Take Care When Drafting Executive Employment Agreements

Before firing an executive for cause, it's important to have drafted the executive employment agreement carefully and to interpret that agreement reasonably, a recent Massachusetts Supreme Judicial Court ruling demonstrates.

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Background

Eric Balles was an executive and shareholder of Babcock Power Inc. The stockholders' agreement entitled the company to repurchase Balles' shares for a nominal amount if his employment ended for cause. The agreement defined "cause" as including fraud or gross insubordination, or willful and material breach of duties and responsibilities to the company that remain uncorrected within 30 days after notice. Balles also executed an employment agreement, entitling him to severance pay unless he was terminated for cause (referencing the definition in the stockholders' agreement).

In 2010, the company's chief executive officer learned that Balles had been having an extramarital affair with a female subordinate. The company's investigation confirmed that Balles and his subordinate had engaged in a sexual relationship for two years. The company also discovered on Balles' computer inappropriate photographs of and text messages with the subordinate, including some of a sexual nature.

Balles had also criticized Babcock and his superiors in text messages to the woman and falsified a travel reimbursement request to conceal the affair (although the trial judge found that this did not result in Balles receiving any undue reimbursement).

During the investigation, Balles was not allowed to meet with the company's board of directors or submit information to the board. Babcock also did not provide Balles with an opportunity to cure (i.e., remedy) his conduct. The board voted to fire Balles for cause, resulting in the forfeiture of his severance and the repurchase of all of Balles' shares in the company for a nominal amount, which meant Balles missed out on dividends worth over $1 million.

Balles then sued Babcock, seeking to recover severance pay, invalidate Babcock's share repurchase and recoup the dividend payments. Babcock countersued Balles, alleging that he breached his fiduciary duties to the company, among other claims.

Decision and Key Takeaways

After a jury trial on most of Babcock's counterclaims, which found for Balles, the trial judge concluded that the evidence did not support firing Balles for cause under the stockholders' agreement and ordered the return of his stock and payment of dividends. However, the judge found that Balles had breached his fiduciary duties to Babcock, ordered Balles to forfeit $412,000 in past salary and rejected his claim for severance pay on the basis that his conduct constituted a breach of his employment agreement. Only Babcock appealed. On appeal, the Massachusetts Supreme Judicial Court (SJC) affirmed the trial court's ruling.

The devil is in the drafting details. Babcock argued that the court should give deference to the board's decision and uphold it unless it was arbitrary and capricious (rather than reviewing all the facts anew and substituting its own judgment) because the stockholders' agreement provided that "a determination of 'cause' may only be made by the board of directors of the company." Assuming, without deciding, that parties can negotiate a particular standard of review, the SJC agreed with the trial court that this language was not ambiguous and the parties here did not intend for the board's decisions to be entitled to deference in court. Therefore, employers that seek the preferential "arbitrary and capricious" standard of review of their decisions in court (under which a decision will be more readily upheld) should include explicit language to that effect in their agreements.

The court also held that there was no error in the trial judge's determination that Balles' conduct did not rise to the level of "fraud" under the common law definition, which requires both fraudulent intent and harm and which were found to be lacking here. The SJC also agreed that Balles did not engage in "gross insubordination" because he did not disregard a direct order, rejecting Babcock's argument that Balles met that standard by violating company policies.

The ruling provides a caution for employers: They should refrain from strained interpretation of contracts to support a desired result. Including a more deferential review standard or a broader definition of cause may help protect the employers against claims by executives for breach of contract. However, such definitions are often negotiated, and employers will need to balance their desire for flexibility against the executive's desire for protection against termination.

Cure does not mean undoing the breach. As is common, one of the categories of "cause" in the stockholders' agreement—a breach of duties owed to Babcock—first required giving Balles notice and an opportunity to "cure," which means to correct, his conduct. The trial judge agreed that Balles had materially breached his duties to Babcock but that Babcock still could not rely on this clause of the cause definition because the board did not give Balles an opportunity to correct his breach.

The SJC agreed with the trial judge and rejected Babcock's argument that it was excused from the cure requirement because Balles' breach was uncorrectable. In the court's view, the effects of Balles' breach could be corrected by monetary damages (which Balles had offered and which Babcock recovered in the case) and by his termination (which did not need to be for cause). The court was unconvinced by Babcock's argument that its risk of being sued for sexual harassment was not curable, noting that such a claim had never materialized and in any event this risk, like other business risks, could be reallocated to Balles by an indemnity agreement.

Courts will try to avoid harsh results, when possible. Underpinning the result in this case is a sense that the courts were seeking to avoid a potentially unfair and harsh result for Balles, who had provided years of valuable service to Babcock. Employers considering terminating an employee for cause should not only adopt a reasoned interpretation of the contract but also consider what process is contractually due to the executive before proceeding.

The case is Balles v. Babcock Power Inc., 476 Mass. 565 (2017).

Stéphanie Smith is an employment attorney with Casner & Edwards in Boston.

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