"Non-Compete Agreement: Protective Fortress or Minefield" by Andrew N. Karlen, Esq.

Originally published in Westchester Commerce, August 2008

The short answer to the question in the headline is “both.” Restrictive covenants – or non–compete agreements – are contractual provisions or agreements that principally upon termination of employment restrict the departed employee from competitive activities that would be damaging to the company’s business. They also can contain bans against soliciting the previous employer’s customers or employees.

Not understanding the judicial standards for enforcement of a restrictive covenant at the time it is prepared is the equivalent of auditioning for a lead role in a future courtroom drama – one of those that chronicles the systematic dismantling of a supposedly ironclad case. The following are questions asked by business owners who value restrictive covenants and know that when challenged they receive exhaustive judicial scrutiny.

1. Why are restrictive covenants so controversial?

They present a public policy conundrum, pitting companies’ needs to protect trade secrets against public policy that abhors preventing a person from earning a living in his or her chosen profession. Other contributing factors are the high stakes and emotions generated by the close scrutiny courts give to the particular facts of each case, including parties’ behavior and motivations. Some states, such as California, won’t enforce them at all. New York will enforce a restrictive covenant if it is reasonable.

2. What advice would you give businesses seeking to have an employee sign a non-compete?

Think ahead when conceiving the terms of the restrictive covenant. Do not be seduced by the leverage you may have over the employee. Instead, imagine yourself in the position of justifying to a court why your former employee should be restrained from working in his or her chosen profession for a period of time. Think about and articulate the legitimate business interest you are seeking to protect and what is reasonably necessary to protect it. Ask yourself questions such as: What harm could this particular employee do if he or she left your company and worked for a competitor or solicited your customers? Did the employee have access to company trade secrets or develop close relationships with customers by virtue of the employment? What kind of restriction would be necessary to protect your company against that harm?

Reflect the answers to these and similar questions in the language of the restrictive covenant. This will help prepare you to articulate your position to a court if necessary and reinforce your position that the covenant was negotiated at arm’s-length and with the employee’s understanding why it was necessary. Your chances will be enhanced if the rationale for and reasonableness of the restrictive covenant are readily apparent.

3. How are restrictive covenants enforced?

When an employee is violating or threatening to violate a restrictive covenant, an award of damages several years hence will do no good. A company seeking to enforce a restrictive covenant needs a court order, called an injunction, to prevent the violation – and it needs that order very quickly. Such a company will seek a preliminary injunction on an expedited basis. This requires the company to establish that without injunctive relief it will suffer actual and imminent harm so serious that a monetary award cannot be adequate compensation (called irreparable harm), and in addition, either that (i) it would likely succeed on the merits after a full trial, or that the issues are fair grounds for litigation and that the balance of hardships tips decidedly in the company’s favor.

The preliminary injunction, in and of itself, is a mechanism to stop the bleeding while the litigation takes its course to determine whether a permanent injunction will be issued. In practice, however, a permanent injunction will usually follow simultaneously or soon after a preliminary injunction, because (i) the legal standards for a preliminary injunction are stringent, (ii) the request for a permanent injunction is typically consolidated into the preliminary injunction process, and (iii) the expense of seeking or opposing a preliminary injunction are substantial and build up very quickly.

The possibility of litigation can deter a competitor from hiring the restricted former employee. The risks of doing so can range from disruption of business to being sued for injunctive relief or damages.

4. What factors will a court consider in determining whether to enforce a restrictive covenant?

New York courts apply a reasonableness standard in determining whether a restrictive covenant should be enforced, weighing the need to protect the employer’s legitimate interests against the public policy against causing loss of livelihood to the former employee. The courts will enforce a covenant that is reasonable in terms of time and geographic area to the extent necessary to prevent a former employee’s solicitation or disclosure of trade secrets or release of confidential information about the employer’s customers, or where the employee’s services are unique or special.

These factors, however, do not readily translate into hard and fast rules. Courts often consider other aspects of the employment relationship as well as the behavior and motivations of the parties.

