WHICH TYPES OF RESTRICTIVE COVENANTS ARE ENFORCEABLE?

UNCERTAINTY IN THE EMPLOYMENT CONTEXT: WHICH TYPES OF RESTRICTIVE COVENANTS ARE ENFORCEABLE?

Hogan, Thomas M

INTRODUCTION

Restrictive covenants have become a classic condition of employment, as employers feel the need to protect business interests.1 Although commonplace, restrictive covenants lead to an overwhelming amount of litigation over enforcement after the employment relationship ends.2 The parties potentially involved in this type of litigation are the former employer, employee, and prospective employer. An employer can draft any of the following three forms of restrictive covenants: non-competition agreements, which restrict employees from working for competitors;3 non-solicitation agreements, which limit employees from contacting former clients;4 or non-disclosure agreements, which prohibit the disclosure of the former employer’s proprietary information to the prospective employer.5

The reality that there are no clear rules regarding the enforceability of restrictive covenants6 can be frustrating for an employer that has a vested interest in sustaining its competitive advantage.7 On the other hand, the employee can also be placed in a vulnerable position,8 as he or she may have refused other employment offers and may not have the benefit of legal counsel when negotiating the employment contract. Ultimately, the employee may endure unnecessary trepidation over the possibility of losing the employment opportunity if the agreement, which may have little chance of being enforced, is not signed.9 Although the agreement was formed between the employee and the previous employer, a third party-the prospective employer-may be introduced to litigation if the former employer believes the new employer obtained access to alleged protected interests. Consequently, prospective employers might be cautious about hiring an individual bound by a covenant because they do not wish to become engaged in expensive litigation where priceless proprietary information may be revealed.10

In analyzing restrictive covenants in an era of high employee mobility,11 it is sometimes difficult to rationalize the need for these agreements. This sentiment is reinforced by the notion that restrictive covenants can be contrary to capitalist principles of free-market competition,12 resulting in numerous courts endorsing invalidation.13 At the same time, there still exists an employer’s countervailing interest in prohibiting former employees from exploiting its information or processes.14

The interests of the three parties create a predictable conflict in restrictive covenant enforcement. There are many sources that provide drafting tips for employers,15 but limited information is available for employees. Restrictive covenants have become very common in the employment context,16 but do employees really understand the ramifications of what they are signing, and, furthermore, do they have the option of negotiating the terms of these agreements? The purpose of this Note is to bring some understanding as to which types of restrictive covenants are enforceable. Clarification of this area of the law is needed as many employers unfairly present these agreements to employees at the commencement of employment with little or no guidance. To that end, this Note will review the restrictive covenant dispute between employers and employees along with the standards of enforcement in the following manner: Part I will examine enforceability standards with respect to English influences and American law. Part II will discuss how the at-will employment relationship affects restrictive covenants. Part III addresses the areas where restrictive covenants are most practical.

Additionally, this Note asserts that employment lawyers should insist that their clients only use restrictive covenants in the narrowest of cases and tailored to the most unique of employees in an effort to limit the amount of litigation in this area. Too often, employers abuse restrictive covenants to deter all levels of employees from pursuing opportunities with competitors. In a time of job insecurity and in a country that prides itself on the entrepreneurial spirit, it is unfair to limit employees from pursuing their employment goals unless the restriction is protecting a bona fide, legitimate interest.17

I. RESTRICTIVE COVENANT LAW

Restrictive covenants can be traced back to the apprenticeship system,18 where English courts were initially hostile towards enforcement because these restrictions tended to disadvantage powerless artisans.19 This rationale continued until Mitchel v. Reynolds,20 in which a baker leased his bakeshop and promised not to compete for the term of the lease.21 When the baker violated the non-competition agreement, the court ultimately enforced it because the baker agreed to abstain from competing in return for payment of the lease.22 Mitchel provided the framework, which exists today in the American judicial system, for determining whether a restrictive covenant is reasonable under the circumstances to warrant enforcement.23 Today in the United States, twenty states have drafted statutes governing the enforceability of restrictive covenants.24 The Restatement provides a realistic picture of how some legislatures and courts analyze restrictive covenants,25 but it is helpful to review the statutes and standards to understand why employers and employees consistently choose to litigate over this issue.

