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Business Law Update
September 2008

  Protecting Business Assets from Former Employees
A practical guide to non-compete agreements

by Stephen Furnari 

Andrea* is a software engineer in the financial services sector who writes code for traders at sophisticated financial institutions. She was recruited for a position with a large, well-known hedge fund manager that she was keenly interested in joining. The work for the firm was going to be challenging, compensation was good for the industry and the bonus potential was outstanding.

Andrea and her employer tentatively agreed on the terms of her employment and the firm's attorneys prepared an employment contract for her to sign. There were a number of clauses in the contract that concerned Andrea, particularly the one that would prevent her from performing computer programming services for any financial services company for the 12 month period following her termination (regardless of whether she or the firm terminated her employment).

There was no guaranteed severance package built into the contract and she was not being employed in an executive capacity. Andrea didn't need a law degree to figure out that the restrictions in the agreement were aggressive, and she had significant concerns about her professional marketability if she ever left the firm.

While Andrea's concerns are understandable, as the owner of two businesses, there are few things more frustrating than spending time, energy and money to train and develop an employee, only to have them go to work for a competitor before you reap the full reward of your investment.

If that employee also tries to steal your clients, it's like throwing salt on a "professional" wound.

This experience is certainly not unique to me, it's something every employer goes through. Nevertheless, after this happens to you one or two times, you start to think about ways to contract your way out of this problem through non-compete agreements with employees. In my law practice, this is a frequent topic of conversation when counseling business owners.

In business, these two divergent viewpoints are difficult to balance. On the one hand, an employer has a legitimate interest in preventing employees from misappropriating their business assets and giving a competitor an unfair advantage. On the other hand, employees have a material interest in their professional mobility and marketability.

Employers, who generally have superior bargaining power over employees, typically try to protect their business assets by having employees enter into agreements not to compete. In a typical agreement, an employee is precluded from working in a particular industry or for a competitor for a specified period of time.

And while an employer has considerable leverage in terms of getting an employee to enter into an agreement not to compete, it's quite another feat to enforce it. This is where courts step in on the side of the employee.

Courts have a duty to protect the public interest in maintaining free and fair competition and in fostering a marketplace that encourages new ventures and innovation. To do so, courts place a heavy burden on employers when it comes to enforcing non-compete agreements.

Nevertheless, in most states, an employer can enforce an agreement not to compete if it can demonstrate a legitimate commercial reason for the agreement and it can ensure that the agreement is not a naked attempt to restrict free competition. Courts generally accept two primary interests as "legitimate justifications" for non-compete agreements: protecting the employer's good will with customers and protecting trade secrets.

To make a non-compete stick, an employer needs to make sure that the restrictions are not greater than what it reasonably needs to protect the company's legitimate interests. According to employment lawyer Edward Hernstadt of the New York firm Hernstadt Atlas LLP, "non-compete agreements can be difficult to enforce because each situation is very fact-specific." This is particularly true in states like New York that have an "at will" employment doctrine (employees can be fired for any reason or for no reason, and at any time). Says Hernstadt, "non-competes run counter to the spirit of the at will doctrine and, as a matter of public policy, courts are cautious in enforcing them."

If you want to use non-compete agreements to help protect your company's assets, here are some general guidelines that you should take into consideration:

Limit restrictions to personnel with special skills. Generally, we're talking about executive employees and employees with technical skills that are so specialized, it would take the Company a very long time to replace the employee, would give the employee a unique competitive advantage over their former employer and the loss of the employee would cause the company irreparable harm. General skills brought to the job or acquired on the job are not protected by non-compete agreements. Also, an employee who is merely good at their job, for example, a superstar salesperson, the loss of which would reduce a company's overall sales revenue, is not considered enough of a specialized skill to justify the enforcement of a non-compete agreement.

