You have undoubtedly heard of cases where a successful employee was wooed to “greener pastures”, and the employee’s know-how, charisma and ambition left with him/her. Did customers leave with the influential employee? Did other employees follow suit, thinking the departing employee was on to something? Can the employer withstand the departure of a key component of its success? Some businesses fail to consider these scenarios until they happen. Restrictive covenants can provide a measure of protection as long as their limitations are kept in mind.
Restrictive covenants are exactly as they sound – legal obligations restricting some behavior or activity. Restrictive covenants like non-competition and non-solicitation clauses are useful in many business situations such as the sale of a company, forming a partnership, or creating an employment contract. These clauses can form a part of a larger document like a purchase contract, or can stand by themselves as an agreement.
A classic non-competition clause prevents a departing employee or business principal from competing with the business. It may bar the departing person from joining a competitor or prohibit the individual from starting a competing business. A non-solicitation clause is less broad. It prevents a departing employee or principal from actively seeking out the old business’s employees or customers. These clauses usually limit activity for a specific period of time and in an identified geographic location. The wording of these clauses varies greatly and many such passages have been scrutinized by the legal system.
Courts consider restrictive covenants to be restraints on trade and are reluctant to limit the competitive nature of the market. More deference, however, is given to restrictive covenants between two or more businesses or between partners that rank equally in a business relationship. Courts often feel that like-minded individuals or companies are free to contract with one another as they see fit unless it is proven that the bargaining power of the parties was unequal.
Employment contracts are studied more carefully. This is mostly due to the inequality of bargaining power, because the employee is often (but not always) less sophisticated in legal matters. Additionally, there is little benefit to an employee under such clauses. When faced with an ultimatum to sign an employment agreement or forfeit the job, an employee will usually sign anything required to obtain the position. Courts will not uphold such clauses in employment agreements if the employer did not put its mind to crafting a valid and enforceable clause.
To be considered valid, a restrictive covenant must:
- Protect a proven and genuine “proprietary interest” of the employer;
- Be reasonable in terms of duration and geographic location; and
- Not be otherwise contrary to public interests.
These principles can be applied to non-competition and non-solicitation clauses in both employment and business settings. Someone trying to enforce a clause (usually the prior employer or business partner) must prove these elements to have the clause deemed valid and enforceable.
First, there must be something worth protecting. This could include interests in confidential information, client lists, intellectual property, technology or the like. Secondly, the judge will want assurances that the restraints are reasonable both in duration and geographic location for all parties. It must not be overbroad and must go no further than necessary to protect the proprietary interest. This is tricky and often rests on characteristics of the business. For example, if the former employer carries on business and is only known in one small town, it is hard to justify that the restrictive covenant should prevent the employee from working anywhere in the world. Likewise, a restriction that lasts forever will be less likely to survive scrutiny.
The third element, public interest, is also fluid and there is no complete list of prohibitions. A clause that promotes racism, for example, or encourages breaking other laws would be the kind of item that fits here.
In reality, the enforceability of any restrictive covenant will depend on the type of transaction, the bargaining power of the parties to it, and the specific industry in which it is used. While courts are sometimes reluctant to fetter trade and could be inclined to strike down the clause, a reasonably drafted restrictive covenant can prevent departing employees or business partners from taking undue advantage of knowledge learned on the job.