You may be a business-owner looking to protect your company’s confidential information or goodwill. Or, you may be a worker with an attractive new job offer and a detailed employment contract to read through. Either way, there’s a good chance that at some point in your professional career, you’re going to have questions about noncompete agreements. They may only seem like a mere formality when accepting a new job, or extending an offer to a new employee, but the ramifications can be significant.
What are Noncompete Agreements?
Noncompete agreements (also referred to as covenants not to compete, noncompetition agreements, or just “noncompetes”) have been around for a long time, but their use has been on the rise recently. As many as twenty percent of American workers are under a noncompete in their current jobs, and as many as forty percent have signed one at some point in their careers. Traditionally, employers only required noncompetes for executives or other high-level employees who might have access to confidential trade secrets or sensitive customer information. Recently, though, with greater workforce mobility and the transition to an information-based economy, more and more employers are insisting upon noncompetes for blue-collar and lower-wage jobs.
So, more employers are requiring them, but what exactly do they do? In a nutshell, a noncompete agreement is a promise by an employee not to be involved in competition against his or her employer after the employment relationship ends. They are designed to prevent employees from going to work for a competitor, or starting a competitive business, using information or customer contacts obtained from their former employers. Most noncompetes are signed as part of an employment contract when the employment relationship begins, but they can also be separate, stand-alone contracts. And they are not limited to formal, full-time employment relationships. Noncompetes are regularly used with seasonal workers, independent contractors, and consultants, too.
When used properly, noncompetes protect businesses by preventing former employees from unfairly taking advantage of confidential information they obtained during their employment. Imagine, for example, that a company spends millions of dollars researching and developing a new product. It wouldn’t be fair to the business to allow a former employee to go to work for a competitive business, or start a new business, using the fruits of the former employer’s research to compete against it. But, on the other hand, it’s also not fair to restrict the former employee’s employment opportunities to the point where he or she can never work in the same field again. And, so, the goal of a good noncompete agreement is to balance the employer’s interest in protecting its sensitive information with the employee’s interest in earning a living.
Limitations on Noncompete Agreements
Because of these competing interests, noncompete agreements must include limitations. Typically, they are limited by scope, geography, and time. “Scope” refers to the fields in which the former employee is prevented from working. A noncompete agreement cannot say that a former employee “can never work in this town again.” It usually must be limited to fields in which the former employer does business. So, for example, a pharmaceutical company might be able to prevent a former employee from working for another pharmaceutical business but could probably not stop the former employee from teaching at a pharmacy school.
“Geography” refers to the area in which the noncompetition clause is effective. For the most part, noncompetes must be geographically limited to areas in which the employer does business. A noncompete usually won’t be enforceable against a former employee who takes a new job in a state in which the former employer does not operate. However, with many businesses operating nationally, or internationally, geographical limitation becomes a trickier question. But an agreement that prohibits a former employee from working in a specific geographic region is more likely to be valid than one that prevents the employee from working anywhere in the country, or in the world.
An oft-cited illustration of geographical scope is a local media company, like a radio station, trying to retain its audience by requiring on-air talent to sign noncompetes. If, for example, a radio station’s most popular disk jockey leaves for a job with a competitive local station, the DJ could potentially bring along a large portion of his or her listeners. But, if the DJ takes another job on the other side of the country, there is little threat to the former employer. Thus, if the geographic scope of the noncompete was limited to the local listening area, it would be reasonably limited geographically to accomplish the station’s purpose. If the agreement prevents the employee from working at any other radio station in the entire country, it’s probably more restrictive than what is necessary to protect the station’s interest and certainly puts a heavier burden on the employee’s ability to earn a living.
This radio station example raises an obvious question: ‘what if the employer has a nationwide audience?’ like with a cable TV network. In that case, a wider geographic scope seems more reasonably designed to protect the employer’s interest. And the noncompete is therefore more likely to be valid. Of course, the agreement still must be limited in scope and time, and, as we will discuss below, a lot will depend on the laws of the state in which a court reviewing the agreement is located.
