A federal court decision last month in the Northern District of Illinois [Chicago] considered a company’s ability to terminate its annual bonus plan in a manner that would lead to lower bonuses to some employees. On remand from the Seventh Circuit, the court found that although the plan created an enforceable contract, the company had reserved to itself “the unambiguous right to terminate the plan and refuse to pay bonuses.” 

However, to me the most interesting thing about the case is that a majority of the Seventh Circuit found a potential violation of the “implied covenant of good faith and fair dealing” in the company’s decision to terminate the plan and the federal trial court only narrowly decided that the company’s decision had not violated that implied covenant.

I have blogged on the concept of implied covenant of good faith and fair dealing as recently as last month (See, “Think Automatic Vesting on a Change in Control Isn’t Important? Ask This Former Employee”). It seems to be coming up more often in executive compensation litigation lately. The Wilson court described it this way:

While “the element of good faith dealing implied in a contract is not an enforceable legal duty to be nice or to behave decently in a general way. … [a]vowedly opportunistic conduct has been treated differently.”

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“Wilson alleges, CEC simply kept for itself more than $5 million it should have paid to its admissions representatives. That looks like the ‘avowedly opportunistic conduct’ that we recognized as actionable.” (citations omitted)

In the court’s view, what won the day for the company was the fact that it had terminated the incentive bonus plan in response to Department of Education regulations prohibiting incentive compensation of the type provided under the company’s bonus plan, which were proposed in June 2010 and finalized in October 2010. The final regulations were effective July 1, 2011. The company terminated the bonus plan effective February 28, 2011, and increased salaries for the affected employees effective March 1, 2011. The court allowed that the plaintiff and some other employees might have received more compensation if the company had terminated the bonus plan a few months later than it did, but found that (i) not all employees would have been better off with a later termination, (ii) the company had more than ample administrative reasons to terminate it in February, and (iii) the company certainly did not violate implied covenant of good faith and fair dealing by the February termination.

The court’s decision provides an interesting (at least if you are a compensation / legal nerd) analysis of the issue and one that compensation professionals should consult in the future if similar circumstances arise.