart, 955 F. Supp. 547,553 (W.D.N.C. 1997)(same);Midwest Sports Mktg. Inc. v. Bradsby of Can. Ltd., 552N.W. 2d 254 (Minn. Ct. App. 1996)(same). Because somestate laws generally prohibit certain restrictive covenants,care should be taken when presenting any employee with aproposed agreement containing such terms. See, e.g., Cal.Bus. and Professions Code § 1600 (generally prohibitingrestraints of trade, such as noncompetition provision);see also discussion below in Section II.B.

(g) Breach of Fiduciary Duty. Employment agreements andother documents that contain explicit termination provisionsmay help protect employers from breach of fiduciary dutyclaims. By way of background, in Massachusetts, allshareholders in a close corporation, but particularly a“controlling group” or a majority shareholder, owe eachother a duty of “utmost good faith and loyalty.” Donahue v.Rodd Electrotype Co. of New England, 367 Mass. 578, 592(1974). Accordingly, Massachusetts courts generally requirethat employers have a legitimate business reason forterminating an employee who is also a minority shareholder

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in a close corporation. Wilkes v. Springside Nursing Home,370 Mass. 842, 850 (1976).

Complying with an employment agreement and purchasing aminority shareholder’s stock at a “fair price” may insulate amajority shareholder from a fiduciary duty claim eventhough the employer/majority shareholder lacked a“legitimate business reason” for terminating the minorityshareholder’s employment. Merola v. Exergen Corp., 423Mass. 461, 465 (1996.) “Questions of good faith and loyaltywith respect to rights on termination or stock purchase do notarise when all the stockholders in advance enter intoagreements concerning termination of employment and forthe purchase of stock of a withdrawing or a deceasedshareholder.” Blank v. Chelmsford Ob/Gyn, P.C. 420 Mass.404, 408 (1995) (where employment contract permittedemployment to be terminated by either party on six monthsnotice, and there is no allegation that the defendants weredenying the plaintiff his or her contractual rights or futurecompensation for past services.); see Donahue, 367 Mass. at599, n.24.

(h) Alternative Dispute Resolution. Including alternativedispute resolution provisions in employment agreementsmay also be useful. Many employers find such provisions,which typically require both the employer and employee tosubmit all employment disputes to arbitration, to be efficientand cost effective. While many courts have enforced suchprovisions in the employment context, see, e.g., Gilmer v.Interstate/Johnson Lane Corporations, 500 U.S. 20 (1991);Seus v. John Nuveen & Co., 146 F.3d 175, 179, 182-83 (3dCir. 1998); Mugnano-Bornstein v. Cromwell, 42 Mass. App.Ct. 347 (1997), the United States Supreme Court has yet todecide whether arbitration clauses included in “contracts ofemployment” (as opposed to other types of documents) areenforceable. It is expected to do so in its current term.Circuit City Stores v. Adams, 194 F.3d 1070 (9th Cir. 1999),cert. granted, 120 S.Ct. 2004, 164 L.Ed. 2d 955 (2000).

The Federal Arbitration Act (“FAA”) generally requirescourts to enforce arbitration agreement, but excludes from itsscope arbitration agreements in “contracts of employment ofseamen, railroad employees, or any other class of workersengaged in foreign or interstate commerce.” 9 U.S.C. § 1.

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Many courts have construed this exclusion to apply only tocontracts of workers actually engaged in moving goods ininterstate commerce, e.g., truck drivers and seamen. E.g.,Tenney Engineering, Inc. v. United Elec. Radio & Mach.Workers, 207 F.2d 450 (3d Cir. 1953) (en banc). The NinthCircuit, however, has held this exclusion applies to any typeof employment agreement. E.g., Circuit City Stores v.Adams, supra (exclusion applies to arbitration agreemententered into in connection with employment application as acondition of at-will employment); Circuit City Stores Inc. v.Ahmed, 195 F.3d 1131 (9th Cir. 1999) (exclusion applies toarbitration agreement in any document employer intends tobe binding on employee). In Circuit City Stores v. Adams,the Supreme Court will decide whether a mandatoryarbitration provision in a contract of employment isenforceable in light of the particular wording the of FAA.However, the Supreme Court will not consider what types ofdocuments constitute “contracts of employment.” Thus, ifthe Supreme Court endorses the Ninth Circuit’s expansiveview of the scope of Section One of the FAA, it will remainunclear whether employees will remain free to usearbitration agreements in other types of documents withemployees such as stock option agreements.

2. Disadvantages and Words of Caution

The following are disadvantages and risks associated withdocumenting the employment relationship.

(a) Ambiguity and Implied Terms. Careful drafting ofemployment agreements is required to avoid ambiguity andthe possibility that a court will imply terms that the employerdid not intend. However, oral assurances also may createbinding obligations on an employer either under a contracttheory or through an employee’s reliance on such assurances.See Nelson v. Energy Exch. Corp., 727 F. Supp. 59,62 (D.Mass. 1989) (salesman may sue for commissions promisedbut not paid).

(b) Breach of the Implied Covenant of Good Faith and FairDealing. Employers must be mindful of the claim known as“breach of good faith and fair dealing.” Employers must actin good faith so as not to deprive the employees of “the fruitsof [a] contract.” Fortune v. National Cash Register Co., 373

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Mass. 96, 103 (1977) (bad faith includes terminating acommissioned employee on the brink of sale, deprivation ofthe portion of any commission, and forfeiture of benefitsalmost earned by the rendering of financial services);Gram v. Liberty Mutual Insurance Co., 384 Mass. 659, 672(1981) (breach of good faith and fair dealing whereterminated employee’s “loss of compensation is so clearlyrelated to an employee’s past service.”). Failing to preciselydefine contractual rights and obligations may make anemployer more susceptible to such claims when terminatingemployees.

