A sizeable number of companies include restrictive covenants in their equity award agreements, such as non-compete, non-solicitation, confidentiality and/or non-disparagement provisions. If a grantee violates the provisions, companies can forfeit the award (if still outstanding at the time of the violation), claw back any shares or proceeds related to the shares (i.e., sale proceeds and dividends) or seek an injunction to cease the employee’s violation of the applicable covenant. The restrictive covenants typically are not tailored by jurisdiction but, rather, of a “one-size-fits-all” variety. As a result, companies should not be surprised to learn that the covenants rarely are enforceable as written, especially the non-compete and non-solicitation covenants.
I think it is fairly well-known that non-competes are generally not enforceable in California, except in a few narrow circumstances (such as a selling shareholder or partnership dissolution). The same cannot be said for other jurisdictions (whether other U.S. states or non-U.S. countries), but it is very unlikely that the “one-size-fits-all” approach will work.
For example, in several countries outside the U.S., in order to enforce a non-compete, the employer has to pay separate consideration to the terminated employee, often expressed as a percentage of the terminated employees salary, during the non-compete period. None of the non-compete provisions I have seen included in an award agreement has provided for such a post-termination payment. As such the failure to do so would likely render the non-compete provisions unenforceable. It should also be noted that the equity award itself or the shares issued pursuant to the award would not constitute sufficient consideration where a post-termination payment is required, since the value received (from a consideration point of view) will typically occur upon grant or vesting (or both). Similarly, in many countries, the notion of what constitutes a reasonable non-compete period or appropriate geographical scope will differ significantly, making it very unlikely that a general non-compete will work in multiple countries, unless it is so watered down as to be ineffective.
So, again, the first take-away is that a uniform restrictive covenant in an award agreement will rarely be enforceable across multiple jurisdictions. And if the underlying restrictive covenant is not enforceable, this means the company generally cannot enforce the corresponding remedy (i.e., forfeiture of the award, clawback) or pursue an injunction.
Restrictive Covenants and Equity Awards – Yes or No?
In light of this, are restrictive covenants in award agreements worth the paper they are written on? The answer is maybe, if all the company is interested in is to create a deterrent for the grantee and bank on the possibility that the grantee may not realize that the provisions are unenforceable. But even this approach is not free from risk. First, including unenforceable provisions in an agreement could lead to the entire agreement (or at least all provisions which could be construed as adverse to the grantee) being declared unenforceable. A severability or reformation clause may mitigate this risk, but the rules and judicial attitudes on severability and contract reformation vary widely, so this risk cannot be eliminated with such language. Further, there may be jurisdictions which view an unenforceable restrictive covenant as contrary to public policy or as an unfair business practice (e.g., California) and penalize a company just for including it.
Another (less quantifiable) potential downside of including covenants such as non-competes and non-solicitations in an award agreement is that they intrinsically link the employment relationship to the awards. This is not an issue where the employer and the grantor of the equity award are identical, but it is undesirable where the parties are not the same and especially where the employer is in a different country than the granting company. As you probably heard me and my colleagues say a million times: it is important to maintain a distinction between the equity awards and the employment relationship, to mitigate against all sorts of potential claims from the employee (e.g., joint employer liability, vested rights/entitlement claims, a right to receive award documents translated into local language, claims to have the awards be factored in when calculating severance pay, etc.).
To maintain this distinction, we advise companies to keep the involvement of the local employer in the award administration to a minimum and not to mention equity awards in any employment documents (e.g., offer letters, employment agreements). By including a non-compete or non-solicitation provision in the award agreement, we undermine the argument that the award is not part of the employment relationship, and open up the issuer to being hauled into court as a joint employer on what might otherwise be a purely local employment dispute with the employee.
So, based on all of the above, unless a company strongly believes in the deterrent effect of the (mostly unenforceable) restrictive covenants and is willing to live with the associated risks described above, my advice must be to remove such restrictive covenants from an award agreement.
What are the Alternatives?
While it would be nice to prevent all employees from jumping ship to work for a competitor, companies usually are most concerned about a small group of key employees. For these employees, companies should consider making the effort of crafting restrictive covenants that are governed by and enforceable under the applicable local law.
However, again, the award agreement is not the right “place” for the covenants. Instead, such covenants are in fact terms of the employment relationship and, as such, should be included in the employment agreement or as a side agreement, such as a Proprietary Interests and Inventions Agreement (“PIIA”) that is concluded with the local employer (not the parent company) at the time of employment. In case the desired restrictive covenants were not included when the employment agreement was first concluded or in case there is no actual employment agreement (quite common for U.S. employers), the company should prepare a separate restrictive covenant agreement, customized for the respective employee’s situation and his or her country, to ensure enforceability. The other party to this agreement is the local employer, and the restrictive covenant becomes an amendment or supplement to any existing employment agreement.
Of course, the question remains how you get the employee to sign this agreement (which generally is not in his or her favor). Well, this is where the equity awards come in. In particular, the next grant of awards will be made conditional upon the employee signing the restrictive covenant agreement. This can and should be verbally communicated to the employee, rather than mentioning the equity awards in the restrictive covenant agreement, or vice versa. As explained above, we want to keep a clear distinction between the awards and the employment relationship, at least from a document standpoint.
The exception to this rule may apply in jurisdictions in which consideration must be provided at the time the restrictive covenant is entered into in order to make the covenant enforceable. However, even in these jurisdictions it should not be necessary to mention the award as consideration for the restrictive covenant agreement, as long as the company is willing to pay the nominal and/or reasonable amount of consideration to the employee, as per applicable law.
To be clear: even though we have now created an enforceable restrictive covenant agreement, I am still not proposing to use the equity awards as a remedy for violation of the agreement (e.g., through a clawback of shares or sale proceeds). Instead, companies will need to take the old-fashioned approach of pursuing an injunction against the employee. While this may seem more burdensome, it has one compelling advantage: it should actually work!
Restrictive covenants in equity award agreements sound like an easy way to force employees to “behave right” or lose their awards. Unfortunately, such covenants are can be difficult to enforce a and can create risks for the company. To create enforceable covenants, they must be tailored to the employee’s circumstances (including his or her country) and should be removed from the award agreement. Equity awards can still play a crucial role in getting employees to agree to restrictive covenants, but in a different way than anticipated by most companies.