Using Deferred Compensation Plans to Enforce Restrictive Covenants

Question:  I want to reward a key employee with additional compensation.  I am concerned that the covenant not to compete which I am asking the employee to sign will not be enforceable.  Any suggestions on how to deal with this?

Answer:  Restrictive covenants contained in employment and other agreements are not always enforceable.  Where an employee covenants to refrain from engaging in a particular industry or soliciting or servicing an employer’s customers following the employee’s termination of employment, the concern always arises that the covenants will not be enforced.  Some states such as California will not enforce restrictive covenants of this sort at all.  Other states impose significant hurdles to the enforcement of these covenants making it difficult for employers to obtain the bargained-for protection.

Another approach may be to impose restrictive covenants in plans governed by the Employee Retirement Income Security Act (“ERISA”), the Federal law governing employee benefits.  Additional benefits afforded to employees can be incorporated into non-qualified deferred compensation plans governed by ERISA.  Courts have been more willing to enforce restrictive covenants contained in ERISA-governed plans than those contained in State law governed employment agreements.  ERISA also has a pre-exemption provision which means that ERISA supersedes the laws of other states which apply to ERISA-governed benefit plans.  While an ERISA plan may contain a non-compete or other restrictive covenant that may not be enforceable under applicable state law, state law may be rendered ineffective as to an ERISA-governed plan due to ERISA’s preemption provision.  Therefore, if an employee violates a restrictive covenant in an ERISA-governed plan, the employee may more readily be required to forfeit benefits under the plan.

To take advantage of the preemption provision of Federal law, the plan must be properly drafted to be covered by ERISA.  While qualified employee benefit plans such as conventional profit-sharing plans, 401(k) plans and defined benefit plans cannot be utilized for this purpose, non-qualified plans which are governed by ERISA can.  To be governed by ERISA in this context, the plan must provide retirement income for employees or result in a deferral of income for periods extending to the termination of employment or beyond. By triggering ERISA coverage, plans can often accomplish indirectly what cannot be accomplished directly.

State law restrictions on enforcing restrictive covenants can thwart employers’ intentions of protecting their businesses and clientele.  With a conventional employment agreement, an employer can be left with the worst of both worlds, having to pay additional compensation to an employee with an unenforceable restrictive covenant.  Incorporating restrictive covenants into an ERISA-governed plan, however, may give an employee pause before breaching a restrictive covenant as such covenants are more likely to be enforced and may cause the employee to forfeit valuable benefits.

 

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.