Noncompetes under fire, the benefits of forfeiture-for-competition clauses getting a fresh look

For decades, companies have used post-employment noncompete agreements to protect their confidential information, trade secrets, and customer relationships. An employee’s contractual obligation not to leverage “insider” information and customer relationships for a competitor – enforceable by an injunction in court – has been a powerful proactive tool in keeping a company from picking off key employees of its competitors, poaching its customers, and stealing its trade secrets and confidential information.

The protective benefits noncompetes offer have always been in tension with the impact they have in limiting an employee who wants to secure a new job in his or her field. The current trend is toward increased restrictions on the use and enforcement of noncompetes, which are in the crosshairs. The Federal Trade Commission (FTC) recently adopted a rule that, if it becomes effective, will ban all post-employment noncompetes with only one narrow exception for certain senior executives. The rule does not apply to noncompetes entered into with the sellers of a business in a bona fide transaction or in certain industries the FTC does not govern, including nonprofits and certain banks, among others. The FTC has likewise used its enforcement powers to pursue employers that use and enforce noncompetes. The rule has been challenged in no fewer than three legal actions questioning the FTC’s authority to regulate noncompetes, and trade organizations from virtually every industry have argued that the FTC’s findings undergirding the rule have no rational relationship to what actually occurs in their respective industries, and is thus arbitrary and capricious. Most commentators expect that the rule will be enjoined and ultimately struck down by the courts.

The General Counsel of the National Labor Relations Board (NLRB) also considers the use and enforcement of noncompetes to constitute an unfair labor practice when applied to workers covered by federal labor law, and is similarly using its enforcement powers to pursue employers that utilize them. This, too, will undoubtedly be challenged in court.

And state legislatures across the country are getting in on the act as well, passing laws restricting the use and enforcement of noncompetes. In 2023, Minnesota became the first state in over a century to ban noncompetes, and a growing number of other states have limited noncompetes with salary thresholds, strict notice requirements, and other technical “hoops” through which an enforcing employer must successfully jump, lest it lose the contractual protections that were a condition of hiring its employees in the first place. Many states also restrict the use and enforcement of noncompetes for certain healthcare practitioners, and some have other industry-specific noncompete laws.

Against this backdrop, employers across the country are understandably concerned and are looking for alternative ways to protect their confidential information, trade secrets, and customer relationships. Enter the “forfeiture-for-competition” clause, a close cousin of the noncompete, but very different in many important respects.

A forfeiture-for-competition clause essentially makes voluntarily not competing post-employment a condition on an employer’s grant of an equity grant or option, severance, or other long-term benefit. If the employee abides by the noncompete restriction, he or she receives the equity grant, options, or other benefit. If the employee does not, he or she cannot be stopped from taking a competitive job, but forfeits the benefit, and may have to repay certain benefits already received. While the FTC’s rule is expected to be struck down, it should be noted that forfeiture-for-competition clauses would be prohibited thereunder because, according to the FTC, they “penalize” employees for working for a competitor. But that is not really how forfeiture-for-competition clauses work in reality; rather, they give a departing employee the choice of either refraining from joining a competitor and keeping the benefit, or joining a competitor and forfeiting or returning it.

Forfeiture-for-competition clauses governed by state law

Specifically, since forfeiture-for-competition clauses do not prevent employees from working, but rather they just impose a penalty for working competitively, they are typically analyzed under what is what is known as the “Employee Choice Doctrine,” which treats such clauses as normal contract terms rather than traditional noncompetes that are subject to a heightened reasonableness analysis. In the state law context, a common place to find these provisions is in partnership and limited liability company agreements, as well as in long-term incentive plans, as opposed to employment agreements.

A recent decision out of the Delaware Supreme Court confirmed that the Employee Choice Doctrine is alive and well in that jurisdiction, where most companies are incorporated and thus its laws govern many operating agreements and long-term incentive plans. In Ainslie v. Cantor Fitzgerald, six former partners of Cantor Fitzgerald initiated the action when the company withheld unpaid installments owed to them from their capital accounts after determining that they had engaged in competition with the partnership within one year of voluntarily withdrawing. The amounts owed to these six former partners range from just under $100,000 to over $5 million. Cantor Fitzgerald’s partnership agreement provided that departing partners receive one fourth of the funds remaining in their capital account each year for four years, but if they engage in competitive activity within that four-year period, they forfeit amounts remaining in their capital accounts.

