This article is reprinted with permission from the
October 29, 1999
edition of
New York Law Journal.
1999 NLP IP Company.

 


'IBM v. Bajorek' - Choice of Law and No-Compete Clauses

By Joseph E. Bachelder

 

IT IS TYPICAL for stock option grants to contain, in some form, a no-compete provision. It also is typical for such grants to contain a choice-of-law provision, frequently that of the jurisdiction in which the employer is headquartered. Such a choice-of-law provision is important for an employer granting stock options to employees in various jurisdictions. For example, an employer headquartered in New York presumably would choose New York, which recognizes no-compete clauses (subject to certain limitations as discussed in this column on Aug. 30th.)

In International Business Machines Corp. v. Bajorek, _ F3d _ 1999 WL 710360 (9th Cir., Sept. 14, 1999),1  the Court of Appeals for the Ninth Circuit, reversing the District Court,2   held that a stock option grant provision making New York law applicable for purposes of the grant preempted the application of California law. The Ninth Circuit indicated that, absent the choice-of-law provision in the stock option, California law would have applied because the executive was resident and employed in California.

While the IBM case turned on a conflict-of-laws point, the conclusion as to choice of law was based on the Court of Appeals' underlying interpretation of California law and public policy toward no-compete agreements. The District Court had concluded that the no-compete clause of the option violated a fundamental rule of California law and that California had a materially greater interest in this issue than New York. (Bajorek was employed in California when he left IBM.) Applying 187 of the Restatement (Second) of Conflict of Laws, discussed below, the District Court held that since a fundamental policy of California was involved, California law should take precedence over New York law notwithstanding the contract choice of law. Under California law, the District Court held the no-compete provision was invalid.

Remand, to Apply New York Law

The Ninth Circuit, in reversing the District Court, held that the no-compete provision did not violate any no-compete rule or other fundamental policy of California and, therefore, it gave effect to the choice-of-law provision in the stock option grant and remanded the case to the District Court for further proceedings applying New York law.

The stock option grant in the IBM case provided that if the holder exercised the option and within six months of exercise went to work for a competitor of IBM, he had to pay back to IBM the value realized on exercise of the option (a so-called "claw-back" provision). IBM, like many employers as noted above, sought to have the law of the jurisdiction in which it is headquartered, New York (where its principal outside counsel and its corporate counsel also are located), apply, for purposes of determining any legal issues involving the stock option.

The choice-of-law provision in the stock option grant reads:3
The Plan and all determinations made and actions taken pursuant hereto, to the extent not otherwise governed by the Code or the securities laws of the United States, shall be governed by the law of the State of New York and construed accordingly.4

The no-compete and "claw-back" provisions read:
(a) A Participant shall not render services for any organization or engage directly or indirectly in any business, [sic] which... is or becomes competitive with the Company, or which organization or business, or the rendering of services to such organization or business, is or becomes otherwise prejudicial to or in conflict with the interests of the Company.
(d) Upon exercise, payment or delivery pursuant to an award, the Participant shall certify on a form acceptable to the Committee that he or she is in compliance with the terms and conditions of the Plan. Failure to comply with the provisions of paragraph (a), (b) or (c) of this Section 13 prior to or during the six months after, [sic] any exercise, payment or delivery pursuant to an award shall cause such exercise, payment or delivery to be rescinded.5

Bajorek had been employed by IBM for 25 years, located during that period in New York, Minnesota and California (where he was employed at the time he left IBM). In February and April 1996 Bajorek exercised the options in question and within six months thereafter, in June 1996, he left to join a competitor. IBM demanded that Bajorek return an amount equal to the gain realized on the options exercised in February and April 1996.

Claw-Back Provision

On Sept. 18, 1996, Bajorek filed an action in a California court seeking a declaratory judgment that he did not breach the no-compete agreement. He asserted that, despite the option provision making New York the choice of law, the correct choice of law was California and that under California law the claw-back provision was unenforceable.

On Oct. 4, 1996, IBM brought an action in New York Supreme Court asserting its right to the option gains on the basis that Bajorek breached the no-compete clause and therefore IBM was entitled to recapture the gains under the "claw-back" clause. IBM also asserted it was entitled to the amounts in issue on grounds of misrepresentation. Each action was removed to a District Court, and the New York action was transferred to California and consolidated with the California action.

As noted above, the core issue for both the District Court and the Court of Appeals was whether, in view of the contract choice-of-law provision, New York law applied. Both courts based their decisions on 187 of the Restatement (Second) of Conflict of Laws. That section provides that the contractual choice of law prevails unless either (a) or (b) applies:
(a) the chosen state has no substantial relationship to the parties or the transaction and there is no other reasonable basis for the parties' choice, or
(b) application of the law of the chosen state would be contrary to a fundamental policy of a state which has a materially greater interest than the chosen state in the determination of the particular issue and which... would be the state of the applicable law in the absence of an effective choice of law by the parties.

The District Court concluded that enforcement of the no-compete clause would violate two basic rules under the California Codes and therefore would be contrary to fundamental policies of California.6  (The District Court also found that California had a "materially greater interest" in these issues than New York.)7  Two provisions of the California Codes were involved:

California Business and Professional Code 16600:
Except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.

