"Bad Boy" and "claw back" restrictive covenants in executive compensation and ERISA severance plans can be an important component of an employer's overall protection of its business from unfair competition.

Restrictive covenants, such as non-competition agreements, are prohibited or disfavored under the law of many states. Employers who wish to limit competition by employees or former employees may, however, be able to circumvent these state laws by adopting an ERISA-governed plan that incorporates a so-called "bad boy" clause, or certain state law-governed plans that offer employees a choice between competing and accepting the compensation offered under the plan.

"Bad boy" clauses are contract provisions that apply to prevent current or former employees from obtaining compensation if, for example, they solicit employees or misappropriate confidential information. A corresponding "claw back" provision enables the employer to recover compensation already paid to the current or former employee.

ERISA covered plans

Whether benefits may be subject to forfeiture and claw back depend on whether the forfeiture relates to a so-called "qualified plan." Vested benefits in a qualified plan — such as, for example, a 401(k) plan or a defined benefit pension plan — cannot be forfeited due to the employee's competition.

Top-hat plans

Conversely, top-hat plans are "unfunded," non-qualified ERISA plans used primarily to provide deferred compensation to a select group of management or highly compensated employees. They are not subject to ERISA's vesting requirements. Consequently, a top-hat plan participant who violates a bad boy provision can forfeit even plan benefits described as "vested," so long as the plan allows a forfeiture in that situation. ERISA governs suits to recover top-hat plan benefits, and preempts state law — including state law that prohibits or disfavors restrictive covenants and non-competition agreements.

Participants who are denied benefits because they violated a bad boy clause will usually have to exhaust the plan's administrative remedies and seek a determination by the plan administrator — most often, the employer or a committee appointed by the employer — before going to court to challenge the restrictions.

If the plan is properly drafted, the courts should give considerable deference to the plan administrator's decision.

Severance pay plans

Properly drafted and administered, severance pay plans may qualify as ERISA-governed employee welfare benefit plans. The advantage to the employer of the severance plan being treated as a welfare benefit plan is that, generally, benefits under a welfare benefit plan do not "vest," and the plan sponsor can reserve the right to terminate and/or amend the plan. Therefore, the employer can change the terms of severance plan before the event that would trigger entitlement to the benefits — such as the termination from employment. And, the severance plan may include a bad boy clause that is conditioned on honoring the restrictive covenants.

Employers should consult with counsel when considering adopting an ERISA-governed severance pay plans. Among other things, the plan should provide:

  • A specific class of potential beneficiaries to be covered by the severance plan;
  • Specific conditions for payment of benefits (for example, a layoff of employees in a situation such as a plant closure, or reduction in force);
  • Discretionary authority on the part of the plan administrator to determine eligibility for benefits under the terms of the plan, and;
  • Specific continuing benefits consisting of more than a lump sum payment (for example, payment of one-quarter of the severance benefits upon termination, and the balance over a two year period).

Plans Governed by State Law

ERISA does not apply to many types of executive compensation programs, such as stock option and restricted stock plans, because most such plans fall outside of the definitions of ERISA-covered retirement and welfare benefit plans. However, even in those plans, restrictions on competition generally enjoy broader enforceability than other restrictive covenants under most states' law because they are often viewed as falling under the "employee choice" doctrine. That is, the employee has a choice — compete or accept the benefit. As one court explained, there is a distinction between provisions that prevent employees from working for a competitor, and provisions that allow benefits to be forfeited if they do so. In other words, withholding the carrot (the compensation) may be appropriate, but attempting to apply the stick (an order preventing post-termination competition) may not be.

Conclusion

Depending on the state law that governs, noncompetition agreements and other restrictive covenants in the employment setting can be difficult, if not impossible, to enforce. ERISA-governed plans, and certain plans governed by state law that offer employees a clear choice between competing (and foregoing compensation) and accepting compensation without competing, can be a more effective and enforceable alternative.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.