The implied covenant of good faith and fair dealing isbreached if an employer terminates an at-will employee inbad faith or other than for good cause resulting in theemployee’s loss of identifiable future compensationreflective of past services. See, e.g., Fortune, 373 Mass. at104-05 (employer cannot terminate employee in bad faith todeprive her of earned but not yet payable compensation);Gram, 384 Mass. at 670 (employer cannot terminate anemployee without good cause, i.e., for reasons which are“bad, unjust and unkind” and contrary to the employee’s“reasonable expectations” and, as a result, deprive theemployee of compensation she has earned but not yetreceived).

Bonus programs, commission incentive programs and equitygrants are all susceptible to breach of the implied covenantclaims. The key question posed is when is a bonus,commission or equity grant “earned”? To the extent poordrafting leaves these questions less than clearly answered, anemployer essentially invites a court to fill in the gaps throughapplication of the implied covenant of good faith and fairdealing. Equity vesting illustrates this issue. When anemployee is terminated shortly before a vesting date, anissue can arise as to whether the employee has “earned” or“virtually earned” vesting. Courts have not dealt with thisquestion uniformly. For example, the First Circuit hasreasoned that a vesting schedule “audibly delineates betweenpart and future services” and, accordingly, already vestedstock corresponds with past services. Sergeant v. Tenaska,Inc., 108 F.3d 5, 9 (1st Cir. 1997). However, in Thompsonv. Sundance Publishing, Inc., Mass. Super., C.A. No. 95-02748 (Dec. 15, 1997), the Superior Court found that an

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employee was entitled to one year’s worth of vesting whenhe was terminated approximately three weeks prior to anannual vesting date.

While there is no unifying principle to these cases, severalsteps can be taken to reduce risks of liability. First,compensation provisions that are tied to performance or vestover time should be drafted clearly and precisely. Second,especially with respect to time-based vesting, the closer intime one is to a significant vesting event, the greater the riska court will stretch to find that vesting has been “earned.”

(c) Obligations. Employers should be aware that, in addition tocompensation, contractual provisions of employment maycreate a wide range of obligations that may be best left forthe employer’s discretion as circumstance change over time(e.g., promising an employee certain office location inwriting). A breach may also support an award of damages.Goldhor v. Hampshire College, 25 Mass. App. Ct. 716, 721(1988) (“A reduction in rank may be a breach of contracteven if there is no reduction in pay or benefits”).

B. Termination Provisions

Any employer who invests time and energy crafting an employmentagreement that documents the employment relationship should include provisionsexplaining how, and under what circumstances, the relationship will end.Termination provisions define the respective rights of both the employer and theemployee at the end of the relationship. There are several varieties of terminationprovisions. Employment may be terminable at will. Alternatively, it may beterminable for “cause” (without a severance pay obligation) as defined by state lawor by the parties.

1. Standards

(a) At-will. Under an at-will employment arrangement, anemployee may be discharged, or he or she may choose toresign, for any or no reason, with or without notice. Jacksonv. Action for Boston Community Dev., Inc., 403 Mass. 8, 9(1988). If an employee is employed at-will rather than for aspecific term, “cause” is not required to terminate thatemployee. Of course, even with respect to an at-willarrangement, the employer may not discharge for a reasonprohibited by law (e.g., unlawful discrimination).

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(b) Common Law Cause. If an employee is employed for a termbut “cause” for termination is not defined, the common lawwill supply the definition. That definition varies fromjurisdiction to jurisdiction. For example, Massachusettscourts have crafted a broad and relatively flexible definitionof just cause for termination. Specifically, “cause” meansthat there existed:

(a) a reasonable basis for employerdissatisfaction with an employee,entertained in good faith, for reasonssuch as lack of capacity or diligence,failure to conform to usual standardsof appropriate conduct, or otherculpable or inappropriate behavior, or

(b) grounds for discharge reasonablyrelated, in the employer’s honestjudgment, to the needs of his business.Discharge for a ‘just cause’ is to becontrasted with discharge onunreasonable grounds or arbitrarily,capriciously, or in bad faith.

Goldhor, 25 Mass. Ct. App. at 722; Klein v. President &Fellows of Harvard College, 25 Mass. Ct. App. 204, 208(1987) (adopting the construction of G&M EmploymentServ., Inc. v. Commonwealth, 358 Mass. 430, 435 (1970),appeal dismissed, 402 U.S. 968 (1971)).

Other states define “cause” differently. See, e.g., Crosier v.United Parcel Service, 150 Cal. App. 3d 1132, 1139-1140(1983), disapproved of other grounds by Foley v. InteractiveData Corp. 47 Cal. 3d 654 (1988) (permitting a moresubjective approach under California law if managementlevel employee involved); Hodge v. Evans Fins. Corp., 823F.2d 559, 568-569 (D.C. Cir. 1987) (objectivereasonableness standard even when applied to managerialemployee).

(c) Negotiated Cause. Employers and employees frequentlychoose not to rely on the common law definition of “cause”and instead define “cause” differently in a contract. There

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are virtually unlimited formulations of a contractualdefinition of “cause.” In defining “cause,” however,employers should incorporate the most important aspects ofthe employee’s job and implications of the employee’sfailure to perform. Typical “cause” provisions include: theemployee’s willful misconduct, or insubordination,dishonesty by the employee, the employee’s commission of aserious crime, the employee’s failure to perform his or herduties and responsibilities, or the employee’s material breachof the agreement.