In January 2023, despite recognizing that the Employee Choice Doctrine is the “majority” approach in Delaware and nationwide, the Delaware Chancery Court nevertheless ruled that the provisions at issue constituted restraints of trade that should be evaluated for reasonableness—the same analysis Delaware courts apply to traditional noncompete agreements. Applying this standard, the Chancery Court concluded Cantor Fitzgerald’s forfeiture-for-competition provisions were facially overbroad and void against public policy, citing the four-year term, unspecified geographic scope, significant amounts potentially forfeited, and potential deterrent effect on employee mobility. Further, the Chancery Court likened the forfeiture-for-competition provisions to disfavored liquidated damages provisions that restrain trade by requiring employees to pay former employers an amount untethered to the employer’s loss, i.e., a penalty.

A year later, in January 2024, the Delaware Supreme Court reversed the Chancery Court, holding that forfeiture-for-competition provisions adopted by sophisticated actors should be enforced just like any other contractual provision; in other words, public policy favors holding these parties to their agreements irrespective of their reasonableness. While the Chancery Court invoked a comparison to liquidated damages, the Delaware high court viewed the provisions as conditions precedent to Cantor Fitzgerald’s obligation to pay any remaining installments remaining in a departed partner’s capital account, i.e., the amounts are not payable unless the condition not to compete has been met. As a result, although employers nationwide held their collective breath for a year while the case worked its way through the judicial system, the ultimate outcome was to maintain the Employee Choice Doctrine. Forfeiture-for-competition clauses thus remain a viable option for employers, and will remain so provided the FTC’s rule is struck down.

Forfeiture-for-competition clauses under ERISA

While the Employee Choice Doctrine is the majority rule, there are jurisdictions that follow the minority rule and treat forfeiture for competition clauses as restraints on trade and accordingly analyze them like restrictive covenants. However, regardless of applicable state law, Employers have another avenue for accessing something akin to the benefit of the Employee Choice Doctrine through federal law.

When a forfeiture-for-competition clause is included in an employee benefit plan rather than a partnership or LLC operating agreement, it drafted appropriately, it falls within the purview of the Employee Retirement Income Security Act (ERISA). ERISA broadly preempts overlapping state law, meaning that forfeiture-for-competition clauses in ERISA plans are governed by federal law.

Related: FTC’s new ban on noncompetes has big impact on health care industry

ERISA top hat plans

The most common type of ERISA plan in which forfeiture-for-competition clauses are included is a nonqualified deferred compensation plan commonly known as a “top hat plan.” A top hat plan is a specific type of nonqualified deferred compensation plan under ERISA maintained “primarily for the purpose of providing compensation to a select group of management or highly compensated employees”. Top hat plans are unfunded, meaning that that the funds that will eventually be paid out in benefits are not held in trust. The company just has an obligation to pay those benefits from its corporate funds when those benefits become payable. Top hat plans are subject to ERISA’s administrative and enforcement provisions, so they trigger preemption of state law, but they are exempt from certain ERISA requirements, including ERISA’s vesting provisions, meaning that they can include provisions forfeiting benefits in certain circumstances, like forfeiture for competition.

Another advantage afforded by ERISA is the applicable standard of review for any judicial challenge. Courts have generally concluded that a benefits decision under a top hat plan is entitled to deferential review.

ERISA severance plans

Another potential ERISA vehicle for a forfeiture for competition clause is an ERISA-governed severance plan. Many severance plans (often intentionally) are not governed by ERISA for a variety of reasons; however, severance plans that include an administrative scheme can be drafted to fall within the purview of ERISA, triggering ERISA preemption of state law and the other benefits attendant to the applicability of ERISA. Employers should consider the cost-benefit analysis of an ERISA-governed severance plan.

Looking ahead

The future of noncompetes is uncertain, but the current trend is decidedly toward limiting their application. Employers are accordingly having to adjust their strategies for protecting trade secrets, confidential information, and company-developed goodwill. Confidentiality agreements are an available tool, and in most jurisdictions, employers still have non-solicitation agreements as another tool to protect their business interests. Forfeiture-for-competition clauses may be a complementary tool and the “next best thing” to a traditional noncompete. They’re certainly worth a fresh look.

Mr. Gerth is a partner in Epstein Becker Green’s Nashville office and a member of the firm’s Employee Benefits and ERISA practice group. Mr. Weibust is a partner in Epstein Becker Green’s Boston office and co-chair of the firm’s Trade Secret and Employee Mobility practice group and a member of its National Litigation Department Steering Committee.