February 29, 2012

The traditional way for companies to prevent employees from competing post-departure has been the non-compete agreement. A typical non-compete agreement provides that a departing employee may not, for a designated period of time after termination (usually no more than two years), compete within a designated geographic area and/or solicit the employer's clients. If the employee violates the agreement, then the employer will be entitled to injunctive relief and damages.

The problem companies encounter, however, is that enforcement is notoriously uncertain. Courts historically have been skeptical of non-compete agreements as being "restraints of trade," and will weigh an employer's right to protect its interests against the employee's ability to earn a livelihood. As a result, it is often difficult for employers to predict whether particular contractual restrictions will be enforced by a reviewing court.

Alternatives to Traditional Non-Compete Agreements

There are certain alternative routes that an employer can take to address this lack of predictability. One option is a "forfeiture-for-competition" provision, which states that an employee who competes will forfeit a certain benefit, such as a stock incentive or some other type of deferred compensation to which the employee otherwise would have been entitled. The appeal of such a provision is that the employer itself creates a negative consequence to the employee for competing, rather than looking to the court system for a remedy. The premise is that the employee will not want to risk forfeiting the benefit, especially if it is substantial.

An employer can also combine a forfeiture-for-compensation provision with a "clawback" provision that requires the employee to repay compensation following a specific event (e.g., working for a competitor following termination). A related device, known as a "bad-boy" provision, is typically used to allow for forfeitures and clawbacks for bad acts such as disclosing the employer's confidential information, committing a crime, violating the employer's policies or disparaging the employer.

An added attraction of forfeiture-for-compensation provisions is that in most jurisdictions they are subject to a lower level of scrutiny than traditional non-compete agreements. Some courts, like the U.S. Court of Appeals for the Seventh Circuit in Illinois, adopt an "employee free choice" perspective (i.e., the former employee chooses to keep the rights to the benefits or risk forfeiture by competing). Therefore, while the effect may be to deter a former employee from competing, these courts will not scrutinize the reasonableness of the post-employment restriction since it does not deprive someone of his or her livelihood. As these courts theorize it, the employee would opt to keep the money (and refrain from competition) only when the total income from the package plus noncompetitive employment exceeds the income the employee could earn from competitive employment.

Even under this approach, however, the special compensation must be designed to incentivize the employee's future performance with the company, and not fall into the category of "regular wages." For example, stock incentives, phantom stock arrangements and management incentive bonuses would be regarded as compensation that supports a forfeiture-for-compensation arrangement, while commissions and ordinary bonuses would not. In fact, providing for the forfeiture of regularly earned income might even be viewed as violating state wage payment laws.

Despite this generally favorable view by many courts, some (albeit a minority) will examine forfeiture-for-competition clauses under the same analytical rubric as traditional non-compete provisions, and will not enforce them if, for example, they are considered overbroad. Enforcement may also be a challenge in these courts if the claimed protectable interest is not sufficiently shown, or if it is believed the restrictions unduly prevent the employee from pursuing his or her livelihood.

A variant of the forfeiture-for-competition provision is "garden leave." Under this type of arrangement, commonly used in England, the employee continues to collect a salary for a defined period of time but does not perform any duties whatsoever for the employer. Although the employee remains idle and does not compete with the employer, he or she is subject to all of the duties that apply to a current employee (e.g., the duty of loyalty). The employer's interests are protected in that the employee is not competing, and the employee's interests are protected in that he or she continues to earn a living.

Navigating Federal ERISA and State Law

Since these devices rely on the existence of executive-level compensation arrangements, their utility to prevent post-employment competition is usually confined to employees who are more likely to receive incentive or deferred compensation arrangements. Furthermore, because these arrangements often are provided through compensation plans, they may be subject either to federal ERISA law or to state law.

For ERISA-covered plans, whether benefits may be subject to forfeiture and clawback depends on whether the forfeiture relates to a so-called "qualified plan." Vested benefits in a qualified plan, such as a 401(k) plan or a defined benefit pension plan, cannot be forfeited due to post-employment competition.

On the other hand, top-hat plans (i.e., unfunded, non-qualified ERISA plans, used primarily to provide deferred compensation to a select group of management or highly compensated employees) are not subject to ERISA's vesting requirements. Therefore, a top-hat plan participant who violates a forfeiture-for-compensation provision can even forfeit plan benefits described as "vested," as long as the plan itself allows a forfeiture in that situation.

The advantage to a forfeiture-for-compensation provision in top-hat plans is that ERISA preempts state laws—including those that prohibit or disfavor non-competition agreements and other restrictive covenants. Therefore, participants who are denied benefits because they violated a forfeiture-for-compensation clause must, before challenging such a denial in court, exhaust the plan's administrative remedies by seeking a determination by the plan administrator, who usually is the employer or a committee appointed by the employer. If the plan is properly drafted, a court should give considerable deference to the plan administrator's decision.

Other plans, such as stock option and restricted stock plans, are not subject to federal law because they tend to fall outside of the definitions of ERISA-covered retirement and welfare benefit plans. However, if the state is one in which courts follow the "employee free choice" doctrine, then the forfeiture-for-compensation clause will be viewed less restrictively than traditional non-compete provisions.

For more information on forfeiture-for-competition and related provisions, please contact a member of the firm's Labor & Employment group or your Much Shelist attorney.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.