(d) Legitimate Business Reason. As discussed above, absent anagreement with explicit termination of employmentprovisions, an employer must have a legitimate businessreason to discharge an employee who is also minorityshareholder in a close corporation. Although courts have notprovided much guidance as to the difference between thisstandard and common law “cause” discussed above, theMassachusetts Supreme Judicial Court has explained that alegitimate business reason may be found where an employeehas a “disruptive nature of an undesirable individual bent oninjuring or destroying the corporation.” Wilkes, 370 Mass.at 852.

(e) Good Reason. Employment agreements may permitemployees to receive severance pay if they resign for a“good reason.” Sometimes, “good reason” is defined as amaterial reduction in duties or responsibilities. Employersare cautioned to define “good reason” narrowly. Looselydefined provisions could trigger a severance pay obligationduring a period of company expansion or re-shuffling of jobduties.

(f) Notice and Cure. Employment agreements often provideemployees with notice and an opportunity to cureperformance deficiencies that would rise to the level of“cause” discharge. Of course, an opportunity to cure will notbe appropriate in all circumstances, such as breach of anoncompetition agreement or commission of a crime.Additionally, such provisions may be awkward toimplement, as they can require an employer to continue to arelationship solely to reduce severance risks after theemployer has lost confidence in the employee’s ability toperform effectively. On the other hand, notice and cure

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provisions should be included in any “good reasons”termination provision, since the normal bases for goodreason typically are more susceptible to a meaningful cure.

(g) Change of Control. Employees frequently seek the right toreceive severance following a change in control. Employersnegotiating a change in control provisions need to payspecial attention to three critical issues. First, thecircumstances that constitute a “change in control” must beconsidered carefully to avoid inadvertently triggering such aprovision, especially for a company that contemplates goingthrough successive rounds of financing on an IPO. Second,the employer must decide whether severance rights will betriggered upon the occurrence of a change in control, withoutmore (a so-called “single trigger”), or the severance rightswill be triggered by termination of a employer’s employmentunder certain circumstances within a specified periodfollowing a change in control (a so-called “double trigger”).Finally, the employer needs to consider the golden parachuteimplications of change in control severance. (See, Part I,Section V above.)

(h) Right to Resign. Employers may choose to include aprovision whereby an employee may terminate his or heremployment, even in the absence of a “good reason.” Forexample, many agreements provide that an employee mayresign after providing the employer with written notice of 30to 60 days. Employees generally should not be entitled toany severance benefit under these circumstances.Alternatively, employers seeking incentives for employees tostay may not want to give employees a contractual right toterminate their employment (at least without a “goodreason.”) Furthermore, an employee’s termination of his orher employment for a specific term without a contractualright to resign could provide the employer with a damagesclaim for the cost of replacement.

(i) Disability. To prevent any ambiguity on the subject,employment agreements should state that an employee’semployment will terminate in the event that he or she isunable to perform the essential functions of the job with orwithout reasonable accommodation. At the same time, theagreement should also state that the provision cannot beapplied in a manner that would impair the employee’s legal

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rights, including those under the Family and Medical LeaveAct of 1993, 29 U.S.C. § 2601 et seq. and the Americanswith Disabilities Act, 42 U.S.C. § 12101 et seq.

2. Severance Period

If the employment agreement is intended to create employment for a term,negotiating severance terms (i.e., the consequences of terminating an employeewithout cause) in advance may be advisable. There is no legal requirement toprovide severance in an employment agreement, but if an employer chooses to doso, the employer should carefully define the circumstances under which severancemay be awarded and the length of the severance period. Additionally, the employercould choose to offset severance pay by compensation from any new employment,and obligate the employee to notify the former employer of any new employmentor self-employment.

Employers should be aware that many, although not all, severance paypractices can constitute “employee welfare benefits plans” that are subject to theEmployee Retirement Income Security Act of 1974 (“ERISA”). ERISA coverageprovides certain benefits and obligations beyond the scope of these materials.

3. Release

Employers should consider requiring a release of claims from departingemployees as a condition of severance benefit eligibility. Because one cannotrequire the signing of a release as a condition to receiving an already existingobligation, it may be sensible to bargain for such a release at the beginning ofemployment and condition any eventual severance payment on the release.

III. RESTRICTIVE COVENANTS

Restrictive covenants are used to prevent employees and former employees fromharming an employer’s business by generally competing against the business, solicitingclients or customers, or raiding its existing employees. By restricting employees’ ability toengage in certain types of activities, restrictive covenants have a secondary benefit ofincenting employees to remain in the employer’s employ. Such covenants, however, aresubject to legal constraints. Moreover, despite these potential benefits, the decisionwhether to use restrictive covenants, and if so, to what extent, is not an easy one foremployers in this market. Conditioning employment offers on an agreement to be boundby restrictive covenants, especially noncompetition agreements, can hinder an employer’srecruitment efforts. Requiring existing employees to execute agreements containingrestrictive covenants, especially noncompetition agreements, can lead to significantdisruptions in the workplace. For example, an employer needs to decide if it is actuallyprepared to terminate an existing employee who refuses to sign a restrictive covenant.

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Efforts to enforce restrictive covenants can be expensive, time consuming and meet withmixed results. Finally, in seeking to enforce such covenants against former employees,employers should consider how such efforts will affect current employees.

Anecdotal information suggests that employees are becoming more and moreresistant to executing agreements that include comprehensive noncompetition provisions.Agreements protecting an employer from solicitation of its customers or employees byformer employees tend to be more palatable to potential employees.

In deciding when or to what extent to require new or existing employees to executeagreements containing restrictive covenants, an employer must balance its concern withproviding maximum protection to the business and its need to attract and retain qualifiedemployees. The following section describes in more detail the purpose and scope of themore common forms of restrictive covenants.

