A recent Missouri federal court decision highlights the different standards that courts employ in evaluating forfeiture-for-competition provisions contained in stock option plans. 

Summary.  Many courts testing the validity of a contractual forfeiture-for-competition provision use a “reasonableness” standard.  Recently, however, a Missouri district court judge aligned himself with the minority view and held that regardless of whether the provision in an employee’s stock option plan is fair or unfair, it is enforceable.  The reason: the plan provided that the Board of Directors, which was not shown (or even alleged) to have engaged in fraud or bad faith, had the right to decide whether to exercise the company’s rights.  Smythe v. Raycom Media, Inc., Case No. 1-13-CV-12 (CEJ) (E.D. Mo., Aug. 15, 2013).

The relevant provision.  Smythe worked for Raycom for 14 years before he retired.  His final position was general manager of the company’s Cape Girardeau, Missouri television station.  During his employment, he was a participant in two stock option plans.  Each plan provided for forfeiture of unpaid awards if “in the opinion of [Raycom’s Board of Directors], the Participant, without the prior written consent of the Company, engages directly or indirectly” in competition with Raycom or any subsidiary.  The plan also stated that “[T]he decisions of the Board and its action with respect to the Plan shall be final, binding and conclusive upon all persons having or claiming to have any right or interest under the Plan.”  The forfeiture provision contained neither a time nor a geographic limitation.

Violation.  A scant three months after retiring from Raycom, Smythe accepted employment with another Cape Girardeau TV station.  Raycom notified him that, as a result, he forfeited all awards issued pursuant to one of the two stock plans.  He filed a declaratory judgment action in a state court challenging the notification.  Raycom removed to federal court based on diversity jurisdiction. 

Delaware law applied, but there were no reported appellate decisions on point from courts in that state.  However, in a 1989 case concerning a forfeiture-for-competition clause applied against an employee who was terminated without cause, the Third Circuit Court of Appeals predicted that Delaware appellate courts would apply a “reasonableness” test.  Subsequently, in 2005, a Delaware Superior Court judge used the “fraud-or-bad-faith” standard.

Ruling in favor of Raycom.  The Missouri federal court decision accords with the minority of rulings concerning the enforceability of a forfeiture clause.  The court held that, because the Board of Raycom was vested with discretion to determine Smythe’s eligibility under the stock plans, the Board’s decision cannot be overturned unless the Board acted fraudulently or in bad faith (neither of which were alleged).   

Takeaways.  The primary purpose of covenants not to (a) compete with the former employer, (b) solicit the former employer’s clients/customers or other employees, and (c) disclose the former employer’s confidential information, is to prevent an employee from engaging in or facilitating unfair competition.  By contrast, while a forfeiture clause might have that effect, its primary purpose is to discourage an employee — by imposing as a penalty the loss of future retirement benefits, contingent bonuses, or stock options — from engaging in competition, fair or unfair, with the employer. 

Like Raycom, an employer in a jurisdiction where a court has not selected the “reasonableness” test for use in forfeiture-for-competition clause litigation may be able, by careful draftsmanship of the clause, to maximize the probability that a “fraud-or-bad-faith” standard will be employed.  In addition to an unequivocal delegation to the Board of Directors of authority to interpret the plan, a forfeiture-for-competition provision might also:

  1. Identify expressly the post-employment benefits that are conditional,
  2. Spell out the circumstances (such as the employee’s violation of post-employment covenants) under which the employer has no obligation to provide those benefits, and
  3. State that the employee will not challenge enforceability of the clause unless a showing can be made that the employer engaged in fraud or bad faith in drafting or invoking the clause. 

Finally, to be amply cautious, the employer should exercise the power of forfeiture in an even-handed and non-discriminatory manner, emphasizing cogent reasons for believing that the employee’s competition will damage the employer.  In that event, the action probably may pass the “reasonableness” test if a court adjudicating the validity of the provision decides to apply that standard.