The Employer’s New Choice: Does Termination Without Cause Bar Enforcement of Noncompetition Agreements?
It is increasingly common for deferred compensation plans to condition those benefits on the employee’s commitment to refrain from competitive activity after the employment relation has ended. While New York law generally proscribes the forfeiture of wages already earned, the forfeiture of non-wage benefits, like stock options and deferred compensation of various forms, is often upheld.1 Where, however, the forfeiture is for engaging in competition with one’s former employer, it is subject to what is commonly called the “employee choice” doctrine. Under that doctrine, courts will enforce such forfeitures without an assessment of reasonableness if the affected employee quits his job and competes because the employee, in that circumstance, had a choice of “preserving his rights under [the benefit plan] by refraining from competition or risking forfeiture of such [benefits] by exercising his right to compete.”2 Nonetheless, “[a]n essential element of the [employee-choice] doctrine is the employer’s ‘continued willingness to employ’ the employee.”3
Some courts have ruled that employers can invoke the doctrine “only if” they demonstrate a “continued willingness to employ” the former employee, 4 and that effectively precludes enforcement of forfeiture-for-competition clauses whenever the affected employee is discharged without cause. Others have gone further still and invoked the doctrine to deny enforcement of noncompetition clauses, even as applied to at-will employees, unless the affected individual quit or was discharged for cause.5
These rulings, however, are extensions of the core doctrine and are not how the employee-choice doctrine has actually been applied by the New York Court of Appeals. It is sometimes said that, under New York’s employee-choice doctrine, employers can never enforce anticompetition forfeitures and restrictive covenants if they terminate their employees involuntarily and without cause. That is a misstatement of the law and needs to be challenged.
The correct rule is that forfeiture-for-competition clauses are enforceable without regard to reasonableness if the employee voluntarily resigns and, if not, might still be enforceable if reasonable under the circumstances. The doctrine should not even be applied to the enforcement of restrictive covenants and certainly not to automatically preclude anticompetition injunctions whenever the affected employee has been discharged without cause.
Enforceability Without Regard to Reasonableness
The employee choice doctrine was born under New York common law. In the seminal case of Kristt v. Whelan, an employer named one of its employees as the beneficiary of a corporate trust, and the trust agreement contained a forfeiture clause that would be triggered if the employee undertook a role in a competing business. 6 The employee voluntarily quit his job and started a competitive enterprise. In enforcing the forfeiture-for-competition clause, the Appellate Division reasoned as follows: “It is no unreasonable restriction of the liberty of a man to earn his living if he may be relieved of the restriction by forfeiting a contract right or by adhering to the provisions of his contract [citations omitted]. The provision for forfeiture here involved did not bar plaintiff from other employment. He had the choice of preserving his rights under the trust by refraining from competition with [his former employer] or risking forfeiture of such rights by exercising his right to compete with [it].”7
Two decades later, the New York Court of Appeals impliedly endorsed Kristt’s employee-choice analysis, but with a qualification that has given rise to the current confusion. In Post v. Merrill Lynch, Pierce, Fenner & Smith, Inc., two account executives sued their former employer, Merrill Lynch, to recover pension benefits that Merrill had deemed forfeited, after it had fired the executives without cause.8 Citing the “strong public policy against forfeiture of benefits” as was reflected by the then-recently enacted Employee Retirement Income Security Act of 1974 (ERISA),9 the court was clearly troubled by the fact that it was a pension benefit that was at issue. The court found that “[u]nder the circumstances of the case at bar,” it was “unconscionable” to deny the employees pension benefits they had already earned when the basis for the forfeiture was “the unwarranted action” of the employer. The court premised its holding on the concept of mutuality of obligation: “Where the employer terminates the employment relationship without cause [. . .] his action necessarily destroys the mutuality of obligation on which the covenant [not to compete] rests as well as the employer’s ability to impose a forfeiture.”10 Thus, while the Post decision preserved the Kristt rule as to employees who voluntary resigned, it appeared to some that Post proscribed such forfeitures for employees who were denied the implied precondition of that bargain by having been discharged without cause.11