A. Covenants Not to Compete

In Massachusetts, a covenant not to compete may be enforced to the extentit is necessary for the protection of an employer's legitimate interests, is reasonablylimited in time and space, and is consistent with the public interest. FerrofluidicsCorp. v. Advanced Vacuum Components, Inc., 968 F.2d 1463 (1st Cir. 1992).Massachusetts courts recognize three types of legitimate interests that may beprotected: (i) goodwill, (ii) trade secrets, and (iii) confidential information. E.g.,Marcam Solutions, Inc. v. Sweeney, 1998 Mass. Super. LEXIS 39, *4.

1. Goodwill

Goodwill can encompass “a variety of intangible business attributes,such as the name, location and reputation, which tends to enable thebusiness to retain [its] patronage” as well as “[a]n employer’s positivereputation or position in the eyes of its clients or potential clients,” which“often manifests itself through repeat business with existing clients andthrough referrals to potential clients.” McFarland v. Schneider, 1998 WL136133, *40 (Mass. Super.) (internal citations omitted). In McFarland,Judge McHugh found that an employer can have protectable goodwillexternally (e.g., with respect to its customers and vendors) and internally(e.g., with respect to its employees and partners).

Drafting Tip: Courts have issued possibly contradictory decisions asto whether goodwill "belongs" to the employee or the employer. CompareFirst Eastern Mortgage Corp. v. Gallagher, C.A. No. 94-3727F, slip op.(Mass. Super. 1994) (concluding that the goodwill the employer sought toprotect was of the employee's own making, which he developed withcustomers as a result of his or her own enthusiasm and abilities) with

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Browne of Boston, Inc. v. Levine, 7 Mass. L. Rptr. 685 (Mass. Super. 1997)(holding that "goodwill" belongs to the employer where the employer hadnurtured goodwill toward clients through the actions of the employee, hadprovided the employee with an expense account to entertain clients, and hadhired the employee to use his or her “knowledge, skill and personality” tocultivate the employer’s goodwill). It is advisable to address that potentialarea of confusion expressly in the noncompetition agreement through, forexample, acknowledgments that all goodwill associated with the employer'sbusiness, regardless of whether generated in whole or part through theefforts of the employee, is the exclusive property of the employer.

2. Trade Secrets and Confidential Information

Massachusetts courts also recognize that employers may preventemployees from competing in order to protect the employers frommisappropriation of their trade secrets and confidential information. NewEngland Canteen Serv. v. Ashley, 372 Mass. 671, 674 (1977). Theinformation the employer seeks to protect, however, must be trulyconfidential and/or actually a trade secret. See, e.g., Caley & WhitmoreCorp. v. Woodward, 7 Mass. L. Rptr. 195 (Mass. Super. 1997) (refusing toenforce a noncompete agreement where the information alleged to beconfidential was “something a competitor could obtain simply by placing atelephone call to the prospective customer”). The standards Massachusettscourts apply to determine whether information constitutes a trade secret orconfidential information are discussed more fully in Part II, Section IV,below.

3. Reasonableness of Noncompetition Covenant

Generally, in determining whether a time restriction is reasonable, acourt considers the nature of the plaintiff’s business and the character of theemployment involved, the necessity of the restriction for the protection ofthe employer’s business, and the employee’s right to work and earn alivelihood. Richmond Brothers, Inc. v. Westinghouse Broadcasting Co.,357 Mass. 106, 110 (1970). Although many facts can influence thepermissible length of a noncompetition period, Massachusetts courts haveenforced covenants of two years and longer. See, e.g., Affinity Partners,Inc. v. Dress, 1996 Mass. Super. LEXIS 647, *12-13 (two year limitationreasonable to protect confidential information); Blackwell v. E.M. Helides,Jr., Inc., 368 Mass. 225, 229 (1975) (three year restriction is reasonable);All Stainless, Inc. v. Colby, 364 Mass. 773, 779 (1974) (two year restrictionreasonable).

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With respect to the reasonableness of a “space” restriction, courtsnormally limit the enforcement of a covenant not to compete to thegeographic area previously served by the former employee in the case ofsalespeople. See All Stainless, Inc. v. Colby, 364 Mass. 773 (1974). Suchrestrictions are narrowly tailored to protect the areas in which the employeecan affect the employer’s goodwill. Broader restrictions can be appropriatefor key executives. E.g., Marcam Corp. v. Orchard, 885 F. Supp. 294(D. Mass. 1995).

In lieu of a defined geographic restriction on competition,Massachusetts courts will enforce a customer-based restriction. In this typeof covenant, an employee may agree not to compete with respect to specificcustomers or prospective customers rather than within a specifiedgeographic area. E.g., McFarland, 1998 WL 136133 (enforcing a five yearrestriction prohibiting former partner from soliciting employer's clients).

Whether to use a geographic restriction, a customer-basedrestriction, or both, in a particular noncompetition agreement depends onthe interests an employer seeks to protect, the scope of its operations andthe employee’s role.

Regardless of whether the scope of a covenant is geographical orcustomer-based, it must be reasonable, must have some nexus to theemployer's legitimate protectable interests, and should bear somerelationship to the employee’s activities for the employer.

4. Significant State Differences

Many states have adopted a three-step reasonableness approach topost-employment restrictions like that employed in Massachusetts. Butenforcement of such restrictions is by no means uniform across the 50states. Some of the more significant differences are set out below. Forexample, when drafting an agreement, an employer should be aware of theavailability of judicial modification in a particular state. In some states,courts may not be allowed to narrow and enforce an over broad restriction,but instead, will strike down an over broad restriction in its entirety. As afinal caveat, employers should be aware that the laws of each state evolvecontinuously and may even be interpreted differently by different courts andjudges in each state.

