May 31, 2011 Articles

An Economic Framework for Analyzing Covenants Not to Compete

Economists should consider this set of principles when evaluating the competitive implications of a covenant not to compete.

By Elaine Fleming, Steven Herscovici, and Keith R. Ugone

Economists should consider this set of principles when evaluating the competitive implications of a covenant not to compete (CNC). A central factor is the speed with which the information that a CNC seeks to protect depreciates over time, space, and scope of activity. These principles should benefit attorneys who are litigating the enforceability of CNCs.

Background
CNCs are employment contracts that "restrict the activities in which an employee may engage after termination of employment." Paul H. Rubin and Peter Shedd, "Human Capital and Covenants Not to Compete," 10 J. of Legal Studies 93, 94 (1981); see also Edward M. Schulman, "An Economic Analysis of Employee Noncompetition Agreements," 69 Denver University Law Review 97 (1992); Mark J. Garmaise, "Ties that Truly Bind: Non-competition Agreements, Executive Compensation and Firm Investment," J. of Law, Econ., and Org. 1 (2009). According to Peter Whitmore:

Noncompetition clauses typically forbid the employee from competing with the employer within a certain geographical region for a specified length of time after the employment relationship has ended. The clauses may also prohibit the employee from engaging in certain activities, such as contacting all or some of the employer's customers, for a certain length of time.

Peter J. Whitmore, "A Statistical Analysis of Noncompetition Clauses in Employment Contracts," 15 J. of Corporate Law 483, 484–85 (1989). Generally, with CNCs, employers are attempting to protect their investments, including investments in the human capital of their employees, investments in confidential business information, and trade secrets to which their employees have access.

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