April 16, 2019

The Bark of the Covenant: Failure to Define and Negotiate Non-Compete Clauses and Other Restrictive Covenants Can Come Back to Bite You

Overview
With baby-boomers aging, and with over 95 million millennials in the job market, the importance of Non-Compete Clauses and Restrictive Covenants in employment agreements is sharply in focus. Boomers are at the age where they may be stepping back, retiring, or selling their businesses, while millennials and techies are starting businesses or changing employers. The result is a proliferation of business sales/purchase agreements and employment agreements, virtually all of which contain non-compete clauses and other restrictive covenants. Unfortunately, many of those agreements are presented and often executed without careful consideration of the long-term consequences. This article discusses – from both the employer and employee perspectives – issues that should be addressed.

The Rise of Restrictive Covenants
There has been a significant increase in the use of restrictive covenants by employers to protect business interests, and an accompanying uptick in efforts to enforce those covenants. It has been reported that litigation to enforce restrictive covenants has increased more than 60% over the last decade, and this figure does not include unreported cases. Restrictive covenants include:

  • Non-compete Agreements

The person or entity agrees not to work within a particular trade or industry, or with certain employers, or within a specified geographic area for a specified period of time.

Non-compete agreements are typically incorporated in or are ancillary to some type of contract or relationship, like an employment agreement or an agreement for the purchase or sale of a business.

  • Confidentiality or Non-disclosure Agreements (NDAs)

A person or entity agrees to keep information (trade secrets, customer lists, monetary amounts, terms and conditions) confidential. NDAs are used in employment agreements, agreements for the sale or purchase of a business, or to restrict or protect information from dissemination.
They are typically incorporated in or are ancillary to some other type of contract, but can be standalone agreements.

  • Non-solicitation Agreements

A contract in which an employee agrees, upon leaving a company, not to solicit the company’s clients, customers, or employees for his or her own benefit or for the benefit of a competitor. Non-solicitation Agreements may also be standalone or incorporated in or ancillary to some type of contract.

Reasonableness Test
In many states, restrictive covenants that limit or unnecessarily restrict post-employment activities are disfavored and considered a violation of public policy. Courts are wary of agreements that constrain competition in the marketplace and prevent individuals from working in their chosen fields or area of expertise. Some states require special consideration for post-employment restrictive covenants. California has a strong public policy under which nearly all restrictive covenants in employment contracts are unenforceable. Most states, however, apply a reasonableness test which will weigh legal factors, including:

  • Is the restrictive covenant necessary to protect a legitimate business interest of the employer or entrepreneur;
  • Is the restrictive covenant reasonably limited in time and geographic scope;
  • Does the restrictive covenant impose undue hardship, or is it too limiting or oppressive;
  • Is the restrictive covenant unreasonable such that it would be injurious to or violate public policy;
  • Was there adequate consideration which supports the restrictive covenant?

These are subjective criteria, but the Illinois Supreme Court in Reliable Fire Equipment Co. v. Arredondo 1 offers an interpretation of the standard for assessing an employer’s legitimate business interest:

[W]hether a legitimate business interest exists is based on the totality of the facts and circumstances of the individual case. Factors to be considered in this analysis include, but are not limited to, the near-permanence of customer relationships, the employee’s acquisition of confidential information through his employment, and time and place restrictions. No factor carries any more weight than any other, but rather its importance will depend on the specific facts and circumstances of the individual case.

The takeaway: Each case is different. Before signing on the dotted line, the reasonableness of restrictive covenants must be evaluated, often with the aid of counsel, within the context of the specific work to be performed.

Adequacy of Consideration
For a restrictive covenant to be enforceable, and before its reasonableness is even analyzed, it must be found to be ancillary to a valid transaction or relationship and supported by adequate consideration. What constitutes adequate consideration may vary widely. Post-employment restrictive covenants restrict an employee’s ability to seek work after his or her employment with the employer has ended. Because such agreements constrain competition in the marketplace and prevent individuals from working in their chosen fields or area of expertise, some states require special consideration for post-employment restrictive covenants. Courts may not enforce a restrictive covenant if the consideration offered is deemed illusory.

Some courts have suggested that two years of continued employment constitutes adequate consideration for a restrictive covenant. Other courts have stated that the analysis is not limited to a numerical formula for determining what constitutes substantial continued employment. Other factors may be relevant.