(a) Contractual Provisions Void. California and North Dakota(which models itself on California) are among the mosthostile to noncompetition agreements. Both have enactedstatutes that generally prohibit them. See CALIF. PROF. &

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BUS. CODE § 16600; N.D. CENT. CODE § 9-08-06.Recently, one California court further held that employmentrelated noncompetition agreements are not only void, butalso illegal. Kolani v. Gluska, 64 Cal. App. 4th 402 (1998).Although no court has addressed the issue, the Kolanifinding of illegality could form the basis of a criminalviolation. See Cal. Labor Code §§ 432.5, 433 (requiring anapplicant for employment to sign a contract containing aprovision prohibited by law is a misdemeanor).

(b) Geographic Scope. Several states, such as Georgia,Louisiana, Virginia and Wisconsin impose stringentrequirements on the geographic scope of a noncompetitionagreement and will not equitably modify an over broadcovenant. For example, in Georgia, geographic limitationsmust be clearly defined, generally with reference to specificcities, counties or a number of miles radius, and be limited tothose areas where the employee actually rendered services onbehalf of the employer. Daruger v. Hedges, 471 S.E.2d 33(Ga. Ct. App. 1996).

(c) Ancillarity Requirement. Certain states require that anenforceable noncompetition agreement be ancillary to anenforceable employment contract. That is, these states maynot enforce such agreement against an employee at-will. InTexas, which adopts a strict approach, this requirement isonly satisfied if (1) the enforceable employment contract hasconsideration based on the employer’s protectable interestand (2) the covenant itself relates directly to the protectableinterest. Light v. Centel Cellular Co., 883 S.W.2d 642 (Tex.1994). While Rhode Island and Pennsylvania each have asimilar ancillary requirement, the parameters of theserequirements are not clear and do not appear to be as strict attheir Texas counterpart. See Thermo-Guard, Inc. v.Cochran, 596 A.2d 188 (Pa. Super. Ct. 1991) (covenant mustbe “incidental to the employment relationship”).

(d) Equitable Modification. Courts in a number of states, suchas New York, Arizona, Alaska, Colorado, Delaware, Florida,Idaho, Illinois, Iowa, Kansas, Kentucky, Maine,Massachusetts, Michigan, Minnesota, Missouri, Nevada,New Hampshire, New Jersey, Ohio, Oklahoma, Oregon,Pennsylvania, Tennessee, Texas, Washington, WestVirginia, Wyoming, will equitably modify (i.e., rewrite)

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otherwise over broad restrictive covenants, so as to renderthem “reasonable” within the meaning of applicable law.See, e.g., BDO Seidman v. Hirschberg, 712 N.E.2d 1220(N.Y. 1990); Key Temporary Personnel, Inc. v. Lox, 884P.2d 1213 (Ok. Civ. App. 1984); Superior Gearbox Co. v.Edwards, 869 S.W. 2d 239 (Mo. Ct. App. 1993) (partialenforcement to extent of protectable interest). Courts thencan enforce such covenants as modified.

In other jurisdictions, such as Indiana, Louisiana,North Carolina and Rhode Island, courts will not modifyover broad covenants, but only will “blue pencil” (i.e.,delete) offending provisions. Enforcement is then onlyavailable if the remaining language is sufficiently clear toform reasonable restraints.

Courts in a small number of states, such as Arkansas,Georgia, Nebraska, Vermont, Virginia, and Wisconsin,refuse to modify over broad covenants in any manner andinstead strike them down in their entirety. See, e.g., Rector-Phillips-Morse, Inc. v. Vroman, 489 S.W.2d 1 (Ark. 1975);Professional Business Services, Inc. v. Resno, 589 N.W.2d862 (Neb. 1999). Only Georgia and Virginia havedefinitively stated that the remaining separate provisions willbe enforced, thus it is possible that the entire agreement maybe unenforceable in the remaining states.

Courts in several states, Connecticut, Hawaii,Maryland, New Mexico, and the District of Columbia havenot clearly addressed which approach they would use.

5. Forfeiture for Competition

Employers may enhance the limited protections afforded employersfrom a former employee’s subsequent competition by including a forfeitureprovision in an agreement governing the terms of employment.

(a) Forfeiture Provisions. Forfeiture provisions require anemployee to forfeit a bonus, benefit or other form of earnedcompensation if that employee chooses to violate his or hernoncompetition obligations after the termination ofemployment.

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(b) Enforceability. In Massachusetts, as with other agreementsrestricting post-employment activities of former employees,the enforceability of a forfeiture provision depends on thefacts of each case. And, as with other agreements, anyprovision must meet the multi-factor test set out in SectionIII.A.3 above. See Struck v. Plymouth Mortgage Co., 414Mass. 118, 121-22 (1993) (employer entitled to withholdcertain commissions as provided for in compensationagreement because former employee went to work for acompetitor); Cheney v. Automatic Sprinkler Corp. Of Am.,377 Mass. 141, 150 (1977) (provisions will be enforced “tothe extent that the restraint is reasonable in time and placeand necessary to protect the former employer’s trade secrets,confidential information or goodwill.”). Additionally, atleast one court has explicitly recognized that a “restrictiveclause may be more reasonable in the case of a keyemployee” because a key employee has sufficient bargainingpower vis-a-vis his or her employer to “enlarge judicialtolerance of restraints”. Kroeger v. Stop & Shop Companies,Inc., 13 Mass. App. Ct. 310, 318-19 (1982), review denied,386 Mass. 1102 (1982).

