NON-COMPETITION “CLAWS” – RETRIEVING SHARE OPTION GAINS
The recent decision of an Ontario Superior Court judge in Nortel Networks Corp. v. Jervis has upheld the validity of a “claw-back” provision in a share option agreement intended to discourage a departing employee from joining a competitor.
Jervis was a senior executive with Nortel who had been granted share options by his employer for several years. The form of option agreement contained a provision which required Jervis to pay Nortel an amount equal to the monies he gained on the exercise of his options should he join a competitor within 12 months [changed to 24 months in later option agreements] from the date of exercise. The payment was to be required if Nortel’s Option Committee found in its “sole” discretion that the employee’s action was “inimical to the best interests of the Corporation”. The Committee later passed a resolution in which, absent special circumstances, employment with a listed competitor would be considered inimical to the best interests of the Corporation.
Jervis quit Nortel and joined Newbridge Networks Corporation, one of the listed competitors. Before doing so, he exercised Nortel options in which he received a gain of $626,857 (early 1998!). When, following his departure, Jervis refused Nortel’s demand to pay the monies over to it, Nortel commenced an action.
The issues for the trial judge were as follows:
1. Was there a lack of consideration?
2. Was the claw-back an unenforceable covenant in restraint of trade?
3. Did the Committee fail to exercise its discretion in good faith or at all?
- Was the repayment obligation unenforceable as a penalty clause?
In finding in favour of Nortel, the trial judge held that a benefit had been conferred on Jervis (the options) at a cost to Nortel, in return for a promise to comply with the terms of the option agreement. This constituted consideration. He also held that the provision was not in restraint of trade as it did not prevent Jervis from competing: it simply required him to forego the benefit if he chose to compete.
In addition the trial judge found that it was not an unreasonable exercise of the Committee’s discretion to provide for an automatic claw-back where the criteria in its resolution were met, since the criteria were reasonable. He held that the resolution did not prohibit the Committee from exercising its discretion and in fact specifically provided that it was not so precluded.
Finally, while the claw-back was found to constitute a penalty, the trial judge held that it was neither unconscionable nor oppressive. The repayment required was based on the cost of the stock options to Nortel and on the corresponding benefit to Jervis. The fact that Jervis had already paid income tax on his gain was immaterial. He was required to repay the gross profit from the exercise of the options and to subsequently seek tax relief.
This case clearly upholds the legitimacy of a restrictive covenant in a share option agreement designed to dissuade executives from cashing in their shares and then moving on to a competitor. We can look for such covenants to become more commonplace in the future.
David Elenbaas
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