When an executive has an employment agreement and his company doesn’t pay, the company might offer a number of excuses based on contract law. One of these contractual defenses is called “impossibility of performance.” Under this defense, when a party enters into a contract and circumstances later change such that the party can’t perform it, the party can be excused from performing.

The Virginia Supreme Court’s recent decision in Hampton Roads Bankshares, Inc. v. Harvard provides a timely example of how this defense actually works in practice. In the Hampton Roads case, the organization established a relationship with government regulators that affected its ability to pay severance. The court held that this change made it impossible for the company to perform an employment agreement, excusing performance.

Neither party to the case disputed that in 2008, Scott Harvard—then the president and CEO of Shore Bank—and Hampton Roads Bankshares, Inc. entered into a lucrative severance contract when Shore Bank merged with and into Hampton Roads and Harvard became a vice president at the new company. Harvard's employment agreement provided a special severance package for Harvard if there was a “change in control” of Hampton Roads. This “change in control” provision permitted Harvard to resign his employment within 6 months after a material change in the ownership of Hampton Roads, whereupon he would be entitled to receive 2.99 times his average annual compensation paid in 60 monthly installments.

After the financial meltdown later in that year, Congress enacted the Emergency Economic Stabilization Act (EESA), authorizing the secretary of the treasury to act to restore liquidity and stability in the financial system. Among the specific tools provided to the secretary was the authority to purchase “troubled assets” from banks and other financial institutions pursuant to the Troubled Assets Relief Program (TARP). Financial institutions seeking to participate in TARP were required to comply with a variety of obligations, including a requirement that they would not make any golden parachute payments to executives. The initial regulations implementing EESA and TARP in October 2008 defined a golden parachute as any severance compensation which equaled or exceeded three times the executive’s base salary.

Hampton Roads, like many other financial institutions, was negatively impacted by the financial crisis, applied for assistance under EESA, and began participating in TARP. It received more than $80 million in capitalization. As part of Hampton Roads’ entry into TARP, Harvard expressly agreed to modify his employment agreement to comply with the initial EESA regulations.

As it entered TARP, Hampton Roads acquired Gateway Bank, another financial institution. This transaction constituted a change in control pursuant to Harvard’s employment agreement and triggered the “change in control” provision. Harvard resigned his employment nearly six months after the TARP transaction and made demand for payment.

But circumstances had changed in between the time Harvard agreed to alter his agreement to comply with the initial TARP regulations and his resignation. Specifically, on February 17, 2009, Congress amended EESA by enacting the American Recovery and Reinvestment Act of 2009 (ARRA).

The Treasury Department then adopted new regulations prohibiting any “golden parachute” payments to top officers by companies that had received TARP funds. Hampton Roads consulted with the Treasury Department about Harvard’s severance request. After the Department told it that it could not make the payment and comply with the law, it refused to pay Harvard.

Harvard then sued Hampton Roads for breaching his employment agreement.

Hampton Roads asserted that it was barred from making the payments and moved to dismiss the action. Harvard responded that the new 2009 regulations materially altered his right to receive severance payments, resulting in an unconstitutional taking.

The trial court rejected the company’s defense and entered final judgment for Harvard after a trial. But the Supreme Court of Virginia took the company’s appeal and reversed Harvard’s victory.

The court concluded that the new 2009 regulations made Hampton Roads’ performance impossible, and therefore the defense of impossibility of performance excused the breach. It noted that the defense arises when there has been an event outside the control of the breaching party and that party has not expressly assumed the risk of the intervening event. Applying this principle to the facts of Harvard’s case, the court noted that Harvard was aware that EESA required the amendment of his employment contract in order for Hampton Roads to participate in TARP. The record did not suggest that Hampton Roads agreed to make the severance payment regardless of any intervening changes to the EESA regulations. Therefore, the court concluded that when “the government has clearly expressed its intent to enforce the law, and the promisor cannot in good faith perform its contractual obligations without violating that law, the promisor is discharged from its obligation.”

It didn’t matter to the court whether the law was constitutional, so long as Hampton Roads had a good-faith basis for complying with it.

The 2008 financial crisis and the resulting regulations were obviously an unusual set of circumstances. However, well-compensated employees should still take heed when the organizations they work for are highly regulated entities, because as the Hampton Roads decision shows, the terms of their agreements with their employers may be altered by outside forces.

Changes to items like severance, which employees only use at the conclusion of their employment, may be particularly difficult for employees who would otherwise rely upon the benefits to see them through difficult times.