A tension exists between our strong belief in the freedom of contract and our equally strong belief that trade should not be restrained. What happens when we contract to restrain trade? What happens when we contract to restrain an employee from postemployment competitive endeavors? Should courts enforce such contracts? In the context of employer-employee restrictive covenants—those contracts that prohibit employees for obtaining competitive employment elsewhere—the debate is not new.
From the 15th through the early 18th centuries, restrictive covenants of the type we would currently view as an employee restrictive covenant were unenforceable. At that time, during the English feudal system, the skilled labor force was based on an apprenticeship model, with masters, journeymen, and apprentices. “The relationship between apprentice and master was a contractual one: the master agreed to provide essential training to the apprentice in exchange for low wage labor over a given period of time, usually seven years,” and at the end of the term, “the apprentice would be free, as a journeyman, to practice his trade, eventually becoming a master.” Mark A. Glick, et al., The Law and Economics of Post-Employment Covenants: A Unified Framework, 11 GEO. MASON L. REV. 357 at 360–61 (2002). Attempts by a master to restrict an apprentice’s trade in a given geographical area once the apprenticeship terminated were unenforceable per se, with “the desire to promote economic freedom and the importance of allowing highly trained apprentices to participate competitively in their trades [being] crucial factors in the rejection of past-employment restraints by the early English courts.” Id.
With the decline of the feudal system, however, and the growth of more modern capitalism, the perspective began to change. Instead, the notion of freedom of contract gained importance, and the first English case upholding a restrictive covenant was issued in 1717. Id. (citing Mitchel v. Reynolds, 1 P. WMS. 181, 24 ENG. REP. 347 (Q.B. 1711)). Thereafter, if the restrictive covenant was supported by adequate consideration and served some essential economic or business purpose, it was upheld. Eventually, courts looked less to the validity of the consideration and more toward the underlying reasonableness of the restraint. Id. at 365–66.
Today, every state has addressed employee restrictive covenants in some fashion. See FOX ROTHSCHILD LLP, NATIONAL SURVEY ON RESTRICTIVE COVENANTS 1 (2012). Those states that permit their enforcement typically require that the restrictive covenant be supported by adequate consideration, be reasonable, and be ancillary to some other agreement. Glick, at 370–71. “Reasonableness” has been defined by “whether (i) the restraint protects a legitimate interest of the employer, not greater than necessary to protect that interest, and reasonable related to the interest being protected; (ii) the restraint does not unreasonably prevent the employee from earning a livelihood; and (iii) the restraint is in accord with public policy.” Id.
Some states, however, have harkened back to the earliest days examining employee restrictive covenants, with California leading the way. Recognizing that freedom of contract may not exist in the way envisioned where employees have significantly less bargaining power than employers, and recognizing further the economic impact of restraining the free flow of labor, these states do not permit enforcement of employee restrictive covenants in the typical employer-employee context (restraints on competition by former owners in a business sale context is still permissible, for example, as are trade secret protections). Thus, a schism has grown between those states that permit employee restrictive covenants (the majority view) and those that do not (California, North Dakota), making it difficult for businesses with a national presence to comply with each state’s laws.
In light of the current economic climate, and with a refocus on the underlying principles supporting or opposing enforcement of employee restrictive covenants, it is appropriate now to reexamine the question of whether employee restrictive covenants should be enforceable.
— Kenneth J. Ashman
Pro: Employee Restrictive Covenants Should Be Enforceable
The Case for Restrictive Covenants
1. Everyone is doing it. Most states allow the enforcement of restrictive covenants. The most common argument courts make is that restrictive covenants are enforceable to protect employers from unfair competition by former employees. The focus is on protection of the employer, not restriction of the former employee. Many jurisdictions, e.g., New York, claim that their courts disfavor or generally decline to enforce noncompetes as an unreasonable restraint on trade, but allow reasonable restrictions. BDO Seidman v. Hirshberg, 93 N.Y. 2d 382, 388–89 (1999).
2. Courts may enforce a noncompete if the restriction is reasonable, although (determined on a case-by-case basis) a noncompete is reasonable if it: is no greater than required to protect an employer’s legitimate protectable interest; does not impose undue hardship on the employee; and is reasonable in scope and geography. Whelan Security Co. v. Kennebrew, 2012 Mo. LEXIS 167, August 14, 2012. Whelan provides a good discussion of what constitutes a legitimate protectable interest, and how courts looks look at whether an employer can make its case for a legitimate protectable interest rather than just trying to stop competition in the marketplace.
