Employers seeking to protect their competitive advantage and find an alternative method of influencing employees to not compete are increasingly relying on so-called “forfeiture for competition” agreements in place of traditional non-competes. This trend is driven, in large part, by the “employee choice” doctrine. In states that have adopted the employee choice doctrine, such as New York, a post-employment non-compete will not be subject to the usual reasonableness standard when it is contingent upon an employee’s choice between receiving and retaining a benefit (e.g., restricted stock, stock options, or some other deferred compensation) and competing.
The validity of the employee choice doctrine was recently affirmed by a New York State court applying Delaware law. See NBTY, Inc. v. O’Connell Vigliante, 2015 N.Y. Slip Op 4 51726(U) (Sup. Ct., Suffolk County, Nov. 24, 2015). The court’s decision in NBTY serves as an important reminder for employers that certain key components of the employee choice doctrine must be present to enforce post-employment non-competes.
NBTY involved a global manufacturer, distributor, and retailer of vitamins and nutritional supplements that sought to preclude three former executives from joining a direct competitor, Piping Rock Health Products, by invoking restrictive covenants contained in stock-option agreements that they had signed in 2011. The stock-option agreements provided the executives options to purchase specific numbers of shares of common stock that would vest over time, subject to certain terms and conditions. The agreements contained restrictive covenants prohibiting the executives from engaging in any competing business in North America, Europe, or China for a period of one year following the end of their employment with NBTY. After the executives resigned in 2014 and 2015 and began employment with Piping Rock, NBTY commenced an action in New York State court to enforce their restrictive covenants.
In its decision, the Supreme Court, Suffolk County, Commercial Division, acknowledged the applicability of the employee choice doctrine under New York law. Citing Lenel Systems Int’l, Inc. v. Smith, 106 A.D.3d 1536, 966 N.Y.S.2d 618 (N.Y. App. Div., 4th Dep’t 2013), and Morris v. Schroder Capital Management Int’l, 7 N.Y.3d 616, 825 N.Y.S.2d 697 (2006), the court explained that the individual defendants had agreed to post-termination non-compete provisions in exchange for the receipt of additional incentive compensation, i.e., stock options. Upon their decision to leave NBTY’s employ, they had the choice of preserving their rights under the stock-option agreements by refraining from competition with NBTY or risking forfeiture of such rights by exercising their right to compete. The court held that the restrictive covenants contained in the stock agreements were unenforceable, but by choosing to compete with NBTY, the individual defendants forfeited their right to the stock options.
As straightforward as the employee doctrine is in theory, in practice, employers seeking to avail themselves of the doctrine should evaluate and craft their agreements to ensure that all key components are present:
A Genuine Choice. An employee must have a genuine choice between retaining the benefits or leaving the employer to engage in competitive activities. If an employee makes the informed decision to compete, the employer may require that he or she forfeit the benefits promised in exchange for the non-compete.
Voluntary Separation. Some courts have interpreted the “genuine choice” requirement to mean that the employee must voluntarily separate from the employer in order for the employee choice doctrine to apply. The reasoning behind this interpretation is that if the employee is terminated, the employer, not the employee, has made the choice to end the relationship. Thus, a court may not be willing to apply the employee choice doctrine to an employee who is terminated without cause or an employee who is “constructively discharged.” If the employee choice doctrine is not applied, any non-compete that the employer seeks to enforce may be subject to the usual reasonableness analysis that would generally be considered by a court analyzing whether to enforce a restrictive covenant.
Consideration. For the employee choice doctrine to apply, consideration is a necessary element. States vary as to whether initial employment or continued employment, standing alone, may serve as sufficient consideration. When a restrictive covenant is entered into after employment begins, new consideration may be required (and, in any event, may be helpful), such as a corresponding benefit or beneficial change in employment status. Even in the context of stock option plans, restricted cash, or other monetary benefits, consideration may still be a concern when restrictive covenants are added to preexisting plans or benefits.
Forfeiture Relief. The employee choice doctrine is about forfeiture, not restriction. In other words, the agreement should not put a blanket restriction on postemployment competition, but rather should memorialize an incentive-driven bargain: the employee’s receipt and retention of certain benefits in exchange for his or her avoidance of post-employment competitive activity. Inclusion of language that seeks to enjoin the employee from engaging in competition undermines the “choice” element of the employee choice doctrine. Generally speaking, forfeiture of benefits (possibly through rescission), not an injunction, is the sought-after remedy. Of course, an employer would not necessarily be prevented from seeking injunctive relief, where appropriate.
State-Specific Standards. Not all states have adopted the employee choice doctrine. Courts in North Dakota, for example, have found forfeiture for competition clauses to be per se unenforceable. Connecticut, Maryland, Massachusetts, and Pennsylvania recognize the concepts of employee choice and forfeiture-for-competition, but apply them in conjunction with a traditional reasonableness analysis. In light of this wide variation, employers should take into consideration the specific state in which they seek to enforce post-employment non-competes when crafting such agreements.
A version of this article originally appeared in the Take 5 newsletter “Five Employment Law Compliance Topics of Interest to Financial Services Industry Employers.”