A. State Statutes

This Note will assign the twenty existing state restrictive covenant statutes to four categories. The first and most common category, which includes eight statutes (those of Alabama, California, Michigan, Montana, North Dakota, Oklahoma, Tennessee, and West Virginia), consists of statutes providing clear public policy language but offering no guidance to courts on what will render a restrictive covenant enforceable.26 The second category examines statutes providing specific criteria for courts to utilize when analyzing restrictive covenants and includes four statutes (those of Florida, Oregon, Texas, and Wisconsin).27 The third category analyzes statutes with detailed exceptions to public policy, which allow for broad interpretation and incorporates five statutes (those of Colorado, Hawaii, Louisiana, Missouri, and Nevada).28 The final category reviews three statutes (those of Georgia, North Carolina, and South Dakota)29 that seem to favor the enforcement of restrictive covenants.

1. Statutes with Unmistakable Public Policy Language But No Criteria for Enforcement

California’s statute exemplifies the first category as it urges that “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.”30 With this statute, California asserts the policy that any contract restricting an individual from the opportunity to earn a living will be considered unenforceable. There are two statutory exceptions that allow restrictive covenants for sale of businesses31 and partnership dissolutions.32 Alabama, Montana, North Dakota, and Oklahoma provide similar public policy language and the two exceptions supporting enforcement.33 Michigan,34 Tennessee,35 and West Virginia36 enacted comparable legislation, but these statutes are not limited to the employment context. Michigan leaves the prohibition open ended, as a restrictive covenant can be deemed void in any “relevant market.”37 Likewise, Tennessee’s statute bars restrictive covenants in “[a]ll arrangements, contracts, agreements, trusts, or combinations between persons or corporations,”38 while West Virginia covers, “[e]very contract” or “combination in the form of trust.”39

2. Statutes Providing Specific Criteria for Enforcement

The second category, those statutes providing standards in determining enforceability, includes Texas, Wisconsin, Florida, and Oregon. The first, Texas, actually requires that courts follow the guidance set forth in its statute.40 The criteria provide that a restrictive covenant will be enforced if it is signed as a supplement or as part of the original agreement; possesses reasonable limitations in geography, duration, and the scope of activity; and “[does] not impose a greater restraint than is necessary to protect” the employer.41 In addition, this statute allows courts to modify unreasonable terms rather than invalidating the entire restrictive covenant.42 Wisconsin, although not expressly requiring its courts to utilize its statutory guidelines, will enforce restrictive covenants “if the restrictions imposed are reasonably necessary for the protection of the employer.”43

Florida illustrates the characteristics of the second category by providing a long list of criteria for enforcement,44 a non-exhaustive record of what is considered a “legitimate business interest,”45 and guidelines for reasonable temporal limits.46 Even with these extensive parameters, critics believe the statute still leads to unpredictable results, particularly because the determination of a legitimate business interest must be resolved on a case-by-case basis.47 Lastly, Oregon provides requirements for enforcement48 and also mentions trade secrets but does not offer concrete examples.49

3. Statutes with Unmistakable Public Policy Language and Additional Exceptions

The third category, those statutes with public policy concerns and detailed exceptions to barring enforcement of restrictive covenants, includes Louisiana, Hawaii, Missouri, Colorado, and Nevada. The opening section of Louisiana’s statute is similar to its counterparts in the first category50 but then indicates that restrictive covenants less than two years in duration may be formed with employees and independent contractors.51 Similarly, Hawaii follows its public policy assertion with an exception for trade secrets.52 Lastly, Missouri exempts trade secrets, confidential information, and client contacts53 but leaves the interpretation and standards to the courts.54

The other statutes within the third category, Colorado55 and Nevada,56 provide strong language prohibiting employers from preventing an employee’s pursuit of an occupation but list several exceptions that seem to weaken the bite of the state’s policy. For instance, Colorado’s statute opens with “any covenant not to compete which restricts the right of any person to receive compensation for performance of skilled or unskilled labor for any employer shall be void”57 but then allows for enforcement where the covenant protects trade secrets, employee training of less than two years, and executive management positions.58 Similarly, Nevada imposes strict penalties for restricting employees59 but does not prohibit non-compete agreements that restrain employees from “pursuing a similar vocation in competition with” the former employer or non-disclosure agreements protecting trade secrets.60 Although initially these statutes seem to benefit the employee, the exceptions, in an attempt to provide impartial language, leave a lot of discretion to the courts.