California Labor Code 221:
It shall be unlawful for any employer to collect or receive from an employee any part of wages theretofore paid by said employer to said employee.

The Ninth Circuit reversed the District Court because it concluded that the contract clause violated neither of the above two provisions of the California Codes.8  In the view of the Ninth Circuit, Bajorek's argument failed because he did not establish that the choice of New York law would be contrary to a "fundamental policy" of California.9

Presumably, on remand, the District Court will find that the claw-back provision is valid under New York law based on International Business Machines Corp. v. Martson, 37 F. Supp. 2d 613 (SDNY 1999), as supplemented, 1999 U.S. Dist. Lexis 4620 (SDNY March 9, 1999). In that case, the District Court for the Southern District of New York granted judgment to IBM on the pleadings, applying New York law to no-compete and claw-back provisions virtually identical to those at issue in International Business Machines Corp. v. Bajorek.

Readers interested in the District Court and Ninth Circuit analyses of the underlying California rules dealing with no-compete agreements will find them discussed at some length in each of the opinions.10

Preparing Contracts

Following is a brief discussion of what employers might do, in preparing contracts like that in the IBM case, to strengthen their position that the choice of law made in the stock option agreement - or other employment-related agreement -should apply:

1. The parties might acknowledge that the state-of-choice under the contract is the most appropriate jurisdiction for reasons which, depending on the circumstances, may include the following:
* location of employer's headquarters
* location of counsel
* employer's state of incorporation
* state with the largest, or one of the largest, populations of employees receiving stock options

2. The parties might acknowledge that it is important to the employer for all such agreements to be governed by the law of a single jurisdiction.

3. The parties might represent that the choice-of-law provision has been specifically reviewed by counsel of each party's choice.

4. Each party might consent to venue in the Federal or state courts located in the state of choice.

5. In addition to the above drafting suggestions in support of the choice-of-law provision, the parties might emphasize the importance of the no-compete clause to the protection of the employer's business. Courts typically examine restrictive covenants carefully to determine the importance of such covenants to the protection of the employer's legitimate business interests. Such interests include the protection of trade secrets, the protection of confidential information about the employer and its customers, and the unique or extraordinary nature of an employee's skills or services.

In addition to contract provisions of the sort just noted, the employer should be alert at all times to any possible dispute regarding the no-compete and choice-of-law clauses. For example, if it appears that an executive is about to violate a "claw-back" provision, the employer should be prepared to bring a lawsuit promptly in a court of its choice. In the event of litigation over a stock option grant with a "claw-back" clause, it might also be helpful to the employer if the grant provides that proceeds from the exercise of the stock option (less amounts, if any, necessary to pay taxes at the time of exercise) will be held back pending the expiration of the "claw-back" period.


FOOTNOTES:

1 The Ninth Circuit opinion is also available at 1999 U.S. App. Lexis 21949.

2 Bajorek v. International Business Machines Corp., No. C96-20806 RMW(PVT) (N.D. Cal., April 16, 1997) (order granting plaintiff's motion for judgment on the pleadings) at 4-6. A copy of the District Court order, which contains its opinion, can be obtained from the United States District Court for the Northern District of California in San Jose.

3 The Ninth Circuit states that the no-compete provision, the claw-back provision and the choice-of-law provision were included in the stock option agreements. _ F3d _; 1999 WL 710360, at *1. (Westlaw citations preceded by an asterisk are to screen/page numbers assigned in the database.) The District Court suggests that the quoted language in fact is contained in the IBM Long Term Performance Plans rather than the grants themselves. Bajorek v. International Business Machines Corp., supra, note 2, at 1-2. If that is so, presumably the grants incorporated the relevant plan provisions. With that assumption, it should not make a difference whether the provisions were explicitly stated in the grants or incorporated by cross-reference. The discussion in the column assumes these provisions are specifically included in the stock option grants.

4 Bajorek v. International Business Machines Corp., supra, note 2, at 6. The quotations of provisions in the stock option agreement are from the opinion of the District Court contained in the District Court order.

5 Id.

6 n7 Id. at 5-6.

7 n6 Id. at 6-9.

8 _ F3d _; 1999 WL 710360, at *4-6. As to California Business and Professional Code 16600, the Ninth Circuit distinguished Muggill v. Ruben H. Donnelly Corp., 62 Cal.2d 39, 42 Cal. Rptr. 107, 398 P2d 147 (Cal. 1965), in which the California Supreme Court held that a covenant was void under 16600 because it made an employee's pension forfeitable if the retired employee at any time entered any occupation or did any act in competition with his former employer. The Ninth Circuit relied on its earlier decisions construing 16600, including Smith v. CMTA-IAM Pension Trust, 654 F2d 650 (9th Cir. 1981), which held that suspension of benefits under a multi-employer pension plan during any period in which an otherwise eligible employee worked in the same industry or for a participating employer did not violate 16600. The court found that because the IBM covenant discouraged an employee from going to work for a competitor for only six months after exercising stock options, it was much more limited than the restrictions in Muggill, or even Smith, and thus did not violate 16600.

9 _ F3d _; 1999 WL 710360, at *6.

10 See _ F3d _; 1999 WL 710360, at *4-6; Bajorek v. International Business Machines Corp., supra, note 2, at 4-9.