Limit the restrictive time period. Agreements with open ended time restrictions will never be enforceable, neither will those with unreasonable time restrictions. The less time an employee is restricted, the greater likelihood the agreement will be enforced. Figure between six and 12 months on average, 18 months at the outset if there are other mitigating factors. Balance the time restriction based on the experience of the employee. Use smaller time restrictions, like six months or less, for lower-level or lower-skilled employees.

Limit the post-employment restricted activities. The more specific you can be about the activities you want to restrict an employee from engaging in after they leave, the more likely the non-compete agreement will hold up. For example, there was case in New York where an oral surgeon signed a non-compete with his employer. The court determined that while the non-compete would be enforceable with respect to physician's practice of oral surgery, a specialized skill, it did not preclude him from practicing general dentistry. In most cases, restrictive agreements that prevent an employee from going to work for a competitor in any capacity will not be enforced.

Be specific about the customers you are trying to protect. Preventing former employees from stealing customers is a legitimate concern for any business. However, if your customer or lead lists can be readily obtained from outside sources, restrictions on their use by former employees will not generally be enforced. For example, if your business serves trucking companies in New York City, a restriction on the use of your customer list may not be as enforceable as the same restriction for a company that refurbishes fine art for wealthy collectors, who tend to be extremely private and who are acquired only by referral. Even if your customer base cannot be readily acquired from outside sources, you'll have better success enforcing a non-compete if you limit the restriction to customers with whom the employee has direct contact through the course of his or her employment.

Identify Trade Secrets in Writing. If your goal in using a non-compete agreement is to protect trade secrets, it's best to list the secrets as part of the agreement. This can be done in a schedule to the agreement and should be updated regularly. The list puts the employee on notice about what they cannot take with them to their next employer, and provides greater specificity for courts in the event you need to enforce it down the road.

Limit Geographic Area. Agreements not to compete must be restricted by geography. However, the level of restriction will be different depending of your industry. For example, a restriction not to compete within a 25-mile radius from a company's main office may provide an employer of a physician enough protection from losing clients, but it may not be sufficient for a software company whose programmers can work remotely from anywhere with an Internet connection. In this case, a geographic area of the continental United States could be enforced. However, in cases where a business requires a larger geographic restriction, serious consideration should be given to reducing the time period of the restriction. In the case of the physician, a one-year ban on competition may be enforceable, where a three to six month ban for the software engineer would be more appropriate.

Write in a "Blue Pencil" Clause. In some states, courts have the ability to amend an overbroad non-compete agreement in order to make it enforceable. This is a practice know as "blue penciling" a contract. Courts do like to rewrite contracts that will impose more restrictive terms on an employee than what they originally agreed to. It may, however, amend an overly broad clause, like reduce a time restriction from 12 months to six months, in lieu of voiding the entire agreement. Consider adding a clause in your agreements that gives the court permission to amend overly broad terms in order to make the entire agreement enforceable. Of course, this does not guarantee that a court will utilize its blue pencil rights in your situation, but it does put an employer in a better position overall.

Offer compensation for the non-compete. If you feel a non-compete is critically important for the survival of your business and you require a longer time period or broader restrictions than what is normally enforceable, additional compensation can mitigate an overly broad restriction. For example, broad restrictive agreements entered into between the seller and buyer of a business often receive greater latitude by courts because of the additional consideration paid in connection with the sale of the business. Another example would be where there is a large, guaranteed severance package that reasonably covers the employee's salary during the restriction period. Says Hernstadt, "if an employer is willing to let the employee get paid while sitting on the bench, courts are more comfortable with enforcing restrictive agreements."

The Deep Pocket Approach

It's no secret that in litigation, the prevailing party is frequently not the one with the best argument, but the party who has the deepest pockets to sustain the expense of trial. Many employers use this leverage over employees when drafting agreements not to compete, relying on the assumption that most employees will not have the resources to dispute their attempt to enforce the restriction. Often times, employees abide by the non-compete even though it wouldn't necessarily be enforceable in court.

In Andrea's case, this appears to be her future employer's strategy. A hedge fund manager with billions of dollars under management is not likely concerned about the expense of a trial to enforce a software engineer's non-compete agreement.

