Do your company's employment agreements include restrictive covenants?
If not, should they? If so, are they likely to be enforced if challenged in court? Restrictive covenants in employment agreements are a hot topic these days, as both their use in new industries and the "creativity" of their drafters continue to expand. Their use has become so widespread, in fact, that they are now turning up in such totally unexpected – and, arguably, ridiculous -- places as employment contracts of dog walkers and teenage summer camp counselors. See "Noncompete Clauses Increasingly Pop Up in Array of Jobs" by Steven Greenhouse, New York Times, June 8, 2014. If the person taking your pet on his daily constitutional is restricted from taking a job with your neighbors, it should come as no surprise that restrictive covenants are becoming more common in a wide range of industries and jobs. This article addresses ways to fine-tune restrictive covenants to make them more likely to be enforced.
What is a restrictive covenant?
"Restrictive covenant" is the legal term for an agreement not to compete. Traditionally, restrictive covenants have been used in employment agreements and contracts for the sale of businesses to prevent the seller from opening a competing business across the street. Unlike restrictive covenants in contracts for the sale of businesses, which are routinely enforced, restrictions in employment agreements are scrutinized more closely by courts. Despite their proliferation, restrictive covenants in employment agreements continue to be reviewed carefully, construed narrowly and enforced cautiously by judges, who view them as anti-competition devices.
Until recently, restrictive covenants in employment agreements were used primarily in contracts for senior executives, outside sales personnel, researchers, scientists and other key employees in industries where trade secrets are common. They have also been used in fields, such as medicine, primarily to protect key relationships and customer information from misappropriation by an existing or departing employee. Much of the litigation over the enforcement of restrictive covenants has involved the efforts of medical practices to enforce covenants against departing doctors.
In recent years, the use of restrictive covenants has been expanded, perhaps as a reaction to the depressed economy, beyond their traditional sphere to cover all types of employees in every conceivable industry. At the same time, aggressive employers have expanded their use beyond the protection of trade secrets and customer relationships to protect other "assets," such as their investment in employee training and education. Although some of these efforts have been successful, generally, the further away an employer gets from the protection of a bona fide trade secret, the more difficult it is to enforce a restrictive covenant. For example, under the trade secret laws of many states, an employer has no protectable interest and cannot prevent its former employee from using generally-held industry skills even where those skills were developed or honed during the employee's prior employment.
The three common types of restrictive covenants, from most restrictive to least, are: (1) agreements not to compete with the former employer; (2) agreements not to solicit the former employer's customers, employees or both; and (3) agreements not to use or disclose certain confidential information of the employer, such as customer data, formulas, pricing or bidding information and business methods. What type of restriction or combination of restrictions is right for your business? The answer depends on the type of business, what you are trying to protect and the particular employee's ability to cause harm to your business if not restrained.
Enforcement of restrictive covenants.
Restrictive covenants are regulated by state law, so their interpretation and enforceability will vary depending upon which state's laws govern the employment contract. For example, a restrictive covenant that might be enforceable in Michigan, might not be enforceable in New York. Nonetheless, some common principles apply to their enforcement in most jurisdictions.
Although courts in most states have, over the years, enforced narrowly-focused restrictive covenants in employment agreements, they are not favored in the law because of their anti-competitive intent and effect. For that reason, they should be drafted as narrowly as possible. Courts view restrictive covenants as restraints on trade, which are incompatible with our (generally) free market economic system. For that reason, most courts refuse to enforce a restrictive covenant that (1) does not protect a legitimate interest of the employer; (2) imposes an undue hardship upon the employee; (3) contains terms (duration, geographic scope and/or breadth of restricted activities) that are broader than necessary to protect the employer's legitimate interests; or (4) cause harm to the public. Conversely, a restriction is more likely to be upheld if it is aimed narrowly at protecting a legitimate business interest, does not impose undue hardship on the employee, lasts no longer and is no broader in geographic scope than necessary and is not injurious of the public interest.
A restrictive covenant that is viewed as nothing more than an attempt to restrict competition, and not as a means of protecting the employer's legitimate business interests will likely not be enforced. For example, a restriction on a low-level employee who has little or no access to the company's trade secrets or other protectable interests will likely not be enforced. Many states have enacted trade secret laws in the last decade or so, which define "trade secret." In addition to covering the traditional scientific formulas and the like, most such laws define the term broadly enough to encompass such things as customer lists and databases, pricing methods and other similar valuable, non-technical business information. Most trade secret laws also require the employer to make a concerted effort to protect the privacy and prevent the unauthorized disclosure of its trade secrets.