Whatever may have been the merits of this reading of Post at one time, it is now precluded by Morris v. Schroder Capital Management, the Court of Appeals’ most recent, and perhaps most thoughtful, articulation of the employee-choice doctrine.12 In Morris, the court answered certified questions from the Second Circuit concerning whether, under the employee-choice doctrine, the forfeiture-for-competition clause of deferred compensation plan could be enforced where (as the plaintiff there alleged) the former employee had been constructively discharged. Reaffirming its prior support of Kristt, the Court ruled that a forfeiture-for-competition clause “will be enforceable without regard to reasonableness if an employee left his employer voluntarily.”13 Where, in contrast, an employee has been fired without cause (or is subject to constructive discharge), reasonableness is no longer automatic, but neither is the forfeiture automatically void. Rather, in such cases, “a court must determine whether forfeiture is ‘reasonable.’”14 Significantly, the court supported this proposition by citing Post, which it characterized as holding that the forfeiture of “pension benefits earned by an employee who competes” was “unreasonable as a matter of law” when the employee is involuntarily discharged, suggesting that a different assessment of reasonableness might obtain if non-pension benefits had been involved.15
Properly understood, the employee-choice doctrine holds that when an employee voluntarily resigns and then goes to work for a competitor, “he will be barred from challenging the reasonableness of a non-competition clause, where forfeiture of some benefit is the penalty for violation,” and if the employee is discharged without cause, he is afforded “the right to challenge the reasonableness” of the forfeiture-for-competition clause, not simply to evade it as of right.16 In one case, the court found it “perfectly reasonable” for the employee to agree to refrain from post-employment actions injurious to his employer’s business in exchange for a grant of stock options. Accordingly, the forfeiture of those options was enforced even though the employee had been discharged without cause.17
Covenants Are Not Clauses
Because forfeiture-for-competition clauses offer employees a choice between receiving certain economic benefits (in exchange for refraining from competition) or engaging in competition (and forfeiting those benefits), a forfeiture-for-competition clause is not simply a stand-in for restrictive covenants that are ancillary to an employment contract. As Judge Posner observed while interpreting New York law in Sarnoff v. American Home Products Corp., “the whole point of Kristt was to distinguish between a covenant not to compete, whereby a former employee could be enjoined from competing with his former employer, and a condition whereby the former employee would merely forfeit a monetary benefit if he went into competition with his former employer.”18 In Morris, this distinction was recognized explicitly: “The ‘employee choice’ doctrine is applicable in cases involving economic relief, rather than injunctive relief.”19
Some courts and commentators have taken an unduly broad view of employee-choice doctrine where an employee is terminated without cause, interpreting that fact to render unenforceable covenants not to compete or to solicit customers when ancillary to employment.20 This is unwarranted.
While restrictive covenants against post-employment competition are not favored and are enforced only to the extent reasonable and necessary, they are nonetheless enforceable when the reasonableness criteria are met.21 Employers create deferred compensation plans both to incentivize their key executives, giving “them a proprietary interest in the company by linking their compensation to [its] profitability and growth,”22 and also to discourage post-employment competition by making those additional benefits conditional on the employee’s continued compliance with his covenant not to compete. An employer ought not be required to forego an otherwise lawful means of protecting its business interests from unfair competition as the price for exercising its independent right to terminate an at-will employee for any reason at all, with or without cause. This is the only approach that balances the public policy of allowing the free movement of talent in the marketplace (the linchpin of the courts’ reluctance to enforce broad restrictive covenants) with the other public policy of allowing parties to contract freely with one another for the exchange of one economic benefit for another (which is what underlies the employee-choice doctrine).
Standards of Reasonableness
There are very few cases that address what standard of “reasonableness” is to be applied when an employee, who has been is terminated involuntarily and without cause, seeks to recover the benefits withheld for his having chosen to engage in competition with his former employer.
