Include Restrictive Covenants in Equity Grants? Why Not?

June 2, 2014

Many companies require all new hires to sign restrictive covenant agreements (e.g., non-compete, non-solicitation, confidentiality and non-disclosure). While the enforceability of such provisions varies by state, courts often take a dim view of such agreements (particularly those with non-competes), and are reluctant to enforce provisions that are not reasonable in duration, geography or scope of duties. Courts may find these provisions overbroad and contrary to public policy because they are seen as limiting the employee’s ability to earn a living without being narrowly tailored to the employer’s legitimate business interests. See, e.g., Home Paramount Pest Cos. v. Shaffer, 282 Va. 412, 718 S.E.2d 762 (2011) (striking down a non-competition agreement that the court had upheld 22 years earlier, by holding that the provision no longer was narrowly tailored to protect the employer’s legitimate interests).

A more refined approach is to apply the restrictive covenant only to those employees who are actually capable of competing unfairly in the event of termination of employment (e.g., senior executives and those in sales, strategy, design and innovation). This practice, however, requires constant supervision over moving talent, especially in organizations where employees are frequently promoted or where employee roles and functions rapidly change.

Restrictive covenants in equity grants of all varieties (e.g., options, restricted stock units and performance shares) traditionally have provided the perfect vehicle through which an employer may reserve the right to forfeit an employee’s compensation (rather than restraining him from working) in the event he or she violates the covenant. Forfeiture provisions are viewed by courts as less restrictive than prohibitions against working for a competitor.

However, in certain circumstances, courts may be willing to go beyond forfeiture and actually impose injunctive relief against the employee − based on restrictions contained in an equity grant. As with other restrictive covenant cases, this analysis depends in large part on whether the facts are favorable to the employer (i.e., a seasoned employee who possesses confidential information, acknowledges covenant terms and seeks to compete directly with the employer). The significance, however, is that such covenants may provide a vehicle not just for forfeiture of awards, but also to restrict the employee’s post-termination activities.

Current Developments

Excluding California, where non-compete agreements are essentially per se unenforceable (admittedly, there exists an exception for trade secrets), two recent decisions strongly suggest that courts will enforce online restrictive covenants in stock award agreements.

MeadWestvaco Corp. v. Bates, No. CL13-1589 (Va. 12th Cir. Ct. Aug. 1, 2013) (unpublished)

In this decision, MeadWestvaco Corp. (MWV), a global packaging company, sought injunctive relief against its senior director of global production design, to restrain him from seeking employment with a direct competitor. The relief sought was based on several documents acknowledged online by the employee, including 2012 stock option awards and restrictive stock award agreements (the 2012 Agreements). The 2012 Agreements provided that during the term of employment and 12 months following termination of employment, the employee would not:

… anywhere in the world where [MWV] or its affiliates do business, directly or indirectly … provide services as an employee … to any business that competes with [MWV] and its affiliates in businesses in which [the employee] was materially involved during the two years prior to [his] termination. [Emphasis supplied.]

Significantly, the 2012 Agreements did not include any language identifying temporary injunctive relief as a remedy for breach. However, the court did not find this essential or even necessary, reasoning that:

  • The functional and geographic restrictions were tailored narrowly to meet MWV’s legitimate business interests;
  • The mere fact that there was no geographic limitation was not fatal;
  • The 12-month duration and functional limitations (relating to the employee’s material involvement and applicable only against businesses in competition with MWV) were not burdensome; and
  • The evidence clearly showed that the employee agreed to online acceptance of a stock award, required by “log-in” and specific “click” to accept the grant (including terms and conditions).

The court also discussed the “inevitable disclosure doctrine,” which holds that an employer may enjoin an employee who has knowledge of a trade secret from accepting employment with a direct competitor if the employee will necessarily have to use or otherwise disclose those trade secrets to perform the duties of his new position.

