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Non-compete agreement

December 19, 2022

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This article is written by Gautam Badlani, a student at Chanakya National Law University, Patna. This article examines the provisions and judicial decisions relating to non-compete agreements in the various states of the US. This article also highlights the judicial position with respect to non-compete clauses in the United Kingdom and Israel. It explains the doctrine of Blue Pencil through an analysis of various judicial pronouncements.

It has been published by Rachit Garg.

Introduction

Non-compete clauses have become an essential constituent of modern-day employment contracts. The concept of non-compete agreements evolved in the British system, and these agreements are based on the concept of equity and seek to bring about a balance between the interests of the employer and employee.

Traditionally, employers used to invest time and resources in training employees. However, once the employees learned about the skills and business secrets of the employer, they established their own independent trades, which resulted in financial loss to their employers. This gave rise to the need for non-compete agreements. This article highlights the meaning, significance and components of the non-compete clauses. Furthermore, it critically analyzes the landmark judicial decisions relating to non-compete clauses.

Meaning and significance

A non-compete agreement refers to an agreement where a party agrees not to engage in such behavior that would enhance the other party’s competition. Such conduct is to be refrained from for a specified period of time. Non-compete clauses are also known as exclusivity clauses or non-poaching clauses. These clauses specify the time period of the limitation, the geographical area of the restriction and the forms of work in which the employee cannot engage. The employee is bound by the terms of the non-compete agreement irrespective of whether he resigns from the job or is terminated from service.

Non-compete clauses have often been subjected to judicial scrutiny because they are believed to be a restraint on trade. Supporters of non-compete clauses argue that these clauses protect the employer’s interests by preventing mobile employees from misusing trade secrets and other sensitive information. On the other hand, it is argued that these clauses restrain skills and talent and thereby curtail innovation.

When and why are non-compete agreements used

Non-compete agreements are primarily used by employers who invest huge amounts of resources in their employees and share their trade secrets with them.

Once the employee acquires the requisite skills and becomes aware of the trade secrets of the employer, he may leave the organization and start a competitive practice thereby hurting the legitimate business interests of the former employer.

The employees acquire skills and expertise in the jobs that they perform. While the employers cannot prevent the employees from leaving the organization and utilizing the general skills that they gained in other ventures, they can prevent them from engaging in a competing business for a specified time period and in a pre-decided geographical location.

Thus, employers often include a non-compete clause in the employment contract to prevent employees from exploiting the business secrets and knowledge that they gain through their association with the employer’s organization. The non-compete agreements ensure that the former employees do not engage in practices that are detrimental to the interests of the primary job. In the absence of a non-compete agreement, the employees would be free to use all the information and secrets that they acquire in the course of their employment to engage in competitive businesses or to join competitors of their primary employers, thereby causing direct or indirect harm to the business interests of the initial employers.

Components of a non-compete agreement

While no standard format of a non-compete agreement is laid down, the most common components of a non-compete agreement are

Duration of the non-compete period: Most non-compete agreements specify the time period during which the employees are prohibited from engaging in competitive practices to the business of their former employer. In certain cases, it may become statutorily mandatory for the agreements to disclose the non-compete duration. Some states such as Connecticut and Washington provide a ceiling time period for the applicability of the restrictive clause and agreements for a duration exceeding the statutory ceiling limit are void.
Scope of the agreement: The restrictive covenant must also specify the practices or services that the employee is prevented to undertake during the non-compete period. For example, the agreement must specify the nature of the business that the employee cannot start and the organizations which he cannot join. The restricted practices are usually similar in nature to that of the business of the employer.
Geographical application of the agreement: In some cases, the non-compete agreements prevent the employees from engaging in competitive practices within a specified geographical area.
Remedy: The non-compete agreements usually specify the relief or remedy to which the employer would be entitled in the event of the breach of the provisions of the agreement by the employee.
Dispute resolution mechanism: The agreement may also specify the mechanism for resolving any dispute that may arise between the parties to the non-compete agreement.

