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Cooley Alert: Non-Competes-Stock Option Forfeitures


A recent decision of the U.S. Court of Appeals for the Ninth Circuit has prompted employers in California to consider whether to require an employee to forfeit stock option gains if the former employee goes to work for a competitor. This decision appears to be a sharp break from the rulings of previous California state courts.

Unlike many other states, California has a strong public policy protecting business competition by former employees. This public policy is embodied in Section 16600 of the California Business and Professions Code, which 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." California courts typically have applied this statute broadly, holding that employers could not avoid the statute by applying to California employees the law of another jurisdiction that upholds noncompete provisions. California courts also have held that an employer cannot require a former employee to forfeit vested benefits such as retirement benefits if the former employee joins a competitor.

The Ninth Circuit recently has taken a different approach by allowing the forfeiture of the gain from vested stock options if a former employee fails to comply with a narrowly tailored noncompetition provision. In International Business Machines Corporation v. Bajorek, 191 F.3d 1033 (9th Cir. 1999), the Ninth Circuit held that a forfeiture provision in an IBM stock option agreement did not violate either a California wage statute (California Labor Code '221) or Section 16600 of the California Business and Professions Code. The provision in Mr. Bajorek's stock option agreement prohibited him from working for a competitor and required him to repay any cash or return any shares received as a result of option exercise if he violated this prohibition within six months after option exercise. Finding that IBM's stock option forfeiture provision did not violate a "fundamental public policy" of California as set forth in Section 16600, the federal court applied New York law, which was provided as the governing law in the stock option plan and in Mr. Bajorek's stock option agreement.

Decision Does Not Bind California State Courts

It is important to understand that the Ninth Circuit Court of Appeals- a federal and not a California state court - decided the Bajorek case. Decisions of federal courts on issues of state law are not binding upon state courts. In addition, the Bajorek Court examined California's statutes not to decide whether IBM's stock option forfeiture provision was enforceable under California law, but rather to determine if it would violate a "fundamental public policy" of California to enforce the law of New York. Finally, in reaching its decision, the Bajorek Court relied principally upon its own prior decisions and only one California state court decision, a 1965 decision of the California Supreme Court. Thus, the question of whether a California state court would enforce a stock option forfeiture provision remains unanswered. Since a challenge to a California employer's effort to enforce a stock option forfeiture provision would, in the case of a resident California employee, typically be a matter for a California state court to decide, the Bajorek decision may not influence the outcome of a dispute in a California state court.

What California-Based Employers Should Consider Doing Now

The Bajorek decision is helpful for employers based in states (such as New York) that are not as protective of the rights of employees, but that have employees in California. The court's decision also can be helpful for California-based employers with employees in other states (such as New York) with laws that are not as protective of the rights of employees as are the laws of California. In both of these situations, the stock option agreement should provide that it is governed by the laws of the other state (in the case of Bajorek, the State of New York).

What is a California-based employer to do if it wants to impose a stock option forfeiture provision on its California employees? Assuming that the employer has considered the possible adverse recruiting and morale impact, is willing to take the substantial risk that a California state court will not follow the Bajorek decision, and still wants to proceed, the forfeiture provision should be drafted as specifically and narrowly as possible. The restriction should narrowly define the precise business segment in which competition is prohibited, narrowly define the geographic area in which it applies, and provide for a short time period during which the restriction is to be effective.

A well-drafted option forfeiture provision will state that it is severable from the remainder of the agreement so that a California court decision that the provision is unenforceable will not upset the other provisions of the agreement. It may also be helpful to have the employee acknowledge in the agreement that the option forfeiture provision does not restrict the employee from engaging in his or her profession, trade or business and identify the employee's precise profession, trade or business. If the employee is based in a state other than California, thought should be given to whether the law of that state should be chosen in the governing document, even if the employer chooses California law to apply to agreements with California-based employees.

Time will tell whether the Ninth Circuit in Bajorek has accurately predicted how state courts in California will respond to stock option forfeiture provisions. In the absence of specific state court guidance, however, employers should proceed cautiously in requiring California-based employees to give up stock option gains in the event of post-employment competition.

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