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Do Non-compete Agreements Really Protect You

December 1, 1999
Related Topics: Staffing and the Law, Featured Article
John Wiley, an account executive for World Net Web Inc., an establishednetwork software provider, has been with his firm for 10 years. He was promotedto his current position eight months ago.

In his current position, John manages accounts for more than 40 clients ofWorld Net. However, it hasn’t been easy for John. Along the way, he’s had tofight the political scene at World Net to even reach his current position. Andnow, although he has attained an executive position at World Net, he stillresents the red tape he endures each time he needs to make a quick decision forone of his client accounts.

Recently, John has been approached by NetStart, a small start-up company thatspecializes in networking software, and asked if he would like to join theirteam as executive vice president. John has been eyeing NetStart since theirentry into the network software market three years earlier. Thinking he couldbring a majority of his client accounts over to NetStart, John decides to resignfrom his job at World Net and accept the position at NetStart.

On John’s last day, the general counsel of World Net enters his office. Thegeneral counsel reminds John that, pursuant to the non-compete agreement hesigned upon his most recent promotion, for one year after his resignation date,he is not allowed to directly or indirectly compete with World Net within 20miles of any location in which John did business for World Net. John disagrees,becomes irritated and asserts that the agreement won’t stop him from moving toNetStart, nor will it dissuade him from using the knowledge he gained at WorldNet for his benefit at NetStart. The general counsel warns John that World Netwill enforce the agreement by filing suit.

Although the actors in the above scenario are fictional, the dilemma facingJohn, World Net and even NetStart is all too real. In recent years, the use ofnon-compete agreements has dramatically increased in the employment setting."Non-compete agreements have increased in use because of the increase inthe technology industry and the need for all companies, regardless of industry,to zealously guard trade secrets, marketing plans and other sensitiveinformation that is specific to the organization and would give its competitorsan edge," says Anne Pasley-Stuart, president and CEO of Pasley-StuartConsulting, a human resource consulting firm based in Boise, Idaho.

As long-term employment relationships have dwindled and loyalty betweenemployers and employees has declined, many employers have found non-competeagreements desirable to prevent unfair competition by former employees. With theincreased use of these agreements, there’s a corresponding increase inlitigation over them. Steven Kayman, chairman of the Non-Compete and TradeSecrets Practice Group at Proskauer Rose in New York City, explains, "Therehas been a general trend toward more ready enforcement of restrictive covenants,including non-compete agreements. To some extent, it’s because there is agreater level of consciousness among practitioners that non-compete agreementsare out there and, to some extent, getting enforced by courts."

What is a non-compete agreement?

Though many people group all restrictive covenants under the umbrella term of"non-compete" agreements, there’s a definitive distinction in thepurpose, operation and potential validity of each type of restrictive covenant."Many companies categorize all restrictive covenants as non-competeclauses. However, companies need to make a distinction between non-competeagreements and other restrictive covenants. If no distinction is made, there isa potential that one part of the agreement will be weakened," says EthanWinning, president of E.A. Winning Associates, a management and human resourcesconsulting firm in Walnut Creek, California.

Non-disclosure covenants prohibit former employees from using or disclosingthe employer’s confidential or proprietary information. Non-solicitationcovenants prohibit former employees from soliciting the employer’s prospectsand customers, and non-raiding clauses prohibit former employees from hiring theemployer’s other employees.

However, a pure non-compete agreement is a provision in an employmentcontract or agreement by which the employee agrees not to directly or indirectlycompete with the employer or work for a competitor after termination of theemployment relationship. In short, the wording of such a clause may readsomething like:

Employee agrees as a condition of employment that, in the event oftermination for any reason, Employee will not directly or indirectly, eitherindividually or as a principal, partner, agent, employee, director officer ofany corporation or association, compete against the Company, or aid or assistany other person, firm or corporation in any business which directly orindirectly competes with the Company or any subsidiary corporation thereof inthe United States.

There will also be time, scope and geographic limitations included in thenon-compete agreement. Generally, the purpose of a non-compete agreement is toprotect the business interests of an employer from unfair competition by aformer employee without imposing an unreasonable restraint on the formeremployee.

Why would an employer want a non-compete agreement?

As the United States continues its transformation from a manufacture-driveneconomy to a service-driven economy, the ability for employers to maximallyprotect their investment in company resources has become a focal point. Suchresources include employees, research and development, client lists and otherconfidential or proprietary information which the employer has a legitimateinterest in protecting against unauthorized disclosure or misappropriation.

Thus, due in part to the unfettered access that many employees enjoy as apure function of their jobs, employers are being forced to devise new ways ofmaintaining the security of proprietary information, trade secrets and otherconfidential information. Such pressure has led many employers to viewpost-employment non-compete covenants as the best method for protecting theirvaluable confidential information and goodwill from misuse by former employees.In fact, the thought is that without such protection, employers could not affordto invest optimally in product development or in their employees, nor couldthere be a free exchange of ideas within a company.

