The Advisors' Blog

Equity award agreements often provide that the awardee will forfeit the awards if they breach various restrictive covenants — usually, non-solicitation, non-competition, and/or confidentiality. These forfeiture provisions can create some challenges for drafters. In May, Liz shared a recent case in which the Delaware Court of Chancery refused to enforce the covenants following the forfeiture of the units, as the agreement explicitly stated that the units were the sole consideration for those covenants.

The 10th Circuit also addressed these terms in an award agreement — and specifically found that the forfeiture provision can be enforceable even when the non-compete itself may not meet the applicable state law’s reasonableness standard. This Proskauer blog describes the facts:

A retirement agreement allowed the former CEO of Spirit AeroSystems (“Spirit”) to receive cash payments and continue vesting in certain stock awards if he continued working for Spirit as a consultant and complied with a non-compete agreement.  The CEO subsequently contracted with a hedge fund that was pursuing a proxy contest against one of Spirit’s suppliers.  Spirit determined that this activity breached the non-compete and therefore stopped payments to the CEO and cut off continued vesting of the stock, resulting in forfeiture of the CEO’s then-unvested stock awards.

As the blog notes, the court distinguished the forfeiture of future compensation from a traditional penalty for competition.

Under Kansas case law, the former is valid and enforceable only if “reasonable under the circumstances and not adverse to the public welfare.”  But the court concluded that Kansas law does not subject the latter to the same reasonableness standard because it does not restrain competition in the same way.  Rather than imposing a penalty, a forfeiture for competition provision “merely provides a monetary incentive in the form of future benefits for not competing.”  The court reasoned that a forfeiture for competition provision gives the worker “a choice between competing and thereby forgoing the future benefits or not competing and receiving those benefits.”  And because the forfeiture applied only to future compensation, it did not amount to a penalty: the executive forfeited only “the opportunity for the shares to vest notwithstanding his retirement.”

The agreement included both a forfeiture-for-competition provision and traditional enforcement rights (to pursue monetary damages and specific performance), but the court found that the two could be severed under the agreement’s terms. The court found that a “forfeiture-for-competition provision should be presumed enforceable” absent the presence of policy concerns — e.g., that imbalanced bargaining power may result in a one-sided non-compete and that overbroad non-competes can have more widespread harm. It found those didn’t apply here and pointed to the specific circumstances of the awardee — a sophisticated executive — and the negotiation — including his support of counsel.

Notably, this is a Federal court applying Kansas law — so the blog notes it’s limited as far as binding authority goes. And some clearly reject forfeiture for competition. But the blog says it provides “meaningful authority for the proposition that a forfeiture for competition provision can be enforced even if applicable law otherwise limits the enforceability of non-compete provisions,” and it provides this drafting tip.

If an agreement has more than one enforcement mechanism (e.g., a right to seek damages and injunctive relief and a separate statement that breach will result in forfeiture of certain compensation or benefits), it is important to make each enforcement mechanism distinct and severable from the others.  The result of this case could have been different if the agreement did not have a severability clause.

It also helps to state clearly that amounts subject to forfeiture are not considered earned or fully vested (even if considered vested for tax purposes) unless and until the employee has satisfied all applicable conditions.  Clarity on this point helps the court to distinguish between a permissible compensatory incentive to comply and a potentially impermissible penalty for breach.

– Meredith Ervine