It is frequently the case that employers design executive compensation arrangements providing for the payment of certain benefits only if the executive does not go to work for a competitor after termination of employment. If the former executive decides to work for a competitor, the employee forfeits any unvested compensation under the terms of many such compensation arrangements.
While the Employee Retirement Income Security Act of 1974 ("ERISA") prohibits forfeiture-for-competition provisions in most employee pension benefit plans, in many executive compensation arrangements which are not governed by ERISA, such clauses continue to be popular. Such compensation arrangements include many types of stock option, bonus or deferred compensation plans. These plans are designed to incentivize executives to remain employed with and loyal to the employer, and to provide the executives with a proprietary interest in the company by linking their compensation to profitability and growth.
In Lucente v. Int'l Bus. Machines, Corp., 117 F .Supp. 2d 336 (S.D.N.Y. 2000), Judge McMahon denied enforcement of a forfeiture-for-competition provision in two IBM stock option and restricted stock plans and subsequently awarded a former IBM executive damages in excess of six million dollars. The Court reasoned that New York State courts would enforce such forfeiture provisions under New York law only if the non-competition agreement were "reasonable" under criteria courts typically apply in considering whether or not to enforce a non-competition agreement. She found the IBM noncompetition agreement unreasonable because IBM was unable to identify any information, trade secrets, or proprietary rights that would be protected by enforcing the noncompetition agreement against the plaintiff more than two years after he left IBM employment, and because the noncompetition agreement was unrestricted in its duration.
On the basis of the application of the so-called "employee choice doctrine" asserted by IBM, the Court also found that IBM could not be excused from proving reasonableness of its forfeiture-for-competition clause. Under that doctrine, if the employee resigned under circumstances where the employer was willing to continue the employee's employment, the employee's departure is deemed voluntary, and the forfeiture has been deemed not to be a violation of public policy.
Two years ago in Lucente v. Int'l Bus. Machines., Corp., 310 F.3d 243 (2d Cir. 2002), the Second Circuit Court of Appeals reversed the trial court's refusal, as a matter of law, to enforce the IBM forfeiture-for-competition provision, remanding the case for trial as to whether or not the provision should be enforced under the employee choice doctrine. The Court reasoned that the district court incorrectly resolved the disputed issue of fact as to whether or not the former executive left IBM's employment voluntarily, an issue properly left for the jury. Accordingly, the Court ruled that a jury should determine whether the employee resigned voluntarily, in which case, the employee choice doctrine would excuse IBM from proving that its noncompetition agreements were reasonable in time, place and scope.
This article analyses the enforceability under New York law of forfeiture-for-competition agreements as well as the application of these principles in Lucente. It also addresses recommendations suggested by Lucente for drafting more effective forfeiture-for-competition provisions in executive compensation arrangements.
Background Of Lucente
At common law, New York courts had upheld the validity of forfeiture-for-competition clauses as being generally consistent with public policy. For example, in Kristt v. Whelan, 4 A.D.2d 195, 164 N.Y.S.2d 239 (1st Dep't 1957), aff'd, 5 N.Y.2d 807, 155 N.E.2d 116, 181 N.Y.S.2d 205 (1958), a former employee of defendant Haire Publishing Company who voluntarily terminated his employment with Haire and subsequently sought employment with a competitor was found to have forfeited his right to income from a corporate trust that was explicitly conditioned on non-competition. The Appellate Division held that "[i]t is no unreasonable restriction of the liberty of a man to earn his living if he may be relieved of the restriction by forfeiting a contract right or by adhering to the provisions of his contract." 4 A.D.2d at 198, 164 N.Y.S.2d at 243. The court further explained that "[t]he provision for forfeiture . . . involved [in Kristt] did not bar plaintiff from other employment. He had the choice of preserving his rights under the trust by refraining from competition . . . or risking forfeiture of such rights by exercising his right to compete . . . ." 4 A.D.2d at 199, 164 N.Y.S.2d at 243.