Based on the above analysis − the employee’s very senior position with access to confidential information, as well as the likelihood (in the court’s words) that Virginia will follow the majority of states in adopting the inevitable disclosure doctrine − the court found that the employee engaged in threatened misappropriation because he would inevitably disclose this confidential information in his position with a direct competitor. Thus, MWV prevailed in obtaining temporary injunctive relief based on the online provisions of the 2012 Agreements even though the grant terms and conditions included a remedy for breach resulting in forfeiture or loss of compensation.

Newell Rubbermaid, Inc. v. Storm, No. 9398-VCN, 2014 Del. Ch. LEXIS 45 (Del. Ch. Mar. 27, 2014)

On the motion of the plaintiff employer, Newell Rubbermaid, Inc. (NR), the Delaware Chancery Court in this decision issued a temporary restraining order against a former NR director of sales who allegedly violated non-solicitation and confidentiality provisions included in a 2013 online stock award agreement (the 2013 Agreement). The specific focus of the decision was on whether or not the employee assented to the post-employment covenants in the 2013 Agreement by accepting the award through a third-party website. The employee’s major arguments were that:

  • Given NR’s historical practice not to include post-employment restrictions in online stock awards, but to include such provisions in written agreements for higher-ranking employees (e.g., separation agreements), there was no mutual assent of the terms;
  • The 2013 Agreement failed to state that NR was modifying her post-employment rights, and she had no notice of any changes to her post-employment obligations to NR; and
  • Consideration for the non-competition covenant was illusory, as the award was conditioned on continued employment, and because the award itself was subject to forfeiture.

The court did not agree, stating:

“A contract is valid if it manifests mutual assent by the parties and they have exchanged adequate consideration.” The use of the internet as the vehicle of contract formation “has not fundamentally changed the principles of contract.” The “threshold issue is the same: did the [party who assented online] have reasonable notice, either actual or constructive, of the terms of the putative agreement and did [that party] manifest assent to those terms.”

Id. at *18 (footnotes omitted). The court’s conclusion was that the employee voluntarily accepted the award and was asked to read the grant terms online, but chose not to do so. In the court’s words:

[NR’s] method of seeking [the employee’s] agreement to the post-employment restrictive covenants, although certainly not the model of transparency and openness with its employees, was not an improper form of contract formation.

Id . at *23.

As to the former employee’s argument that the consideration offered was illusory, the court responded that such analysis was improperly based on Texas law in the “at-will” employment context, where consideration may not be conditioned on future employment. The court quickly noted that Delaware law permits continued employment to serve as consideration, and noted further that the stock award held actual value, despite the fact that it was subject to forfeiture under certain circumstances.

Key Takeaways

MeadWestvaco and Newell leave us with the following:

  • Restrictive covenants are enforceable so long as they are narrowly drawn to protect the employer’s legitimate business interest and not unduly burdensome on the employee’s ability to earn a living or against public policy or local statutes.
  • Courts will enforce electronic stock award agreements, as online acceptance is a viable method through which to seek employee consent of terms and conditions.
  • Courts will likely grant injunctive relief whether or not such remedy is included in stock award terms and conditions.
  • Stock awards are a useful compensation tool through which an employer can apply restrictive covenant agreements to a more select group of key personnel.
  • Employers should carefully consider how an employee is asked to agree to stock award terms and conditions. If the employee is required to agree to award terms by actually viewing the terms and then clicking “accept” to each specific award agreement, in contrast to consenting to abide by an entire website’s terms (typically as a condition to entering the site), there will be a greater likelihood of enforcing the stock award’s restrictive covenants.
  • The facts still matter – enforcement of a restrictive covenant will be greatly enhanced if (i) the employee breaching the covenant is high-ranking and has access to confidential information; (ii) the covenant terms and conditions are properly disclosed; and (iii) the employee’s consent to such terms and conditions is obtained and documented.

For further information, please contact one of the authors, Maria P. Rasmussen and Rodney A. Satterwhite.