Reevaluating Restrictive Covenants in Equity Award Agreements

Given recent developments and trends in the United States relating to restricted covenants (especially non-competes), companies should take another look at any restrictive covenants included in equity award agreements.

What Are Restrictive Covenants?

Restrictive covenants are used in employment agreements in the form of non-compete, non-solicitation (of other employees and/or customers/clients), confidentiality and/or non-disparagement provisions. Restrictive covenants usually attempt to limit employees' behavior during their employment as well as impose post-termination restrictions.

Recent US Developments

On January 5, 2023, the Federal Trade Commission (FTC) took action on the July 2021 Executive Order on Promoting Competition in the American Economy and proposed a rule declaring employer / employee non-compete clauses an “unfair method of competition.” The proposed rule states that employers cannot enter into, or attempt to enter into, a non-compete clause with a worker; maintain a non-compete clause with a worker; or represent to a worker that the worker is subject to a non-compete clause where the employer has no good-faith basis to believe that the worker is subject to an enforceable non-compete clause.

Most recently, legislation has also been introduced in Congress seeking to ban non-competes for low-wage earners and nonexempt employees under the Fair Labor Standards Act.

Additionally, multiple states have enacted legislation limiting the use of non-compete agreements for low-wage earners in recent years, including Illinois, Massachusetts, Washington, and Oregon. And there are other states which have had similar restrictions for a while, such as California, North Dakota and Oklahoma.

Restrictive Covenants in Equity Award Agreements

In addition to including restrictive covenants in employment agreements, companies frequently include them in equity award agreements. The idea is that, if the company failed to impose or negotiate restrictive covenants when the employee entered into the employment relationship, it can implement them now in consideration for the grant of equity awards.

Additionally, the equity awards present another penalty if restrictive covenants are violated: not only can the company attempt to enjoin the employee from the violating behavior (e.g., working for a competitor), but it can also provide for forfeiture of the award (if still outstanding at the time of the violation) and/or claw back of any shares or proceeds related to the shares (i.e., sale proceeds and dividends).

One-size Does Not Fit All

In the past, companies rarely tailored restrictive covenants in equity award agreements to each jurisdiction (US states or countries outside the United States). Now, with so many new restrictions in the United States, it is more typical for companies to tailor the restrictive covenants for compliance with applicable US state law.

However, outside the United States, enforcing restrictive covenants in an award agreement is even more problematic, especially non-compete and non-solicitation covenants. One threshold hurdle is that restrictive covenants have to be agreed to between the employee and employer, but the granting company is generally not the employing entity. It is questionable if a local court will grant an injunction based on a restrictive covenant that is not part of the employment agreement.

At the same time, the concept of what constitutes a reasonable non-compete period or appropriate geographical scope will differ significantly from country to country, and there are a number of countries that allow enforcing a post-termination non-compete only if the terminated employee is compensated during the non-compete period (usually by payment of a percentage of their salary as an employee). The equity award itself, or the shares issued pursuant to the award, are unlikely to constitute sufficient compensation in this instance.

What Is the Downside of Including Restrictive Covenants in Equity Award Agreements?

Most companies prefer not to tailor their restrictive covenants in award agreements for compliance with non-US laws, given it is a significant undertaking that may not even guarantee enforceability, but opt to retain them to have a deterrent effect. (As mentioned above, however, we are seeing more companies tailor provisions to comply with US state law.)

In practice, this may be an acceptable solution, but companies should consider the following issues:

• Including restrictive covenants that prove unenforceable could lead to the entire agreement (or at least all provisions which could be construed as adverse to the grantee) being declared unenforceable or subjecting the company to penalties if viewed as contrary to public policy or as an unfair business practice. While severability clauses in award agreements will help mitigate these claims, they do not fully eliminate the risk.
• Including restrictive covenants in the award agreement inherently links the awards to the employment relationship, which is typically something companies want to avoid. Instead, they want to argue that the awards are a discretionary benefit provided by the foreign parent company that is completely separate from 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.).

Again, many of these issues are more theoretical in nature, but with an increased global focus on restrictive covenants (especially non-competes), employees may start paying more attention to such provisions and try to leverage them in their favor.

What Are the Possible Approaches?

Companies can take a variety of approaches to deal with restrictive covenants for employees outside the United States. The most conservative approach is to remove the restrictive covenants from the equity award agreements and have the local employer enter into separate restrictive covenant agreements with the relevant employees which are tailored to the employee's jurisdiction.

Such provisions can either be included in the employment agreement (for new employees) or in a side agreement that functions as an amendment to the employment agreement (for existing employees). In the latter case, the promise of a grant of equity awards could be used to convince the employee to execute the agreement.

Alternatively, companies could take the approach of removing the more problematic restrictive covenants (i.e., non-competition and non-solicitation provisions) while maintaining the non-disparagement and confidentiality provisions.

Lastly, companies could choose to keep the restrictive covenants in equity award agreements (without tailoring them to local law) but limit the penalty to forfeiture of the award and/or clawback (not injunction of violating behavior). While this may be enforceable in a number of countries (on the basis that the equity awards are governed by US law and therefore, the restrictive covenants do not have to comply with local law), there are countries in which even a forfeiture or clawback will not be enforceable (due to the unenforceability of the underlying restrictive covenant under local law). In a few countries, an employee may argue they are entitled to post-termination compensation if a company attempts to forfeit an award or claw back proceeds as a result of violation of a non-compete.

Conclusion

Unfortunately, there are no easy answers for companies intent on being able to enforce restrictive covenants but (understandably) not willing to create country-specific restrictive covenant agreements. Companies content with the deterrent effect of restrictive covenant provisions may get comfortable with the risks of including unenforceable restrictive covenants in their award agreements, but should regularly evaluate the related risks, given this is an area developing rapidly.