A Primer on Enforceability of Non-Compete Agreements and Other Restrictive Covenant Agreements
Overview: This article provides an overview of the various elements(i.e., legal requirements) used by courts to determine the enforceability of restrictive covenant agreements. The term “restrictive covenant” broadly refers to various agreements which restrict an employee’s actions during employment and,in many cases, for a period of time post-employment. The most common of these include non-compete agreements, non-solicitation of customers (or clients) agreements, and non-disclosure agreements.
State law differences: Nearly all states – with some limited exceptions, like California where most restrictive covenants are void understate law – will apply more-or-less the same legal standards when determining whether or not to enforce a restrictive covenant. For example, all states require “consideration”(i.e., an exchange of something of value between employer and employee) for a restrictive covenant to be enforceable.
Of course, state laws do occasionally differ with respect to more technical requirements. For example,in some states a threat to terminate a current employee if they do not sign a restrictive covenant is considered sufficient consideration, while in other states, like Pennsylvania, a threat of termination is not enough (where current employees must receive something tangible,like a raise or cash payment).
This article addresses general legal principles that are common to most states (except those few states where restrictive covenants are partially or fully prohibited by state law). While these principles provide the starting point for enforceability analysis, it is important to recognize that states may indeed have different standards for how these principles are applied.
Adequate “consideration”: First, in order to be enforceable a restrictive covenant (like any other contract) must be supported by adequate “consideration”,which is a legal term meaning something of value. It is important to note that consideration can take many forms other than cash, such as an increase in benefits, apromotion in status only (with no corresponding raise), a new bigger office,and so on.
The adequacy of consideration depends first on whether the contract is entered into at the time of hire, or sometime after hire. In the case of the former, the offer of employment which is contingent on signing a restrictive covenant constitutes adequate consideration. Easy and straightforward.For current employees, on the otherhand, determining the adequacy of consideration is trickier.
Pennsylvania is one of very few states which still holds that a threat of termination is not adequate consideration. So, while “sign this or you’re fired” may workin other states, it won’t work in states like Pennsylvania, where companies must instead provide current employees some “new” consideration.
Unfortunately, there is no bright line rule governing what is, and is not, adequate consideration – it all depends on the particular facts. For example, whereas a one-time payment of$1,000 may constitute adequate consideration for an employee earning $45,000 per year, it probably won’t be adequate for someone making $100,000. Because the issue of adequate consideration requires a highly fact-specific analysis, companies should seek legal advice before entering into covenants with current employees.
Once employers clear the consideration hurdle, that’s when it really gets murky. In order to be enforceable a covenant must also be “reasonably necessary to protect the employer’s legitimate business interests.” In broad terms, courts consider the following factors when determining whether the facts meet this legal test (in no particular order of importance).
Geographic extent and duration of covenant: Courts must determine whether the geographic extent and duration of the restriction are “reasonable”under the circumstances. Geography means how far does the restriction reaches (e.g.,a 20-mile radius from company, the entire country, the entire world, etc.), and duration means how long it lasts (e.g., 6 months post-employment, 1 year, 2 years,etc.). Like all things related to restrictive covenants, the reasonableness of geographic extent and duration is determined through a highly fact-specific analysis.
Among other factors, determining reasonableness of geography and duration requires consideration of person’s ability to earn a living post-employment,and the public interest which may be harmed if the covenant is enforced. Moreover, this will often require the balancing of two competing interests. For example, while a 20-mile radius maybe reasonable for a spine surgeon relative to their ability to find a job outside this range, covenants for highly-skilled surgeons are rarely enforced beyond two miles, since the public interest wouldbe harmed by depriving the community of such a scarce but vital resource.
In addition, a particular geography will only be enforced if it is necessary to protect a legitimate business interest (the scope of legally protectable business interests is discussed below). Some cases are rather clear-cut. For example, if a company only does business within a 20-mile radius, a non-compete restriction will almost never been forced beyond this 20-mile radius. But this rule is not absolute. For example,a non-disclosure of trade secrets agreement can extend around the world, regardless of where the company actually does business.
Determining reasonableness of duration is a little more straightforward. As a general rule, anon-compete or non-solicitation restriction lasting 6 months after employment will almost always be enforced, while a 3-year restriction will very rarely be enforced. A 12-month restriction has a good chance of being enforced. Like geographical extent, this analysis also looks at factors such as a person’s ability to earn a living post-employment, the public interest which may be harmed if the covenant is enforced, and whether the particular duration is necessary to protect a legitimate business interest.
