Legal Outline For California Agencies - Chapter 2
LEGAL OUTLINE FOR CALIFORNIA INSURANCE AGENCIES CHAPTER TWO CONTRACTS 2.1 Contracts every agency should consider. An insurance production agency is a creature of contracts. It has agency contracts with its carriers. If it is a brokerage, it may have agreements with its insureds. It deals in contracts of insurance with its customers. It should have internal contracts as well with its producers and among its owners. A production agency may have little control over many of the contracts it deals with. However, every agency can avoid potential litigation by having certain types of contracts in place. This chapter deals with those contracts. Producer contracts are important for independent contractors or employees, as well as for the production agency they are associated with, to spell out everyone's rights and duties. In particular, the agreement should state whether it is terminable at will, what benefits the contractor/employee may expect, and how errors & omissions claims are to be handled. Anti-Piracy Agreements are important for owners of expirations, whether individual producers or production agencies, to protect trade secrets. Non-competition Agreements are also important in those cases where such agreements are legal, i.e., when an owner is selling his entire interest in the agency. Buy-sell Agreements or similar arrangements are needed to provide for the death or departure of an owner. Corporate documents such as minutes of incorporated agencies should be kept current, in order to preserve the corporation from attempts to 'pierce the corporate veil' and sue the individual owners. 2.2 Producer contracts. Every agency should have a form of employment (or independent contractor) contract with its producers at a minimum, and ideally with each of its employees. Such agreements are needed to spell out the status of the producer as employee or independent contractor. They state who owns the expirations being serviced by the producer, and how they are to be protected. They cover how the agreement is to be terminated, and protect against improper termination by the employer and against groundless wrongful termination suits by the employee. 2.2.1 Employee or independent contractor. A threshold question is whether the producer is to be an employee or an independent contractor. The basic distinction between an employee and an independent contractor is that the employer has the right to direct an employee on the means by which he is to accomplish the task, whereas for an independent contractor the employee can only determine the results to be accomplished, with the means to be determined by the contractor. The distinction is very important. At the present time, both the Internal Revenue Service and the California Employment Development Department are auditing employers who they believe have improperly classified employees as independent contractors. They look at twenty different factors to determine the right to control. If they determine that the employee has been improperly categorized as an independent contractor, they can impose substantial penalties, which can easily run $30,000 per 'contractor' re-categorized as an employee. For this reason, the employer is wise to treat a producer as an employee if there is any question as to his status. The independent contractor status makes most sense where the individual producer comes to the agency with his own book of business, retains ownership of his expirations, pays a portion of his commissions to the production agency in exchange for use of its facilities, and can leave and take his expirations with him. The historical right of an agent to ownership of his expirations gives more economic substance to an independent contractor relationship in the property & casualty insurance field than in others. 2.2.2 Compensation. Producer compensation is to some extent determined by supply & demand. The salary or commission paid by an agency must approach what is paid by the agency down the street, or the best producers will be lost. On the other hand, the total compensation package must be low enough to let the agency generate a profit. Compensating and rewarding top producers adequately without giving away all the agency profits is obviously important in light of slim agency profit margins. Insurance producers are sometimes compensated with a salary, possibly coupled with a production bonus. More frequently, producers are given a percentage of the commissions they produce, possibly with a draw against commissions. The agreement should spell out the commission calculation. Return commissions are normally offset. Normally contingency or profit-sharing payments are excluded in the calculation of the producer's compensation. The producer who brings a book of business to the agency may keep ownership. He may sell ownership to the agency, which will permit the agency to obtain a covenant not to compete, but creates problems of how to make the payments deductible to the agency. The producer may allow the agency to have ownership of the new expirations information, usually in exchange for deferred compensation rights, which makes payments deductible but makes legal protection of the expirations by the agency more difficult. The following distinctions are frequently made in determining what commission percentage is to be paid to