Even a covenant that is designed to protect a legitimate interest of the employer will have difficulty finding favor in a court if it makes it virtually impossible for a departing employee to find employment in his field. Laws in many states allow judges to "blue pencil" such a contract to allow some protection for the employer's legitimate interests, while lessening the deleterious impact on the departing employee.
Likewise, an overly broad restrictive covenant that is viewed by the court as lasting too long, covering too wide a geographic scope or both, will either be denied enforcement or, more likely, "blue-penciled" to make it shorter in duration, narrower in geographic scope or both. Similarly, a court can reduce the scope of what is covered by the covenant or agree to enforce a non-solicitation or non-disclosure clause in the agreement, but not the non-competition clause in the same agreement. In all such cases, the court's goal will be to narrow the scope of the restriction to the minimum required to protect the employer's legitimate interest without imposing an undue burden on the employee.
Finally, where enforcing a restriction results in harm to an area of public interest, it will not be enforced, although the court might craft some other equitable remedy to protect the employer's interest while mitigating the damage to the public. Many court cases that involve issues of public interest arise in the medical field, including, for example, cases where the enforcement of a restrictive covenant against a medical specialist would result in that specialty becoming unavailable or scarce in the geographic region involved.
The future of restrictive covenants.
An emerging trend in the law might make this article irrelevant in a few years. In typical fashion, California took the lead several years ago by banning enforcement of restrictive covenants in employment agreements, except in very limited circumstances. No other state followed its lead until recently. Fueled by public policy concerns about unemployment, several states, including New Jersey, New Hampshire, Massachusetts, Maryland, Minnesota, Michigan and others are now considering legislation to ban or restrict enforcement of restrictive covenants in employment agreements. After all, a state can ill afford to pay unemployment benefits to its dog walkers, who would otherwise be gainfully employed but for the restrictive covenants in their employment agreements.
In addition, legislation was just introduced in the United States Senate to limit the use of non-competition agreements for certain low-wage employees of companies involved in interstate commerce. The Bill, which is entitled "Mobility and Opportunity for Vulnerable Employees Act" (or, the "MOVE Act"), defines the term "covenant not to compete", but it is unclear whether the definition covers non-solicitation and non-disclosure agreements.
The take-away.
Though legislation has been introduced in several states to limit the enforceability of restrictive covenants, they continue to be generally enforceable everywhere except California, subject to the principles discussed above. In fact, they are being used more frequently today and in just about every conceivable type of business, as employers are more aggressively trying to protect their businesses. At the same time, courts remain cautious about restraining trade and will generally not enforce them unless they are narrowly tailored to protect a specific, legitimate business interest. For these reasons, if you want to assure that your employment agreements with restrictive covenants are enforceable, you should take the following steps:
- Limit the use of restrictive covenants to those key employees who have access to your most important trade secrets or key customer relationships. Check your state's laws to see what falls within the definition of "trade secret" in your jurisdiction.
- Choose the least restrictive type of covenant that will get the job done for you. Do not use a non-competition agreement where a simple non-disclosure agreement will suffice.
- Define as precisely and as narrowly as possible what is restricted. If the language you choose is overly broad, the court will probably cut it back, or it might refuse to enforce it.
- Limit the geographic scope and duration of the restriction to what you really need to protect your business. If you think it will take you 6 months to hire a new sales manager and get her up to speed to compete with the departing manager, then limit the duration of the customer non-solicitation provision to 6 months.
- If there are public policy concerns that might be triggered by enforcement of your contract, try to find a creative way in your contract to ameliorate the negative public impact.
- If you are thinking about imposing a new restrictive covenant on an existing employee, check with an employment lawyer in your state; many, but not all, states require that additional consideration be given to the employee to make the new covenant enforceable.
To make your restrictive covenants rock-solid and give them the best chance of being enforced, seek to protect only legitimate business interests, resist the urge to try to prevent lawful competition and always choose the least restrictive option to protect those interests.
J. Philip Kirchner is a Chair of Flaster/Greenberg's Litigation Department. He concentrates his practice on resolving business disputes, including complex litigation of all types of business issues in both the federal and state courts of New Jersey and Pennsylvania. He can be reached at 856.661.2268 or phil.krichner@flastergreenberg.com.
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