However, it is pertinent to note that under some state laws, non-compete agreements that provide for adjudication outside the state are void. It may also be possible that the non-compete agreements signed in a particular state may not be enforceable in any other state. Hence, the non-compete agreement must clearly specify the jurisdiction within which it would be applicable.

Non-solicitation clauses: The non-compete agreement often contains non-solicitation clauses. The non-solicitation clauses imply that the employee is not to solicit the clients or the other employees of the organization in the post-employment period.

Hence, the following things must be kept in mind while drafting a non-compete agreement:

The time period and geographic location stipulated in the non-compete agreement must be reasonable.
The non-compete agreement may also contain a provision regarding compensation for the non-compete period. In some states, the non-compete agreements are enforceable only if the employees are provided compensation for the non-compete period.
The nature and extent of the restrictions and the remedy available to the employer must be clearly laid down in the non-compete agreement.
The laws of the jurisdiction within which the non-compete agreement is to be executed must be critically analyzed. The validity of the agreement varies from state to state.

Industries that use non-compete agreements

Non-compete agreements are frequently used in industries such as financing, manufacturing, construction, insurance, information technology, and real estate. These industries involve the exchange of sensitive information between employers and employees, and hence, non-compete agreements are common in these industries.

Usually, the employees who handle sensitive information or are engaged in managing client information are bound by non-compete agreements.

American position

The courts of the United States have applied the reasonableness test to determine the validity of the non-compete losses.

The federal government has been intending to limit and restrict the use of non-compete agreements in order to fuel economic growth. In view of the fact that large-scale companies restrict the mobility of their employees by requiring them to enter into a non-compete, a recent executive order signed by the President required the Federal Trade Commission to take steps to curtail the use of unfair non-compete agreements by companies that restrict the ability of their employees to switch jobs.

The laws with regard to non-compete agreements differ from state to state. States have jurisdiction when it comes to enacting legislation concerning the validity of non-compete agreements. In Hawaii, high-tech companies are prohibited from requiring employees to enter into non-compete and non-solicitation agreements. California, Oklahoma and North Dakota do not permit non-compete agreements, and such agreements are illegal in these states while Montana permits non-compete agreements only if they do not amount to a complete restraint on the employee’s mobility. Montana law is strongly anti-restrictive covenants and disfavors non-compete agreements.

The doctrine of Blue Penciling

The doctrine of Blue Pencil implies that an overboard non-competition agreement can be modified by the court in order to narrow its scope and make the agreement enforceable. Under this Doctrine, the court can strike down a part of the agreement that is objectionable and save the overall effect of the agreement. States such as California, Arkansas, Georgia and Oklahoma prevent blue-pencilling either completely or to some degree. On the other hand, states such as Connecticut, Colorado, Florida and Washington permit blue pencilling. The issue is disputed in New Mexico, South Carolina and Maryland.

A situation may also arise where the non-competition agreement may itself contain a clause providing that the court can modify such geographical or time-based provisions of the agreement that are overbroad. Thus, the agreement can itself permit the court to blue pencil. The Nevada Supreme Court, in the case of Duong v. Fielden Hanson Isaacs Miyada Robison Yeh, Ltd. (2020), held that the non-competition agreement under consideration contained a provision stating that the Court can modify the agreement to redeem the objectionable clause. The Court held that where the agreement itself empowers the court to blue pencil an agreement, the Court can exercise the power of modifying the objectionable clause.

Connecticut

In Connecticut, a non-compete agreement cannot be extended for a period of more than 1 year post the termination of the service of the employee. However, if a worker is paid the salary and benefits for the period of the non-compete agreement, then in such a case, the maximum period of the agreement can be 2 years.

Moreover, a non-compete agreement can be entered into only where the employer’s business interests cannot be protected by non-disclosure or non-solicitation agreements or other less restrictive measures. The terms of the agreement should not be more restrictive than those that are essential to protect the employer’s interests. The agreement should also not interfere with public interests.

The non-compete agreements entered into with employees who are earning less than the minimum wages prescribed by the state will be illegal. However, it is pertinent to note that an illegal non-compete clause would not invalidate other provisions of the agreement or contract.