4. Statutes Favoring Enforcement

The final category presents three statutes that seem to support enforcement of restrictive covenants. First, South Dakota allows non-competition and non-solicitation agreements for periods of less than two years.61 Unlike other statutes, enforcement may simply depend on whether the employee signed the agreement.62 Similarly, North Carolina enforces restrictive covenants as long as they are in writing and signed by the employee.63

Georgia enacted one of the more detailed statutes concerning restrictive covenants.64 This statute explicitly states that reasonable restrictive covenants are compatible with public policy notions.65 Reasonable durational limits vary between two and three years depending on the restricted activity.66 The statute also provides that an employer only has to predict in good faith which post-employment activities need to be restricted at the time of termination.67 Ultimately, a broad restrictive covenant can be narrowly tailored to the specific opportunity the terminated employee is pursuing. Furthermore, similar to the law in Texas, Georgia courts are directed to modify partial restraints of trade by severing any unreasonable terms.68

B. Conflicts Between State Restrictive Covenant Laws

In a time of employee mobility,69 it is common for employees to travel interstate to acquire new positions, which frequently creates conflict among state laws.70 Under section 187 of the Restatement of Conflict of Laws, although parties may include forum selection clauses, courts may view such provisions as being contrary to state public policies.71 Furthermore, a court will disregard the parties’ agreed choice of law in two cases: (1) where the chosen state does not possess a “substantial relationship to the parties” or (2) where the agreed law would be contrary to the state law most related to the transaction.72

The first exception, as opposed to the second exception, is somewhat straightforward due to guidance under section 188 of the Restatement. This section provides five contacts to be considered in determining a substantial state relationship: “(a) the place of contracting, (b) the place of negotiation of the contract, (c) the place of performance, (d) the location of the subject matter of the contract, and (e) the domicil, residence, nationality, place of incorporation and place of business of the parties.”73 The second exception is not as clear, and therefore warrants further review. For example, in Application Group, Inc., v. Hunter Group, Inc.,14 the employee signed a non-compete agreement in Maryland but later resigned and acquired a new position with a competitor in California.75 Due to the companies’ differing principal places of business, a choice of law conflict arose based on Maryland’s flexibility in enforcing restrictive covenants76 as compared to California’s strong public policy against enforcement.77 Ultimately, the court applied California law, finding that California would face greater injury if its laws were subordinated to Maryland’s.78

This decision may have its opponents,79 but other courts have followed the same reasoning. For example, Massachusetts courts typically respect the parties’ choice of law unless a different state has a “materially greater interest” in determining enforceability.80 Alabama is more stringent as it refuses to apply a different state’s law if the restrictive covenant is unenforceable under Alabama law.81 Likewise, Georgia simply will not apply a state law that may be harmful to Georgia’s interests concerning restrictive covenants.82

C. State Court Standards

It is encouraged that the parties in an employment relationship understand how states without statutes governing restrictive covenants evaluate such agreements.83 Typically, the first hurdle in enforcing restrictive covenants is based on the reasonableness of the geographical and temporal limits in light of the employment circumstances.84 The second hurdle traditionally reviews whether the employer possesses a legitimate reason for restricting the employee.85

1. First Hurdle: Reasonable Geographic and Durational Limits

Courts have different standards for what is considered a reasonable geographic boundary for the regulated activity. One instructive case defined a proper geographic limit as one that is “well-defined and no greater than what is required to protect the employer’s business or goodwill.”86 The determination of what constitutes a proper geographic limit varies, but there are conventional guidelines.

First, if there are no explicit geographical limits, courts have typically found the entire restrictive covenant unenforceable87 unless they have chosen to modify the covenant using the blue-pencil method to retain the reasonable portions.88 Second, courts have found restrictive covenants with geographical limits covering one state or less to be reasonable.89 Lastly, courts have also tolerated restrictive covenants that are conditioned on the employer’s regional client base.90 Under this qualification, the employee could conceivably be banned from soliciting clients throughout the country, thus leading to unpredictable results in enforcement.91

As opposed to the various approaches used with geographic boundaries, courts are more consistent with temporal limits. Similar to limitless geographical restraints, provisions drafted without expiration will render a restrictive covenant invalid.92 The common threshold courts follow for durational purposes is two years or less.93

2. Second Hurdle: “Legitimate” Interest

Under the second hurdle, the determination of what constitutes an employer’s legitimate interest involves a thorough analysis by courts. The degree of authenticity of the business interest will influence a court’s judgment on the reasonableness of the geographic and durational limits. In Illinois, courts allow employers to protect different types of interests: (1) customer relationships that exist solely due to the employee’s connection to the employer and (2) confidential information obtained from the employer and utilized by the employee post-termination.94 In order to determine the first type, Illinois courts choose between two tests, consisting of either a standard that balances seven factors relating to the history, quality, and extent of the client contact95 or a test that inquires whether the business in question warrants protection.96 Illinois courts typically use the latter standard, referred to as “the nature of the business test,” to review whether the employer’s product is specialized and if the company’s success is dependent on long-term customer loyalty.97 If the company cannot easily be tested by this method, a court can utilize the seven-factor test, but it is not mandatory that they do so.98 The second area, protection of confidential information, is satisfied through two steps. First, the employer must prove that the employee accessed this information while employed and then tried to utilize it after termination.99 Second, regardless of whether this is accurate, the employer must demonstrate that the confidential information is worth protecting through the means of a restrictive covenant.100 Similar to Illinois, Minnesota courts stipulate that the second step is only achieved if the restrictive covenant “protect [s] a legitimate interest of the employer.”101

