DRAFTING ENFORCEABLE NON-COMPETE AGREEMENTS

DRAFTING E N F O RC E A B L E NON-COMPETE AGREEMENTS E DWA R D E . S H A R K E Y 4 6 4 1 M O N T G O M E R Y AV E N U E SUITE 500 BETHESDA, MD 20814 ...
Author: Angelina Golden
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DRAFTING E N F O RC E A B L E NON-COMPETE AGREEMENTS

E DWA R D E . S H A R K E Y 4 6 4 1 M O N T G O M E R Y AV E N U E SUITE 500 BETHESDA, MD 20814 (301) 657-8184 E S H A R K E Y @ S H A R K E Y L A W. C O M W W W. S H A R K E Y L A W. C O M

CONTENTS Introduction .................................................................................... 3  Historical context ........................................................................... 4  When is an enforceable non-compete agreement entered? ..... 5  Who may be bound by a non-compete agreement? ................. 6  Keys to reasonableness .................................................................. 7  Relevant principles of contract law ............................................. 8  Judicial enforcement ...................................................................... 9  Recommendations ........................................................................ 10 

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INTRODUCTION Entrepreneurs invest significant resources in developing the formulas, methods, and procedures upon which their businesses are based. The owner of a bakery, for example, might spend years developing the perfect cake recipe. The proprietor of a manufacturing company might base his or her pricing models upon years of specialized education and experience. Any company’s customer list is developed as the company’s products and services are used and appreciated by consumers. Such formulas, customer lists, methods, and procedures, known as trade secrets, provide the businesses that develop them an advantage over competitors. For this reason, maintaining the confidentiality of trade secrets is crucial. At the same time, it is often necessary for employees to have access to the trade secrets so that they are able to perform their job duties. For example, it would be of no use for the bakery owner to hire a baker if the recipe could not be shared with him or her. For this reason, employers must do something, aside from keeping employees uninformed, to prevent a disgruntled, disloyal, or opportunistic employee or former employee from sharing trade secrets with competitors. One way an employer can protect its trade secrets and other confidential and proprietary information is by drafting and enforcing effective non-compete agreements. Non-compete agreements are contracts by which employees agree not to take certain actions that would harm the employer’s business. An agreement not to compete may include, among other things, terms by which an employee obligates him or herself to maintain the confidentiality of the company’s trade secrets, promises not to solicit the company’s customers, and agrees not to work in a similar field in a geographically close location. Because, by nature, non-compete agreements restrain free trade, only those that are deemed to be reasonable will be enforced by the courts. This paper generally describes the key elements of reasonable non-compete agreements. Any individual involved in hiring can use it as a general guide to crafting effective non-compete agreements. After reviewing the general information provided herein, readers should carefully review the laws of the relevant jurisdiction. Every state has its own law and variations on these principles of construction. For this reason, the considerations outlined in this paper should not be taken as determinative of the law of any particular jurisdiction.

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HISTORICAL CONTEXT When first faced with the prospect of enforcing non-compete agreements, courts declined to do so. The reasoning of these early courts was that, because society benefits from competition, no individual should be able to sign away the right to ply his chosen trade on his or her own terms. Eventually, courts developed an exception to this total ban. The exception is known as the Rule of Reason, and, pursuant to it, courts will enforce non-compete agreements that they find to be reasonable. In general, a non-compete agreement will be found to be reasonable only if it is not more extensive than is necessary for the protection of the employer’s business, it does not harm the consumer, and it does not cause undue hardship to the employee. Today, although the law differs widely among states,1 courts in the majority of states apply the Rule of Reason to evaluate the enforceability of non-compete agreements.

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Non-compete agreements are still unenforceable in California, for example. 4

HOW IS AN ENFORCEABLE NON-COMPETE AGREEMENT FORMED? Typically, to be enforceable, a non-compete contract must have a connection to an employment agreement. This is because, if it does not have such a connection, a court will view it as an unenforceable attempt to form a cartel or fix prices. The easy way for an employer to ensure that it is clear that a non-compete provision is connected to an employment contract is to include the non-compete language in the employment contract itself. A non-compete provision need not be included in the employment contract to be enforceable, though. Such a provision is enforceable as long as it is executed during the employee’s time on the job. Similarly, a non-compete agreement that arises out of an at-will employment relationship is enforceable as long as the at-will employment continues for some time after the employee enters the agreement. While there is no strict rule as to how long the employment must continue, it is clear that, if the employer presents an at-will employee with a non-compete agreement as the employment relationship is ending, the agreement probably will not be enforced by the courts absent some other consideration. The requirement that the employment continue after the agreement helps to ensure that the employee understood the agreement. The continued employment also serves as the consideration, or thing of value, that the employee receives in exchange for agreeing not to compete.