One approach was taken in York v. Actmedia, Inc., where, as a condition for participating in certain stock option plans, the employee had agreed that he would not, for two years following his employment, divert the company’s clients or induce those clients to reduce their business with the company.23 It was, the court said, “perfectly reasonable” for the parties to have agreed “that, in consideration of the stock options, [the employee] would refrain from certain steps injuring the business of defendant after he left its employ.”24 Focusing on the economic realities of the deal struck by the employee with his employer, the court noted that the restriction on competition was limited to a two-year period, and that no effort was being made by the former employer to enjoin the former employee from engaging in his business or to recover damages against him for having done so.
Under New York law, when an employer seeks to enforce by injunction its restrictive covenant with a former employee, part of the assessment of reasonableness is whether the restriction was “not greater than required for the protection of the legitimate interests of the employer.”25 Courts have recognized these protectable interests to be (1) preventing the use or disclosure of trade secrets or other confidential information, (2) maintaining goodwill by preventing the solicitation of established customers and (3) retaining the services of key employees whose services are extraordinary or unique.26 It is significant that the court in Actmedia apparently found it unnecessary to consider any of those factors in concluding that the forfeiture of stock options was reasonable in the case before it.
In contrast, when the district court in Lucente analyzed the propriety of an employer’s cancellation of stock options for competition, it expressed a more exacting view of precisely which employer interests merit protection under “reasonableness” determination.27 As the district judge there saw it, New York law “does not distinguish between enjoining an employee from competing with his former employ and imposing some sort of financial penalty for doing so” — whether as liquidated damages for breach or as forfeiture of previously awarded stock options — and, therefore, that the well-established injunction standard applied to forfeitures as well.28 The implication of the Lucente approach is that enforcement of forfeiture clauses will require a “protectable interest” (such as the protection of trade secrets or customer relations) if the former employer was discharged without cause, but otherwise not.
The Lucente’s court’s analysis of BDO Seidman v. Hirschburg,29 on which it relied, is open to question. All that BDO Seidman said was that an anticompetition clause that imposes liquidated damages for violation will be “carefully scrutinized by the courts,” not that it would utilize the precise same standards as would apply to an injunction.30 In fact, what the court actually did in BDO Seidman was to remand the case for a determination of whether the liquidated damages amount was reasonable as an estimate of actual damages or a disguised penalty, which the courts would not enforce.31
Moreover, liquidated damages is cash out of pocket and effectively reduces what the former employee will earn for his future efforts. In contrast, forfeiture of a previously awarded benefit will defeat past expectations and may or may not be reasonable depending on the circumstances and the nature of the benefit involved, but it does not constrict the capacity to earn a living going forward. Whether an anticompetition restraint serves a recognized protectable interest of the employer seems irrelevant to whether a forfeiture-for-competition clause.
In any event, two different standards of reasonableness have now been articulated under the employee-choice doctrine when the “reasonableness” determination needs to be made. The law on this issue must be regarded as unsettled at the present time.
Choice and Severance
Special problems arise when the benefit subject to forfeiture is severance, and the law there continues to evolve. In Scott v. Beth Israel Med. Ctr., the First Department denied summary judgment to a hospital on the allegation of its former employee, an orthopedist, that it had breached his fixed-term employment contract by terminating him without cause and then depriving him of severance benefits specified in the agreement for non-cause terminations.32 In so ruling, the court rejected the hospital’s contention that it was excused from its obligation for severance because those benefits were expressly conditioned on the good doctor’s not engaging in medical practice, which he had, in fact, done from the very same day that his termination became effective. Citing the employee-choice doctrine, the Second Department ruled that, given that the termination was without cause, “the fact that Dr. Scott went to work elsewhere is an insufficient basis to dismiss” his causes of action for breach of contract and for the contractually specified severance benefit.33
The Scott court appears to have conflated the employee-choice doctrine with certain other settled principles of employment law. Under New York law, employers cannot, generally speaking, enter into fixed-term employment contacts and reserve to themselves the right to terminate without cause prior to that contract’s expiration, as that destroys mutuality of obligation.34 One recognized exception to this rule is where the employer, in exchange for the early termination, becomes obligated to pay and does pay a “penalty,” which is what severance pay in such circumstances is intended to be.35 When, in Scott, the hospital terminated the orthopedist prior to the expiration of his fixed term of employment and, then, withheld severance benefits required by the employment contract because he had subsequently competed, the hospital itself destroyed the very condition necessary to make its early termination without cause lawful. This explains why Dr. Scott should have a cause of action for breach of contract, but allowing him, as well, an action for the contractually specified severance is, frankly, not fully explicated by the court.
