Risk Management

Non-Competes: The Dark Side of Tight Labor

Employers may face liability for non-compete agreements if they place overly broad restrictions on an employee's ability to earn a living.
David KatzFebruary 1, 2001

Non-compete agreements are the dark side of the tight labor market. They’re the stick many companies use to keep employees from jumping ship to competitors.

Unlike such carrots as signing bonuses and stock options, non-competes provide employers with a punitive way to keep their best employees—and client lists and intellectual property—from moving to their market opponents.

The covenants—typically agreements in which employees agree not to work for a competitor for a given period of time or risk being sued—have come into wide use with the emergence of the new economy.

They provide employers with a way to hold on to their human capital and intellectual assets in a time when information and the brains in which it’s stored have become the essential commodities.

But senior executives might do well to take another look at how broadly their non-competes restrain the future working lives of their employees. An overly sweeping pact might open employers up to lawsuits, employment lawyers say. And talented workers might have hesitations about working for a company that puts them in chains for years after leaving the firm.

In fact, a well-publicized California appeals court ruling involving a non-compete provision that went against an employer on December 21 could trigger widespread reassessments of such provisions.

Playhut, Inc., a City of Industry, Calif.-based toy maker, asked Richard D’Sa, a new employee, to sign the company’s standard “confidentiality agreement” that contained a non-compete covenant. He refused to sign the agreement, was fired, and sued for wrongful termination. After a California trial court dismissed D’Sa’s complaint, the appeals court ruled in his favor.

In his argument, D’Sa didn’t object to the agreement’s provisions binding employees not to disclose trade secrets and to transfer inventions and patents to Playhut.

Instead, he sued over a non-compete provision barring the employee from working on a “competing product” for a year after separating from the company. The non-compete also said that for a period of five years following the employee’s separation from the company, the employee would have to notify Playhut of each new employer’s name and address within 30 days.

The appeals court agreed with D’Sa that the non-compete provision was illegal because it violated “public policy,” in the form of a California law that states that “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.”

D’Sa, an art director with sons ages 3 and 7, was indeed worried about being restrained in his livelihood and not being able to pay his bills if he were laid off by the company, according to The New York Times. For its part, Playhut now has something worse to worry about: D’Sa has the ability to seek punitive damages.

State Laws Differ

Employment lawyers say that such an outright ban on non-competes is unique to California and that companies should look at their employment agreements on a state-by-state basis. But remember: California is also uniquely endowed with the kind of new- economy companies that feel the pressure of competition for talented technology workers.

One thing Playhut may have done wrong was to try to impose a broad non- compete agreement on an existing workforce, rather than negotiating the provision beforehand, Martin A. Traber, a partner with Foley & Lardner in Tampa, Fla., who often represents software makers, tells CFO.com.

One way some employers have coped with such a situation is by providing a bonus of, say, $5,000 to $10,000, to sign the agreement, says Traber. This would allow the employer to argue for the agreement’s enforceability under the legal theory that it has provided “fair consideration” to the employee for signing.

It’s hard to see how a bonus of that size would have placated D’Sa’s fears about earning a living, however. A better approach might have been to narrow the agreement to suit the employer’s specific concerns about what might happen if the employee moved to a competitor.

In any event, lawyers say, executives should draw up their non-compete pacts with as much precision as possible to steer clear of the courts. Traber points out that courts tend to disapprove of very broad non- competes, such as those that curb an employee from working in the telecommunications industry in general for a period of time.

On the other hand, courts look favorably on “highly, highly precise, non-solicitation” agreements that protect specific data and seek to keep sales and marketing executives from bringing their prospect lists and existing customers over to a new company, he says.

In general, says John L. Monroe Jr., a partner with the law firm of Ford & Harrison in Atlanta, “we’re seeing a little bit of movement toward the center” in terms of courts balancing the interests of employees and employers. “As our economy becomes more information-based, we see some willingness in the courts to protect things like customer goodwill [and] business information,” he adds.

At the same time, the timing of non-competes should be tightly tailored to a specific industry to get a favorable viewing by the courts. For instance, the timing of a non-compete in the technology sector, where product offerings change quickly, could encompass a sales cycle of four to six months, from the point of first contact with the sales target to the close of the sale, Traber says.

Such a non-compete agreement would be inappropriate for a sales person working for an old-economy company, such as an auto-parts company with “a very static product suite,” Traber says.

Monroe says the time period specified in the agreement “has to be relevant” to the job the employee or executive has.

“If a CEO has developed the grand strategy for the next five years and then goes to work for the very company the employer is competing with, then that period of time would be appropriate,” for the length of the non-compete agreement, he says.

Employees should also not be barred from working for a different division of a competing company. If a technology employer has an employee working in its solutions division, “I don’t have to keep him from working in the support division of [the] competition” after he or she leaves the company, Traber notes.

As part of a non-compete contract, employers should also allow departing employees to sell other services or products to the same customers they served at the first company, he says. This flexibility would enable the contract to be “highly enforceable.”

Overall, companies stand on their firmest legal and ethical ground when their non-compete agreements focus on non-disclosure of vital company information and the protection of intellectual property.

“If I’ve got some really cool source code, I’m not so sure telling that man that he can’t play” with the code at a new employer is illegitimate, especially if the non-compete agreement allows the employee to work for a competitor, Traber says.

“Courts are far more willing to enforce nondisclosure than a prohibition against an employee getting a job in a particular industry for a given period of time,” says Monroe.

“I would advise employers to protect themselves with a nondisclosure [agreement applying to all] employees,” he adds. At the same time, a non-compete should be used “only where some protectable interest does exist, where it would be appropriate because of the nature of the employee’s job.”

But a non-compete shouldn’t threaten an employee’s livelihood if he or she leaves a company. David M. Weiner, a partner with Seyfarth Shaw in Chicago, says a noncompete is overly punitive “when you can’t make a living…It’s almost like being treated as a child in that case.”

The best advice to employers thus seems to be: Use a non-compete to protect your business interests, but don’t let it threaten an employee’s ability to survive in the labor market.

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