|10. Stock Option Agreements
Stock Option Non-compete Forfeiture Agreements are Enforceable
It is one thing to tell a man that if he wants his pension, he cannot ever work in his trade again,...and quite another to tell him that if he wants a million dollars from his stock options, he has to refrain from going to work for a competitor for six months.
Departing executives may be forced to return profits earned from the sale of lucrative stock options. Such is one of the many ramifications of a recent decision of the federal court in California.
The Ninth Circuit Court of Appeals, which is the federal appeals court for several western states, recently decided IBM v. Bajorek, in which an IBM executive, on the eve of his departure from the company, executed and sold all of his stock options (totaling over $900,000). At the time the options were granted, the executive, Bajorek, signed an agreement requiring him to disgorge any profits from the sale of such options in the event that he went to work for a competitor within six months of such sale. IBM's forfeiture agreement with its plan participants reads as follows: "[A] participant shall not render services for any organization or engage directly or indirectly in any business...competitive with the Company...." Failure to comply with the provision "during the six months after any exercise, payment or delivery pursuant to an Award shall cause such exercise, payment or delivery to be rescinded." After exercising his options, Bajorek promptly left IBM and went to work for a competitor.
Not surprisingly, IBM brought suit against Bajorek in order to force him to return his profits from the sale of the options.
In defense of his actions, Bajorek argued in court that the agreement was unenforceable because:
(1) it ran afoul of a California law prohibiting employers from collecting wages from employees after those wages have been paid; and
(2) it violated another California statute which struck down any contract "by which anyone is restrained from engaging in a lawful profession, trade, or business."
The trial court agreed with both of Bajorek's arguments, and refused to enforce the contract. The Court of Appeals, however, reversed, and upheld the forfeiture provision in IBM's contract.
California law prohibits employers from collecting or receiving "from an employee any part of wages theretofore paid by said employer to said employee." The Court of Appeals, however, held that profits earned from the exercise of stock options were not "wages" within the meaning of this statute, finding that "[s]tock options are not...money at all. They are contractual rights to buy shares of stock." The Court went on to find that the statute was enacted in 1937 in order to stop employers from making "secret deductions" or taking "kick-backs" from their employees in order to avoid minimum wage laws and collective bargaining agreements. As this was not IBM's intent in recovering Bajorek's $900,000 profit, the Court found the statute to be inapplicable.
The Court also distinguished Bajorek's stock option profits from money earned in profit-sharing plans, which has been treated as wages in some cases. "The analogy fails because profit sharing is ordinarily an ascertainable amount awarded pursuant to a formula for past labor, but stock options... are not an 'amount' at all."
The Forfeiture Provision Did Not Restrain Bajorek from his Lawful Trade
California law provides that "every contract by which anyone is restrained from engaging in a lawful profession, trade or business of any kind is to that extent void."
However, the federal court, in examining IBM's forfeiture provision, found that it did not prohibit Bajorek from "engaging in his profession, trade or business", but only excluded him "from one small corner of the market." The Court further found solace in the fact that the restriction waslimited in duration, and also limited only "to competitors" of IBM:
Bajorek could have kept the money and gone to work for a competitor immediately upon quitting, had he elected to exercise his stock options six months before he quit. And he was free to work in his profession and in the same industry and keep the money, so long as he did not work for a competitor. And he could work for a competitor if he gave up what was paid in part for his promise not to.... It is one thing to tell a man that if he wants his pension, he cannot ever work in his trade again,...and quite another to tell him that if he wants a million dollars from his stock options, he has to refrain from going to work for a competitor for six months.
Because the scope of the restrictive covenant was so limited, the Court found that it did not deprive Bajorek of his right to engage in his chosen profession. Accordingly, the Court rejected his argument, paving the way for other California employers to implement similar incentives for their executives to stick around.
Implications for other States
While the Bajorek decision has not yet been cited in other jurisdictions, it is likely that other commercial centers, such as New York, would reach the same result on both aspects of the Bajorek ruling.
First, the Court's ruling that the stock forfeiture provision was not a restraint of trade follows the same reasoning as a New York State court's ruling in Maltby v. Harlow Meyer Savage, Inc. (discussed in the March/April 1998 issue of the Davis & Gilbert Digest). There, a New York court upheld the restrictive covenant in the employment contracts of a group of currency brokers, and enjoined the group from going to work for a competitor. Under the terms of the contracts, the brokers were to be paid their base salary for six months after electing to terminate their employment, and they were prohibited from going to work for a competitor. The brokers made arguments similar to those made by Bajorek. There, too, the Court upheld the restrictive covenant in the employment contracts, finding them reasonable, "in that each protects the employer from severe economic injury while - at the same time - it protects the employee's livelihood, by requiring that he be paid his base salary." The Maltby court identified what it called "the modern trend" in favor of "according such covenants full effect when they are not unduly burdensome." That trend now continues with the Bajorek decision.
Second, other jurisdictions have statutes similar to the California law prohibiting employers from reclaiming or withholding "wages." In New York, for example, Section 193 of New York's Labor Law makes it unlawful for an employer to withhold "wages" from an employee, almost regardless of the circumstances. Violations of the statute can expose employers to treble damages and attorneys' fees. However, stock benefits are unlikely to be deemed "wages" for purposes of the New York statute. Bajorek decision, were it to be applied to a New York employer, would not violate the New York statute, just as it did not violate the California statute.
Given the Bajorek decision, we expect to see more stock forfeiture provisions in executive contracts. This will be particularly true as more and more executive compensation is based on stock option grants, and as the competition for executives grows along with the steamrolling economy.