The third essential limitation for noncompetes, “time,” refers to how long the noncompete provision stays effective after the employment relationship ends. The restricted period cannot go on indefinitely; there must be some endpoint. Unfortunately, except in states that have placed statutory caps on the permissible duration of noncompetition agreements, there is no hard and fast rule as to precisely how long the restriction can remain in place – it just has to be “reasonable.” What counts as a reasonable duration depends upon the specific facts of the employment relationship, but, generally speaking, anything over two years will usually start to raise suspicions with courts in most jurisdictions.
As an example, let’s say a tech company requires its engineers to sign noncompete agreements that are effective for ten years. In the agreement, the company says that the reason for the noncompetition clause is to protect the company’s new, cutting-edge designs and programs from falling into the hands of its competitors. However, although protecting new technology seems like a legitimate business purpose, things move so quickly in the tech industry that a design that is cutting-edge now will probably be obsolete in ten years. So, the duration of the noncompete provision in our example is, in all likelihood, longer than what is reasonably necessary to protect the employer, and there’s a good chance that a court reviewing the agreement would decide that it is overly restrictive and therefore unenforceable.
Legitimate Business Purpose
As we alluded to in the prior example, along with being limited by scope, geography, and time, a noncompete agreement must also serve some legitimate business purpose of the employer. That is, an employer cannot require its employees to sign noncompete agreements just to be spiteful or to prevent employees from leaving – or because the employer doesn’t want to have to deal with any normal market competition. The employer must truly be attempting to protect itself from unfair competition, not any competition at all. Importantly, the business purpose being protected should be stated in the agreement, and the noncompete provision must actually be designed to protect that interest. If the circumstances suggest that the stated purpose is just a pretense for restricting the former employee’s ability to earn a living, the agreement will probably be invalid.
Returning to our prior example, a tech company would probably have a legitimate business interest in protecting its latest innovations. It would be unfair to allow an employee to take a job with a rival company, or start a new company, using technology developed by the former employer to compete against it. The idea is that, if the former employer invested in the research and development necessary to develop a new product, it should be the one that benefits from bringing the new product to market – and not a competitor who hires its former employee. The logic is similar to patent law. If businesses don’t know that they will reap the financial rewards of new innovations, they have less incentive to innovate.
For the tech company, a noncompete agreement would serve a legitimate business purpose for as long as the new technology remains state-of-the-art. But, if the duration of the noncompete goes beyond that point, the business interest is diminished. Thus, the “reasonableness” of the scope, time, and geography limitations is determined, in part, based upon the legitimate business purpose the employer is attempting to protect.
Determining what exactly qualifies as a “legitimate” interest can be a complex question. Some states have adopted laws specifically defining the types of business interests that can be protected by a noncompete. Purposes commonly cited include avoiding disclosure of trade secrets, marketing strategies, and customer lists, and protecting the goodwill the employer has with the public. Each of these interests are valuable assets that belong to the business, and so the business wants to ensure that it, and not its competitors, benefit from those assets. If the former employer expended significant resources in developing the protected information, but an ex-employee’s new employer acquires the information solely because it hired the ex-employee, the new employer potentially has an unfair competitive advantage over the old one.
Depending upon the nature of the employer’s business, a list of customers might be one of the company’s most valuable assets. It may have taken years of effort – and a fortune in marketing costs – to develop the list. As a result, an ex-employee’s use of customer lists to poach customers for a new venture could seriously undermine the former employer. And the former employee may therefore have a legitimate business purpose in protecting its customer list through noncompete agreements.
Whether protection of a customer list constitutes a legitimate business purpose depends in large part on how difficult it would be for someone from outside the business to create the list. If the list was developed just by searching online or looking in the phone book, then protecting the list looks less like a legitimate purpose and more like a pretense for restricting fair competition. Again, stating a business purpose alone is insufficient for an enforceable agreement; the purpose must be legitimately necessary to protect the business so that, if it is not protected, competitors will gain an unfair advantage.
