Stock Option Forfeiture Based On Work For A Competitor Sustained By Ninth Circuit

As many out-of-state companies have learned to their regret, California (unlike virtually every other state) has a strong public policy against the enforcement of restrictive covenants in the employment context, such as covenants not to compete. See Termination for Refusal to Sign Non-Compete Agreements Leads to Million Dollar Verdict. Under California Business & Professions Code section 16600, with limited exceptions, “every contract by which anyone is restrained from engaging in a lawful profession, trade or business of any kind is to that extent void.” However, a recent decision by the U.S. Court of Appeals for the Ninth Circuit, in San Francisco, may have softened the impact of this provision at least as it affects employers headquartered outside California.

In International Business Machines Corp. v. Bajorek, 191 F.3d 1033 (9th Cir. 1999), the appellate court ruled that a stock option agreement that required a former IBM employee to return any profits from the exercise of stock options if he went to work for a competitor within six months after exercising the options did not violate section 16600. The employee, who worked most of his 25 years for IBM in California, had made more than $900,000 from exercise of the options. He filed suit in California, arguing in part that the stock option plan constituted an illegal restraint of trade under section 16600. The Court of Appeals (vacating a district court judgment entered in the employee’s favor) found that the California statute “only makes illegal those restraints which preclude one from engaging in a lawful profession, trade, or business,” but does not void a contract that restricts the employee from pursuing “only a limited part of the business, trade or profession.” The restrictions at issue, the Court found, were limited in nature in that the employee could have retained his option profits while working in his profession in the same industry, so long as he did not work for a competitor; he also would have been free to work for a competitor, without forfeiting his option profits, if he had exercised the options six months before leaving IBM.

An important factor in the Ninth Circuit’s decision was the fact that the parties had agreed to be bound by New York law. The stock option agreements at issue provided that the plan and all determinations made pursuant to it would be governed by the law of New York. Applying choice of law principles, the Ninth Circuit held first that the employee was bound by this contractual choice of law provision. The Court then rejected his argument that application of New York law would violate the fundamental public policy of California as set forth in section 16600. A California court applying California law in the first instance might well reach a different conclusion. Accordingly, notwithstanding the specific result in Bajorek, there remain substantial risks for employers who, directly or indirectly, seek to obtain restrictive covenants from California employees.