There are times in the life of many companies when it is clear that the President (also sometimes known as Chief Executive Officer or CEO) must be terminated. Quite often the CEO is also a Director of a company and may even be a shareholder. At times the CEO has a written employment contract. All these factors must be taken into account before termination is attempted by the Board of Directors or Stockholders. To attempt to terminate an officer without careful analysis of what rights and duties apply to the situation both based on corporate structure and contract, is to court dispute and destructive turmoil within a company.
All too often this office is brought into the picture only after a termination letter is already delivered to a CEO who, outraged and vengeful, immediately seeks legal counsel whose task it is to determine if the corporation violated some corporate rule or contractual protection in terminating the CEO. If so, one can expect either expensive litigation or the possibility that the “terminated” employee may have to be retained in the previous position. At the least, such an error will result in the need to offer an expensive severance package to avoid the litigation.
Why do fights over employment happen so often? The typical scenario revolves around the fact that most officers are also shareholders, often owning a less than majority interest in the company. In California there is no obligation of a nonpublic corporation to pay dividends or sell itself minus majority vote of the stockholders and Board of Directors. Thus, one obtains value from the company normally by being employed and receiving a salary and bonuses. If one is not employed, one may own stock, but one’s stock will only generate wealth if dividends are declared or the company is sold. It is not atypical for a 40% shareholder to be fired by the majority shareholder and continue to hold stock that is, essentially, of no value. To maintain your position as an employed officer may be the most critical economic aspect of ownership in a company and if you own less than 50% of the stock, you may face a definite danger of having your ownership reduced to nil value.
Thus the termination of a CEO is a task fraught with significance not only for the corporation, but for the CEO which can make a tremendous economic difference in the value of the investment and can make decades of service to a company suddenly have no economic value whatsoever. And thus attorneys are quite often necessary to effectuate the appropriate termination since the results of an error can be a struggle for supremacy and access to power within the company lasting for years.
One experienced business woman who had been through a particularly brutal termination struggle commented wryly when all was said and done that it pained her that an extra hour of discussion with legal counsel and ten minutes of an emergency board meeting could have avoided nineteen months of litigation and one hundred thousand dollars of attorneys fees and costs. She was correct and the lesson to be drawn is that termination of employment of a key employee requires as much preparation as the initial selection of the individual as a CEO. To simply act in haste or without advice of legal counsel is to risk structural problems and expense.
This article shall briefly recite the key areas of concern that any company should factor into their plans before electing to terminate a CEO and outline the usual steps that are appropriate to terminate the CEO of a California corporation. This is an outline, a road map of the tasks a Corporation must consider and accomplish before taking action. It is vital to also strategize implementation of these steps with experienced legal counsel and perhaps tax professionals.
THE BASICS OF TERMINATION
Aside from the statutory protection afforded any employee that the State and Federal government provides (protection against discrimination based on race, religion, sex, age, etc,) which are subjects of other articles, there are two primary areas of protection afforded a CEO before he or she can be terminated. The first is that found in the power structure within a California nonpublic corporation, e.g., who has the right to decide to terminate a CEO and how. The second is any contractual protection that in addition the CEO may have. We shall consider both areas of protection in order.
THE POWER STRUCTURE OF A CALIFORNIA CORPORATION: WHAT STRUCTURAL ARMOR DOES THE CEO HAVE?
1. STRUCTURAL PROTECTIONS:
A good place to start is recalling the essential power structure within a California corporation and the reader should review the web article Corporate Struggles. Who Has What Power When Push Comes to Shove? For a summary of the basic power of stockholders, directors and officers within a corporation. For the rest of this article, it shall be assumed that the reader has read that article.
Essentially, stockholders elect by majority vote the board of directors. The board of directors elects the officers. Stockholders can remove directors by appropriate voting due to malfeance of the directors or expiration of their terms, but it is the directors who can remove an officer, subject to the possible restrictions of contractual protection of the officer discussed below. While the Bylaws of a corporation may afford additional protection to the officers, in almost all cases the Bylaws provide that the officers serve at the pleasure of the Board of Directors. Your first task: check the Bylaws. Assuming the Bylaws are typical, then the Directors are the persons who may vote, by majority vote, to remove an officer.
The Directors, in turn, are elected by the shareholders. While the rules of Cumulative Voting can be quite complex, the simple rule is that the shareholder or shareholders who control 51% of the vote can elect a majority of the Board and a majority of the Board may terminate an officer.
Quite often the CEO is also a shareholder and director of the company. In that case, he or she has a right as a stockholder to vote his or her shares to elect directors and also a right, as a director, to vote on whether he or she is terminated. (There could be an argument advanced that the CEO should recluse him or herself from voting as a director as to whether he or she should be terminated but the simple fact is that unless there is a majority of directors voting to remove a CEO, he or she is not going to be terminated so normally that issue is moot.)
While shareholders can elect directors, normally annually, they can not remove an officer. Only the Directors can. Thus, if you are a shareholder wishing that an officer is removed, even if you have majority stockholdings, until you control directly or by persuasion a majority of the board of directors, you will not be able to remove the officer. It is thus quite common for the removal of an officer to require a two step process: First, one must gain control of the Board of Directors and only then can the Board be called to remove the officer.
It must be noted that the process can thus require a year or even longer. First, one must wait until it is time to elect a new Board of Directors, who normally serves a one year terms. Unless there is good cause for removal, the dissatisfied shareholder, even if owning a majority of the stock, may have to await the next meeting. Even then, once the new Board is elected they may have to call a special meeting to consider termination of the officer.