Courts across the country are no more uniform intheir approach to the enforcement of forfeiture provisionsthan they are with other provisions affecting employees’post-employment activities. Some courts have adopted amulti factor approach like that of Massachusetts’, see FoodFair Stores, Inc. v. Greeley, 264 Md. 105, 116-19 (1972);Lavey v. Edwards, 264 Or. 331 (1971); Snarr v. PickerCorp., 29 Ohio App.3d 254 (1985) while others distinguishforfeiture clauses from noncompetition arrangements and donot perform this analysis. See Rochester Corp. v. Rochester,450 F.2d 118 (4th Cir.) (applying Virginia law); Van Pelt v.Berefco, 60 Ill. App.2d 415 (1965) (profit sharing plans aremere gratuities upon which an employer may placeconditions).

(c) Choice of Law. As the above discussion illustrates, therecan be significant differences in different states’ approachesto noncompetition agreements. It is therefore worthwhile foran employer to analyze the states with which it has asignificant relationship and from whose protections it wouldmost benefit. The employer should therefore include aprovision providing that that state’s law will govern the

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interpretation and enforcement of the employmentagreements in any agreement documenting the employmentrelationship.

Most states enforcing choice of law provisions haveadopted the Restatement (Second) Conflict of Laws § 187(2)approach under which a choice of law provision wouldgenerally be enforced unless the chosen state (1) has nosubstantial relationship to the parties or the transaction andthere is no other reasonable basis for the parties’ choice, or(2) application of the chosen law would violate fundamentalpublic policy of a state with a materially greater interest inthe action than the chosen state and that state would haveapplied the applicable law if there had been no choice of lawprovision. See Restatement (Second) of Conflicts § 187(2);Ferrofluidics Corp. v. Advance of Vacuum Components,Inc., 968 F.2d 1463, 1467 (1st Cir. 1992) (incorporation inMassachusetts is a substantial relationship); Valley JuiceLtd. v. Evan. Waters, 87 F.3d 604 (2nd Cir. 1986).

B. Nonsolicitation of Customers

A nonsolicitation provision prohibits a former employee from soliciting anyof his or her former employer’s customers for the benefit of someone else and fromencouraging customers to decrease or diminish their existing relationships with theformer employer. A nonsolicitation of customers provision is just another form ofnoncompetition provision. See McFarland v. Schneider, 1998 WL 136133, *40(Mass. Super.) (internal citations omitted). Therefore, it will be enforceable only tothe extent it is reasonable. In several cases, moreover, courts have refused to drawa distinction between impermissible solicitation initiated by the former employeeand that initiated for a customer. See Alexander & Alexander, Inc. v. Danahy, 21Mass. App. Ct. 488, 499 (1986); McFarland, 1998 WL 136133, at *38.

Drafting Tip: The term "solicitation" is open to interpretation and possiblemanipulation. For example, is it "solicitation" if the former employee merelyinforms the employer's customers of her new business affiliation and thosecustomers, on their own initiative, switch their business to follow him or her?What if the former employee informs his or her customers she cannot "solicit"them, but they are free to call on him or her? The best way to avoid these issues (asnot all courts will follow the McFarland approach) is to not be limited byambiguous terms such as "solicit" and, instead to state expressly, for example, thatthe former employee cannot solicit or accept business from the employer'scustomers, and cannot induce such customers to reduce their business with theemployer.

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C. Nonsolicitation of Employees (a/k/a Anti-Raiding)

A nonsolicitation of employees provision prevents a former employee fromcherry picking, or raiding, the employers’ employees after his or her employmentends. As with other post-employment restrictions, courts lack uniformity in theirapproach to anti-raiding provisions. Some states have likened covenants not tosolicit employees to covenants not to compete for customers. In these cases, thecourts note the value businesses place both on well-trained and experiencedemployees and also on valuable, long-term customers. The courts reason that bothare a significant asset for any company. Still other courts enforce the provisions aswritten using basic contract principles without reference to the multi-factor analysisperformed on noncompetition provisions.

Massachusetts courts routinely enforce nonsolicitation of employeesprovisions which protect an employer’s legitimate interests. Modis, Inc. v. TheRevolution Group, Ltd., 1999 WL 144918 (Mass. Super. 1999) (enforcing a two-year anti-raiding provision); see also Cambridge Technology Partners v. Sims,Civil Action No. 00-1687 (Mass. Super. August 15, 2000); State StreetCorporation. v. Barr, Civil Action No. 99-4291 F (Mass. Super. October 22, 1999).While Massachusetts has not formally decided which approach its courts must take,recent case law indicates that courts will enforce anti-raiding provisions as a matterof contract. Compare Cambridge Technology Partners, supra; (analyzingdefendants’ violation of contract); State Street Corporation, supra (same) withModis, Inc., supra (performing multi-factor restrictive analysis on anti-raidingprovision).

Alternatively, various state courts have firmly held that covenants not tosolicit employees are subject to the same restrictions and requirements as covenantsnot to compete. That is, they must be reasonable in duration, scope, andgeographical area. See, e.g., ALW Marketing Corp. v. McKinney, 205 Ga. App.184, 421 S.E.2d 565 (1992) (holding a nonsolicitation clause unenforceablebecause it was without a time limitation); Club Properties, Inc. v. Atlanta Offices-Perimeter, Inc., 180 Ga. App. 352, 348 S.E.2d 919 (1986) (holding a no-raidingagreement unenforceable because no time limit was specified in agreement).

Drafting Tip: To the extent that judges can be persuaded that employershave a protectable goodwill interest with respect to their employees, it is morelikely that such covenants would be enforced. Consider expressly providing that ananti-raiding provision is intended to protect the employer’s goodwill with respect toits employees.