Much like the approach outlined in the Restatement, New York applies a three-prong reasonableness standard that finds a restrictive covenant enforceable “only if it (1) is no greater than is required for the protection of the legitimate interest of the employer, (2) does not impose undue hardship on the employee, and (3) is not injurious to the public.”102 Under the first factor, a legitimate interest may include customer relationships,103 unique services,104 or confidential customer information.105 Similar to the analysis employed in Illinois, the second factor in New York recognizes that all or none of these areas may be protected depending on the extent to which the restrictive covenant places an undue hardship on the employee. For example, in BDO Seidman v. Hirshberg,106 the New York Court of Appeals found that protecting existing client relationships of an accounting firm was a legitimate interest, whereas developing prospective clients within the accounting industry was not.107 Lastly, under the third factor, the New York standard slightly deviates from that of Illinois by taking into account the public’s interest in whether to enforce a particular restrictive covenant.108 For example, New York courts will consider principles of good faith and fair dealing prior to enforcement.109

Virginia and Maryland courts promote standards similar to those used in New York, as the restraint is balanced between the positions of the employer, employee, and the public.110 In Grant v. Carotek, Inc.,111 the Fourth Circuit applied Virginia law to determine that a restrictive covenant limiting an employee from competing for five years was too great an imposition on the employee and the public.112 In Labor Ready, Inc. v. Abis,113 the Court of Special Appeals of Maryland reviewed a non-compete that prohibited a former employee from “operating]” for one year in the temporary-worker recruiting industry within a ten-mile radius from the employer’s office.114 Although the non-compete covenant may seem reasonable at first glance, in light of the earlier discussion as to geographical limitations,115 the court remanded the case in order to determine the meaning of “operate,” because if this term was interpreted broadly, it would be an extensive restriction and injurious in the public’s eyes.116

II. THE EFFECT OF AT-WILL EMPLOYMENT ON RESTRICTIVE COVENANTS

A. Maw v. Advanced Clinical Communications, Inc.: Can an Employee Be Terminated for Refusing to Sign a Non-Compete Provision?

In Maw v. Advanced Clinical Communications, Inc.,117 the plaintiff, Ms. Karol Maw, was fired for refusing to sign a restrictive covenant containing non-compete, non-solicitation, and non-disclosure provisions that was presented to her three years after the commencement of employment.118 Ms. Maw did not object to the disclosure and solicitation portions, but disputed the non-compete provision because she felt it would restrict her from future employment opportunities.119 Similar to other states,120 New Jersey courts weigh the interests of the employee versus the employer with due consideration for the public’s “concern in fostering competition, creativity, and ingenuity.”121 The court found for the employer, reasoning that Ms. Maw could dispute the non-competition provision when the employer attempted to enforce it.122

In Maw, essentially, the court decided that an employee’s one channel for disputing a restrictive covenant was in response to the employer’s attempt at enforcement through legal means.123 Although the court reasoned that the burden of enforcement was on the employer, this Note asserts that the opinion failed to recognize that the employee would be placed in an unfavorable economic and legal position.124 Although the Maw decision is persuasive, not all states agree with its line of reasoning. For example, contrary to Maw, California case law has suggested that an employee cannot be fired for the failure to sign a restrictive covenant because the employee does not have equal bargaining power for negotiation when faced with an impending termination.125 Regardless, the Maw decision brought a “sigh of relief to employers and may have far-reaching implications in encouraging the use of restrictive covenants.126

B. Do Restrictive Covenants Persevere When the Employee Was Fired?

The termination of an employee bound by a restrictive covenant will probably be considered in determining enforceability. In situations where an employer is properly exercising at-will termination, state courts apply one of three approaches.127 The first method, employed solely by New York, considers enforcement where the employee was terminated for cause128 but invalidates covenants applied against employees terminated without cause.129 The second approach, followed in a majority of states, places a heavier burden of persuasion on the employer for enforcement after termination than would be required if the employee had instead resigned.130 The last approach, utilized only by Florida, refuses to factor the involuntary termination into its review of the restrictive covenant’s enforceability.131

C. Is the Expectation of Continued Employment Adequate Consideration?

One of the basic arguments supporting the enforcement of restrictive covenants is that the employee receives sufficient consideration in exchange for the promise not to compete, solicit former clients or employees, or disclose information.132 The main debate in this area is whether the promise of continued employment constitutes sufficient consideration.133 Unfortunately, neither the Restatement of Contracts134 nor state statutes provide much guidance to help clarify this issue.135 Furthermore, unlike other variables surrounding enforcement where state courts may support one another, this is an area where courts disagree.136 As this determination is left to the court’s discretion, an employer looking to relieve uncertainty should offer separate consideration in exchange for the employee’s agreement to enter into a restrictive covenant.