The protection of “trade secrets,” generally defined as business information with independent economic value arising from its not being known to the general public, is frequently named as a purpose justifying a noncompete agreement. To qualify as a legitimate business purpose, the trade secrets must not be accessible by the public, and the business must make real efforts to keep the information secret. As with customer lists, to support a noncompete, trade secrets must be sufficiently sensitive that disclosure would put the business at a competitive disadvantage against its competitors.
The secret formula for Coke is the textbook example of a trade secret. The Coca-Cola Company has kept the recipe secret for years – including from most of its employees. If PepsiCo got ahold of that information, Coca-Cola would be devastated (in theory, anyway). So, if Coca-Cola required any employees who have access to the secret recipe to sign a noncompete, it would almost certainly have a legitimate business purpose. However, if a rival soft-drink company posted its own recipe on its website – or used a recipe that it found online – that information alone would not constitute a trade secret. And, therefore, protecting it would not be a legitimate business purpose.
Company “goodwill” is a more ambiguous, and difficult to define, concept which noncompete agreements are often designed to protect. A business’s goodwill is basically its positive reputation with its customers and the public at large. Noncompetes protect goodwill by ensuring that, for example, the reputation for quality service that a business has earned with its customers belongs to the business itself and not to the individual employees who provided the service.
If customers always speak with the same employee whenever they deal with a company, they may be tempted to follow that employee if he or she takes a position with a new employer. A noncompete could prevent that from happening by ensuring that the employee who is the “face” of the company does not go to work for a competitor. Whether protection of goodwill amounts to a legitimate purpose depends significantly on the employee’s job duties and role with the business. If the employee is a sales manager who handles most customer inquiries and regularly makes on-site visits to customers’ offices, then protection of goodwill by preventing the sales manager from starting a competitive business stands a good chance of being a legitimate business purpose. But if the employee works behind the scenes and barely ever interacts with customers, then protection of goodwill is much less of a legitimate concern.
Noncompete Agreements are contracts and, like any other contract, they are subject to the normal rules of contractual construction. One such rule is the concept of consideration. Consideration is the idea that, to be enforceable, a contract cannot be unilateral – it must involve some sort of exchange. Both sides must be providing something or giving something up. For noncompetes, this means that the employee must have received something of value – at least theoretically – in order for the agreement to be a valid, legal contract supported by consideration.
For most noncompete agreements, consideration comes in the form of the offer of employment. In exchange for the employer hiring the employee, the employee agrees to the terms of the noncompete. The noncompetition provision might be included within an employment contract, or it might be separate document signed when employment commences. But either way, the agreement will probably state that noncompetition is a condition of the offer of employment. This raises concerns over whether employees – especially in lower-skilled jobs – actually have any real bargaining power at the time of hiring, but, in most cases, a noncompete signed as a condition of initial employment is deemed as being supported by adequate consideration.
In some situations, employers will ask for a noncompete after employment has already started. For the most part, continued employment is not viewed as adequate consideration. That is, an employer’s agreement to continue employing the worker alone will not support a noncompete agreement. If the employment relationship was already underway, there must be a new form of consideration. This is due to what is known as the “pre-existing duty rule,” which says that one party’s agreement to do something that it was already going to do does not create consideration for a contract. So, for a noncompetition agreement signed after commencement of employment to be valid, there must be some new benefit to the employee. A raise, bonus, and/or a promotion can all provide consideration for a noncompete signed by an existing employee.
Occasionally, an employee will sign a noncompete at the conclusion of his or her employment. In this situation, the noncompete is typically part of a severance agreement. The consideration received by the employee in exchange for signing the noncompete is usually a severance package or other benefits offered upon termination of the employment relationship.
Whether signed before, during, or after employment, a noncompete agreement should expressly state the consideration provided to the employee for the agreement. If a noncompete fails to set forth precisely what the employee is receiving in exchange, it is significantly more likely to be held invalid in the event that an enforcement action becomes necessary.
