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Non-Competition Agreements Their Lifespan and Other Methods to Protect a Companys Most Valuable Commodities

December 15, 2006
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To stay competitive and thrive today, a company must safeguard its most precious assets--human capital, client relationships and trade secrets.

    Several ways exist for a diligent company to institute such protections. Two of the most common vehicles are nondisclosure agreements for proprietary information and nonsolicitation agreements for employees. Historically, however, the noncompetition agreement is an employer’s most-favored mechanism to protect its investments. But a recent California case that exemplifies the state’s abhorrence of noncompetition agreements may be a harbinger for other states of toughening restrictions on covenants not to compete.

    In its simplest form, a noncompetition agreement restricts a former employee from competing against his or her former employer. Noncompetition agreements may take on different time, scope and geographical limitations. For example, an agreement may preclude a former employee from ever competing against his or her former employer in the same field anywhere in the world. A narrower covenant may bar competition only for a one-year period in a limited geographical area, such as the same county that the former employer’s principal place of business is located.

    Unlike other mechanisms that may protect an employer’s commodities, the noncompetition agreement tends to be the most favored because it serves to completely stifle competition. An employee who agrees that he will not work in the same field as his employer for a certain period of time after his employment ends is less likely to compete for fear that his former employer may attempt to enforce the agreement.

    Because noncompetition agreements have a chilling effect on competition, courts closely scrutinize them to ensure that they do not impose an unfair restriction on an individual’s right to earn his or her livelihood. The rationale is that a person has a substantial interest in the unrestrained pursuit of his or her livelihood and must, within limits, be allowed to change employers and compete for available business and customers.

    Indeed, each state has a body of law, whether statutory, case law or both, that addresses whether noncompetition agreements are enforceable, and, if so, the permissible scope of such covenants. A common thread among the different states is the principle that the law will enforce covenants that are lawfully tied to a protectable interest of the employer. Some states, such as Vermont, permit broad noncompetition agreements subject to scrutiny for reasonableness and justification. Other states, such as California, enforce noncompetition agreements only in the rarest of circumstances.

    California has a long-standing ban on noncompetition agreements. The general rule prohibiting noncompetition covenants is codified in California Business and Professions Code Section 16600, which provides: "[E]very contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void."

    The code carves out limited exceptions to the general rule, providing that covenants not to compete may be enforceable when given by:

  • Anyone selling the goodwill of a business.

  • A shareholder "selling or disposing" of all of his or her shares in a corporation.

  • A shareholder of a corporation that sells all or substantially all of its operating assets and goodwill, or all of the shares of a subsidiary.

  • A partner upon dissolution of the partnership, the partner’s withdrawal from the partnership or disposition of the partner’s interest.

    California law also recognizes a limited exception for noncompete agreements to protect an employer’s trade secrets. It should be noted, however, that these types of agreements are not conventional noncompete agreements, but rather take the form of a "proprietary information agreement" or some agreement with a similar name. By these agreements, an employee agrees not to misappropriate his or her employer’s trade secrets during or after employment.

    While the California courts traditionally have applied the exceptions conservatively, federal courts in California have been more liberal, recognizing a "narrow restraint" exception. This exception allows a noncompete agreement to prohibit a former employee from competing in a narrow portion of the market. The "narrow restraint" exception came under scrutiny in the recent California state court case, Edwards v. Arthur Andersen.

    Raymond Edwards, who was hired by Arthur Andersen in 1997, brought the case. At that time, he was required to sign a standard noncompetition agreement, which, among other things, prohibited him from working for or soliciting business from certain firm clients for a limited period after the end of his employment.

    In 2002, as Andersen’s business was folding, it sold the practice group in which Edwards worked to HSBC. As a condition of employment with HSBC, Andersen required Edwards and others to sign an agreement that released Edwards from his noncompetition agreement, in exchange for which Edwards released all claims against Andersen.

    When Edwards refused to sign the agreement, his offer of employment with HSBC was withdrawn, prompting him to sue and assert various claims, including intentional interference with prospective business advantage (Edwards’ employment opportunity with HSBC).

    The state court, invoking the "narrow restraint" exception, ruled that the noncompetition covenant was enforceable. The Court of Appeal reversed, holding that California law does not honor the "narrow restraint" exception. The court concluded that the common-law exception to Business & Professions Code Section 16600 only allowed agreements where necessary to protect an employer’s trade secrets. In so ruling, the court clarified and confirmed California’s strong public policy against noncompetition covenants.

    Whether the Edwards decision signals a larger, national trend tightening the restrictions on covenants not to compete remains unclear. Cases at the other end of the spectrum, upholding noncompetition agreements, undoubtedly still are being rendered in multiple jurisdictions. Nevertheless, with the advent of other agreements to safeguard sensitive employer information, the standard inclusion of noncompetition covenants in employment agreements may be over.

    This prediction is supported by statistical evidence that shows that, unlike a generation ago, employees today are more likely to move more frequently from job to job. Therefore, a noncompetition agreement in today’s economy is more likely to have a detrimental impact on a larger segment of our society and stifle competition more than it did a generation ago when an employee was more likely to stay with one company for his or her entire career.

    In light of the changing legal climate toward noncompetition agreements, employers should consider the following suggestions:

  • Employers should engage competent employment law counsel to determine whether their state’s law enforces covenants not to compete and, if so, under what circumstances.

  • Employers should review their agreements to ensure that they do not continue to carry noncompetition provisions. In spite of some states’ prohibition of noncompetition agreements in the employment context, as in California, many employers have historically chosen to retain noncompete agreements. They rationalize that even if the clauses are unenforceable, they may accomplish the goal of stifling competition by former employees. Using noncompete agreements for this purpose, however, should be considered closely. California employers who retain noncompete agreements or condition employment on their execution now face almost certain liability.

  • Employers should revisit their current employment agreements to protect what still lawfully may be protected. While courts may invalidate efforts undertaken to restrict an employee’s ability to earn his or her livelihood, the law of most states retains a strong body of statutory and case law that protects one of an employer’s most valuable commodities: its proprietary information and trade secrets.

  • Employers, therefore, are encouraged to formulate strong policies to guard against misappropriation and other acts of unfair competition. Agreements covering confidentiality, nondisclosure and nonsolicitation of employees should be presented to all employees.

  • Before hiring a job candidate, employers should conduct due diligence to determine whether any noncompetition agreements or similar agreements to protect against disclosure of proprietary information bind the new employee. A company that is unaware of such conflicts could invite litigation if it retains an employee bound by restrictive covenants.

  • Finally, employers should implement internal security measures to protect sensitive proprietary information and trade secrets.

    Collectively, these efforts should have the effect of not only minimizing exposure to liability, but also diminishing any potential harm done by departing employees. With the broad freedom of mobility afforded employees in many states, it is imperative that employers not permit the departing employee to "take the farm" along with his or her final paycheck.

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