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IV. PROTECTION OF CONFIDENTIAL INFORMATIONAND TRADE SECRETS

Less controversial than restrictive covenants, but perhaps more importantultimately to a business’ long-term success, are provisions designed to safeguard anemployer’s confidential information and trade secrets from unintended use or disclosure.Trade secrets and confidential information generally are entitled to protection only so longas an employer undertakes reasonable efforts to protect such information from use ordisclosure. Further, such information generally is of value to the employer only to theextent that it in fact is kept confidential. While, as discussed below, the common lawand/or statutes in virtually all states protect trade secret information to a certain extent,contractual agreements protecting an employer’s confidential information can be quiteimportant.

A. Common Law and Statutory Protections

Trade secrets are subject to statutory and/or common law protection under the lawof most states. Massachusetts law provides that statutory and common-law protection.

Mass. Gen. L. ch. 266, §30(4) defines “trade secret” to include:

. . . anything tangible or intangible or electronically kept or stored,which constitutes, represents, evidences or records a secretscientific, technical, merchandising, production or managementinformation, design, process, procedure, formula, invention orimprovement.

Mass. Gen. L. ch. 93, §42 provides a statutory cause of action for misappropriation oftrade secrets:

Whoever embezzles, steals, or unlawfully takes, carries away,conceals, or copies, or by fraud or by deception obtains, from anyperson or corporation with intent to convert to his own use, anytrade secret, regardless of value, shall be liable in tort to suchperson or corporation for all damages resulting therefrom.

The Massachusetts courts have defined a common law “trade secret” to include:

Any formula, pattern, device or compilation of information which is used inone’s business, and which gives [one] an opportunity to obtain an advantageover competitors who do not know or use it. It may be a formula for achemical compound, a process of manufacturing, treating or preservingmaterials, a pattern for a machine or other device, or a list of customers . . . .

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A trade secret is a process or device for continuous use in the operation of thebusiness.

J.T. Healey & Son, Inc. v. James A. Murphy & Son, Inc., 357 Mass. 728, 736(1970) (quoting Restatement (First) of Torts § 757 Comment (b) (1939)). Six factorsgenerally are considered in determining whether or not something constitutes a tradesecret:

(1) The extent to which the information is known outside of the business;

(2) The extent to which it is known by employees and others involved inthe business;

(3) The extent of measures taken by the employer to guard the secrecy ofthe information;

(4) The value of the information to the employer and its competitors;

(5) The amount of effort or money expended by the employer indeveloping the information; and

(6) The ease or difficulty with which the information could be properlyacquired or duplicated by others.

Warner-Lambert Co. v. Execuquest Corp., 427 Mass. 46, 49 n.5 (1998).

Massachusetts courts have found that protectable trade secrets includeengineering information and blueprints, computer software, recipes and patents.However, the courts will not prohibit an employee upon the termination of his or heremployment from carrying away and using the general skills or knowledge acquiredduring the course of employment. Shipley Co. v. Clark, 728 F. Supp. 818 (D. Mass.1990) (court denies preliminary injunction barring former sales agent from disclosingtrade secrets, where the agent’s expertise resulted from his or her pre-existingexperience in the industry and was not a result of any exposure to the company’s tradesecrets).

Almost every state (except New Jersey) provides statutory protection of tradesecrets. Several states, including California, Colorado, Connecticut, Georgia,Nebraska and New Hampshire have adopted the Uniform Trade Secrets Act (“USTA”)which employs a two-part definition of a trade secret somewhat broader than thatemployed in Massachusetts. Under the USTA formulation, information is a tradesecret if it:

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(1) derives economic value, actual or potential, fromnot being generally known to the public or to otherpersons who can obtain economic value from itsdisclosure and use; and

(2) is the subject of efforts that are reasonable under thecircumstances to maintain its secrecy.

See, e.g., West’s Ann. Cal. Civ. Code § 3426.1 (California’s version of theUSTA). Most states (including New Jersey) provide common law protection of anemployer’s confidential information. Their definitions, however, vary.

B. Confidentiality Agreements

It is nevertheless risky for an employer to rely exclusively on common law andstatutory protections. The statutory and common law definition may not be sufficiently broadto cover all the information an employer would like to protect. Further, because the definitionis generalized and imprecise, proving that a particular type of information is a trade secretmay be a difficult burden. The inquiry is largely fact based and the outcome is unpredictable.

An employer with valuable information should ensure that its employees have signedsome form of contract, whether it be an employment agreement, confidentiality agreement orother agreement limiting post-employment activities, that includes a confidentiality clause.Such a clause expressly places employees on notice of their obligations, identifies the types ofinformation the employer treats as confidential, and demonstrates that the employer in fact istaking appropriate steps to protect its confidential information and trade secrets. The list oftypes of information that are identified as confidential should be tailored to an employer’sspecific business. That specification can make a difference if it appears reasonable. While anemployer’s designation in an employment agreement is not controlling, a carefully craftedclause is generally used by the courts as a factor in determining the existence of protectabletrade secrets or confidential information. However, a boilerplate clause that identifiesvirtually everything as “confidential,” without any apparent relationship to the employer’sbusiness, will be given little weight and may cause a court to react with skepticism for theemployer’s claims.

V. ASSIGNMENT OF INVENTION RIGHTS

Copyright law provides protection to employers with respect to copyrightable materialcreated by an employee in the course of employment. See, 17 U.S.C. § 201. Such works forhire belong to the employer. Aside from specific rights provided to employers throughcopyright law, employers have few if any rights with respect to inventions created byemployees, regardless of how closely related to the employer’s business such inventions maybe. Accordingly, it is advisable for an employer to contractually obtain, to the fullest extentpermitted by law, an assignment by employees of rights to inventions. Such agreements are

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especially important with respect to employees who are employed in a creative or productivecapacity.