Enforcement of Noncompete Agreements
If an employer believes that a former employee is violating a noncompete agreement, the employer must first decide if enforcing the agreement is worth the trouble and potential legal costs. It may be that the ex-employee is in technical violation of the agreement, but the violation is not causing any real harm to the employer. In that situation, it would not make sense for the employer to spend money on a lawyer if there is no real benefit to be gained by enforcing the agreement.
Assuming that the employer concludes it is being harmed, and enforcement is therefore worthwhile, the next step typically will be that the employer’s attorney will send a cease and desist letter to the ex-employee, and possibly to his or her new employer. The letter will advise the former employee that he or she is in violation of the noncompete and demand that the violation be discontinued. Usually, this means either resigning from the job that violates the noncompete or discontinuing operation of the ex-employee’s new business which is in competition with the former employer.
If the former employee refuses to comply with the cease and desist letter, the company’s next step is to file a lawsuit alleging breach of contract and seeking enforcement of the noncompete. The suit will ask the court to issue an injunction – a court order directing the ex-employee to cease further conduct that breaches the noncompete – along with a judgment in the amount of the monetary damages, if any, the company has incurred as a result of the violation of the noncompete. If faced with such a lawsuit, the former employee should hire an experienced attorney if he or she wants to contest enforcement of the noncompete agreement.
Once a lawsuit is filed, it’s up to the court to decide whether to enforce the noncompete. Whether a specific agreement is enforceable depends in large part upon which state’s law applies to the agreement, and there is tremendous variation from state to state. Some states will enforce noncompetes only in limited circumstances. Some allow enforcement but restrict the duration or the fields from which an employee can be prohibited from working. California bars noncompete agreements altogether, but other states, like Florida, view protection of company information as especially important and therefore enforce noncompetes strictly. As a result, an agreement that is enforceable in one state may be void in another.
Historically, under the English Common Law system largely adopted in the United States, noncompete agreements were viewed as an unenforceable restraint on trade. The common law favored free market competition and weighed a worker’s right to earn a living as more important than a business’s right to protect itself from potentially unfair competition. In the more modern era, courts began viewing noncompete agreements as more of a private contractual matter between employer and employee and less of a question of public policy.
Increased enforcement in the courts has inspired many state legislatures to enact laws placing limitations on noncompete agreements. Because California’s legislature thought that any restrictions on a worker’s right to earn a living are unfair, it banned noncompetes altogether, other than in a very few, limited circumstances, such as when the former employee was an owner of the employer-business. California views noncompetes so unfavorably, that employers are not even allowed to ask employees to sign them, and California courts usually will not enforce otherwise valid noncompetes executed in another state by an ex-employee now working in California.
Most states do allow noncompete agreements, though they are mostly viewed with suspicion. In deciding whether an individual agreement is enforceable, the factors usually considered by the court are (1) the potential threat to the employer; (2) the hardship that would be placed on the employee if the agreement is enforced; (3) whether the agreement is supported by adequate consideration; and (4) whether there is any public interest in preventing enforcement.
Because these factors are largely subjective, much depends on how the court views the specific facts of the case before it. Whether a business purpose is indeed legitimate will depend upon the nature of the employer’s business and the precise interest asserted. For the most part, if a legitimate business purpose is not shown by the employer, the noncompete will be unenforceable. The purpose cannot be just to discourage employees from leaving, or to punish those who do.
Courts generally require that, for a noncompete to be enforceable, it must set forth reasonable, well-defined limitations on the time, scope, and geographic area of the competition restrictions. The agreement should not be any more restrictive on the former employee than what is reasonably necessary to protect the employer’s interest. If an agreement is found to be more restrictive than necessary, the court can either refuse to enforce it or limit its application to the point that it becomes reasonable.
