Covenants Not to Compete: Some Basic Information

Covenants Not to Compete: Some Basic Information

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I. The Myth: Non-Competition Agreements and Non-Solicitation Agreements Are Worthless

Employment contracts often contain covenants not to compete. These can be a clause in an employment contract which states that the employee agrees not to work for a competing company for a set period of time, or it may be a separate agreement. The covenant not to compete prohibits an employee from working at a competing company, in substantially the same position or engaging in substantially the same work, for a set period of time. The terms of a covenant not to compete help to protect a company’s good will, confidential information, trade secrets and customer lists.

As an employer, you do not want your competitors hiring away your top employees in order to gain an unfair competitive advantage – you have invested the time in building your business, researching your product or service, and building your client base; you deserve the benefits of all your hard work. As an employee, however, you want to be able to freely change jobs. If another company offers you a substantial raise and better benefits, you want to be able to take that job without having to worry about any legal action that your former company can take. For these, and a multitude of other reasons, it is important to know what a restrictive covenant is and how it operates.

A covenant not to compete has three elements: (1) a limitation on the work that may be pursued by the employee, (2) a definite time, and (3) a definite geographical area. The time and geographical restrictions are usually straightforward; the limitation on work is a little more complex. For example, the employee may be prohibited from working for another company engaged in the same type of business, or the employee may be prohibited from using customer lists to solicit business for his new employer. The employee may be prohibited from owning or managing a company in the same industry, or the employee may not start his own business in the same industry.

The non-compete clause should probably be tailored to the type of work that the employee does. Using a standardized non-compete clause may seem less costly, but may result in an unenforceable non-compete clause. Generally, a covenant not to compete has to be reasonable in order to be enforceable, though in some states these covenants are completely unenforceable. In Connecticut, five factors are considered in determining whether a particular covenant is reasonable: (1) the length of time the restriction operates; (2) the geographical area covered; (3) the fairness of the protection accorded to the employer; (4) the extent of the restraint on the employee’s opportunity to pursue his occupation; and (5) the extent of interference with the public’s interests. Whether an employee voluntarily left his employment or was discharged is not relevant in determining whether a covenant is reasonable.

For example, suppose your company distributes specialized chemical compounds to companies in New England. Each customer needs a specific “mix” of chemical compounds. Your company has expended a great deal of time and resources over the last few years creating exactly the right “mix” for each customer. You may want a broad non-compete clause for salesmen because of the intimate knowledge they have of your product and customer lists. The same applies to management. For chemists working on the compounds, however, you may want a narrower non-compete clause that only prohibits them from engaging in substantially the same work in the same industry. A clause prohibiting the chemist from working at a competing company may be overly broad if the chemist does not do any work for the competing company in the same field.

What happens if the covenant is unenforceable? Ordinarily, if any part of the covenant is unreasonable, then the entire covenant is unenforceable. Some states, Connecticut included, follow the “blue pencil rule.” Simply put, the “blue pencil rule” allows a court in certain circumstances to modify a restrictive covenant to make it reasonable. However, Connecticut’s “blue pencil rule” is rather narrowly drawn. The “blue pencil rule” can only remove severable parts of the restrictive covenant. If the covenant is intended by the parties to be one entire covenant rather than several distinct covenants, then the covenant cannot be severed and the court cannot modify the covenant.

Time is of the essence when litigating non-competition agreements. The longer the employee is permitted to work in violation of the non-competition agreement, the more damage is done to your company. As soon as the violation of the non-competition agreement is discovered, the company should have counsel seek a Temporary Restraining Order. The temporary restraining order, if granted, would prevent the employee from working for the competitor for a specific period of time. The employee will probably be prohibited from working for the competitor until the end of the lawsuit. You can also sue the former employee to recover damages if your company’s business has suffered.

Even if there is no non-competition agreement, in the event that an employee is misusing or has stolen a former employee’s trade secret, Connecticut’s Uniform Trade Secrets Act (CUTSA) provides the former employer with some remedy. CUTSA prohibits the acquisition of trade secrets through theft, bribery, misrepresentation, breach or inducement of a breach of duty to maintain secrecy, or espionage through electronic or other means, including searching through trash. A plaintiff victimized by a defendant’s wrongful acquisition of a trade secret may be awarded money damages in the amount of the actual loss suffered or the amount by which the misappropriating party has been unjustly enriched. A plaintiff may also sue for injunctive relief. In cases of willful and malicious misappropriation, the court may award punitive damages.

II. Enforcing Covenants Through Forfeiture Clauses

An interesting method of incentivizing employees not to compete is to include a clause in the employment contract which forfeits deferred compensation if the employee engages in competition after leaving employment. For example, consider an employment contract where an employee receives commissions on the sales of service contracts. The employment contract provides that the employee will continue to receive commissions on service contract renewals for a period of three years after the employment is terminated unless the employee goes to work for a competitor within twenty miles of the employer. If the employee goes to work for a competitor, he immediately loses all rights to receive renewal commissions.

A recent Connecticut Supreme Court case adopted the minority view that such a clause is in effect a restrictive covenant not to compete rather than a forfeiture clause. The Court compared a forfeiture clause to a restrictive covenant not to compete and found no meaningful difference. In the Court’s words, “[a] total prohibition against competition, enforced by a forfeiture of accrued benefits, subjecting the employee to an economic loss undoubtedly is designed to deter competition.” By treating the clause as a restrictive covenant, the clause is subject to reasonableness analysis. Note that a forfeiture clause is not per se invalid – if the clause is reasonable, it will be enforced, even if it is deemed to be a restrictive covenant.

III. Covenants Not to Compete in Business Transactions

Where restrictive covenants in employment contracts are subjected to a higher level of scrutiny, those covenants in sale of business contracts are given substantial deference. Restrictive covenants add to the value of a business by guaranteeing that the goodwill sold to the buyer will remain with the buyer instead of returning to the seller when the seller opens up shop down the street. In addition, where an employee may have little bargaining power, the sale of a business involves arms-length negotiations where both parties enjoy equal bargaining power. As one court noted, to excuse a defendant “from the performance of his agreement would amount to returning to him a large part of what he has sold and would work a real hardship on the plaintiff.”

Click here to read an article about a case the Firm recently handled involving non-competition agreements.