And during this period of time the CEO is of course aware of much of what is going on if he or she is a director or shareholder since he or she would have been given notice of all such meetings and would have a right to vote. The typical corporate struggle occurs during the period of time that the officer realizes a fight is happening and maneuvers occur to delay or prevent a new election of a Board of Directors or to influence their vote. The effect on the ongoing business, of course, can be disastrous.
The officer and the directors have a fiduciary duty to the corporation. Theoretically, this requires them to act in the best interests of the corporation even during the struggle. It is not uncommon, however, for an officer knowing that eventually he or she will be ousted, to begin preparations to commence a competing business including seeking to alienate existing clients or employees of the corporation. This action can theoretically lead to personal liability against that officer but is often hard to prove. Assuming it can be proved, it would be grounds for immediate termination-IF the Board so votes. Such a breach would even obviate the contractual protections that an officer would have, as discussed below.
It is apparent that appropriate timing of the move to have the Board vote to terminate the officer is therefore a vital aspect of the termination process. Ideally, informal discussions of the issue will have occurred with enough Board members to assure the appropriate vote or, if such Board members are not currently in place, with the shareholders to allow a new Board to be elected. To avoid delay in termination, having the vote at the regular meeting of the shareholders (to elect the Board) and the Board (to terminate the officer) would be ideal and careful preparation for both meetings is an important element in the implementation of the plan.
Remember: the key is to control a majority of the shares so that you can control a majority of the board and thus legally terminate the officer at the meeting. Ensuring a quorum attends and that the agenda is properly prepared and that the cumulative voting rules are known (for the shareholder’s meeting) are all aspects that the corporate counsel should be involved in formulating.
2. CONTRACTUAL PROTECTIONS
Realizing that failure to control the Board or own a majority of stock can lead to termination, the wise officer in such a position will insist upon a written employment agreement that gives various protections against being terminated at will. Put simply, one can be protected by ownership of control or contract…or both.
Indeed, the contract is often more powerful than ownership in that it can provide for substantial severance, various fringe benefits, and limit the fiduciary duty that an owner of majority interest might otherwise face in California. For instance, a officer or majority stock holder may be required to forgo certain monetary benefits or self dealing which an employee, with contractual rights spelled out, can enjoy. Since the contract between the officer and the company can act to waive certain rights that the company might otherwise have, contracts give added flexibility to the rights and obligations to the employee.
Thus a company seeking to terminate an officer must carefully examine all contractual rights the employee may have and to rely on the corporate power to terminate and ignore the contractual protections existing can lead to disaster. And if one is a minority shareholder, it is in the employment agreement that one must seek protection from majority shareholders who otherwise would easily terminate the minority shareholder as described above.
At times one discovers that the employee will claim that a verbal agreement limits the powers of the Board to fire. The Statute of Frauds in California normally requires such important agreements to be in writing. For a period in the nineties the Courts favored “implied contracts” in which employees were given protection from termination predicated on what the Court considered acts of the employer that led the employee to reasonably believe that a contractual protection was in place. The courts have retreated from this extreme position and unless the employee is a very long term one, in a protected class, or received express representations from the employer leading to reasonable expectation of a long term position, the courts are unlikely to imply an employment agreement that prohibits termination. The reader is advised to consult with legal counsel if there is any question that the employee may claim that reasonable interpretation of the employer’s conduct implied a binding agreement not to terminate.
In terms of written contracts, the provisions of the contract will bind the corporation regardless of the percentage of ownership of the officer. A contract provision barring termination for a number of years or without cause will bind the company and if the corporation violates the contract by voting the officer out of office, damages may be assessed against the company.
If it can be proven that the employee violated his or her fiduciary duty to the corporation by such actions as secret competition, theft, acting beyond the scope of his or her authority, then the corporation may be able to argue that the employee was terminated for good cause and thus did not violate the contract but that is an affirmative defense available to the corporation and thus the corporation would have to prove that by a preponderance of the evidence. At the least, expensive litigation is likely…unless the contract has good provisions such as arbitration and an attorney’s fees clause. See the web article on Binding Contracts and Legal Actions Predicated on Breach of Contract for a fuller discussion of the various aspects of litigation likely to ensue if the corporation elects to ignore the contract and terminate the officer.
ROAD MAP FOR DECISION TO TERMINATE
Based on the above, then, the following are the initial steps the corporation must take to seek to terminate an officer:
1. Determine the Power Structure. Does the employee have enough stock or enough directors to stop termination. Is there a contract that protects the employee from termination regardless of power structure?
2. Time the steps correctly. Keep in mind that control of the Board must precede the Board terminating the employee and that can be a process taking many months.
3. Consider the effect on the business on the possibly long process of termination.
4. Be sure to get both legal advice and, perhaps, tax advise.
5. Make sure the employee is not in a protected class that requires additional protection. (e.g. age, race, ethnic discrimination is prohibited by law, etc.)
6. Consider whether a severance package that is attractive to the employee might not be a more beneficial manner of terminating the relationship.
7. Be sure to make sure access to confidential information, key employees, customers and vendors is well protected during the period you decide to terminate.
8. Check your non competition contract (if any) and if you do not have one, consider whether you might wish to obtain one before taking action. There are limits to the legality of such agreements and the reader should read The Employment Non-compete Contract in California.
9. Above all, plan carefully, well in advance, and do NOT let temper or anger determine how and when you will seek to terminate the officer. Take your cue from Samuel Butler who wrote in 1888, “Man is the only animal that can remain on friendly terms with the victim he intends to eat until he eats them.”
If you are not careful, the “victim” may very well eat you!