Claw-back did not have an oppressive penalty

Employee required to hand over profits to ex-employer for stock purchase made before quitting

Brian Jervis was employed with Nortel Networks Corporation from 1989 until 1998. During his employment with Nortel, he received annual stock option grants as part of his compensation package. Each grant was subject to certain terms and conditions as laid out in a standard contract between Nortel and Mr. Jervis referred to as the Instrument of Grant: Non-qualified Stock Options (the grant contract).

One of the conditions of the grant was that if Mr. Jervis went to work for a competitor of Nortel within 12 months from the date of exercise of the stock option grant, Nortel had the discretion to seek repayment of the excess of market value received on the exercise of the options. Nortel could exercise this discretion when it determined that Mr. Jervis’ actions were “inimical to the best interests of the corporation.” In the 1997 and 1998 contracts, the period of time that Mr. Jervis was subject to the “claw-back” was extended from 12 months to 24 months.

Between January 1996 and January 1998, Mr. Jervis exercised his stock option grants a total of three times making a total profit of $626,857.74 (the difference between the option price per share and the shares’ market value).

During the course of his employment with Nortel, Mr. Jervis was contacted regularly by recruiters to work elsewhere. In June 1998 he was contacted by Newbridge Networks Corporation, one of Nortel’s competitors. In September 1998 Mr. Jervis decided to accept the Newbridge offer and resigned his position with Nortel on Oct. 31, 1998. Mr. Jervis knew that he might be subject to the claw-back provision of the grant contract, so he negotiated a provision in his employment contract with Newbridge that indemnified him as a result of any claw-back.

Prior to 1998 when Nortel was faced with an employee who received stock option grants and who went to work for a competitor, the director of executive compensation would prepare material for the stock option committee’s review to decide if Nortel would exercise its discretion to claw-back. This procedure changed in 1998 because of the large number of Nortel employees who were receiving stock options.

A resolution was passed whereby it was considered inimical to the best interests of Nortel if employees on the executive management team went to work for a competitor listed in a schedule and whose claw-back would exceed $50,000. In such a case the director of executive compensation would, in the absence of special circumstances, make a formal demand to the former employee for repayment.

When Mr. Jervis went to work for Newbridge this formula was applied to him: he was part of the executive management team; Newbridge was listed as a scheduled competitor; and his claw-back exceeded $50,000. As a result the director of executive compensation sent a letter dated Nov. 20, 1998, to Mr. Jervis demanding reimbursement of the sum of $626,857.74 pursuant to the grant contracts.

Mr. Jervis refused to pay, responding that the claw-back provisions of the grant contracts were in restraint of trade and not enforceable. He further argued that the provision lacked consideration and that the committee was not exercising its discretion in good faith. Nortel brought an action against Mr. Jervis for recovery of the $626,857.74.

On the issue of restraint of trade the Court held that it was not a restraint of trade where a former employee is required to forego a benefit if he or she chooses to compete. The claw-back provision in the grant contracts does not restrain an employee from going to a competitor. Mr. Jervis was not restrained from competing with Nortel; the claw-back provision was merely an economic disincentive for him from doing so.

On the issue of bad-faith exercise of discretion the Court held that it was not an unreasonable exercise of the committee’s discretion to provide for the automatic claw-back to apply when certain outlined criteria were met. The criteria were reasonable. The automatic claw-back only applied where there were no special circumstances. The committee was not precluded from exercising its discretion by merely providing for the automatic claw-back. If special circumstances were present the committee would consider the matter directly.

In this case Mr. Jervis had the opportunity to provide special circumstances to the committee but he chose not to. The Court would not give him the opportunity to ask the Court now that the claw-back not be applied to him when he said nothing to the committee.

The final issue raised by Mr. Jervis was the argument that the claw-back provision was not enforceable because it constituted a penalty. The Court agreed that requiring Mr. Jervis to disgorge his gross profits from the exercise of the stock options within 12 or 24 months of accepting employment with a competitor constituted a penalty.

However, for a penalty to be unenforceable there must be oppression. There was no oppression in this case. Mr. Jervis knew of and understood the significance of the claw-back provision. He knew that when he left to go work for Newbridge he might be subject to the claw-back as was evidenced by his employment contract with Newbridge. The penalty required Mr. Jervis to repay only the gross profit he received.

The Court held that the claw-back provision was not oppressive or unconscionable and ordered that Mr. Jervis pay Nortel the sum of $626,857.74.

For more information:

Nortel Networks Corp. v. Jervis, Ontario Superior Court of Justice, Docket No. 99-CV-174311, Jan. 4/02.

Latest stories