New England Biz Law Update
Corporate directors and management are accustomed to broad discretion in governing a company’s internal affairs, but Balles v. Babcock Power, Inc., 476 Mass. 565 (2017), is a cautionary tale that urges restraint when the issue involves interpreting employment contracts and cancelling benefits that exceed harm caused by employee misconduct.
In a decision that may seem paradoxical, the Supreme Judicial Court affirmed a judgment that: (i) restored stock and dividends to a “management investor” and company executive after the company terminated his employment and repurchased his stock as a sanction for concealing an affair with a subordinate, yet simultaneously (ii) required the employee to forfeit compensation because he violated his fiduciary duty. In addition, each side was awarded attorneys’ fees for claims on which it prevailed.
Ultimately, the monetary award to the employee exceeded that to the company by over $2 million including attorneys’ fees and interest, but not including the very substantial value of the restored stock.
Despite the apparent incongruity, the trial and appellate decisions reflect sophisticated analysis of facts found by a jury and a Superior Court judge. The trial and appellate decisions teach the importance of internal due process and restraint in cases that inflame emotions, especially when the sanction for misconduct exceeds the resulting harm.
The employee, Eric Balles, was a vice president and senior engineer with eight years of service. Among a select group of executives, he was allowed to purchase common stock at a price of $0.001 per share (in his case, 100,000 shares for $100) subject to a stockholders’ agreement. The arrangement was intended to incentivize performance.
According to the stockholders’ agreement, a management investor could keep the stock if the company terminated his employment without a finding of “cause.” If terminated for cause, however, the company could repurchase the stock for $0.001 per share.
“Cause” was contractually defined as “fraud, embezzlement or gross insubordination on the part of the Management Investor” that was not corrected within 30 days of notice. Only the board of directors could make a determination of cause.
Upon discovering Balles’ affair, management conducted an investigation assisted by outside counsel and recommended termination for cause.
Balles admitted the affair and did not contest the termination of his employment. However, he requested a meeting with the directors, offered to relinquish $500,000 in compensation to “correct” his misconduct, and sought to retain his stock.
The board elected not to meet with Balles, rejected his proposal to forfeit $500,000, voted to terminate his employment for cause, and repurchased his stock for $100, thereby triggering the litigation.
In a bifurcated trial, a jury rejected Babcock’s counterclaims for breach of the duties of loyalty and good faith, waste of corporate assets, misrepresentation, nondisclosure, conversion, and breach of the implied contractual duty of good faith and fair dealing.
Addressing Balles’ remaining claims for declaratory judgment and breach of the stockholders’ agreement in a detailed 115-page decision, the trial judge concluded that:
(i) the company’s investigation was inadequate, one-sided and biased;
(ii) the board received a flawed presentation that included incorrect facts, speculation and misleading conclusions presented as fact;
(iii) the presentation had legal errors and omissions, resulting in a “watered down and incorrect” understanding of the stockholders’ agreement;
(iv) company decision-makers acted out of inflamed emotion and a desire for retribution; and
(v) some of the decision-makers benefitted personally by stripping Balles of his stock.
Nevertheless, on the one remaining counterclaim that was not submitted to a jury, the trial judge assessed Balles $412,000 in equitable forfeiture of past salary and rejected Balles’ claim for severance pay because he committed a material breach of an employment agreement, which was separate from the stockholders’ agreement.
The company argued on appeal that:
(i) the court should defer to the board of directors’ decision and should not interfere unless the decision was arbitrary, capricious or in bad faith;
(ii) the court erred in concluding that Balles’ conduct did not constitute cause; and
(iii) Balles’ alleged material breach of the stockholders’ agreement precluded recovery for breach of contract.
The SJC disagreed and affirmed the judgment in all respects, offering at least four lessons for companies in similar situations.
1. Acknowledge the standard of review.
Because the stockholders’ agreement said that “for purposes of this Agreement, a determination of ‘Cause’ may only be made by the Board,” Babcock erroneously assumed that courts would defer to the directors’ finding that the company had cause to repurchase Balles’ stock.
However, contract interpretation is a matter of law and does not qualify for the business judgment rule. Although a decision to terminate for cause was reserved for the directors, the stockholders’ agreement went on to state that any controversy would be decided by a court without a jury because the issues “would be inherently complex.” It did not say that the court should defer to the directors.