James W. Wimberly, a principal with Wimberly, Lawson, Steckel, Nelson &Schneider, a management side labor and employment firm based in Atlanta,observes, "The biggest benefit to an employer [would be] a situation inwhich the business would be devastated by the immediate transfer of an employeeto a competitor, or having the employee start his or her business in competitionwith the former employer. A few employers have told me they’ve almost been runout of business by certain practices, and it’s frustrating for them to hearthat often there’s nothing that can be done about the situation, in theabsence of some type of an agreement with the former employee."

However, non-compete agreements have traditionally been looked upon withdisfavor. Why? The courts generally articulate two policy reasons for theirdisfavor of non-compete clauses: (1) the employee’s right to sell his or herown labor and (2) the public’s interest in unimpeded trade.

The former policy reason recognizes that the employer usually has an economicadvantage over the employee. Specifically, there is a concern that the employee,in entering into a non-compete agreement, may succumb to pressure and sign awaythe right to work in the employment realm for which the employee is mostqualified. Therefore, due to the fact that non-compete agreements forceemployees to relinquish freedom to use information, customer contacts, andgeneralized skills they’ve acquired, these covenants restrain the economicmobility and personal freedom of employees.

Based on such considerations, at least one organization, Affiliated ResourceGroup, a Columbus, Ohio-based company that helps growing and mid-marketcompanies manage their information assets, has implemented a firm policy of notseeking or requiring non-compete agreements with its employees. Explains MichaelMoran, president of Affiliated Resource Group, "Why should we hinder anyone’scareer? If someone is happy, challenged and properly compensated, they’ll staywhere they are."

The second policy rationale recognizes the potentially negative impact ofnon-compete clauses on competition in the marketplace. Courts have noted thatnon-competition clauses restrain the free flow of ideas and information.Therefore, enforcement of such clauses may by be injurious to the general publicby rendering employee skills developed during employment unavailable.

When is a non-compete agreement appropriate?

Despite the benefits a non-compete agreement affords an employer, non-competeagreements aren’t appropriate for every employer or employee. The necessity ofan agreement depends on such factors as the nature of the employer’s businessand the character of the employer-employee relationship. Pasley-Stuart of Pasley-StuartConsulting emphasizes that "non-compete agreements should be limited tothose people who have positions that are sensitive and have access toconfidential or proprietary information."

For those companies whose survival is strictly contingent upon maintainingconfidential or proprietary information, there seems to be an increased need fornon-compete agreements. For instance, certain high-tech companies, such ascomputer and Internet organizations, are more likely to require non-competeagreements. Moreover, there are certain industries, such as insurance andsecurities, that have historically implemented a policy of requiring non-competeagreements with certain employees. Even certain occupations, such as sales, havea higher tendency to require non-compete agreements, due in part to highcustomer interaction.

Even for those companies fitting within the above-mentioned description,before requiring any employee (temporary or permanent) or consultant to sign anagreement, it’s advisable for the employer to focus on the nature andcharacter of the employer-employee/consultant relationship. For instance, whatamount of access does the employee have to the employer’s trade secrets andproprietary information? What amount of access does the employee have to theemployer’s customers? What is the likelihood of grievous harm to the employeeif the clause is enforced? What is the likelihood of grievous harm to theemployer if a non-compete is not signed?

An employer considering the necessity of a non-compete agreement shouldcandidly and thoughtfully decide why such an agreement is necessary. Not allinformation learned during employment is truly confidential or proprietary. Notall competition by a former employee is unreasonable. Therefore, an employershouldn’t seek to obtain non-competition agreements from all employees acrossthe board, nor even all employees of a particular job classification. Instead,an individual assessment should be made regarding the necessity for anon-compete agreement with respect to each separate job.

"Most employers are convinced that everything they have is sensitive. SoI always advise companies to bring in legal counsel to walk through what theyreally need and what they actually are trying to protect. Often, when you get acompany to systematically go through what information they’re trying toprotect and how little it is and how few employees it really impacts, it canchange the company’s approach to requiring non-compete agreements," saysPasley-Stuart.

When will a court uphold a non-compete agreement?

Because of the impediment to free competition that a non-compete agreementinvolves, courts have generally been reluctant to limit an employee’s freedombased on such provisions.

Due to the employer’s interest in protecting its information, the employee’sinterest in freedom, and the public’s interest in promoting the free flow oftrade, a balance between the competing interests must be reached in drafting anenforceable non-compete agreement. "The courts have traditionally and havecontinued to employ a highly fact-sensitive analysis in evaluating non-competeagreements. On one hand, that makes sense because the facts do vary so much. Onthe other hand, it creates enormous uncertainty for employees who want to jumpship or employers that wonder whether they ought to adopt a non-compete policyor should attempt to enforce one if a former employee is violating anon-compete."

The basic test of enforceability of non-compete agreements used by mostcourts is a measure of the reasonableness of the agreement under the particularcircumstances. The employer must be able to articulate a legitimate interestwhich deserves protection, such as trade secrets, customer lists or otherconfidential information. The court deciding whether to enforce a non-competeagreement will decide whether the interests to be protected are reasonable andlegitimate. The court will also weigh the hardship that might be imposed uponthe employee, as well as the public at large, and the agreement must be nobroader than is reasonably necessary to protect the employer’s interests.