5. What kinds of legitimate interests are employers permitted to protect?

A court will test the reasonableness of a restrictive covenant only when the covenant seeks to protect a legitimate business interest. This evaluation often centers on whether the employee had access to the company’s trade secrets or whether the employee’s services were in some way unique or extraordinary.

Under New York law, a trade secret may consist of any formula, pattern, device or compilation which is used in a company’s business and which gives the owner opportunity for a competitive advantage over competitors who do not know or use it. The company must have taken reasonable steps to keep it confidential. The factors a court may consider in determining whether particular information is a trade secret include the extent to which it was known outside the business and employees and others involved in the business, the company’s efforts to keep it secret, its value to the company and its competitors, the money or effort spent in developing it and the ease or difficulty with which others could obtain or duplicate it.

A scientific formula is likely to be considered a trade secret while generic knowledge of the nature and operation of a company’s business is not (absent circumstances such as misappropriation either by theft or memorization). A customer list may or may not be a trade secret depending on factors such as the amount of money and effort expended developing it, the ease or difficulty of identifying the customers and the sensitivity of the customer information.

Decisions regarding whether an employee’s unique or extraordinary services to the company are a basis for a “protectable interest” tend to focus on the employee’s relationship with the employer and the value of his or her services rather than the individual’s special talents. For example, courts have recognized companies’ legitimate interests in protecting itself against misappropriation of the benefits of relationships developed at the company’s expense.

6. How do courts decide if the geographic scope and duration of a restrictive covenant are reasonable? What happens when a court finds that one or more terms of a non-compete are excessive?

The employer must convince the court that the geographic scope and duration of the restrictive covenant are reasonably necessary to protect the employer’s reasonable business interests.

Normally, in order to be reasonable a restrictive covenant must be limited to the geographic area in which business as usual is transacted. This issue may be clear cut if the employer’s business is conducted entirely or primarily within a limited geographic area. In a world where “normally” is redefined daily, however, the distinctions become much more difficult and require careful analysis.

The duration of a restrictive covenant should be the amount of time necessary for the company to recover from the employee’s departure to level the competitive landscape. This can depend on a multitude of factors. For example, a restriction on soliciting the employer’s customers for one year may be viewed more favorably than working for any competitor for that same period. Or, a six-month restriction may be too long in an industry in which the value of particular information is short-lived or where the employer can quickly assign a new account representative who can readily establish a rapport with customers. A court may also consider whether the employer has agreed to or is willing to pay the employee during the period of the restriction. While not determinative, such an arrangement can serve to ameliorate concerns that the employee would be unable to earn a living during the restricted period.

For example, a Federal court applying New York law ruled on a covenant whose geographic scope was, in effect, worldwide and the duration of which was twelve months. The Estee Lauder Companies, Inc. v. Batra, 430 F. Supp. 2d 158 (S.D.N.Y. 2006). The court upheld the covenant’s worldwide geographic scope but reduced the duration of the covenant to four months. Key factors in the decision to uphold the worldwide scope included the fact that the employee was a senior executive who had access to the employer’s trade secrets, the nature of the industry and the employer’s obligation under the covenant to pay the executive during the restricted period. In reducing the duration, the court noted that the employer had reduced the duration of other executives’ covenants and, in fact, had offered to reduce the covenant at issue.

This illustrates the power of New York courts to grant partial enforcement of overbroad restrictive covenants where the employer demonstrates that it has sought in good faith to protect its legitimate business interests without overreaching or using its dominant negotiating position in a coercive manner. The willingness of courts to modify a restrictive covenant rather than strike it down varies from state to state and is a fact-specific inquiry

7. Can I require my current employees to sign restrictive covenants?

When a restrictive covenant is part of the original employment agreement at the time the employment is accepted, the offer of employment is considered adequate consideration. The issue of consideration is less clear when an employer requires an existing employee to sign a restrictive covenant. New York courts have held that a non-compete entered into during the course of at-will employment is not void for lack of consideration if dismissal is the alternative to signing or if the employee remains with the employer for a substantial period after signing the covenant.

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What harm could this particular employee do if he or she left your company and worked for a competitor or solicited your customers?…What kind of restriction would be necessary to protect your company against that harm?