Not too long ago, non-competition agreements were typically seen only in relation to high-level executives and business equity partners. The agreements were designed to discourage the company's captain from disembarking to a competing ship, thus leaving his prior charge leaderless and adrift. Times have changed, and now middle manager sailors and yeomen commonly find that signing a non-competition agreement is a condition to coming aboard with a new employer.
This increase in the use of non-competition agreements has led to an increase in litigation on enforceability. From the standpoint of an employer or a franchisor, non-competition agreements might be a critical part of protecting the brand. Ultimately, however, only enforceable agreements provide protection. The key to enforcing a non-competition agreement is to ensure that the agreement is ancillary to an otherwise valid relationship or transaction and to strike the proper balance between protecting the former employer and not unreasonably restricting the free movement of services.
Whether an agreement is ancillary to an otherwise valid relationship or transaction is best illustrated through examples. Assume that Fred works for X-Company as a salesman of X-Co's widgets and that Fred's sales territory is greater Cleveland. X-Company requires Fred to sign a non-competition agreement providing that if he leaves the company, he cannot sell products that compete against X-Co's widgets within Cleveland for a period of three years following his departure from the company. The relevant restriction is that Fred is prohibited from competing against his prior employer in the same business and in the same location. This restriction is ancillary to the prior relationship (employer/employee) between Fred and X-Co.
In contrast, assume that Fred is a sole proprietor and is the best salesman of widgets in Cleveland. X-Co is in the widget business but does not yet have a presence in Cleveland. X-Co asks Fred to sign a non-competition agreement whereby Fred will agree not to compete against X-Co, thus clearing the way for X-Co to expand into Cleveland without the costly annoyance of a competitive market. This agreement would not be enforceable because the restriction on competition would not be tied to any valid relationship. If, however, X-Co expanded into Cleveland by purchasing Fred's business, an associated agreement prohibiting Fred from competing against X-Co in Cleveland for a period of time would be enforceable because the agreement would be ancillary to a valid transaction (the sale of Fred's business to X-Co).
Be reasonable
Even when a non-competition agreement is clearly ancillary to a valid relationship or transaction, the agreement must also be reasonable. Generally speaking, courts will consider the following factors when weighing whether a non-competition agreement is reasonable: (1) how broad the limitations are and whether such breadth is necessary to protect a legitimate interest; (2) the effect on the party executing the non-competition agreement; and (3) the effect of the agreement on public welfare and common good.
The first factor is the most common stumbling block for parties seeking to enforce a non-competition agreement. Naturally, a party seeking to prevent its former employees from competing against it will want the prohibitions to be broad and to be in place for a long period of time. This motivation must be balanced against the risk of imposing restrictions that are not enforceable, thereby leaving the former employer with no protection at all.
The point to keep in mind is that half a loaf (a narrow and enforceable agreement) is better than no loaf at all (a broad, unenforceable and ultimately useless agreement). The breadth of a non-competition agreement is usually considered in the context of industry, geography and time. Clearly, a non-competition agreement will be seen as unreasonable and unenforceable if it prohibits the former employee from engaging in businesses that have nothing or little to do with his or her former employment. Rather, the prohibitions must deal with the same or similar industries.
The reasonableness of geographical restrictions will depend on the type of business. If the business operates only in one city, a non-compete agreement purporting to impose a nationwide restriction on competition likely will be unenforceable. If the company is a multi-national conglomerate, nationwide—or even broader—restrictions might pass the reasonable test. That said, courts generally have been reluctant to enforce hugely expansive geographical restrictions, even in the case of a national or multi-national business.
Non-compete agreements must also set forth a reasonable period of time. Once again, whether the restrictions are reasonable will depend on the facts of the particular case. If the person who signed the non-competition agreement was the CEO of the company who is now retired, a rather lengthy restriction might be appropriate. In the case of a middle manager who has worked for the company for only a few years, a lengthy restriction would be seen as less reasonable.
In practice, courts have commonly enforced non-competition agreements with time restrictions within the range of one to three years. Outside of that time period, the party seeking enforcement likely will need to demonstrate special or unusual circumstances.
Courts will also look at the effect of the non-competition agreement on the former employee, as well as the effect on the public welfare and common good. These elements are a recognition that the free movement of goods and services should be encouraged in a robust market economy. Non-competition agreements are considered a narrow exception to that general rule. Therefore, the effect of the agreement must be weighed against the overall effect on trade and on the economy.
For example, if a company makes every single employee sign non-competition agreements, a court could view this practice as an overbearing attempt to discourage employees from freely choosing to change jobs. And, such a court might reason, if workers are not free to leave an employer, this ultimately would lead to a less dynamic and healthy economy. Employers should consider this element in determining not only the content of a non-competition agreement, but also in the policies of who at the company is required to execute such an agreement.
Non-competition agreements are an important and powerful tool in the environment of job-hopping employees, valuable intellectual property and trade secrets. Employers therefore should consider including this tool in their overall human resource and company policy toolboxes. However, the tool must be honed properly. Otherwise, the employer could find itself unable to use the tool for its intended purpose.
Jason Binford is a director in the Dallas-based law firm of Kane Russell Coleman & Logan PC where he practices in the firm’s Insolvency, Bankruptcy & Creditor Rights section. His experience includes representation of debtors and creditors in large to mid-size Chapter 11 and Chapter 7 cases. He has significant familiarity and expertise in issues unique to vendor creditors, as well as 363 sales, intellectual property, landlord/tenant and franchise issues.
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