Florida

In Florida, non-compete agreements are valid provided that they protect the legitimate business of the employer and are not unreasonable by virtue of their scope. The non-compete covenant can be enforced only if it is in writing and the burden of proving the prima facie legitimate business interests is on the person who seeks to enforce the agreement. Once the person seeking to enforce the agreement discharges the burden of proving prima facie reasonableness, the burden shifts on the opposing party to prove that the agreement is unreasonable

Since non-compete agreements are valid only to the extent that they protect the legitimate business interest, it becomes essential to understand what could be included in the expression ‘legitimate business interest’. It includes trade secrets, customer or client relationships, or valuable confidential information.

Washington

Under Washington law, the non-compete agreement is valid only if the employee draws a salary above the prescribed threshold. Moreover, the agreement should not require the employee to enforce the agreement beyond Washington state. The Washington law lays down the following conditions for a non-compete agreement to be enforceable:

The employer must disclose the non-compete covenant to the employee at the time of acceptance of the employment contract.
Where the employee is terminated through lay off, he should be provided compensation for the non-compete period which should be equivalent to the base salary. However, the amount that the laid-off employee earns through subsequent employment will be deducted from the compensation.
The law also lays down a statutory presumption that any non-compete agreement for a period exceeding 18 months is unreasonable. A party seeking to enforce the non-compete agreement exceeding 18 months has to rebut the presumption through convincing and unambiguous evidence that such a period is essential to protect the legitimate business interest or goodwill.

California

Under California law, all non-compete clauses, irrespective of whether they are reasonable or not, are unenforceable and void. As per the California Business and Professions Code, any contract which restricts any person from undertaking any lawful business, profession or trade is void under California law.

Businesses that operate outside California but employ Californian residents are also prohibited from incorporating non-compete clauses into employment contracts. The contracts which permits the employer to enforce the contracts outside California in a State which permits non-compete agreements are also void.

Moreover, where the employees are forced to approach the court against an illegal non-compete agreement, the employees are entitled to receive compensation from the employer for the fees of their attorney. At the same time, the employer cannot claim such compensation from the employees.

However, a non-compete agreement can be enforced against a former business partner or a business seller or a former LLC member. Employers can also restrict their former employees from using their trade secrets. Thus, while non-compete agreements are illegal in California, a person selling a business can enter into a non-compete agreement with the purchaser.

Position in the UK

Under English law, a restraint on trade is valid if it safeguards a valid interest of the party imposing the restraint. The restraint must be reasonable in order to protect the concerned interest and the restraint should not be contrary to the larger public Interest. The courts usually protect certain categories of interests of the employer such as trade secrets, trade connections, and other confidential information that is necessary to maintain the stability of the workforce. Factors such as the scope of the restraint, the bargaining power of the parties, the nature of the business, and the factual background are considered by the court while determining the validity of the restrictive covenant.

The onus is on the employer to prove before the court that the restriction is justified and reasonable to protect the legitimate business interests of the employer. It is important to note here that under English law, the courts can also modify the objectionable part of the restrictive covenant in order to give effect to the overall agreement.

Tillman v. Egon Zehnder Ltd.

In the case of Tillman v. Egon Zehnder Ltd. (2019), UK Apex Court held that the Court can alter a non-compete agreement in order to save the effect of the non-compete clauses. In this case, Ms. Tillman was terminated from her job and intended to start as a competitor but her employment contract contained a non-compete clause that provided that in the following six months of the end of her employment, she was not to be engaged, concerned or interested, directly or indirectly, in any business that was a competition to her firm. However, Ms Tillman had contended that as per the agreement, she was restricted from even having any interest in a competitive business and such restriction was unreasonable.

The Court agreed that the “interested” part of the Covenant was objectionable, but such an objectionable part of the contract can be altered by the application of the three-fold criteria laid down in the case of Beckett Investment Management Group Ltd v Hall (2007). Firstly, the objectionable part of the restrictive covenant could be removed without modifying the remaining provisions of the agreement. Secondly, even after removing the objectionable provisions, the remaining terms would continue to be backed by adequate consideration. Lastly, altering of the objectionable provision would not bring about any substantial change in the overall effect of the contract.

