Are Stock “Clawback” Provisions Unenforceable Penalties?

Many executives and other high-level employees receive stock options, restricted stock units (RSUs) and other forms of deferred compensation as part of their compensation packages.  Often, the employers who issue these forms of equity to their employees include non-compete agreements and other restrictive covenants in the stock agreements.  These provisions frequently include “clawback” provisions that require the employee to return the value of the equity they received if they violate the terms of one of the restrictive covenants.

However, these provisions may not be enforceable under either New Jersey or New York law.  In both states, the law is clear that penalty provisions in contracts are not enforceable.  But a contract can contain a liquidated damages provision, meaning an agreement in advance about the amount of damages when the parties expect it will be difficult to prove the actual damages caused by a breach.

Are Clawback Provisions Unenforceable?As the New Jersey Supreme Court explained in a 1994 case, Wasserman’s Inc. v. Township of Middletown, a liquidated damages provision must be a “reasonable forecast of the provable injury resulting from breach” of contract at the time the contract was written.  In other words, the agreed-upon amount of damages has to be a fair estimate of what the actual damages are likely to be.  If it is not, then “the clause will be unenforceable as a penalty and the non-breaching party will be limited to conventional damage measures,” meaning it will have to prove its actual damages.  While Wasserman’s itself does not involve a clawback provision, in an 2011 unpublished opinion, Schiavi v. AT&T Corp., the New Jersey Appellate Division recognized that the same principles apply to stock clawback clauses.

The problem with clawback provisions is that, by definition, they do not select an agreed-upon amount that is a prediction of the actual damages likely to be caused by a breach of contract.  Rather, the amount the employee would have to pay back to the company for breaching the agreement depends on the future value of the employee’s stock interests.  That amount can be zero, such as with a stock option that is underwater, or hundreds of thousands or millions of dollars if the employee has a large amount of equity and the stock has substantially appreciated in value.

However, there is little if any reason to believe the value of the employee’s equity will have any correlation with the actual damages caused by his future breach of a non-compete agreement.  Rather, the amount the employee would owe the company would vary depending on the number of shares of stock or stock options he received, if and when he exercised his options or sold his stock, and how well the company’s stock has performed.  Those factors are unlikely to have any relationship to the anticipated damages that working for a competitor or breaching another restrictive covenant is likely to cause the employer.

Moreover, the amount of those damages would be the same irrespective of whether the employee worked for a direct competitor and took substantial business away from it, or merely engaged in some technical violation of the agreement that caused little or no harm.  Instead, the same clawback provision would apply under either scenario.  As a result, clawback provisions seem to provide an arbitrary method to calculate damages rather than a reasonable prediction of actual damages.  As a result, there is a very strong argument that they are unenforceable penalty provisions under New Jersey or New York law.