United States: Not All Is Lost For California Employers: Enforce Non-Compete Forfeiture Provisions Through ERISA Top Hat Plans?

Even before the California Supreme Court decided Edwards in 2008, employers knew all too well the woes of attempting to enforce non-competes against California employees.  Edwards simply reaffirmed California's long-standing policy in favor of employee mobility, finding that employee non-competition agreements are typically void in California unless they fall within one of the exceptions to Business and Professions Code section 16600.  But this need not become the fate of every non-compete; notwithstanding Edwards and recent California decisions applying the state's notorious statute, section 16600, it may be possible for employers to enforce non-competition forfeiture provisions by including them in deferred compensation top hat plans subject to the Employee Retirement Income Security Act of 1974 (ERISA).

Congress enacted ERISA to establish minimum vesting standards for employee benefits and define permissible forfeitures.  29 U.S.C. § 1053, see also Hummell v. S.E. Rykoff & Co., 634 F.2d 446, 448 (9th Cir. 1980).  To enforce these minimum vesting standards and ensure uniformity in enforcement, Congress explicitly built "powerful preemptive force" into ERISA.  See Cleghorn v. Blue Shield of California, 408 F.3d 1222, 1225 (9th Cir. 2005).  Subject to a few statutory exemptions, ERISA expressly preempts all state laws that "relate to" any employee benefit plan.  ERISA also contains a comprehensive remedial scheme, thereby preempting any state cause of action falling within that scheme.

The Ninth Circuit has previously determined that the inclusion of non-competition forfeiture provisions in ERISA plans is permissible under ERISA and may be enforced against employees who violate non-competition provisions, subject to ERISA's minimum vesting standards.  See Hummell, supra, 634 F.2d at 450; Lojek v. Thomas, 716 F.2d 675, 678 (9th Cir. 1983); Weinfurther v. Source Services Corp. Employees Profit Sharing Plan and Trust, 759 F. Supp. 599 (N.D. Cal. 1991).  As far as preempting state law, the Ninth Circuit has held that state law plays "no part" in assessing the validity of a non-competition forfeiture provision in a plan governed by ERISA.  Clark v. Lauren Young Tire Center Profit Sharing Trust, 816 F.2d 480, 481 (9th Cir. 1987).  Just last year, the Southern District of California applied ERISA preemption and dismissed a former employee's claim for denial of benefits under an ERISA plan where he had violated the plan's non-compete provision.  Elbling v. Crawford & Co., No. 16cv2951-L(KSC), 2018 WL 1536717 (S.D. Cal. Mar. 29, 2018).

In Elbling, the plaintiff entered into the defendant's deferred compensation plan and when he retired had earned over $76,000 worth of long-term incentive credits. Immediately after retiring, plaintiff began working for defendant's competitor. Shortly thereafter, defendant notified plaintiff that his benefits were forfeited because he violated a non-compete provision included in the plan. Plaintiff unsuccessfully appealed to the plan administrator and then filed an action in California federal court alleging claims for denial of benefits under ERISA, declaratory relief that the non-compete violated California law,  breach of contract, tortious breach of implied covenant, and unfair competition in violation of Business Professions Code Section 17200.

The court dismissed plaintiff's claims. First, the court found that plaintiff's claim that defendant violated ERISA by denying his vested credits as forfeited under the non-compete provision lacked merit because the minimum vesting standards did not apply to the plan which was subject to an exception and exemption to ERISA as a top hat plan. Next, the court rejected plaintiff's claim that California law compelled defendant to pay because the non-compete provision allegedly was unenforceable. The court found, however, that the state law claims were prempted by ERISA. The court found that the state law claims fall within the scope of ERISA's exclusive remedial scheme, which states in pertinent part:

A civil action may be brought (1) by a participant or beneficiary.... (B) to recover benefits due to him under  the terms of his plan, to enforce his rights under the terms of the plan.

Thus, employers may plausibly argue that non-competition forfeiture provisions are not subject to section 16600, so long as they are baked into an employee benefit plan that is truly governed by ERISA.  But see Barker v. Insight Global, LLC, 2018 WL 6334992 (N.D. Cal. 2018)(allowing Section 17200 and declaratory relief claims against employer premised on alleged violations of section 16600 to proceed in connection with deferred compensation plan).  Employers should be mindful of similar non-ERISA plans, such as incentive programs or bonus plans, which are distinct from benefit plans.  Incentive programs, even ones featuring retirement-style vesting, are typically governed by state law and will not be preempted by ERISA.

Why "Top-Hat" Plans, Specifically?

