Let me start this week’s blog with a big disclaimer – I’m not a lawyer, so everything I say here is purely from my own head and is definitely not legal advice. Okay, that all said – I’ve always got my ear to the ground to see what’s going on in the courts relative to equity compensation. This week I noticed a wee court case that made the news related to stock options. There are some interesting takeaways that could certainly be discussed with counsel, so I figured they’re worth a mention.

A Stock Option, A Termination and a Non-Compete

Many of us are familiar with references to non-compete agreements that are often included in stock option agreements. This topic became front and center in a recent New York appeals case (Lenel Systems Intl. v. Smith). In short, an employee was granted stock options as part of his employment with the company. The option agreement contained a clause referencing a requirement to not compete. The agreement did not explicitly state that the agreement could be terminated if the non-compete was violated, but it did say that the employee’s agreement to not compete was consideration for the options. Fast forward – the employee left the company, and subsequently violated his non-compete agreement. Since the company did not have the ability to outright terminate the former employee’s stock options, they did the next best thing: they sought to rescind the agreement.

A recent Herman law blog summarized the court’s reaction to this approach as follows:

“The court summarized that rescission is an equitable remedy that allows a court to declare a contract void from its inception. As a general rule, rescission of a contract is permitted where there is a breach of contract that is material and willful, or so substantial and fundamental “as to strongly tend to defeat the object of the parties in making the contract.” The court rejected the defendant’s argument that an express forfeiture clause in the option agreement was required in order for option to be subject to rescission. Instead, the court reasoned that the noncompetition covenant was the sole consideration for the option agreement, and when the defendant chose to compete with Lenel “in violation of the only material condition of the agreements,” he would give up his right to the stock options promised in exchange.

In is also worth noting that two of the appellate judges dissented from this decision, arguing that the consideration for the option consisted of two parts, one being the compliance with the covenant during the term of employment and the other part for the post-termination period. The dissent reasoned that since the defendant did comply with the covenant during his six years of employment with Lenel, it cannot be said that he did not provide any consideration for the option, thereby reducing the argument in favor of rescission.”

Although the company won their appeal (and was permitted to use rescission as an appropriate recourse for the employee’s violation of the non-compete), it wasn’t entirely a slam dunk. For one thing, two judges dissented and raised some interesting points – questioning whether in six years of employment the employee did not provide any other type of consideration for the option. This thought didn’t prevail amongst the appellate judges, but hmm…something to think about.

One message that seems clear to me is that perhaps companies should check on those clauses in the option agreement that refer to non-compete. Is the course of action fully defined? Or is it vague? While the company came out on top in its quest to rescind the option agreement, there certainly was a lot of time, money and effort spent on this pursuit. It lends thought to whether it would be easier to revisit grant agreement language to clarify whether the agreement can be terminated in this type of situation.

I’m not suggesting that everyone immediately line up, option agreement in hand, to ask their lawyers. But this is a situation where having some clearer language in the agreement could have achieved this result much more expeditiously. I’m just saying. If your company is drafting new grant agreements, or revisiting option terms, this may be a question to bring to the table.

-Jennifer