April 02, 2009
Daily Journal Reprinted and/or posted with the permission of Daily Journal Corp. (2009).
The California Supreme Court’s decision in Edwards v. Arthur Andersen LLP, 44 Cal.4th 937 (2008), reaffirmed that employee non-competition agreements are void in California unless they fall within narrow exceptions to Business and Professions Code Section 16600.
Notwithstanding the Edwards decision, it may be possible for employers to enforce non-competition forfeiture provisions in California by including them in retirement plans subject to the Employee Retirement Income Security Act of 1974. ERISA is a federal statute that governs most employee benefit plans (except those provided by government entities and churches), including retirement plans. ERISA plans are protected by a well-formed pre-emption doctrine that applies to most state laws except those regulating insurance, banking or securities matters.
In a series of cases dating back as early as 1980, the 9th Circuit has examined the inclusion of non-competition forfeiture provisions in ERISA plans and has determined that such clauses are permissible under ERISA, with some limitation, and state law is pre-empted on this issue.
It is important to point out that a non-competition forfeiture provision in an ERISA plan cannot apply to any amount an employee voluntarily contributes to a plan because such amounts are always automatically 100 percent vested and not otherwise subject to forfeiture. Similarly, a forfeiture provision added to an ERISA plan could not apply to benefits earned prior to the adoption of the amendment.
Also, ERISA’s vesting rules generally establish a maximum time period over which employer contributions to a plan must vest. At the time most of the relevant 9th Circuit cases were decided, ERISA permitted employers to choose between one of two vesting schedules for employer contributions. One schedule was a 10-year "cliff vesting" schedule whereby an employee was zero percent vested until he or she worked for the employer for 10 years, at which time the employee became 100 percent vested. The other schedule provided for a graduated vesting schedule that allowed an employee to vest in incremental percentages (usually 10-20 percent) over time, but not to exceed 15 years.
These vesting rules have been amended a number of times over the years, and currently, employer contributions to profit-sharing and 401(k) plans must vest under either a three-year cliff vesting schedule or a six-year graduated schedule at the rate of 20 percent, beginning with the second year of service.
Accordingly, including a forfeiture provision in a profit-sharing or 401(k) plan may not be as effective as it was when the relevant cases were decided. Now, however, it may be more effective to include non-competition forfeiture provisions in top-hat or other executive compensation plans (which are generally ERISA plans that are exempt from the vesting rules). And there are others commentators who have suggested adding forfeiture provisions to ERISA-covered severance plans as another way of achieving this goal. No 9th Circuit cases have examined whether a forfeiture provision could be included in a top-hat or ERISA-covered severance plan but the arguments in favor of ERISA pre-emption should be the same as in the relevant cases. Instructively, the 2nd Circuit has held that state law was pre-empted by ERISA in the context of a top-hat plan containing a non-competition forfeiture clause and found that the forfeiture provision was valid. One of the earliest cases to examine the inclusion of a non-competition forfeiture provision was the pre-ERISA case of Muggill v. The Reuben H. Donnelley Corporation, 62 Cal. 2d 239 (1965). In Muggill, the California Supreme Court analyzed the validity of a provision in a pension plan that provided that an employee’s right to receive payments from the plan would be terminated if he went to work for a competitor. The court held that the pension plan became part of the employment contract and, therefore, the forfeiture provision was invalid under Section 16600 – "[e]xcept 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."
ERISA was enacted in 1974 and, thereafter, the 9th Circuit’s first occasion to analyze a non-competition forfeiture provision in an ERISA plan was in Hummell v. S.E. Rykoff & Co., 634 F.2d 446 (9th Cir. 1980). In Hummell, the court examined a plan provision that provided for the forfeiture of a percentage of the competing former employee’s retirement benefits derived from employer contributions. The plan stated that the forfeiture provision only applied to former employees with less than 15 years of experience with the company who competed with the company (those with more than 15 years were fully vested, regardless of competitive activity).
In examining an issue of first impression, the court held that ERISA does not prohibit limited non-competition provisions that apply to amounts in excess of the minimum vesting requirements in ERISA. Ultimately, the court held that the forfeiture provision in the plan was invalid as to the plaintiff because he had more than the minimum years of service required to be 100 percent vested under that plan. Thus, the forfeiture provision was valid but it could not be applied by the company.
In Lojek v. Thomas, 716 F.2d 675 (9th Cir. 1983), the court examined a non-competition forfeiture provision contained in an ERISA-governed profit sharing plan sponsored by a law firm. The provision called for the forfeiture of all employer contributions made on behalf of an attorney who left the firm before completing 10 years of employment and engaged in competitive employment within two years of leaving within a five-county area.
The trial court granted partial summary judgment on a number of issues including that ERISA pre-empts Idaho state law on vesting and forfeiture of pension plan rights and non-competition forfeiture clauses are valid under ERISA. Lojek appealed arguing, inter alia, that Idaho common law on non-competition clauses should control and invalidated the provision. The court disagreed and held that the district court properly decided that ERISA pre-empted Idaho law and federal law governed the validity of the plan.
The plan at issue contained a vesting schedule more liberal than required by ERISA. It allowed attorneys to fully vest after completing five years of employment (the cliff vesting provision under ERISA at the time was 10 years). If an attorney worked for at least 10 years, the non-competition provision did not apply. As a result, the court held that the vesting schedule was valid.
Similarly, in Clark v. Lauren Young Tire Center Profit Sharing Trust, 816 F. 2nd 480 (9th Cir. 1987), the plaintiff argued that a forfeiture clause in an ERISA plan violated Oregon law and the plaintiff urged to the court to incorporate that law and invalidate the provision. In rejecting the plaintiff’s argument, the court held that the reasoning in Lojek applied and that state law played "no part in assessing the validity of [a non-competition forfeiture provision] in an ERISA plan."
The court in Clark further held that non-competition forfeiture clauses in ERISA plans are valid so long as the plan provides that benefits earned after 10 years of service cannot be forfeited. Because ERISA’s vesting requirements have been reduced, it is likely that a court reviewing facts similar to Clark today would require that the plan provide that benefits earned after three years of service cannot be forfeited (assuming the court followed the ERISA preemption authority).
Finally, in Weinfurther v. Source Services Corporation Employees Profit Sharing Plan and Trust, 759 F.Supp. 599 (N.D. Cal. 1991), the court reiterated that non-competition forfeiture clauses in the Ninth Circuit are valid (citing Lojek and Clark with approval).
Accordingly, based on the 9th Circuit authorities discussed above, employers have a plausible argument that non-competition forfeiture provisions included in ERISA plans should be analyzed under ERISA and are not subject to Business and Professions Code Section 16600. Employers should considering including ERISA plan provisions providing that an employee forfeits employer contributions exceeding ERISA’s minimum vesting rules if the employee violates a non-competition provision included in the plan. The non-competition forfeiture provisions should be limited in scope and duration to the extent necessary to protect legitimate business interests.
Additionally, employers may consider trying to extend the ERISA approach to top-hat plans and ERISA severance plans (with structured payouts over time).
These approaches are not without risk and counsel should be consulted before including any non-competition forfeiture provisions as there is always a possibility that notwithstanding ERISA preemption that a court may find that it does not apply based on the strong public policy of Section 16600.