A. Common Law Rights

1. Implied Assignment -- Hired to Invent

Where the employee is hired to invent, or aid in the invention of, aparticular product or products, those products belong to the employer. SeeVigitron, Inc. v. Ferguson, 419 A.2d 1115, 1117-18 (N.H. 1980); IngersollRand Co. v. Ciavatta, 542 A.2d 879, 886 (N.J. 1988); Davis, 369 S.W.2dat 802; Steranko, 5 Mass. App. Ct. 269 (1977). But, where the employee’swork resulted in enhancing his or her skills and knowledge, the employee’s useof those skills and knowledge to invent a product does not necessarily give theemployer the right to the product, even where it was created duringemployment. See Vigitron, 419 A.2d at 1118.

2. Implied Assignment -- Fiduciary Duties

Some states, such as Colorado, may impose a duty on certainemployees to assign inventions through application of fiduciary dutyprinciples. See, e.g., Lacy v. Rotating Production Systems, 961 P.2d 1144,1445-46 (Colo. App. 1998) (employee with a fiduciary duty to his or heremployer by virtue of his or her position (i.e., a corporate officer but anemployee who is not an officer, however, has no such fiduciary duty); Davis v.Alwac International, Inc., 369 S.W.2d 797, 802 (Tex. App. 1963) (Fiduciaryobligation imposed on individual acting as officer and director of corporationto assign inventions developed while occupying position and which relate tocorporation’s occupation).

3. Shop Rights

In some states, such as New Jersey and Nebraska, where the employeeis not hired specifically to design or invent, but nevertheless conceives of adevice during working hours with the use of the employer’s materials andequipment, the employer at least is granted an irrevocable but non-exclusiveright to use the invention under the “shop right rule.” Ingersoll Rand, 542A.2d at 886; see also Hutton v. City of Omaha, 198 N.W. 146, 147 (Neb.1924) (recognizing irrevocable license on part of employer to use employee’sinvention). A shop right is the employer’s royalty or fee, a non-exclusive andnon-transferable license to use an employee’s patented invention. Id.

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B. Assignment Agreements

An employee may assign rights to inventions created while employed throughan express agreement. E.g., George C. Miller Co. v. Beagen, 293 Mass. 54, 59 (1935).Given the limited common law rights an employer has to most inventions and thetypes of property rights that could be implicated by all or portions of an invention(e.g., patent rights, trade secret rights, trademark rights), it is important for anemployer to describe precisely the scope of the assignment and impose upon theemployee affirmative obligations to assist the employer in taking such steps asreasonably may be necessary to secure the rights as against third parties.

1. Limits on Agreements

A number of states prohibit certain employee assignments by limitingthe scope of any employment agreement. Generally, in these states, employersmay not enter agreements which purport to assign to the employer anyinvention created (a) on the employee’s own time and without the use of theemployer’s property, or (b) which do not relate to the employer’s business, orresult from the employee’s work for the employer. See West’s Cal. LaborCode § 2870, TLCS 765, 10601/2; K.S.A. § 44-130; M.S.A § 181.78;N.C.G.S.A. § 66-57.1; Wash. RCN 49.44.10; DE Code Ann. § 805.

2. Disclosure of Limits

Several states, including California, Illinois, Minnesota, and Kansas,require that employers specifically disclose the limits of any assignment ofinventions clause to their employees. See West’s Ann. Cal. Labor Code§§ 2870, 2872; Ill. Rev. Stat. § 30213; Minn. Ann. Stat. § 181.78; Wash. RCN49.44.13013. Employers should include language referencing these statutes, asapplicable, which explains the limits discussed above in Part II, Section V.B.1,in any agreement that will be interpreted under the laws of these states.

VI. RECENT LEGAL CHANGES WITH RESPECT TO EMPLOYMENT-RELATED VISAS

On October 17, 2000, President Clinton signed into law two bills with relevance toemployers who employ non-immigrant aliens. The following provisions briefly summarizesome of the more salient points of the recently enacted and pending legislation:

C S.2045 -- The American Competitiveness in the 21st Century Act:

C Increases the cap on H-1B visas for each of fiscal years 2001, 2002 and2003 to 195,000 per year.

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C Backlogged petitions pending prior to September 1, 2000 will beprocessed under the fiscal year 2000 cap, which essentially has been liftedfor purposes of processing the backlog.

C An employee currently possessing an H-1B status may accept employmentwith a new employer upon the filing of a new H-1B petition by the newemployer rather than needing to wait until the approval of the newemployer H-1B petition. Note, however, that while a non-immigrant alienmay transfer jobs upon filing of an H-1B application by his or her newemployer, that employer presumably must have obtained a LaborCondition Application (“LCA”) through the Department of Labor.

C The Act also increases the possibility of job mobility for aliens on H-1Bstatus who have applied for permanent residence. (i.e., so-called “greencard” status). If an application of permanent residence has been pendingfor 180 days, such an individual may change employers if the new job isin the same or a similar occupational classification as that job for whichthe permanent residence petition originally was filed.

C For non-immigrant aliens who are waiting approval of green card statusand are facing expiration of the six year H-1B visa period, two provisionsmay provide significant protection. First, non-immigrant aliens whose H-1B status is about to expire, have properly applied for permanent statusbut are subject to country-based employment quotas, may have their H-1Bstatus extended on a year-to-year basis until their petitions are adjudicated.Second, any non-immigrant alien whose permanent residence case hasbeen pending for 365 days or more, H-1B status extended if: 1) theindividual’s labor certification has been approved and his/her preferencepetition is still pending, or 2) if no labor certification is required, thepreference petition has been pending for one year.

C Increased Filing Fees for H-1B Visa - H.R. 5362

C Effective December 17, 2000, the portion of the H-1B filing fee, whichmust be paid by the employer, is increased from $500 to $1,000 per H-1Bpetition. The portion of the filing fee generally paid by employers, butmay be paid by beneficiary remains $110.00.

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