The New York Court of Appeals subsequently reinforced Kristt's continued validity, at least with respect to situations where the employee voluntarily chooses to terminate employment. In Post v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 48 N.Y.2d 84, 397 N.E.2d 358, 421 N.Y.S.2d 847 (1979), two account executives brought an action against their former employer to recover pension benefits which they had forfeited when they were dismissed without cause and went to work for a competitor. Citing Kristt with approval, the Court nonetheless limited its application to cases where the employee left the employer voluntarily and commenced employment with a competitor. However, because the employees in Post were involuntarily discharged without cause and thereafter engaged in competition with their former employer, the forfeiture of earned pension benefits was found to be unreasonable as a matter of law. 48 N.Y.2d at 89, 397 N.E.2d at 361. The court reasoned that "[w]here the employer terminates the employment relationship without cause, . . . his action necessarily destroys the mutuality of obligation on which the covenant rests as well as the employer's ability to impose a forfeiture. An employer should not be permitted to use offensively an anticompetition clause coupled with a forfeiture provision to economically cripple a former employee and simultaneously deny other potential employers his services." Id.
With ERISA enacted in 1974, Congress prohibited the use of forfeiture-for-competition provisions in most employee pension benefit plans. See 29 U.S.C. § 1053(a)(3)(B). For example, an employee's right to accrued pension benefits attributable to his own contributions cannot be forfeited. By contrast, vested rights attributable to employer contributions can be forfeited or can be suspended under narrowly defined circumstances. However, ERISA does not prohibit the forfeiture of all benefits, and to the extent that a benefit plan is not governed by ERISA, the principles of state law still must be applied.
Courts in New York continue to apply both Kristt and Post in upholding forfeiture-for-competition clauses. For example, the Court in Int'l Bus. Machines Corp. v. Martson, 37 F. Supp. 2d 613, 617 (S.D.N.Y. 1999), held that a former executive could be divested of the profits realized from his exercise of the options without running afoul of New York's prohibition against forfeiture of earned wages. The Court in Martson cited Post favorably, and reinforced its holding that "a forfeiture-for-competition provision in an incentive compensation plan [is] not enforceable only when termination [is] involuntary and without cause." Id., at 620. The Court also recognized that Post's citation to Kristt reaffirmed the continuing validity of that case.
The most recent application of New York State law to a forfeiture-for-competition provision is the Second Circuit's decision in Lucente.
The Lucente Case
The former president of IBM's Asia Pacific Division, the plaintiff in Lucente, was one of IBM's key executives who reported directly to IBM's then CEO, John Akers. Lucente had been employed by IBM for 30 years, during which time he had participated in an incentive program awarding restricted stock and in another program awarding stock options. Under both types of programs, Lucente's restricted stock and stock options were subject to non-competition provisions which authorized IBM to cancel any deferred, unpaid or unexpired awards if an employee went to work for a company that IBM deemed a "competitor." The non-compete clauses contained no limitation as to time, place or scope.
Akers informed Lucente that he would be replaced in Tokyo and that he should find another job either within IBM, one of lesser responsibility, or at another company. Thereafter, Lucente accepted a position at Northern Telecom, Ltd., a job that IBM had advised him would not be deemed an IBM competitor under the restricted stock and stock option programs. As part of his retirement package, IBM paid Lucente $675,000. Lucente also signed a letter agreement containing a non-competition provision that was unlimited in duration and scope.
Two years later, Lucente left Northern Telecom and joined Digital Equipment Corp., at which time IBM advised Lucente that his new employment violated the non-competition clauses, and that it would be canceling his outstanding stock options and restricted stock awards. Lucente then sued IBM for breach of contract, seeking damages resulting from the forfeiture of the restricted stock and stock options. IBM filed a counterclaim for breach of contract, seeking to recover the $675,000 severance payment.