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WHO MAY BE BOUND BY A NON-COMPETE AGREEMENT? The enforceability of a non-compete agreement depends, in part, upon the type of employee against whom enforcement is sought. It is important to know which employees are subject to such agreements because, while blanketing your work force (or even prospective personnel) with non-compete agreements might scare some exempt persons into voluntary compliance, it could also lead to expensive, and unsuccessful, litigation. Because, pursuant to the Rule of Reason, the enforceability of a non-compete agreement is limited to the extent that it is needed to protect a legitimate interest of the employer, a non-compete agreement will not be enforced against an employee unless the employee has the ability to compromise the employer’s business. An employee has the ability to compromise the employer’s business if he or she possesses unique skills, is privy to sensitive information, or has been tasked exclusively with customer relations. Accordingly, when assessing whether an employee may be bound by an agreement not to compete, courts scrutinize the nature of the employee’s responsibilities. The simplest way to determine whether the employee meets the skills standard is to assess how easily the employer could find a replacement. If the employer need only draw from the general labor pool to replace the employee, then the employee is probably not sufficiently skilled to justify a non-compete agreement. Consistent with this, an employer cannot enforce a non-compete agreement against a low-level employee who does not have access to sensitive information. In addition, individuals who practice certain professions may be prohibited from entering binding non-compete agreements. In many states, lawyers, doctors, dentists, psychologists, pharmacists, veterinarians, physical therapists, and/or members of the broadcast media are not permitted by law to enter into non-compete agreements. Similarly, many of the professions’ licensing boards have established ethics rules that prohibit their members from entering into non-compete agreements. For example, state bar associations preclude lawyers from agreeing not to compete. These limitations on professionals’ abilities to enter into non-compete agreements likely arise from their responsibility, unique to their respective professions, to society as a whole. Accordingly, even in the absence of ethical or state law prohibitions, courts may decline to enforce non-compete agreements among professionals for the benefit of society. For example, a court would likely refuse to enforce a non-compete agreement among the only two horse veterinarians in a rural town. Non-compete agreements are also generally unenforceable against independent contractors. This is because an independent contractor’s agreement not to compete is much like a cartel. When assessing whether an individual designated as an independent contractor may be bound by a non-compete agreement, courts look beyond the designation to examine whether the “independent contractor” is actually an at-will employee. If the court finds that he or she is actually an employee, the non-compete agreement will likely be enforced as long as the employment continues for some time after the agreement is entered.

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KEYS TO REASONABLENESS Not unduly burdensome: Where compliance with a non-compete agreement would cause an “undue hardship” to the employee, the agreement is not reasonable and, accordingly, unenforceable. While the precise meaning of “undue hardship” is elusive and varies among jurisdictions, the intended concept is the unfairness that results when, as a result of abiding by the terms of a non-compete agreement, the employee suffers a precipitous drop in pay or working conditions. In other words, to be reasonable and enforceable, the terms and conditions of a non-compete agreement may not be overly oppressive or punitive. Where, for example, compliance would require the employee to move to another part of the country, work for a much lower wage, perform menial tasks, or take extraordinary steps such as cutting off all contact with friends from the old job, there is a high probability that a court will find the agreement unreasonable and refuse to enforce it. Limited geographic scope: Non-compete agreements often obligate employees not to do certain things, such as provide work for others that is similar to the work performed for the employer, within certain geographic areas, such as within specific counties or a certain number of miles of the employer’s offices. Consistent with the notion that non-compete agreements are permitted only to the extent necessary for the protection of the employer’s business, in general, the narrower the geographic area, the more likely the restriction is to be deemed reasonable and enforced by the courts. Because employers are often unable to establish that their businesses would be threatened if one of their employees competed in a geographically distant area, courts generally decline to enforce agreements that cover a large geographic area. As businesses have become highly specialized and global, however, a narrow exception has emerged. Continent- or world-wide non-compete agreements may be enforced if a high-tech or specialized manufacturing employer proves that its business really does extend continent- or world-wide or that there are only a small number of similarly qualified persons worldwide. In the event that the agreement not to compete does not set forth its geographic scope, a court reviewing the agreement will treat it as a world-wide restraint or, in some jurisdictions, it may read a geographic limitation into the document. The risk, however, is that the court will deem the agreement an attempt to restrain competition world-wide. In that event, unless the employer is a high-tech or specialized employer whose business truly is world-wide, the agreement will likely be deemed unenforceable. Limited duration: To be enforceable, a non-compete agreement must also limit the length of time during which the employee must comply with its provisions. Any non-compete agreement that lasts for an indefinite period is not enforceable. In general, two to three years from the date of separation of employment, at most, is a reasonable duration for a non-compete agreement. Although an agreement whose duration is longer than three years is vulnerable to challenge on the ground that its scope exceeds what is necessary to protect the business of the employer, courts have, in several instances, upheld agreements with five-year durations.