the producer: Accounts the producer brings on arriving at the agency, versus those produced afterward. The producer sometimes gets a higher percentage for the former. Accounts the producer produces himself, and 'house accounts' that the producer is given to service. The latter almost always pays a lower percentage. Original versus renewal commissions. Some agencies pay different percentages and some do not. Commercial lines versus personal lines (particularly if the latter are directly billed by the company and require little servicing). Personal lines frequently have differing arrangements from commercial lines, sometimes only paying a one time commission. Different lines-Property & casualty and group insurance that tend to renew, vs life insurance that is probably a one shot commission. Life always commands a higher split to the producer. Agents are often given bonuses for exceeding targets in new production, or superior loss ratios. They may also have their commissions reduced for lack of persistence, or for involuntary premium financing when they put insurance in force but fail to collect the premiums. I have seen commission spits on the producer's own new property & casualty production range from 50% for the producer (usually in family situations where the producer owns the expirations) to 20% for the producer (usually with some sort of bonus or deferred commission added). 35% to 40% is a normal range. One shot life insurance is always higher in my experience, in the 70% range. Deferred commissions may be part of the commission package. They can give a producer a form of equity in the agency, but will be deductible by the agency when the producer leaves. They can provide an incentive to production. They also can give the producer an incentive not to pirate the accounts when he leaves, but rather to keep them on the books. The right to future commissions might be conditioned on achieving a level of new production or total production, and might vest over a period of time, often from 5 to 10 years. The application of the federal Pension Reform Act or ERISA to deferred commission arrangements is not totally clear. If deferred commissions are viewed as a plan to 'provide retirement income to employees, or...[which] results in a deferral of income by employees for periods extending to the termination of covered employment or beyond...', then they fall within the definition of a 'pension plan' under ERISA. ERISA 3(2). The case law, however, seems to make ERISA inapplicable. The case law has held that ERISA excludes employment contract deferred compensation arrangements. Rocky Mountain Motor Tariff Bureau, Inc. v. Leonard (DColo 1987) 652 F.Supp. 1473. ERISA also excludes plans for owners. Kennedy v. Allied Mut. Ins. Co. (CA9 1991) 952 F.2d 262. It excludes true independent contractors because they are not employees. It may exclude highly compensated employee payments wholly or in part. ERISA 3(2), 3(36), 201(2), 301(a), 401(a). It also may exclude incentive bonus plans. The Dept. of Labor ruled in one case that an incentive bonus plan was not a pension plan. (Advisory Opinion 89-07A (4/27/89). A more detailed discussion of how to structure producer compensation is found in Jaques, Producer Planning, Compensation and Equity Options, cited at the end of this chapter. 2.2.3 Who owns the expirations, name and good will. It is very important to spell out who owns the expirations, good will and name of the agency. The agreement should specify that the agency owns its name. It should also provide that it owns its expirations and good will. If the individual producer is bringing expirations and intends to retain ownership, or if he is an independent contractor who will own his expirations, his rights in both old and new business should be spelled out, and his accounts in which he retains ownership should be kept separately coded. If the producer leaves, the agreement should spell out what happens to his expirations. He might retain the right to take them with him. It might be required (or have the option) to sell them to the agency, and the agency might be required (or have the option) to buy them. An alternative often used is to give a producer a deferred commission split in business originally produced by him if he leaves the agency and does not pirate its accounts. This right is usually vested for accounts he brings, but often is vested over a period of years for accounts he produces while at the agency. It gives the producer something akin to equity in the agency, and also gives him an incentive to keep the business on the agency's books. The agency can deduct the payments. 2.2.4. Covenants not to compete. If an owner is selling the entire interest in an insurance agency business and its good will, or a partnership interest or stock in an insurance agency business, the situation is totally different. The buyer may lawfully obtain a covenant from the seller not to compete with the buyer in those counties in which seller did business, so long as the buyer or someone taking title from the buyer is conducting an insurance agency business in those counties. Bus. & Prof. Code Sections 16600-16602. This eliminates the antitrust problems that exist for non-owner producers. 