On Oct.1, Massachusetts will join several other US states such as Utah and Idaho in banning or limiting noncompete agreements in employment. And in April, two identical bills were introduced in Congress that, if enacted, would for all practical purposes amount to a nationwide ban on employee covenants not to compete post-termination of their employment.
Restrictive covenants are an important tool for employers when trying to protect their business. This is particularly the case for knowledge-based industries or those that rely on the strength of personal relationships.
Seeing an employee who has been trained, developed ties with key customers and had access to the employer’s most sensitive proprietary information walk out of the door is a blow for most employers; but when that person leaves to join a competitor, the employer risks handing a substantial element of their goodwill to a competing business. When that key employee moves and tries to take the other members of their profitable team with them, the failure to have any restriction in their contract preventing them from doing this may be highly damaging to a successful business.
During employment, there are certain implied terms as to confidentiality, fidelity and good faith that will protect the employer. However, restrictive covenants limiting an employee’s activities post-termination must be specifically agreed between an employer and an employee in writing and are often included in an employment contract signed at the start of employment. Such clauses usually cover restrictions on the following activities:
- Setting up in competition or joining a competitor’s business (noncompete)
- Poaching clients (client nonsolicit or nondeal)
- Poaching staff (employee nonsolicit or nondeal).
The problem is that, in most jurisdictions as a matter of public policy, restrictions on a person’s right to earn their living once their contract is terminated are seen as a restraint of trade unless the restrictions are reasonable in the context in which they have been agreed.
There has always been a debate over whether such clauses are enforceable, and much will depend on the individual circumstances of the case, but recently noncompete clauses in particular, have come under fire.
Passing laws to restrict the use of noncompete restrictive covenants is a trend that has been gathering pace across US state legislatures. It started when the Obama Administration issued a “State Call to Action on Non-Compete Agreements” in October 2016.
Since then, eight states have enacted laws restricting the use of noncompete clauses and five more have proposed legislation either prohibiting noncompete agreements with low wage workers, limiting the length or geographic area, or proposing an outright ban. This has resulted in a patchwork of rules that will challenge employers operating in more than one state.
The courts also differ in their approach to the interpretation of poorly drafted clauses. In some states, courts will throw out a defective clause entirely – this is known as the “red pencil” doctrine. Alternatively, the courts may seek to correct the clause by deleting wording that may render it unenforceable – this is known as the “blue pencil” test. In other states, the courts are empowered to rewrite a clause that doesn’t reflect the intention of the parties.
In the UK, noncompete clauses are generally viewed as a restraint of trade unless they are reasonable to protect the legitimate business interests of the employer. They must also be reasonable in geographical scope and duration. A restriction designed to prevent competition, rather than protect an interest, will not be upheld.
Generally speaking, such clauses are more likely to be enforceable where the employee holds a senior position and has the capacity to harm the employer’s business by competing directly. In addition, any nonsolicitation of, or nondealing with clients must usually be restricted to those clients with whom the employee had contact within a defined period prior to termination e.g. six months.
Courts in the UK may delete words in a poorly drafted covenant that render the clause unenforceable, provided it is otherwise reasonable. But they will not accept substantial amendments or seek to rewrite the clause for it to be effective.
In a recent case, the Court of Appeal refused to sever certain words from a clause in a former employee’s contract because even without those words it was still too wide. In addition, the court would not sever that part of the clause that effectively prevented the former employee from holding shares, even a minor shareholding, in a competing business.
The clause sought to restrict her, for a period of six months, against “directly or indirectly to engage or be concerned or interested in any business carried on in competition with any of the businesses of the Company or any Group Company which are carried on at the Termination Date or during the period of twelve months prior to that date and with which you were materially concerned during such period”.
The Court held the clause was unenforceable, finding that it is settled law that the constituent parts of a single covenant cannot be severed. The case has been appealed to the Supreme Court, so further guidance on the principles around severance may be forthcoming.
Draft With Care
Due to the difficulties in enforcing a noncompete agreement, it is better to rely on well-drafted nonsolicitation and nondealing clauses to protect the interests of the business.
In the UK, where employees have a statutory right to a paid notice period on termination, it is also common for employers to reserve the right to place an employee on “garden leave” for the duration of their notice period. During this time the implied duties of fidelity and good faith prevent the employee from working in the competing business, and they no longer have access to confidential information or clients and employees, thus weakening the impact of their leaving.
The Massachusetts Noncompetition Agreement Act draws on this concept by requiring that most noncompete periods be limited to one-year, during which the employee receives garden-leave pay or some “other mutually agreed-upon consideration.”
This is yet another area of the law that employers must watch carefully and get specialist legal advice when employing key members of staff.