According to the SJC, “this recognition of the innate complexity of disputes arising under the contract and of the need for resolution by judges rather than juries is consistent with the application by judges of the usual de novo standard of review.”
The standard of review may vary depending on the precise language of the contract. For example, where a contract specified that cause shall mean “willful misconduct … as determined by [the employer], which determination shall be conclusive,” the 1st Circuit ruled that the employer’s determination “is not unreviewable, nor reviewable de novo, but instead [the] courts may perform a limited review of the decision to determine if it was arbitrary, capricious or made in bad faith.” Noonan v. Staples, Inc., 556 F.3d 34 (1st Cir. 2009).
However, there are good business reasons for companies not to provide a deferential standard, because deferential review can undermine confidence in the integrity of the bargain. In any event, the SJC opted for a de novo standard of review on the facts presented in Balles.
2. Err on the side of due process and providing opportunities to cure.
According to the trial judge, the decision-making process was flawed because the board rejected Balles’ requests for a face-to-face meeting and relied exclusively on management’s presentation without entertaining contrary evidence or argument.
Moreover, the presentation was one-sided, and the facts were “considerably less serious than the Board was told or found.” The judge determined that management’s most serious findings were incorrect: Although Balles knew he was violating company policy and intentionally concealing the violation, “he believed, however mistakenly, that he had found a way to do his job and promote the company’s interests while also carrying on his affair.”
The court found that Balles’ false statements about the affair had not caused harm; that Balles did not intend to cause harm; and that Balles’ misconduct, while certainly justifying termination of his employment, did not constitute “defiance of authority” such as defiance of a direct order or disrespect directed personally to a supervisor.
Moreover, even if Balles’ affair with the female subordinate and attempts to conceal it constituted a willful and material breach that might otherwise justify repurchase of his stock, the company denied Balles the opportunity to “correct” the violation by providing monetary compensation — as Balles had offered. The SJC rejected the argument that the breach was uncorrectable because, in the court’s view, it could be corrected by monetary compensation.
Significantly, the outcome in Balles did not depend on de novo review. Although the SJC applied the de novo standard, the trial court made alternative findings that the board’s decision was arbitrary and capricious because it misinterpreted the definition of cause and did not give Balles an opportunity to correct his transgression by compensating Babcock for actual harm.
3. Resist emotionally induced bias.
Between the lines in the trial court decision is an element of sympathy for the sincere emotional pain that Babcock decision-makers experienced because of Balles’ betrayal. But sincerity was not the issue. Although feelings of betrayal were understandable and predictable, and would most likely be experienced by any decision-maker in similar circumstances, the board in Balles was misled to the company’s detriment by emotionally induced bias.
4. Avoid punitive sanctions.
A final and very important lesson is that, regardless of the moral implications of an employee’s misconduct, contracts should not be used as a pretext for punitive sanctions that exceed just compensation.
The trial court found that, during his employment, Balles had made precisely the kind of contribution the stockholders’ agreement was designed to incentivize. His subsequent actions, although exceedingly unwise, did not materially detract from the value of his contribution. A breach of contract cannot normally justify punitive damages.
Balles did not emerge unscathed. He accepted the trial court’s decision to equitably forfeit $412,000 in past compensation and the right to severance pay. But as the court noted, Balles had offered to forfeit $500,000 in dividends and a limited noncompete agreement prior to commencing litigation. The board unwisely rejected the opportunity to “correct” Balles’ violations by means of reasonable financial compensation.
The lesson of Balles is that decision-makers should exercise restraint when they are tempted to penalize employees for misconduct, and that judicial deference to corporate decisions is subject to limits that are hard to predict.
The evidence persuaded the trial judge and jury that the board had overreached, presumably because of the emotionally charged issues. The SJC found no reason to disturb the trial court findings and affirmed the conclusion that Balles was entitled to the benefit of his company stock.
James C. Donnelly Jr. is of counsel at Mirick O’Connell in Worcester, Massachusetts. A member of the litigation department, his practice focuses on civil litigation and business disputes. Alexandra N. Mansfield is an associate at the firm.