2.2.5 Protecting expirations and other trade secrets. Anti-piracy agreements, most frequently made a part of employment agreements, are needed to protect ownership of expirations and the good will connected with them. This is true whether the expirations are owned by the agency or the producer. If proper steps are not taken to protect them, they could lose their protected status as trade secrets. California's Uniform Trade Secrets Act, Civil Code Section 3426-3426.11, codifies the law on trade secrets. It defines 'trade secret' as 'information...that: (1) Derives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use; and (2) Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.' Civil Code Section 3426.1. It makes 'misappropriation' of a trade secret unlawful. Such misappropriation may give rise to double damages and attorneys' fees recoveries. Insurance expirations information is normally a trade secret. State Farm Mut. etc. Ins. Co. v. Dempster (1954) 174 Cal.App.2d 418, 344 P.2d 821. A contract that takes steps to preserve secrecy is important to maintain trade secret status. The provisions of the trade secret law have to be interpreted in connection with the provisions of the California antitrust law, Business & Professions Code Section 16600, which provides: 'except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.' This means that employees generally have the right to use their skill and knowledge to earn a living if they do not take and use the agency's trade secret materials. Rigging Internat. Maintenance Co. v. Gwin (1982) 128 Cal.App.3d 594, 180 Cal.Rptr. 451. A notice of a new business location by a departing producer, if that is all he does, is normally proper. Agencies frequently use clauses requiring a short wait, such as 30 days, before such a notice is sent, though no case has ruled on this practice. Use of an employer's lists to send out notices poses problems. The cases are unclear on whether a departing producer can use material from the agency to send out such notices, but they appear to turn on whether the lists themselves are trade secrets, and possibly on whether the material was written or remembered. Anti-solicitation clauses have been upheld when necessary to protect trade secrets. Moss, Adams & Company v. John D. Shilling (1986) 179 Cal.App.3d 124, 224 Cal.Rptr. 456, held that where the departing employee knew the customers names from dealing with them personally, the names were not trade secrets, and use of a rollodex to get addresses was not improper when the addresses were available elsewhere. This court stated that employees were not required to 'wipe clean the slate of their memories'. On the other hand, American Credit Indemnity Company v. Sacks (1989) 213 Cal.App.3d 626, 262 Cal.Rptr. 92, held that where the names of customers for a specialty type of insurance were not generally known, use of the company's material to solicit the customers was improper. Loan expiration material was protected from use in soliciting customers in Greeley v. Cooper (1978) 77 Cal.App.3d 393, 143 Cal.Rptr. 514. In sum, sending a notice of one's new business location is reasonably safe, if one does not solicit business and does not use the former employer's material to send out the notice. Using the former employer's expirations material to solicit its customers is normally improper. I would advise a departing producer who has written material on the agency's expirations (as opposed to his own) to return every scrap of paper to the agency, including the agent's personal notes. I would advise the agency to do the same regarding expirations owned by a departing producer. I would not use the other party's written material to send out notices. Covenants against solicitation of the agency's customers, or against accepting business from the agency's customers, are of questionable validity in California unless they can be tied to a sale of the business of protection of a trade secret. The law generally is that such clauses will be upheld if reasonable. However, at least one case has held that this rule of reason does not apply in California. Scott v. Snelling and Snelling, Inc. (ND Cal 1990) 732 F.Supp. 1034. Anti-solicitation covenants may be proper against non-owners when given by the producer in exchange for deferred commissions, and the sanction for violation of the covenant is loss of the deferred commission rights that are based on earnings of the accounts being solicited. Such covenants may also be proper if the rationale for the covenant is that the employee is using remembered trade secret information. Covenants on accepting business from former customers may also be sustainable on the same grounds as anti-solicitation covenants. The Court upheld such covenants among former law partners in Howard v. Babcock (1993) 4 Cal.4th 409, 25 Cal.Rptr.2d 80. That case, however, dealt with lawyer-owners, and I am not sure to what extent it supports agency non solicitation and non acceptance covenants. An alternative to an outright prohibition against soliciting or accepting business is to use a reasonable commission split if an account wishes to follow a departing producer, whether or not the account was solicited. The bottom line is that covenants against solicitations of accounts should be narrowly drafted if the drafters want to avoid a challenge. 