3. “Judge, we only want to protect our truly protectable interest, our good will, trade secrets, and confidential information.” Trade secrets can be generally defined as “technical or nontechnical data, a formula, pattern, compilation, program, device, method, technique or process that derives independent economic value, actual or potential from not being generally known to, and not being readily ascertainable by proper means by other persons who can derive economic value from its disclosure or use.” Conseco Finance Serv. v. North Amer. Mortgage Co., 381 F.3d 811, 818–19 (8th Cir. 2004). Practice note: this could be defined by statute in your jurisdiction. Be aware that the employer must have taken reasonable steps to protect the information from disclosure. What is confidential information? What is good will?
4. Reasonable in scope and geography. This analysis is done on a case-by-case basis. For example in Ticor Title Ins. Co. v. Cohen, 173 F.3d 63 (2d Cir. 1999), the court analyzed whether the restrictive covenant could include restricting the departing employee from selling out-of-state properties to New York customers. The court determined that it could because so much of the defendant’s business was just that: New York customers buying out-of-state properties. Although this geographic area is a bit broader than many courts will enforce, this is a good discussion of the process courts use to make this determination.
— Joan M. Swartz
Con: Employee Restrictive Covenants Should Not Be Enforceable
Covenants not to compete should not be enforced because they restrain trade and, in turn, hurt our free market economy. Even assuming an employer can articulate a legitimate business interest that can only be protected by a noncompete, the harm to employees, customers, and the public in general outweighs the employer’s interest.
The premise of a free market economy is that a successful business will make a consistent profit in a field of competitors. A free market economy is driven by individual innovation and the notion that hard work and ingenuity will be rewarded by success. Competition in the marketplace provides the best possible product to the customer at the best price. When a new product is invented, it usually starts out at a high price. Once it is in the market for a period of time, and other companies begin to copy it, the price goes down as new, similar products emerge. Restrictive covenants are contrary to free market principles because they stifle innovation and prevent the market from choosing the best service or product.
There are few circumstances where an employer has a legitimate business purpose for restraining an employee. In states that enforce restrictive covenants, the usual stated reason is to protect specialized training created by the employer, trade secrets, or confidential information or substantial (exclusive) customer relationships. See FLORIDA STATUTES ANNOTATED §542.335; Alex Sheshunoff Mgmt. Servs., L.P. v. Johnson, 209 S.W.3d 644 (Tex. 2006); Geritrex Corp. v. Dermarite Indus., LLC, 910 F. Supp. 955, 959 (S.D.N.Y. 1996) (internal citations omitted). But in most instances, the information the employer seeks to protect is readily available in the public domain or the employee brought his or her specialized skills to the relationship.
Below are some key policy reasons for not enforcing restrictive covenants:
• Noncompetition agreements are typically contracts of adhesion in which the employee has no bargaining power. In addition, the employee is usually unsophisticated in these legal issues.
• The noncompete contains a representation stating that an employer is protecting confidential information, and the representation is false. For example, a staffing company that places temporary employees for customers cannot state that its customer preferences are confidential. It is standard practice for employers to post job openings on their websites, and they are certainly willing to share those preferences with anyone who has a candidate lead for them.
• The covenant limits an employee’s skills and experience that the employee worked hard to develop without the assistance of the employer.
• The covenant limits a customer’s freedom to do business as they choose. Unless a customer has an exclusive agreement with the employer (which seldom occurs), customers must be free to choose the best service or product. Should not a patient be able to use the best doctor to treat his or her disease?
• Employers can use the covenant as a sword. Employees are afraid to quit when an employer fails to honor its bargain because the employee is restricted from competing after termination of employment.
• The employee does not have resources to protect rights even when he or she can prove the covenant is unenforceable. In addition, customers are often key witnesses, but customers do not want to be involved in litigation.
Because there are few circumstances where an employer can state a legitimate basis for limiting an employee’s mobility and the benefit to the employer is typically outweighed by the harm to the employee and the public, states should start with the premise that the covenants are illegal restraints of trade. See Hill Medical Corp. v. Wycoff, 86 Cal. App. 4th 895 (2001). For that reason, the burden of enforcing a covenant should rest with the employer. An employer should bear all reasonable litigation costs until that employer prevails at the preliminary injunction hearing. If after trial on the merits, the employer fails to prove that it has a legitimate business interest worthy of protection by a covenant not to compete, the employee should have the ability to recover his or her reasonable fees and costs. In addition, employers should be prohibited from forcing employees to sign covenants as a condition of employment.
As a practical matter, putting the burden of enforceability on the employer would not be onerous under the circumstances. These cases are typically resolved at by settlement early in the case either using alternative dispute resolution or due to uncertainty by the parties as to how a court will rule on the enforcement of the covenant.
In closing, some states allow reformation of the covenant or follow the blue pencil doctrine when a covenant is not reasonably limited in scope, activity, time or geographic area. This should be prohibited because it encourages employers to draft covenants that are overbroad. Further, a court should not be placed in the position of substituting its judgment in place of the intent of the parties as stated in the agreement.
—Rick L. Lambert