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Recent NY Court Decision on Rescission of Stock Option Agreement

Posted on May 12th, 2013

Employee stock options are an essential component of compensation in technology companies.  Options and other equity incentives allow employers to attract and retain talented personnel who hope to profit from a successful sale of the business that they help create.  While there has been substantial attention in recent years to the manner in which options are awarded, a topic less often discussed, but equally important, is how they may be rightfully terminated by an employer following a separation.  A recent decision by a New York appellate court’s decision in Lenel Systems Intl. v. Smith illustrates what can arise if this issue is not expressly addressed in the option agreement.

In Lenel, an employer sought to terminate an employee’s stock options who had violated his noncompetition agreement after leaving Lenel’s employment.  While the stock option agreement did not have an express provision entitling the company to terminate the agreement, it did provide that the employee’s agreement not to compete was consideration for the options.  Not having the express right to terminate, the employer sought to rescind the option on equitable grounds.

The court summarized that rescission is an equitable remedy that allows a court to declare a contract void from its inception.  As a general rule, rescission of a contract is permitted where there is a breach of contract that is material and willful, or so substantial and fundamental “as to strongly tend to defeat the object of the parties in making the contract.”  The court rejected the defendant’s argument that an express forfeiture clause in the option agreement was required in order for option to be subject to rescission.  Instead, the court reasoned that the noncompetition covenant was the sole consideration for the option agreement, and when the defendant chose to compete with Lenel “in violation of the only material condition of the agreements,” he would give up his right to the stock options promised in exchange.

In is also worth noting that two of the appellate judges dissented from this decision, arguing that the consideration for the option consisted of two parts, one being the compliance with the covenant during the term of employment and the other part for the post-termination period.  The dissent reasoned that since the defendant did comply with the covenant during his six years of employment with Lenel, it cannot be said that he did not provide any consideration for the option, thereby reducing the argument in  favor of rescission.

As a lower appellate court decision, the Lenel case is more likely to lead an academic interest than to have an binding impact on the law on this issue.  However, the case illustrates that while rescission may be available as a remedy for employers, it is a difficult path to travel and that addressing termination rights in the option agreements may be advisable.