The court concluded that the words “or interested” could be altered from the agreement and that the same would not bring about any change in the legal effect of the restraint.

Reforms

In order to promote innovation and economic growth, the UK government has been considering certain reforms to the validity of non-compete clauses. The two options being considered by the government are:

Making it mandatory for the employees to provide compensation to the employees for the period of the non-compete agreement. This would also include introducing additional transparency measures and fixing a statutory timeline for the time period of the non-compete agreements.

Since the enforcement of the non-compete classes would involve a financial cost, it is likely to disincentivize employers from using the non-compete clauses in a routine and casual manner. The employees would use the non-compete clauses only where they are extremely necessary to protect a vital business interest.

Moreover, since the employees are getting compensated for the period of the applicability of the non-compete clause, they are less likely to breach an enforceable non-compete agreement.

This measure of statutorily mandated compensation for the period of the non-compete clause is applicable in several countries, such as Germany, Italy, and France.

The second and more stringent option is to make the non-compete agreements unenforceable by law. Such a measure would provide greater certainty to all the concerned parties. However, there would be a need to consider if certain exceptions could be provided.

Pros and cons of non-compete agreements

The non-compete agreements have several merits as well as demerits and have been subjected to a long history of legal scrutiny.

Pros

The primary merit of the non-compete agreement is that the employers are able to safeguard sensitive client information and business secrets from being exploited by the employees.
Employees usually enter into non-compete agreements only when the benefits that they receive from their job are more than the harm caused by the restriction on their mobility. Moreover, employees often receive compensation for the non-compete period.
The non-compete agreement creates confidence in the mind of the employers and incentivizes them to invest more in the skills and training of the employees.

Cons

The non-compete agreements are also used by employers who are engaged in industries which do not involve any trade secrets or sensitive information. Where no secret information is shared with the employees, the non-compete agreements amount to an unfair restriction on their mobility.
In most cases, the employees do not enjoy a similar bargaining power to that of the employers. In such situations, the employers are able to force the terms of the non-compete agreements on the employees.
Non-compete agreements lead to lower competition in the market as they restrict the mobility of the employees. This may also lead to less job satisfaction.
In certain cases, employees are not informed about the non-compete agreements at the time of entering into the contract of employment but are asked to enter into a non-compete agreement at a later stage.

Sample Agreement

This Non-Compete Agreement is entered into between ________ (Employee) and ________ (Company Name) on the __ day of ____ in the year 20 ____. [Company Name] is located at [Address] and is represented by [name of representative] in this agreement.

WHEREAS, the Company is in the business of [describe type of business].

WHEREAS, the Employee and the Employer have entered into a formal Employment agreement where the Employee will perform duties related to their position as a [Job Title]; and

WHEREAS, the Employee agrees to the restrictions described herein as binding.

THEREFORE, the Employer and the Employee agree to the following terms:

NON-COMPETITION. For the entire duration of this agreement, and for [length of time] after the Employer’s relationship with the Employee has been terminated for any reason, the Employee will not work as an employee, officer, director, partner, consultant, agent, owner or engage in any other capacity with a competing company. This means that Employee must not perform any work for [describe type of company] in [geographic area].
EMPLOYEE ACKNOWLEDGEMENTS. The Employee acknowledges that they have been provided with the opportunity to negotiate this agreement, have had the opportunity to seek legal counsel before signing this agreement, and that the restrictions imposed are fair and necessary for the Company’s business interests. Finally, the Employee agrees that these restrictions are reasonable and do not constitute a threat to their livelihood.
APPLICABLE LAW. This agreement and its interpretation shall be governed by the laws of [state, province, or territory].

IN WITNESS WHEREOF, both parties agree to these terms and give their consent and authority to this agreement below.

