NY Appellate Court Holds Rescission of Stock Options Can Be Remedy for Non-Compete Breach

A recent decision out of New York’s Appellate Division, Fourth Department, raises the interesting consideration of non-compete agreements and rescission.   The case apparently has been in litigation for several years, but the recent appellate decision is worth a look.

Back in 2004, Richard Smith left a company called Lenel Systems, which develops, manufactures and sells security systems.   While at Lenel, Smith had served as the Director of International Sales and Marketing, then later as a corporate Vice President.   As part of his compensation, Smith was granted certain stock options.  The stock option agreement contained a restrictive covenant.  Essentially, as consideration for the stock options, Smith signed a non-compete agreement, agreeing to stay out of the security system business for two years.   Smith subsequently tendered to Lenel approximately $130,000 to exercise certain of those stock options.   Shortly thereafter, Smith resigned and immediately began working for a competitor, S2 Corporation.

Lenel returned the $130,000 to Smith, minus a dividend that it had already paid.  Lenel then filed suit alleging that Smith had breached his non-compete agreement and seeking rescission of the stock option agreements.  According to Lenel, the grant of stock option agreements was expressly conditioned on Smith’s promise not to compete.  According to Smith, the stock options were part of his employment package, which was used to induce him to move to the area and take the job with Lenel.

What followed, apparently, was more than seven years of litigation and numerous appeals.   After extensive discovery and a trip up and down the appellate ladder, Smith moved for summary judgment seeking dismissal of the amended complaint (which seeks rescission of the option agreements) and judgment on his counterclaims which seek money damages based on the value of the stocks.  The core of Smith’s argument was that the plaintiff was not entitled to rescission both because (1) the stock options were part of his overall employment compensation, not just consideration for the non-compete agreement and (2) the non-compete was unreasonable and therefore unenforceable.

In rejecting these arguments, the Appellate Division concluded that all of these arguments involve disputed issues of fact.  The question of whether or not Smith breached the non-compete agreement implicated numerous issues of fact, including the issue of whether or not his new company, S2, was a competitor (an issue that was hotly disputed on the record).   Likewise, issues surrounding the remedy of rescission also implicated disputed issues of fact.  As the court explained, rescission is generally available where a breach of contract is “material and willful” or, even if not willful, where the breach is “so substantial and fundamental as to . . . defeat the object of the parties in making the contract.”   And in the case at bar, there are triable issues of fact, not only in regard to whether the agreement was breached, but if so, whether the breach was willful or so substantial as to defeat the purpose of the contract.

There are a number of takeaways here, on both sides.  For employers, the case suggests that there may be some benefit in clearly linking stock options to the non-compete restriction (rather than to employment, generally).  Also, there is the somewhat obvious point that attorneys prosecuting non-compete cases should always evaluate the issue of stocks and rescission.

Going after rescission of stock grants or stock options, depending on the value of those stocks, can create another source of financial pressure on the defendant and another source of a prospective financial recovery for the plaintiff.  This is particularly compelling where the non-compete agreement was reasonable and has been breached, but damages are minimal, speculative or very difficult to prove.

Suppose that the stocks are worth $500,000 and were clearly linked to a non-compete restriction.  Now suppose the plaintiff succeeds in establishing a breach of a reasonable non-compete agreement, but there are virtually no damages from the unfair competition.  If I am the ex-employer, I may not want to enforce the agreement.  I may just want rescission.  I may want that $500,000 back.

On the employee side, the case suggests that high level employees (the type who are likely to have stocks or stock options) should, to the extent possible, seek to negotiate the terms on which those stocks are awarded.  As a high level executive, you do not want the stocks/options tied to a non-compete agreement.  Instead, you want the stocks/options awarded either as part of an overall compensation package, or, as a bonus for past performance.  When stocks and options are tied to non-compete obligations, that can create problems down the road.

The case is Lenel Sys. Int’l, Inc. v. Smith, 1113, 2013 WL 1849214 (N.Y. App. Div. May 3, 2013).

Jonathan Pollard is a trial lawyer and litigator based in Fort Lauderdale, Florida.  He focuses his practice on cases involving non-compete disputes and represents clients in Florida and throughout the country.