Necessary to protect a “legitimate business interest”: In order to be enforceable, the covenant must also be reasonably necessary to protect a legitimate business interest. Many different factors go into this analysis, including (as discussed above) the reasonableness of the covenant’s geographic extent and duration. Courts also look at whether the thing to be protected is recognized by law as a protectable “legitimate business interest.”
Some things are clearly legitimate business interests, like trade secrets for example. But what exactly is a trade secret? Unfortunately,this is a legal term which requires branching off into yet another multi-factor test. Suffice to say that not everything a company deems a trade secret will necessarily constitute a “trade secret” as defined by law. For example, a company could have spent a lot of time and money concocting a proprietary cupcake recipe. Ordinarily, this would be a protectable trade secret. But what if, unbeknownst to the company, this exact same recipe was already previously developed by ABC Cupcake Company and made available to the public through one of their recipe books? No longer a trade secret, since one of the legal elements requires that the proprietary information not be readily available through public or lawful means.
Companies often ask – and often misunderstand – whether customer lists can constitute a protectable trade secret. They answer is yes, they can. But the rule is not absolute, and the answer will depend on additional facts (including whether the particular customer information is readily available through public or lawful means). The precise contours of what constitutes a trade secret is beyond the scope of this primer. Companies seeking to protect any type of proprietary information should always seek appropriate legal advice.
Customer “goodwill” is another business interest which can be protected by a restrictive covenant. This is why covenants prohibiting solicitation of a company’s customers (or clients) are often enforced: businesses often invest significant time and money into building and nurturing customer relationships,and the law recognizes this “goodwill” belongs to the company, not to a departing employee.
Let’s say Frank spends years building a relationship with ABC Company’s customer, Acme. Frank leaves ABC Company and calls Acme to solicit its business on behalf of Frank,LLC. Acme is likely to stop doing business with ABC Company and give its business to Frank, LLC because Frank is who they know and trust, and who knows their business better than anyone. Courts say this isn’t fair – after all, the only reason Frank was able to build and foster the relationship with Acme in the first place was because he did it on behalf of, and at the expense of, ABC Company. Frank, LLC should not be able to reap the benefits of ABC Company’s investment, to the detriment of ABC Company.
Investing time and money into developing an employee’s skill can also constitute a protectable business interest. For example, if Company A pays for an employee to be trained and certified in the use of complex software, the law recognizes it would be unjust if that employee was permitted to work utilizing those new skills for Company B, a competitor of Company A. This makes sense: Company B should not be permitted to benefit from Company A’s investment, to the detriment of Company A. As with most things in the restrictive covenant realm, investing into building an employee’s knowledge or skill is not always a protectable business interest. The analysis requires examination of various other factors, including: the nature of the position, the nature of the skill or knowledge invested in, the amount of time and money invested, and other factors.
Dispelling the myth that restrictive covenants are unenforceable: There is a common myth that restrictive covenants, particularly non-compete agreements, are never (or almost never) enforced. This is not true. What is true, however, is that many restrictive covenant agreements are poorly drafted, without appropriate understanding and application of the various enforceability elements (discussed above). To the extent that courts appear to frequently rule restrictive covenants are unenforceable, this is the main reason, as opposed to some pre-existing legal principles.
While it may also be true that courts in most states “disfavor”restrictive covenant agreements, this only means that courts will closely scrutinize the agreement to ensure that the relevant restrictions are “reasonably necessary to protect a legitimate business interest.” But if an agreement is drafted carefully and according to existing governing case law, most restrictive covenants will survive the court’s close scrutiny, and will be enforced. The key is to do it right.
Moreover, if done right the first time then often the worst-case scenario is that a court will not enforce the agreement as-written but will instead enforce it after modified by the court – this is called “blue penciling”(a mechanism available in most states). For example, a court may find a 50-mile radius is unreasonable because he company only has relevant protectable business interests within a 40-mile radius: the court scratches off “50” and writes in “40.” But courts will usually only apply blue penciling if the original agreement does not overreach – the agreement must come close to matching the applicable governing law. For example, courts will rarely enforce a modified agreement if the geographic extent of a non-compete is nation-wide, but where the company only does business regionally.
Avoiding common mistakes: Some common drafting mistakes include, for example: having a one-size-fits-all agreement (i.e., companies only have one agreement which applies to all employees, regardless of position); including a geographic extent that makes no sense relative to the business interest sought to be protected; and attempting to protect customer goodwill through an onerous non-competition agreement (whereas non-solicitation agreement would by itself be sufficient).
Conclusion: As should be evident by now, determining the enforceability of restrictive covenants requires applying complex, multi-faceted legal tests. The analysis is highly fact-specific, and often no two cases are the same.
Let us know how we can help.