In Fifield v. Premier Dealer Services, Inc. 2, the First District Court of Appeals suggested Illinois uses a bright line test: “Illinois courts have repeatedly held that there must be at least two years or more of continued employment to constitute adequate consideration in support of a restrictive covenant.”3 However, some federal courts considering Illinois case law have concluded that Illinois does not offer a clear rule for determining whether consideration for an employment agreement is adequate. In Montel Aetnastak, Inc. v. Miessen,4 the federal court determined that Illinois courts have considered factors other than the period of continued employment – including whether the employee or the employer terminated the employment relationship, amounts and forms of compensation including raises and bonuses, changing responsibilities and the nature of the work performed – when determining whether adequate consideration was provided.5

While the federal court in Instant Technology,LLC v. DeFazio6 considered the fact-specific approach applied in Montel v. Aetnastak, the court ultimately seemed to favor the bright line test articulated in Fifield, noting however that there was no evidence at trial other than length of employment for the agreement to be bound by the restrictive covenant. The federal court decided that since the employment did not last two years, Illinois would not find the restrictive covenant enforceable. Notably, most federal courts construing Illinois law have followed the fact-specific approach.

Although Illinois courts have found that two years of continued employment constitutes adequate consideration to support a restrictive covenant, other factors may be taken into account. Was the duration of employment equal to the length of the post-employment restrictive covenant? Was there some other form of consideration provided? The courts will not enforce a restrictive covenant where the consideration is illusory, such as promises from the employer of benefits which may never come to fruition. Examples of such promises include: future payment of bonuses; promises of promotion; the employers’ assistance in obtaining professional privileges; access to new referral sources; additional vacation time; and the promise of continued at-will employment.

Monetary compensation has been accepted by several states as adequate consideration in support of a restrictive covenant. However, the amount which would be sufficient is not clearly defined and would appear to be dependent on the facts of the case, including the type of job involved and the perceived value of the information to be protected or kept confidential. An Indiana court has found that an employee’s giving up of another opportunity along with the expense of relocation constituted adequate consideration.7

All of these factors may need to be evaluated on a case-by-case basis. In the transfer, sale, or divestiture of a business, or in the case of new employment, restrictive covenants may not be a part of the initial negotiations, but may be incorporated in the applicable written agreement. Most new employees are presented with an employment agreement for execution at the time or near the time of hiring, including after the job offer has been made and accepted. However, it is not unusual, and there may be a reasonable basis, for existing employees to be asked to execute a new or updated employment agreement. While it is irrelevant whether the employment agreement is executed at the beginning of the relationship or at a subsequent time, whether the employee or employer terminated employment may be a factor.

Summary
In addition to reasonableness, adequacy of consideration is critical to the enforceability of restrictive covenants. What constitutes adequate consideration varies from state to state and even from case to case. Bright line tests may not be so bright.

While all of these metrics are important in analyzing restrictive covenants and particularly post-employment restrictive covenants, parties requiring and wishing to enforce restrictive covenants should have them reviewed by counsel to evaluate whether the terms are reasonable and enforceable and how they may be scrutinized by the courts in the particular jurisdiction or jurisdictions in which they will be applied.

If an employment agreement is required, and most employers should require them, it will typically contain restrictive covenants. Employers must be careful not to overreach and should expect that their agreements will be scrutinized, particularly for the adequacy of consideration. Eager new employees may execute such agreements without considering the future consequences of doing so.

The takeaway: Early in the relationship is the time for considering, discussing and, if necessary, negotiating terms, conditions, time and scope. Restrictive covenants should be reviewed by competent counsel before they are presented or signed, because once the agreement is executed, it becomes more difficult for the employee to challenge and, if it is not properly drafted, for the employer to enforce.

1 Reliable Fire Equipment Co. v. Arredondo, 2011 IL 111871
2 Fifield v. Premier Dealer Services, Inc., 2013IL App(1st) 120327
3 Id. But see McInninis v. OAG Motorcycle Ventures, Inc., 394 Ill. Dec.107, 35 N.E. 3d1076(Ill.App.Ct. 2015)
4 Montel Aetnastak, Inc. v. Miessen, 998 F. Supp. 2d 694 (N.D. Ill.2014)
5 Id. Allied Waste Services of North America, LLC v. Tibble, 177 F. Supp 3d 1103 (2016)
6 Instant Technology,LLC v. DeFazio, 2014 WL 1759814 (N.D. Ill. May 2, 2014)
7 Wior v. Anchor Industries, Inc. 669 N.E.2d 172 (Ind. 1996)