The “reasonableness” of an agreement’s scope, time, and geography restrictions will depend upon the nature of the employer’s business and the interest being protected. A noncompete that prohibits an employee from ever again working in a field in which the employer does business will almost never be enforceable, even if it is narrowly limited in scope and area. Likewise, it is usually not reasonable to prohibit a former employee from working in a geographic area in which the former employee has no business presence; nor is it reasonable to prohibit the employee from working in a business field in which the employer is not involved. In this way, a noncompete agreement in favor of a large company doing business nationwide in a wide variety of fields might be enforceable where the same agreement, if in favor of a more limited, regional business, might be unenforceable.
A few states, such as Utah, have enacted legislation limiting the duration of noncompetes. And some states limit geographic restrictions to areas in which the ex-employee actually worked. But, for the most part, whether a noncompete agreement is overly burdensome on the ex-employee depends upon the specific facts of the case and the language of the agreement itself.
Courts will sometimes consider facts not directly related to the noncompetition restrictions when deciding whether a noncompete places an unreasonable hardship on the former employee. The manner in which the employment relationship ended, for example, can affect how the court will view the case. If the employee voluntarily resigned to take a job with a competitor, or to start a competing business, the court is more likely to enforce the noncompetition agreement. On the other hand, if the employee was laid off, or arbitrarily terminated, the court will be more likely to view restrictions on the ex-employee’s ability to earn a living as overly burdensome. As a matter of public policy, it is better to have a laid-off employee gainfully employed by a competitor than unemployed.
Some courts require employers to demonstrate “special facts” which would give the former employee an unfair competitive advantage if a noncompete agreement is not enforced. Special facts could include specialized training provided to the employee beyond general skills easily accessed by the public, employee access to trade secrets or confidential employer information not easily ascertainable outside the company, or close relationships between the ex-employee and company customers which could result in loss of company goodwill if the employee is allowed to compete against the former employer.
Public policy can also be a factor in determining whether the type of industry restricted by a noncompete should be limited. For certain professions, such as attorneys and physicians, courts have found that it is contrary to the public’s interest to enforce noncompete agreements. Fields in which restrictions are disfavored as a matter of public policy usually involve personalized service by a professional. A client represented by a specific lawyer whose employment with a law firm ends might suffer if that lawyer is prohibited from continuing representation due to a noncompete signed by the lawyer in favor of the former firm. Similarly, a doctor who has been treating a patient for years should not, as a matter of public policy, be prohibited from continuing treatment. In Texas, a noncompete agreement is unenforceable to the extent it would prevent a doctor from continuing to treat a patient already under the doctor’s care. With lawyers, the rules of professional conduct place some limitations on the application of noncompetes.
How a court will treat an overly broad noncompete agreement again depends upon the laws of the state governing the agreement. Some courts will limit the agreement to the point where it becomes reasonable, or only enforce the portions of the agreement which are reasonable, while others will throw it out altogether. If a court finds that a noncompete agreement is valid and enforceable, the ex-employee may be ordered to leave his or her new job or cease operation of a business in competition with the former employer. In cases in which the former employer is able to prove that it suffered financial damages as a result of the ex-employee’s violation of the noncompete, the court may also enter a judgment for money damages against the former employee.
Criticisms of Noncompete Agreements
Along with the recent trend of employers increasingly requiring noncompete agreements has come a counter trend of state legislatures in both red and blue states limiting enforcement of noncompetes. Critics of the agreements, and the legislators who favor limited enforcement, argue that noncompetes stifle competition and are an unhealthy restraint on trade and workers’ rights. More practically, states that strictly enforce noncompetes could potentially lose skilled workers to states that limit enforcement.
Labor advocates contend that workers, particularly those in low-level jobs, have unequal bargaining power at the commencement of employment and therefore are not in a position to meaningfully negotiate. According to this line of thinking, unskilled workers are essentially forced to choose between signing a noncompete or being unemployed and are therefore effectively coerced into signing the agreements. Labor advocates also argue that noncompetes artificially keep wages down by restricting workers’ mobility and advancement opportunities. Workers are prevented from making the most of their increased experience, critics say, when they are unable to take higher-paying jobs with any competitors doing business in their fields of expertise. Along the same lines, critics question whether it is sound public policy to allow laid-off employees to be contractually bound to avoid working in fields in which they have experience.