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RELEVANT PRINCIPLES OF CONTRACT LAW Illegal provisions: An issue that arises in non-compete agreements, as well as other types of contracts, is what to do in the event that a contract includes both enforceable and illegal provisions. Should the illegal provisions be ignored and the remainder of the agreement enforced? Or, should the entire contract be invalidated because of the inclusion of an illegal term? Courts in the majority of jurisdictions apply the “Blue Pencil Rule” to answer these questions. Named for the editor’s trademark writing instrument, the Blue Pencil Rule allows courts to cross out and ignore unenforceable terms, read the remainder of the agreement, and, if the agreement still makes sense, enforce its legal provisions2. The Blue Pencil Rule is powerful in the context of non-compete agreements. An example will illustrate this. Imagine a non-compete agreement, entered into by a financial services firm and its employee, which prohibits the employee from soliciting the firm’s clients or accepting a job with any firm located east of the Mississippi River. A court asked to enforce the agreement is likely to find the non-solicitation portion reasonable, but is also likely to determine that the geographic scope is unreasonably broad and unenforceable. If the court is in a jurisdiction in which the Blue Pencil Rule applies, it will ignore the overly broad geographic restriction, but enforce the non-solicitation provision. If the court were not in a Blue Pencil Rule jurisdiction, on the other hand, the entire agreement may be deemed unenforceable.   Ambiguity: Another issue is what to do in the event that a non-compete agreement includes ambiguous terms. In general, courts resolve ambiguities in contracts against the party who drafted the agreement. For example, imagine that a landscape architect enters into a non-compete agreement, drafted by its employer, a landscape design firm, which prohibits the architect from providing design services to any of the firm’s “existing clients” for a period of two years. Prior to the architect’s separation from the firm, a homeowner phones the firm to discuss the possibility of hiring it to perform design services. Before the homeowner actually hires the firm, the architect’s employment with the firm terminates. During the term of the non-compete agreement, the homeowner hires the architect to perform the design services. Because the term “existing clients” may mean only clients who retained the firm prior to the architect’s departure, a court would not be likely to find that the architect breached the agreement by providing services for a homeowner that was merely a prospective client during his tenure at the firm. To prevent such interpretations, employers must be careful to define all of the material terms in a noncompete agreement.

 Not all state courts apply the Blue Pencil Rule. Courts in Georgia, for example, decline to enforce entire agreements on the ground that they contain some unenforceable language. In some other states, courts actually re-write the illegal provisions to make them enforceable. 2

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JUDICIAL ENFORCEMENT Timeliness of lawsuit: If an employer suspects that an employee or former employee is violating the terms of a valid non-compete agreement and wants the agreement enforced by a court, the employer must act quickly. Most states require that a lawsuit for breach of a non-compete contract be initiated within two to three years of the breach or of when the employer reasonably should have discovered the breach. Typically, injunctive relief will only be available when the employer can demonstrate imminent, irreparable harm arising from the breach. Any undue delay in reaching the courthouse could be construed as evidence of the converse. There are several things to consider when deciding whether to file suit to enforce a non-compete agreement: Relief available: An employer may request that the court order the employee to comply with the terms of the agreement by issuing an injunction and/or award money damages to the employer to compensate him or her for the employee’s breach. While an employer need not limit the relief requested, it is important to note that courts are unlikely to both issue an injunction and award money damages. Judge or jury: In most states, a judge decides cases in which equitable relief, such as injunctions, are sought. Juries, on the other hand, decide cases seeking money damages. Juries notoriously favor individuals over businesses, and they are likely to identify with a worker trying to make a living. This may make a request for injunction more appealing to an employer than it otherwise might be. Choice of Law:  Because different states apply different rules with respect to non-compete agreements, the question of which state’s law applies to a dispute arising out of an agreement not to compete may be crucial. For this reason, many employers include a choice of law provision in the non-compete agreements. As long as there is a valid reason for an employer’s choice of law, most courts will apply the law chosen in the agreement. Valid reasons for selecting a certain law as the controlling law include that it is the law of the jurisdiction where the contract was signed, where the employee lives, or where the company is located. Where the law was selected randomly or for reasons such as the law’s favorability toward employers or distance from the employee’s home, in most3 states, the selection will not be honored.

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In an effort to attract businesses, some states have recently passed laws that require courts to apply the choice of law identified in the contract regardless of the reason for the choice.

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RECOMMENDATIONS Because non-compete agreements restrain trade, courts will enforce such agreements only to the extent necessary to protect the employer’s business. By carefully drafting non-compete agreements with the following in mind, employers can increase the likelihood that a court will enforce the non-compete agreements their employees have entered: (1) Include non-compete language in an employment contract. (2) Limit use of non-compete agreements to employees who have unique skills, are privy to sensitive information, or are responsible for customer relations. (3) Define all of the non-compete agreement’s material terms. (4) Include a choice of law provision and be prepared to show a valid reason for the choice of law. (5) Limit the geographic scope and duration of the non-compete agreement so that it is only as broad as necessary to protect your business. (6) Do not include provisions that would require the employee to suffer a precipitous drop in pay or working conditions.

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