Employee Signature ____________ Date ____________ Employer Representative Signature ______________ Date

How do you get out of a non-compete agreement

In several cases, the employees find themselves bound by an unfair non-compete agreement. This may happen in cases where the employees do not read or do not give much consideration to the terms of the non-compete agreement before signing it. Where the contract of employment includes a non-compete clause, the clause is often overlooked by the employees.

The unfair non-compete agreement prevents the employees from availing themselves of better opportunities that are available at their disposal. In order to free himself from an unfair non-compete agreement, the employee must observe the following steps:

The first step is to carefully read the non-compete agreement that was signed between the employer and the employee and to understand the restrictions that it places on the employee.
The second step is to understand the legal standing of the contract on the basis of the law of the State in which the contract was entered into.
- If the time period on the geographical location of the contract is unreasonable then it is most likely to be declared void by a court of law.
- In some states, it is mandatory to abide by the statutory time ceiling or to provide compensation for the non-compete period. If the agreement does not contain the statutorily mandatory provisions, then it is liable to be declared void.
- Most of the states provide that only the employees drawing wages above a stipulated limit can be bound by the non-compete agreement. If the employee draws wages below the statutory limit, then he can file an appeal against the validity of the non-compete agreement.
Another step is to set up a meeting with the employer and the other concerned parties and to negotiate the terms on which the employee may be set free of the non-compete agreement.Employee must ensure that any terms which the employer and the other concerned party agrees to are noted down in writing. The parties may also agree to opt for mediation.

Non-compete vs. non-disclosure agreements

Basis of distinction	Non-compete agreement	Non-disclosure agreement
Definition	A non-compete agreement is an agreement which prevents the employee from engaging in competing practices or joining a competing firm in the post-employment period. Thus, the primary purpose of a non-compete agreement is to protect the employer from unfair competition.	A Non-disclosure Agreement (NDA) is a confidential agreement and an employee is required to sign the NDA where he is provided access to privileged information. The NDA binds one or all the parties to the agreement from sharing the concerning confidential information. The primary purpose of NDA is to safeguard the confidential and private information of an organization.
Scope	A non-compete agreement merely specifies the activities from which the employee will be prevented from undertaking in the post-employment period.	An NDA, on the other hand, is much wider in scope as compared to a non-compete agreement. An NDA provides the information that the employee has to keep confidential.
Restriction on mobility	A non-compete agreement restricts the mobility of the employee.	An NDA, on the other hand, does not restrict the mobility of the employee and does not prevent him from joining a competing organization.
Time period and geographical location	The non-compete agreements are applicable only for a specified time period and geographical location.	The employer may not specify any particular geographical location and the time period for which the NDA is applicable. The duration of an NDA is usually longer than that of a non-compete agreement.
Mutual nature	A non-compete agreement binds only one party, that is, the employee, from engaging in certain specified practices or businesses.	The NDA, however, can bind both parties to the agreement. Therefore, the NDA can be one-sided as well as mutual. In a mutual NDA, the employee as well as an employer is prevented from sharing confidential information.

Conclusion

Due to their restrictive nature, most countries have laws which render non-compete agreements either unenforceable or enforceable under certain limited circumstances. The need for non-compete agreements and their impact on the economy continues to remain controversial. In order to enforce non-compete agreements the employer is required to prove before the court that a breach of the agreement by the employee has caused damage to his legitimate business interests.

While in some cases, these clauses are necessary to protect vital business interests, these clauses are often misused by large corporations to exploit their employees. The non-compete agreements must not be permitted in industries that do not involve any exchange of trade secrets or sharing of sensitive information with the employees.

Frequently asked questions (FAQs)

What is the legal validity of non-compete agreements under the law of Israel?

To some extent, Israel has followed the same approach in respect of restrictive clauses as California. In Israel, the enforcement of the non-compete agreements has been significantly limited by the strict standards set by the courts. In Israel, the non-compete agreements can be enforced only where the employee unlawfully uses the trade secret of the employer or where the employer receives any special consideration for the non-compete agreement or where the employer invested certain valuable resources in the training of the employee.

References

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