The severance pay at issue in Scott was traded, in theory, both for the employer’s ability to end the contract term early (which would otherwise be a breach) and also for its ability to demand Dr. Scott’s forbearance from competition. The implication of the court’s decision in Scott appears to be that such “dual purpose” severance benefits are unenforceable.
Perhaps the court’s (unstated) rationale was that it is “unreasonable” as a matter of law to force an employee to choose between competition and a severance benefit when that severance benefit is also the “penalty” that validated the employer’s early contract termination. Thus understood, Scott is a special application of the employee-choice doctrine to the severance provisions of fixed-term employment contracts (as Post may have been limited to pension benefits), but does not stand for the more sweeping proposition that any forfeiture-for-competition clause is unenforceable where the employee is terminated without cause, as that would contradict what the Court of Appeals said in Morris.
Obtaining an injunction to enforce a covenant not to compete requires the initiation of litigation that can be both expensive and prolonged. And, its effect, if successful, is to “restrict [. . . ] the liberty of a man to earn his living” from his chosen occupation.36 The looming revocation of a valuable deferred benefit can preemptively discourage an employee from quitting to work for a competitor. It is effectively self-enforcing by the employer, and it does not prevent the employees from earning a living by competing with his former employer, though it does mean that the choice is no longer cost-free.
That the employer was the party who chose to terminate the employment relationship, and did so without cause, does not automatically render unreasonable the enforcement of that initial bargain. Nor is that involuntary termination by itself a reason to deny a court injunction to enforce restrictive covenants that are otherwise reasonable and necessary to protect the employer’s legitimate interests in preventing unfair competition by former employees. It does not appear that any New York State court, and certainly not the Court of Appeals, ever held that it was.37
This article is for general information purposes and is not intended to be and should not be taken as legal advice.
This article first appeared in the March 26, 2012, issue of the New York Law Journal.
15 Id. See, also, York v. Actmedia, Inc. 1990 WL 41760, at *2 (S.D.N.Y. Mar. 30, 1990) (“Post does not hold that all non-competition for future clauses are unenforceable as a matter of law if an employee is terminated without cause”); Wise v. Transco, Inc., 73 A.D.2d 1039 (1980) (holding that forfeiture of non-pension benefit was not “unreasonable as a matter of law solely because the discharge was involuntary”).
16 York v. Actmedia, Inc., at *1. See also Lucente v. Int’l. Bus. Machines Corp., 262 F.Supp.2d 109, 113 (S.D.N.Y. 2003) (“a court must determine whether the covenant is ‘reasonable’ if the employee left involuntarily and without cause”); Int’l. Bus. Machines Corp. v Martson, 37 F.Supp.2d 613, 619 (S.D.N.Y. 1999).
36 Kristt v. Whelan, 4 A.D.2d at 199; see also Columbia Ribbon & Carbon Mfg. Co., Inc. v. A-1-A Corp., 42 N.Y.2d 496, 499 (1977) (“powerful considerations of public policy [. . .] militate against sanctioning the loss of a man’s livelihood”).
37 Kristt v. Whelan, 4 A.D.2d at 199; see also Columbia Ribbon & Carbon Mfg. Co., Inc. v. A-1-A Corp., 42 N.Y.2d 496, 499 (1977) (“powerful considerations of public policy [. . .] militate against sanctioning the loss of a man’s livelihood”).