Lucente and IBM each moved for summary judgment on their respective claims for breach of contract. Judge McMahon ruled that IBM had failed to present evidence that it had been willing to retain Lucente, and that the employee choice doctrine was consequently inapplicable to both Lucente and IBM's claims for breach of contract. The Court further ruled that because the non-competition provisions in the incentive programs and the letter agreement were unlimited in scope and duration, they were unreasonable as a matter of law and thus unenforceable. Based on these findings, the Court granted summary judgment for Lucente on his breach of contract claim and dismissed IBM's counterclaim.
On appeal, the Second Circuit reversed the district court's ruling, on the ground that it had improperly decided the factual question of whether Lucente had voluntarily left IBM or had been involuntarily discharged. The Second Circuit reasoned that the district judge had improperly "usurped the jury's province as fact finder," and relied on "selective and incomplete deposition testimony while ignoring substantial evidence that Lucente's departure from IBM was indeed voluntary." Lucente, 310 F.3d at 255. The Court of Appeals thus reversed the district court's determination that the employee choice doctrine was inapplicable. The Second Circuit further reasoned that the "factual inquiry into the reasonableness of [the] provisions [could not] be undertaken until a jury determine[d] whether Lucente had a choice to remain at IBM or was involuntarily terminated, and therefore whether the employee choice doctrine applie[d] to this case." Id. at 256. The Court of Appeals remanded the case to the lower court for further proceedings.
Importance Of Careful Drafting
Lucente suggests a number of lessons for employers who wish to maximize the likelihood that a court will enforce their forfeiture-for-competition provisions in their executive compensation arrangements:
First, employers who wish to take advantage of the employee choice doctrine as a basis for extending the duration and scope of their forfeiture-for-competition provisions should seek to avoid any ambiguity relating to an executive's voluntary resignation from employment. For example, in Lucente, as a condition to his being paid substantial severance benefits, IBM might have sought from Lucente a simple written acknowledgement in connection with his departure from IBM employment that IBM had extended to Lucente the opportunity to continue working for IBM and that he had chosen of his own volition to resign from his position to pursue other opportunities. Such a written acknowledgement might have been sufficient to prevent Lucente from claiming, as he did in the Lucente case, that he left IBM involuntarily.
Employers also might choose to revise their forfeiture-for-competition provisions to address separately, on the one hand, resignations or terminations for cause from, on the other hand, terminations of employment without cause. Where the employee's employment is terminated due to a resignation or for cause, the employee choice doctrine should provide the employer a strong argument for enforcement of the forfeiture-for-competition provision without regard to the reasonableness of the noncompetition agreement.
By contrast, if the employer terminates the employee's employment without cause, as the Second Circuit held in Lucente, under the employee choice doctrine as it exists in New York, courts will enforce the forfeiture-for-competition provision only if the noncompetition covenant serves to protect the legitimate interests of the employer and is reasonable in duration, geography and scope. Accordingly, in order to maximize the enforceability of the forfeiture-for-competition provision, employers may wish to narrowly tailor the provision to the bare minimum duration, geography and scope.
Of course, balancing against the benefits of such a two-tiered approach is the additional length and complexity added to the employment agreement due to such a provision. Thus, employers who would prefer to "keep it simple" may wish to use a broad unrestricted clause, recognizing that such a clause may be effective only in curtailing competition by employees who resign or whose employment is terminated for cause. Alternatively, employers who require broader applicability of their forfeiture for competition provisions may wish to use a narrowly restricted clause which typically will require a clause with greater length and complexity. By using such a clause, the employer may curtail competition not only by employees who resign, but also from employees whose employment is terminated both with or without cause. Employers should balance these options carefully, after considering their unique circumstances, as well as governing law in the relevant jurisdictions.
Jeffrey S. Klein and Nicholas J. Pappas are Partners in the Labor and Employment Practice Group of Weil, Gotshal & Manges LLP. This article is adapted from an earlier article appearing in The New York Law Journal on February 3, 2003.