III. AREAS WHERE RESTRICTIVE COVENANTS HAVE AN INCREASED CHANCE OF ENFORCEMENT

A. “Legitimate” Trade secrets

Employers usually invoke the inevitable disclosure doctrine to protect trade secrets and allege that an employee has violated a non-disclosure agreement simply by accepting new employment.137 As one esteemed scholar indicated, it is understandable that employers wish to safeguard their interests in such a technologically advanced workplace.138 But what constitutes a trade secret? As discussed earlier, both legislatures and courts have struggled in their attempt to determine what falls under this label.139

The Restatement of Torts points out that trade secrets “may consist of any formula, pattern, device or compilation of information which is used in one’s business, and which gives [a person] an opportunity to obtain an advantage over competitors who do not know or use it;”140 this model was later approved as a national standard.141 Unfortunately, the determination of what falls under this definition is complicated because of the perpetually changing nature of the business world.142 Consequently, courts are left to balance, on a case-by case basis, the extent to which competitors and the general public are familiar with the information against the irreparable harm to the company were the information disclosed.143 Under this approach, the trade secret must be genuinely unique;144 thus, information that is considered readily available to the public will not be protected.145

B. Nature of the Contractual Relationship

There are two additional conditions that support an argument for enforcement. The first circumstance, where a seller, lessor, or departing partner signs a restrictive covenant, induces minimal debate concerning the document’s enforcement for two reasons: (1) statutory exceptions allow for enforcement146 and (2) courts are willing to favor enforcement in this area.147 The second argument for enforcement is where the employee’s learned skills are so specialized that the employer will inevitably suffer severe harm when the employee leaves.148 The determination of what constitutes a special service hinges on the employment relationship-specifically, the extent to which the company depends on the employee’s talents and the ability of the employer to staff the position after the employee leaves.149 Although restrictive covenants in these areas have an increased chance of enforceability, it is important to use reasonable temporal and geographic restrictions in order to avoid judgments that modify or invalidate the agreements.150

CONCLUSION

With such a vast amount of state law to digest in comprehending the limits of restrictive covenants, it is understandable that employers and employees may become disillusioned in deciphering their respective rights. Unfortunately, there probably is not much else legislatures or judges can propose to clarify this issue. Furthermore, it is unlikely that the United States Supreme Court will supply a common standard because each state has its own justifications for enforcing or invalidating restrictive covenants. Laws governing restrictive covenants have originated from state policy, thus leading to inconsistencies in what states feel is crucial in determining enforcement. Additionally, the concept of legitimate business interests is a moving target as a result of an everchanging technological world.

A possible improvement would be for state standards to place more emphasis on the education of both parties. In order for an employer to elicit favor from the courts, restrictive covenants have to be tailored to the specific activity, possess reasonable limits, and protect only those interests that are indeed legitimate and undisclosed. Anything more restrictive is not worth an attorney’s fees for drafting, as boilerplate restrictive covenants are not looked upon favorably.151

Additionally, it is strongly recommended that employees seek legal counsel prior to signing restrictive covenants. In light of recent case law, it may not be a prudent idea to refuse to sign, but rather to recognize fully the ramifications of the covenant and evaluate whether the position is worth relinquishing certain future opportunities in return for imminent employment. Furthermore, after receiving an offer and prior to exhausting other employment opportunities, it is advised that an employee inquire about the employer’s policy concerning restrictive covenants as a condition of initial employment or later in the employment relationship. This may alleviate some of the inequity in the respective parties’ bargaining positions when an employee is confronted with a restrictive covenant at either the commencement of or during employment. Although these are some of the many suggestions for improvement, employers and employees should heed the advice of outside counsel prior to forming a contractual relationship because our court dockets cannot endure much more litigation in this area.152

THOMAS M. HOGAN[dagger]

[dagger] J.D. Candidate, June 2006, St. John’s University School of Law; B.S., Industrial & Labor Relations, May 1999, Cornell University.

Copyright St. John’s Law Review Association Winter 2006

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