As mentioned above, non-competition forfeiture provisions in ERISA plans are generally subject to ERISA's minimum vesting requirements.  These requirements, which have been amended numerous times over the years, establish a maximum time period over which employer contributions to a subject plan must vest.  Currently, employer contributions to individual "qualified" plans, including profit-sharing and 401(k) plans, must vest under either a three-year "cliff vesting" schedule—whereby an employee remains zero percent vested until he or she meets the specified time period—or a six-year graduated vesting schedule at the rate of 20 percent beginning in the second year of service.  Therefore, it is important to note that a non-competition forfeiture provision in an ERISA plan cannot apply to (1) amounts that are fully vested, for example any amount voluntarily contributed by an employee or any benefits earned prior to the adoption of the relevant amendment, or (2) employees who are fully vested, i.e., have met the minimum number of years of service required under the plan.  See Hummell, supra, 634 F.2d at 451-52 (upholding the forfeiture provision within the employer's ERISA plan as valid, yet inapplicable to the plaintiff because he had served the minimum number of years for his benefits to be 100 percent vested).

Fortunately for employers with California executive employees, so-called "top-hat" plans conforming to the definition set forth in ERISA section 201(2), are not subject to these minimum vesting requirements.  Benefits under a top-hat plan may be forfeited without regard to vesting requirements, even by employees who have met the minimum number of years of service.  However, employers looking to protect their interests without worrying about minimum vesting requirements should take care to ensure that the plan at issue tracks section 201(2) closely; the plan must be an unfunded, non-qualified ERISA plan.  Furthermore, top-hat plans function primarily as a vehicle for deferring compensation to a select group of management or otherwise high-level employees (this is a key detail; top-hat plans are only for employees in need of fewer protections – in exchange for greater flexibility).

Remedies

Another advantage to housing non-competition forfeiture provisions within an ERISA plan, qualified or non-qualified, is that doing so opens the door to ERISA remedies.  A former employee seeking to challenge a denial of benefits upon violation of the non-competition provision(s) in his or her plan, is subject to ERISA's grievance mechanisms before he or she may take the challenge to a court.  The former employee must exhaust his or her administrative remedies, namely, by seeking a determination from the plan administrator, which will likely receive deference from a later-reviewing court, unless the administrator's determination was arbitrary or capricious.

In addition, although the typical avenue for employers to seek recourse for violation of a non-competition provision is injunctive relief, forfeiture presents may present a more cost-effective opportunity for self-enforcement.  See Oce North America, Inc. v. Caputo, 416 F. Supp. 2d 1321, 1328 (S.D. Fla. 2006) (considering employer's motion for preliminary injunction to enforce terms of non-compete that was also subject to a forfeiture of stock options).  Moreover, a non-competition forfeiture provision may be preferable to courts in pro-employee mobility states, because it does not force an employee to not compete, but gives the employee a choice to compete based on a cost-benefit analysis.  Although there is little case law on the issue of whether an employer may both obtain an injunction and enforce the forfeiture, a non-competition forfeiture provision equips employers with more options and at a minimum, at least the possibility of forfeiture, to motivate conduct.

Takeaways

The potential loss of deferred compensation by key employees might meaningfully deter employees from competing, or at least make the choice to compete more difficult, with the risk of losing deferred compensation.  On the other hand, a forfeiture provision may not be enough to change employee behavior or assure the protection of trade secrets and other confidential information.  Employers should consider other forms of trade secret protection, including confidentiality agreements and related company policies, carefully limited non-solicitation agreements designed to protect trade secrets, and proper choice of law and forum selection provisions.  Employers may also consider trying to extend the ERISA approach to severance plans with structured payouts over time with legally permissible out of state choice of law and out of state forum selection provisions.

This approach (of including non-competition forfeiture provisions in "top-hat" ERISA plans) is not without risks.  Virtually all of the issues in this area remain largely untested, and this is especially true with respect to ERISA preemption over section 16600 or other states' equivalents, e.g. Louisiana Rev. Stat. section 23:921.  See Muggill v. The Reuben H. Donnelley Corporation, 62 Cal. 2d 239 (1965) (invalidating under section 16600 a pre-ERISA non-competition forfeiture provision included in employee pension plan).  It is also worth noting that this strategy is best suited for employees subject to non-qualified top-hat plans, as they are most likely to compete, solicit, and otherwise engage in activities employers may want to prevent, in exchange for deferred compensation.  Of course, any non-competition forfeiture provisions should be limited in scope and duration to the extent necessary to protect legitimate business interests, and interested employers should consult counsel before including any such provisions in qualified plans.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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