Tenth Circuit Rules Forfeiture-for-Competition Not Subject to Non-Compete Reasonableness Test
In Lawson v. Spirit AeroSystems, Inc., U.S. Court of Appeals, Tenth Circuit, upheld the forfeiture of stock awards for violation of a covenant to not compete. The Tenth Circuit reached this conclusion despite the fact that the executive’s agreement included both a forfeiture-for-competition provision and traditional enforcement rights (i.e., the right for the company to pursue monetary damages and specific performance). This is because the agreement terms allowed the forfeiture provision to be separated from the traditional enforcement provisions. The Tenth Circuit reached this conclusion even though the executive’s agreement included both a forfeiture-for-competition provision and traditional enforcement rights (i.e., the right for the company to pursue monetary damages and specific performance), because the agreement terms enabled the forfeiture provision to be severed from the traditional enforcement provisions.
Background and the Court’s Analysis
A retirement agreement allowed the former CEO of Spirit AeroSystems (“Spirit”) to receive cash payments and continue vesting in certain stock awards if he continued working for Spirit as a consultant and complied with a non-compete agreement. The CEO then contracted with a fund that was conducting a proxy battle against one of Spirit AeroSystems’ suppliers. Spirit determined that the CEO’s actions violated the non-compete agreement and stopped paying him and halted the vesting of his stock. This resulted in the forfeiture of his unvested stock awards. Spirit did not try to recover cash already paid or stock already vested. Only future compensation and vesting was affected. Kansas case law holds that a traditional penalty for competition is valid and enforceable if it is “reasonable in the circumstances and does not harm the public welfare.” However, the court found that Kansas law does apply a different standard to forfeiture of future compensation because it does restrict competition differently. Rather than imposing a penalty, a forfeiture for competition provision “merely provides a monetary incentive in the form of future benefits for not competing.” The court reasoned that a forfeiture for competition provision gives the worker “a choice between competing and thereby forgoing the future benefits or not competing and receiving those benefits.” And because the forfeiture applied only to future compensation, it did not amount to a penalty: the executive forfeited only “the opportunity for the shares to vest notwithstanding his retirement.”
Second, the court reasoned that the policy justifications for reasonableness review did not apply to forfeiture in this case. The court stated that reasonableness review addresses the risk that (1) the employer’s bargaining power can lead to a one-sided non-compete that leaves former employees unable to support themselves after their employment ends and (2) “overbroad” restrictions on competition can “decrease options available to consumers and generate market inefficiencies.” The court concluded that neither of those risks were present in this case, noting that the executive was sophisticated and had support of counsel and that the executive had an opportunity to receive substantial compensation if he had complied with the covenant.
Third, the court reasoned that “
reedom of contract is the fountainhead of Kansas contract law.” Accordingly, the court determined that the forfeiture-for-competition provision should be presumed enforceable, absent the policy concerns described above.[f]Unlike the Seventh Circuit in LKQ–which certified a question of Delaware law to the Delaware Supreme Court–the Tenth Circuit refused to certify the question of Kansas law to the Kansas Supreme Court. For the reasons described above, the court determined that it could predict the Kansas Supreme Court’s interpretation of Kansas law with sufficient confidence to make certification unnecessary.
Finally, the court rejected an argument that reasonableness review should be required because Spirit had both the right to invoke forfeiture and the right to seek traditional enforcement (monetary damages and specific performance). The court found that in this case the right to seek traditional enforcer could be separated from the right of forfeiture. Because Spirit relied exclusively on the forfeiture provision and expressly declined to pursue traditional enforcement, the fact that Spirit could have pursued traditional enforcement was not fatal.
Takeaways
Although Lawson is binding only on federal courts in the Tenth Circuit that are applying Kansas state law (and Kansas state courts could still reach a different conclusion), it provides meaningful authority for the proposition that a forfeiture for competition provision can be enforced even if applicable law otherwise limits the enforceability of non-compete provisions. (Notably, however, some states reject forfeiture for competition.) The decision offers a few important practical takeaways:
The particular facts matter. In this case, it was noted that the forfeiture provisions had been negotiated with sophisticated parties represented by lawyers and that there were no policy concerns about non-compete clauses (interfering in the ability to earn a living or causing market inefficiencies).
- Drafting matters. If an agreement contains more than one enforcement mechanism, such as a right to seek injunctive and damages relief and a separate statement stating that a breach will result in the forfeiture of certain benefits or compensation, it is important that each enforcement mechanism be distinct and severable. This case might have had a different outcome if the contract did not include a clause on severability. It is also helpful to state that amounts subjected to forfeiture (even if they are considered vested tax purposes) are not considered earned until the employee has met all applicable conditions. Clarity on this point helps the court to distinguish between a permissible compensatory incentive to comply and a potentially impermissible penalty for breach.
- Enforcement strategy matters. The court stressed that Spirit did seek injunctive or damages relief and that the forfeiture only applied to future payments and vesting. If Spirit had sought to clawback prior payments or stock which was already vested in the company, the court could have treated the forfeiture like a penalty requiring a reasonableness review.
