Covenants Not to Compete Are Not Easy to Enforce and May Even Back-Fire

August 7, 2013

A recent high court decision shows the difficulties and risks of trying to enforce non-compete agreements; and, thus, that technology and other employers should draft such agreements carefully, right down to the choice of law and forum provisions. It is dangerous for the employer simply to casually fill-in the blanks in a form non-compete, confidentiality, and assignment of inventions agreement (especially one that is over-reaching) and have the employee agree to it as a condition of employment or continuing employment. Far more thought and specificity are likely to be required if the employer has to go to court to enforce such agreements, the employer needs to understand the potential back-fire types of risks involved in such enforcement, and the employer should have alternative means to protect against risks that drafting alone cannot solve. [1]

In that case, Tradesman International, Inc. v. Black [2], the U.S. Court of Appeals for the 7th Circuit affirmed the lower court’s denial of an injunction requested by an employer (“Tradesman”) against its former employees (collectively, the “Employees”). Tradesman was a construction staffing service provider. Thus, the case is applicable most closely to technology companies that sell products or services. However, it also raises some issues that should be addressed by technology and other companies in developing software and hardware.

Some of the take-away points, from that case, that employers should consider, are:

1. The importance of which state’s law governs the validity and interpretation of the non-compete agreement. One of the first issues addressed by the Court was the choice of which state’s law to apply. Under the Court’s decision, a non-compete that includes a designation of the state with the governing law (in this case, Ohio) is honored. However (a) the public policy of the state where the litigation is pending (in this case, Illinois) may overcome that; and (b) as the concurring opinion points out, the state chosen needs to have more than a minimal connection with the parties or the transaction. Furthermore, as the concurring opinion in the case also points out, the choice of law may be critical, especially if the subject non-compete is over-reaching. The laws of some states, such as Ohio, may allow the court to revise, or delete part of, the language of the non-compete and uphold it as so altered. However, the laws of other states may simply void the non-compete entirely since, otherwise, an employer’s over-reaching may have an in terrorem effect with no downside risk to the employer. [3] 2. The general rules governing the enforceability of non-compete agreements. Since Ohio law was deemed to apply in Tradesman, supra, the Court quoted, from the Ohio case of Raimonde v. Van Vlerah [4], as follows:

“a covenant not to compete which imposes unreasonable restrictions upon an employee will be enforced to the extent necessary to protect the employer’s legitimate interests. A covenant restraining an employee from competing with his former employer upon termination of employment is reasonable if it is no greater than is required for the protection of the employer, does not impose undue hardship on the employee, and is not injurious to the public. Courts are empowered to modify or amend employment agreements to achieve such results.” 3. The factors to consider in judging reasonableness. For the factors applicable to determining the reasonableness of the non-compete involved under Ohio law, the Court quoted Rogers v. Runfola & Assocs., Inc. [5] as follows:

“the absence or presence of limitations as to time and space; ․ . . [w]hether the employee represents the sole contact with the customer; whether the employee is possessed with confidential information or trade secrets; whether the covenant seeks to eliminate competition which would be unfair to the employer or merely seeks to eliminate ordinary competition; whether the covenant seeks to stifle the inherent skill and experience of the employee; whether the benefit to the employer is disproportional to the detriment to the employee; whether the covenant operates as a bar to the employee’s sole means of support; whether the employee’s talent which the employer seeks to suppress was actually developed during the period of employment; and whether the forbidden employment is merely incidental to the main employment.”

4. Judging reasonableness includes a detailed analysis the particular information involved and whether the departing employee actually used it in his/her new position. While employed with Tradesman, the Defendants admittedly e-mailed, to themselves, certain information that Tradesman felt was proprietary. Thus, unlike in a number of cases, forensic analysis proving that this information was actually misappropriated was not a problem for Tradesman. However, the Court appears to hold that Tradesman had to show that the subject information is more than just proprietary; i.e. Tradesman had to show that that information amounted to trade secrets or goodwill. Secondly, the Court distinguished between (a) training provided by the employer that consists of only general know-how, and (b) information provided by the employer that would provide the Employees with an unfair advantage amounting to more than ordinary competition. Thirdly, the Court didn’t probe into whether the Employees’ skills were developed during the course of their employment via the opportunities Tradesman provided (even though that is one of the factors cited in Raimonde, supra). Fourthly, the Court also seems to require that Tradesman to prove the importance of the subject information by having previously imposed confidentiality protections upon it, and by seeking a temporary restraining order or preliminary injunction at the beginning of the litigation. Lastly, the Court also seems to have required Tradesman to prove that the Employees actually used the subject information in their new positions. [6]