According to Hernstadt, the problem with this strategy is where an employee joins a company that has even deeper pockets and the fight in court gets prolonged. If an employer loses their attempt to enforce a non-compete agreement, not only have they paid significant legal fees in a losing battle, but all other employees and former employees of the company will now have precedent to demonstrate the invalidity of their restrictive agreements. The company can work to get existing employees to sign a revised agreement that is less restrictive, but it may have big problems with respect to recently terminated employees subjected to the voided agreement.

Enforcing a Violated Non-Compete Agreement

If you suspect a former employee is violating the terms of a non-compete agreement, swift action is necessary to prevent irreparable harm.

See the Quick Tip for a summary of the measures a company would typically take.

When it comes to enforcing agreements not to compete, Hernstadt tries to get his clients to focus on their goals. "On the one hand, you want to stop your former employee from stealing clients and show other employees that you are serious about protecting businesses assets. On the other hand, by taking too aggressive an approach, you may risk sending a message to your clients or industry that you are difficult to deal with, damaging your reputation."

In 2005, Microsoft sought to enforce a non-compete signed by one of their executive level employees who left to join Google. Microsoft CEO, Steve Ballmer, wanted to make an example of the employee to scare other Microsoft employees into remaining at the company. In the end, the executive was restricted from performing certain tasks at Google, but was not precluded from working there. Both Google and Microsoft claimed victory.

Says Hernstadt, "the process of enforcing a non-compete can get expensive. If there's a way to reach a middle ground quickly, both the employer and the employee end up with a favorable result."

As for Andrea, the financial reward that the hedge fund manager presented far outweighed the prospect of being out of work for 12 months if she was terminated from her position. She ultimately accepted the job and hopes that the restrictive agreement doesn't ever become an issue. Nevertheless, she took comfort in the fact that the non-compete agreement would not likely be enforceable if ever challenged in court.

*Fictitious name is used to protect this person's identity.

   
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QUICK TIP:

Steps to Take if an Employee Violates a Non-Compete Agreement
 
If you think a former employee has been or is about to violate the terms of an agreement not to compete, contact your company's attorney right away.  Your business could suffer irreparable harm of immediate action is not taken.
 
Your lawyer will likely take the following measures.
 
1.  Assess Your Goals.  What are you trying to protect and what are the risks of attempting to enforce the restrictive agreement versus doing nothing.  Ultimately, what are you trying to achieve and how much are you willing to spend on legal fees to accomplish your goals.  
 
2.  Send Warning Letters.  Warning letters will go out to the former employee reminding them of the terms of the agreement, and to their new employer advising them of the terms of the agreement.
 
3.  Temporary Restraining Order.  Your lawyer will file an "order to show cause", and expedited court proceeding, potentially without the other party being present, seeking a temporary court order (TRO) preventing the employee and new employer from violating the terms of the agreement.
 
4.  Preliminary Injunction. Your lawyer will file for a preliminary injunction with your local state court, which is the next step after the TRO.  The employee and his or her employer will likely attend and argue on their behalf.  If you win, the employee is ordered by the court to discontinue the activity that is violating the restrictive agreement until such time as you can obtain a permanent injunction.
 
5.  Permanent Injunction/Damages.  After the preliminary injunction, your lawyer can seek a permanent injunction, and seek monetary damages for violating the terms of the agreement through a trial.  If you prevail, the employee and the new employer is permanently restricted from engaging in the activities that violate the non-compete, and you may be entitled to monetary damages if you seek them.
 
6.  Settlement.  During all these stages, your attorney should be trying to work out a settlement between your company, the former employee and their new employer to achieve the fastest resolution to your issue.  The outcome of these disputes are uncertain and the fight is expensive. Often times, these cases are resolved prior to filing for the TRO, and almost always resolved, either by settlement or the employee quitting their new position if you can obtain a preliminary injunction.  


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