2.2.6 Severability clauses. Because of the uncertainty in covenants not to compete and against unfair competition, it is customary to have a severability clause in the contract that provides that if the court finds the contract partially invalid, it should sever that part and enforce the rest of the contract. Courts are usually willing to do so in this area of the law. 2.2.7 Termination of contract. It is important for an employment contract to specify when it may be terminated. If the employee can only be terminated for cause, or if the employment is for a specified term, the agreement should spell this out. On the other hand, if the agreement has no term and may be terminated at will and without giving any reason, this should be stated also. The contracts will reduce the risk of wrongful terminations, and wrongful termination suits, by clarifying the rights of the agency and of the producer. The agency must be careful not to contradict the terms of the employment agreement with employee manuals, letters, or even oral promises. Even an at will employment contract may not be terminated for statutorily forbidden reasons, such as race, sex, religion, national origin, handicapped status, age, or other statutorily established public policy reasons. Dismissals or resignations arising out of sexual harassment are presently the subject of much litigation. Improper harassment claims put the agency in a particularly difficult position, since it may face a claim by the complaining party if it does not stop the harassment, but also may face a claim by the other party if that party is not given procedural fairness. If there has been an advance against commissions that was not earned, one case has held that an express agreement to repay them will be enforced. Kerry of California v. Lefkowitz (1955) 131 Cal.App.2d 389, 280 P.2d 910. Many contracts provide for offset of amounts owed by the employee against amounts owed by the employer, under C.C.P. 431.70. One case has held that this right of offset cannot be used to deny an employee his 'wages', a term defined to include 'commissions'. Labor Code 200-203; Barnhill v. Robert Saunders & Co (1981) 125 Cal.App.3d 1, 177 Cal.Rptr. 803. The safe course is to pay commissions due on termination, and sue for the offset. 2.2.8 Alternate dispute resolution. The parties to contracts, such as those between producer and production agency, buyer and seller, or among partners and shareholders, may provide for alternate dispute resolution. Mediation and arbitration are the most common types of alternate dispute resolution. They can greatly reduce the cost of resolving disputes. Mediation is non-binding, and it has little downside. Arbitration may be binding to the extent the parties make it so, and it may involve surrendering significant legal rights. Arbitration and mediation are discussed in greater detail in the chapter on litigation, at paragraph 4.5. 2.3 Buy-sell or other agreements to cover if the owner dies prematurely, becomes disabled, or leaves. Owners of insurance production agencies should decide how they intend to dispose of their agency interest on retirement or death when they first determine the form of the agency, and on every change of form thereafter. The intangible assets of a production agency can be lost very quickly on the disability or death of a producer, so some arrangement should be in place to deal with them quickly. In addition, some foresight can reduce the tax cost of selling or transferring the agency. 2.3.1 Individual producer agreements with agencies covering purchase of book of business on retirement. Individual producers often enter agreements with agencies in which the producer retains ownership of his expirations, the agency handles internal matters for a split of commissions, and on retirement the agency buys the expirations or otherwise retires the producer. The producer may be paid a deductible deferred commission. He may also be paid for his expirations (capital gain) and a covenant not to compete (probably ordinary income), which are amortized over 15 years. 2.3.2 Buy-sell agreements for corporate shareholders, and partnership retirement agreements for partners. Partners or corporate shareholders should have provisions for divorce, disability, retirement, or death in their partnership agreement or in an agreement among the shareholders/corporation. Retiring partners may be paid deductible liquidation payments, which are ordinary income. Retiring shareholders may be paid non-deductible payments for their stock (capital gain), interest, payments for covenants not to compete, or deferred compensation (ordinary income). The different approaches to selling or transferring an agency interest are set forth in chapters 5 and 6 on disposing of interests in an agency. The time to start addressing the problem is now, not on retirement or death. 2.3.3 Life insurance funding. It is common for agencies or owners to maintain life insurance, particularly term insurance. Life insurance can be owned by an individual (or his spouse) on his life, by the agency (agency purchase), or by an individual on another partner/shareholder's life (cross-purchase). If the agency owns the policy, it may keep the proceeds as 'key man' insurance. It might also use the proceeds to buy out the deceased owner's interest. The remaining owners get no step up in the income tax basis of their ownership interest. Premiums are probably not deductible to the agency, but the income to pay them is only taxed once.
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