Non-Compete Agreements with Employees

Winter 2016 Article

Non-Compete Agreements with Employees

Non-compete agreements have the purpose of delaying the employment of an employee in a competing business. Situations in which a business may wish to use non-compete agreements with its employees are various: The immediate aim is that of preventing competitors to have access at low cost to human resources which have been developed at considerable cost. A secondary aim is that of avoiding the disclosure of trade secrets to competitors, where a simple confidentiality agreement may be less effective. A non-compete agreement could also reduce the turnover, limiting employees’ ability to find employment with businesses with which it could leverage its expertise.

A typical non-compete agreement comes into effect after termination or expiration of the employment relationship. It is not necessary to require that employees commit to a non-compete provision during the employment, since the employment relationship usually requires a duty of loyalty/exclusivity. Non-compete agreements are usually limited to managerial level or key employees, but can extend to employees of all levels.

Non-compete agreements are common in the United States.  Recent reports indicate that 18% of all employees are bound by a non-compete agreement[1]. In general the United States is permissive with respect to agreements not to compete, within reasonable limits similar to those in effect in other countries. In general, the employer can bind an employee to a non-compete agreement, provided that reasonable limits are respected, which are usually identified in limits to the territory, the scope, and duration.  This matter is left to the states to regulate, and there are considerable differences from state to state.

States have developed various criteria to regulate non-compete agreements, both by legislature and common law principles. The regulations attempt to find a balance between the principle of freedom of contract – under which an employee can validly commit to a contract – and the principle of “free trade” under which restrictions to competition and free trade are looked upon with suspicion. 

The criteria used by the states vary considerably, and include:  

  • Reasonableness with respect to the duration. Courts tend to accept duration of one or even two years. In general the duration must not exceed the time necessary to protect the legitimate interest of the employer, and therefore can vary depending on the circumstances, the sector, and the level of the employee.
     
  • Reasonableness with respect to the scope. The limitations imposed on the employee must not be excessive with respect to the purpose of protecting the employer’s business interest.  
     
  • Reasonableness with respect to the territory. In many instances, the restrictions must refer to the area in which the employee carried out his or her activity, not the area in which the business of the employer is carried out.  Again, the reasonableness of the territory varies depending on the nature of the business.  
     
  • A “protectable business interest” of the employer must exist which can consist in goodwill protection, protection of confidential information, need to protect relationships with customers, issues pertaining a specialized training, etc.
     
  • The non-compete must be an accessory to a valid employment contract. The agreement is not valid if it has no function other than providing for a covenant non to compete.
     
  •  In certain states (Colorado, Georgia, Delaware) non-compete agreements are not enforceable except with respect to employees in managerial or key positions. 
     
  • Public interest: Non-compete agreements can be held invalid if they violate a specific public interest which is considered superior with respect to the protection of the interest of the employer. Non-compete with doctors are a typical example.
     
  • Circumstances pertaining to the termination of the employment: In New York State if the employer terminates employment without cause the non-compete could be held unenforceable.
     
  • A determination of the extent the agreement not to compete limits the employee’s ability to work, keeping in mind their specialty and experience. Thus, in New York State agreements not to compete are enforceable as long as the employee can support him or herself, and the limitations are not greater than what is required to protect the legitimate interest of the employer, impose undue hardship on the employee, and damage the public interest. At the same time, in other states (Florida) the law requires the judge not to consider specific potential difficulties of the employee because of the agreement not to compete.
     
  • Consideration: An agreement not to compete required from someone who is already an employee is not enforceable if nothing is offered in exchange (such as a promotion or a salary increase) with limited exceptions in the case of an employment at will.  If the agreement not to compete is contained in the employment agreement, it is usually held that the hiring is itself sufficient consideration, even though no portion of the compensation is expressly allocated to the agreement not to compete.

Not all states follow these principles. California, Oklahoma, Montana, and North Dakota in general prohibit non-compete agreements with employees, irrespective of reasonableness in duration, scope, territory or consideration. Notably, in those states the refusal to hire an employee who refuses to execute a non-compete agreement is unlawful.

California permits covenants not to compete with employees solely when employees sold their business to the employer.  The exception only applies when: (a) a person sells his or her business (either through a sale of assets or shares), (b) the seller agrees not to carry out similar activities in competition with those of the purchased business, in a defined geographic area in which the business is conducted. (Cal. Bus. & Prof. Code § 16601.)  The prohibition cannot be avoided through the choice of a more favorable law. If the employment takes place predominantly in California, California law applies even though the contract is governed by the laws of another state, and even if the company is incorporated in another state: For example, Delaware law is much more permissive on this subject, but all companies incorporated in Delaware must apply California law to employees located in California.  

If a court decides that a covenant not to compete exceeds the reasonableness limits as to scope, duration and territory, the remedies again vary from state to state: 

  • “Equitrable Reform”: Many States take the “equitable reform” approach, which is more favorable to the employer, and allow modifying the contract and reduce it to more acceptable limits, in line with the state’s requirements. For example, an excessive territory can be reduced, a period that is unreasonably long can be shortened, etc.  
     
  • “Blue Pencil”:  Other States, including for example North Carolina, permit the elimination of the invalid provisions, if by so doing the other provisions of the non-compete become valid. However, the judge cannot modify the agreement. For example, if the territory consists of ten states, the judge can eliminate one or more states. But if the term is 5 years, the judge cannot reduce the term to one, thus rewriting the clause.    
     
  • “Red Pencil”:  Other states, in order to discourage employers to adopt illegal clauses, provide that the entire covenant not to compete be eliminated if it contains provisions that are even partially unlawful.  Nebraska, Virginia, Arkansas e Wisconsin use this approach.

Thus, where blue pencil is not allowed, the clauses must be drafted carefully and conservatively; in states where blue pencil is permitted, possible excesses can be reduced while keeping the general clause in effect.  If a covenant not to compete would be held invalid, other provisions can be included, including customer non-solicitation, and confidentiality.  

Given the considerable differences between the states it is important to seek legal advice before including a non–competition clause in an employment agreement. 

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Requests for information or insights on the issue discussed in this article may be addressed to majda.barazzutti@vallalaw.com.  This article is for information purposes only and does not constitute legal advice. The information contained herein may be outdated or incomplete, and shall in no way be taken as an indication of future results. The transmission of this article is not intended to create, nor does its receipt constitute, an attorney-client relationship between preparer and reader. You should not act on the information contained in this article without first seeking the advice of an attorney.

[1] See, White House Report, Non-Compete Agreements: Analysis of the Usage, Potential Issues, and State Responses, May 2016. See, also, Office of Economic Policy U.S. Department of the Treasury, Non-compete Contracts: Economic Effects and Policy Implications, March 2016.