Finally, a court will evaluate the reasonableness of the specific terms ofthe agreement, such as the duration or time limitations for the agreement, theterritory or area in which competition is restricted, what the employee receivedin exchange for agreeing to be bound by the non-compete agreement, and thecircumstances surrounding the termination of employment.

The law on non-compete agreements varies from state to state. For instance,non-compete agreements are generally unenforceable in California, Montana, NorthDakota and Oklahoma. In other states, such as Connecticut, Minnesota andIllinois, the enforceability of non-compete agreements depends on the facts ofeach case. As a result of the varying positions states take on non-competeclauses, questions pertaining to the enforceability of a non-compete agreementin a particular state should be addressed to competent counsel familiar withthat state’s requirements. Says Winning, "Every state and within everystate, every court and judge has their own personal idiosyncrasies when it comesto hearing such cases." Nonetheless, the general rule remains a rule ofreasonableness of the agreement and its terms, under the unique circumstances ofeach case.

What happens if an employee breaks the agreement?

The most frequently invoked remedy for breach of a non-compete clause is aninjunction that restrains the former employee from violating the agreement. Aninjunction is the favored remedy due to the fact that it appears to be the mosteffective method for eliminating the potential harm to the employer. Sometimesan employer may be awarded damages as a result of a breach of a non-competeagreement. In most circumstances, courts will find damage awards appropriate ifa former employee has already injured the employer as a result of the breach.

Historically, former employers have rarely enforced non-compete agreementsdue to the cost and uncertainty of enforcement. The existence of the non-competeserved as a fallback in particularly egregious situations. "There is a widevariance to the degree to which companies seek to enforce their non-competes.Some companies will try to enforce every agreement and other companies willalmost never try to enforce an agreement. Most are somewhere in between,evaluating on a case-by-case basis, and looking principally -- and largely basedon the advice of counsel -- on their chance of success and how badly the formeremployee can hurt them," explains Kayman of Proskauer Rose.

However, in recent years, due in part to the increased mobility of theAmerican workforce, there has been an increase not only in the use ofnon-compete agreements, but an increase in the efforts of former employers toenforce such agreements. In fact, in some cases, the former employee is alsosuing the subsequent employer for interfering with a contractual relationship,aiding and abetting a contractual violation and civil conspiracy.

Further, while punitive damages generally aren’t available in a suit toenforce a non-compete clause, a court may assess punitive damages against thesubsequent employer. For instance, one court ruled that a business engaged intortious interference with a contract and was liable for punitive damages whereit knowingly hired two individuals who had signed non-compete clauses with theirformer employer and then encouraged the employees to use confidentialinformation in violation of that non-compete clause.

What are the risks of requiring a non-compete agreement?

One of the biggest risks of having a non-compete agreement is that of"running off" employees or potential employees who refuse to sign theagreement. In an age when good employees are getting increasingly harder tofind, employers may be limiting their recruitment efforts. "In someinstances, the employee may refuse to sign and will seek another job. Andobviously, getting talented people now is difficult," says John Yates, anattorney who heads the Technology Practice Group of Morris, Manning and Martinin Atlanta.

There’s a school of thought that requiring employees to sign a non-competeagreement can set the employer-employee relationship off on a bad start, in thatthe agreement may impart a feeling of distrust between the two parties. Becauseof the difficulty and potential resentment of getting employees to sign anon-compete agreement, some companies have overall policies that forbid suchagreements.

Michael Moran of Affiliated Resource Group is in charge of such a company. Inresponse to whether he’s concerned about the potential exposure, Moran says,"The reason we aren’t concerned with the potential exposure is because wetry to have a good relationship with our clients and with our employees. Are weperfect? No. However, the impetus is on the company to provide an opportunityfor the employee and to render a valued service to our clients."

Even in states where non-compete agreements can be upheld, an employer willhave to spend money enforcing such an agreement. In fact, a former employee mayfeel compelled to sue the former employer for a "declaratory judgment"as to the enforceability of the restrictive covenant. Accordingly, it’spossible for the existence of such an agreement to increase an employer’slegal bills, even in circumstances where the employer doesn’t intend toenforce the agreement. Says Winning, "Non-compete agreements are going tobe expensive and difficult to litigate."

As the American economy continues to shift toward a service-oriented market,the value placed on a company’s confidential and proprietary information willcorrespondingly increase. Due to the fact that a company’s own employees canultimately turn out to be future competitors, there remains a desire forcompanies to try to protect their legitimate business interests from misuse byformer employees.

However, the American free-market society thrives on competition and the freeflow of ideas. Consequently, there’s a conflict. As a means of resolving theconflict by virtue of contract law, companies have pushed the use of non-competeagreements. Their role will be determined by those who request them, those whoaccept them and those who enforce them.

This article is intended to provide useful information, but should not beconstrued as legal advice or legal opinion.

Workforce, December1999, Vol. 78, No. 12, pp. 48-55 -- Subscribenow!

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