Some economists have asserted that noncompete agreements reduce innovation and entrepreneurship, and therefore hinder economic growth. Proponents of this argument point to the success of Silicon Valley, located in California where noncompetes are prohibited, and its tradition of high worker mobility and tech firm employees setting out with their own start-ups. Economists who dislike noncompete agreements acknowledge that loss of employees to competitors, or to the employees’ own ventures, can be difficult for an individual company, but they maintain that restricting enforcement of noncompetes benefits consumers, and the economy as a whole, by increasing market competition.
Proponents of noncompetition enforcement note that, in an information-based economy, knowledge has become an increasingly important part of any company’s assets. Businesses should have a right to protect their intellectual property and know-how because they have invested the time and resources into developing them. Similarly, proponents argue that a business that has invested years in developing good relationships with its customer base should not have to risk losing its goodwill when a key employee defects to a competitor. And it would not be fair to allow a competitor to reap the rewards of specialized training provided to an employee at the former employer’s expense. According to this reasoning, refusal to enforce noncompete agreements will disincentivize employers from investing resources in developing their employees.
Depending upon the situation and the jurisdiction, alternatives to noncompete agreements are sometimes available for employers looking to protect business interests in the event an employee departs, but who do not want to use a traditional noncompete. These alternatives may allow for enforcement of noncompetition provisions in a state in which they are disfavored and may also address potential concerns regarding unequal bargaining power and adequate consideration.
A garden leave agreement is similar to a noncompete but provides for compensation to the former employee during the time in which competition is restricted. Thus, as with a noncompete, the former employee is prohibited from competing with the employer, but, with a garden leave agreement, the ex-employee is paid by the former employer for avoiding competition. Although garden leave agreements provide for more concrete consideration to employees and can address employer concerns about loss of trade secrets or goodwill, they effectively require employers to pay former employees not to work, so the additional expense can make them impractical.
Conversely, employers and employees can enter into agreements under which former employees are not absolutely prevented from entering into competition with former employers but must provide some sort of consideration to the employer for the privilege of doing so. The consideration can come in the form of a simple cash payment or surrender of certain benefits. An agreement along these lines basically amounts to a noncompete with a buy-out. Because they do not absolutely restrict competition, these agreements may be more easily enforced in jurisdictions which view noncompete agreements with disfavor. However, the agreement might not adequately address the concerns of a business worried about protecting trade secrets.
Under a non-solicitation agreement, the former employee is not prohibited from competing with the former employer but does promise not to do business with any of the former employer’s customers for a defined period. A non-solicitation agreement can address concerns over loss of goodwill or customer base. However, for an employer more interested in protecting trade secrets, the effectiveness of a non-solicitation agreement will be limited.
Noncompete agreements seem like a simple idea in theory, but the application can get tricky. With so much variance between states, and with judicial enforcement depending substantially upon the specifics of each scenario, there is no one-size-fits-all noncompete agreement that will work for every business in every situation. Consequently, employers considering introducing noncompetition provisions into their employment contracts should consult with an experienced attorney familiar with the laws of the state that will apply to the agreement. A noncompete agreement carefully drafted by an experienced professional stands a much better chance of being upheld in court than an agreement created through cut-and-paste.
For workers, a noncompete provision may just seem like a technicality in your employment agreement, but the long-term consequences can be profound. Not only may the noncompete prevent you from working in your chosen profession, it may put you in a position where you are forced to choose between relocating or taking work outside of your field. If you have any doubts about how a noncompete will apply to your situation, you should consult with a lawyer with experience in employment law. The short-term consultation fee may very well save you years of restrictions on your ability to earn a living.
You Need to Know
For individuals seeking to defend themselves against a former employer, it is imperative that you involve your attorney as soon as possible. Usually, the employer will request a quick hearing on its request for an injunction, sometimes within just a few days. The more time your attorney has to investigate the basis of the complaint, the better your defense will be at the injunction hearing.
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