5. Geographic and time limitations upon the restrictions. The Court also refused to enforce the subject non-compete, as being unreasonable, because it found that it would effectively prevent the Employees from working anywhere in the U.S. Geographic limitations upon non-competes are an old requirement that may make sense with respect to Tradesman’s business of supplying construction staffing or other types of territorial businesses. Other cases may have addressed such electronic and remote technology or services, or cases such as the Elelis case cited herein may do so. In the meantime, since almost no one wants to be a test case, prudent drafting would seem to require that at least time and geographic limitations be explained, and imposed upon the non-compete restrictions, as much as possible (while still providing reasonable protection, to the employer, to protect its investment). If the restrictions are not sufficiently limited, the court may find that they are unreasonable, impose undue hardship upon the employee, and/or are so anti-competitive as to injure the public. [7]

6. The former employer has to prove its damages with reasonable certainty. Tradesman admitted that it had to prove its damages with “reasonable certainty” and “without speculation”. The Court seems to have agreed with that and required more than simply a comparison of gross sales figures. Although Tradesman did not do a good job of explaining those figures, it is unclear whether the Court was requiring Tradesman to risk alienating its former customers even further by calling them as witnesses? It seems to me that, if and when a breached is proved, the question of damages should be considered separately and the court should give further consideration to which side should bear that risk.

7. Risks of back-fire. Even if another state’s law applies to the validity and interpretation of the subject agreement, the law of the forum state may still apply in determining claims and defenses that are deemed procedural. In Tradesman, supra, the law of the forum, Illinois, includes a Trade Secrets Act, which provides, in relevant part, at 765 Ill. Comp. Stat, 1065/5: “If (i) a claim of misappropriation is made in bad faith, . . . the court may award reasonable attorney’s fees to the prevailing party.” This put Tradesman at risk both in instituting, and in maintaining, its suit based upon the facts then available at each point in time. Thus, in drafting a non-compete agreement, each party should consider selecting, as a forum, a state with both jurisdiction and desirable law.

[1] On the other hand, of course, one alternative for the employer is not to have a written agreement with the employee, but to rely solely upon statutory and common law causes of action. See, for example, the additional Counts in Tradesman, supra; Elelis Inc. v. KeyW Corp., now pending as Case No. 1:13-cv-00839 in the U.S. Dist. Ct., E.D. Vir., Alexandria Div.; and the Winklevoss brothers’ law suit against Facebook, ConnectU LLC v. Zuckerberg, Civil Action No. 04-1923 (U.S. Dist. Ct. D. Mass., 2004). However, such common law and statutory causes of action don’t provide the express contractual specificity and other opportunity to avoid some of the problems discussed herein, or a way to eliminate various possible factual disputes, the way a written agreement can.

This article focuses upon the Tradesman case because it is so new and rendered by such a high court. Thus, it focuses upon non-compete agreements, not upon related agreements (such as confidentiality agreements, patents, third-party distribution agreements, and other security precautions) or the liability the former employer may have – to its customers, other employees or other third parties – with respect to the release of the subject information.

This article talks in terms of the employer/employee relationship because that is the subject of the Tradesman case. However, the many of the same issues may arise with respect to joint venture, licensing and outsourcing agreements. [2] Nos. 11-3715 and 12-2032 (August 1, 2013)

[3] Another example, which the Court in Tradesman, supra did not mention, is that, if Illinois law governs, Illinois courts impose – at least in the absence of perhaps special consideration, such as stock options or A signing bonus – a two-year rule to determine whether a restrictive covenant is enforceable. Specifically, in Fifield v. Premier Dealer Services, Inc., 2013 Il. App (1st) 120327, 2013 Ill. App. LEXIS 424 (June 24, 2013), the Court held:

“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. [citations omitted] This rule is maintained even if the employee resigns on his own instead of being terminated. [citations omitted]” The Court in Fifield refused to enforce the restrictive covenant even though the employee voluntarily resigned after only a little longer than three months.

[4] 325 N.E.2d 544 (1975)

[5] 565 N.E. 2d 540, 547 (Ohio 1991)

[6] Note, by contrast, the allegations, in the complaint filed in Elelis, supra, regarding the elaborate security protections, the plaintiff/former employer had imposed to protect the subject information. Note, also, that obtaining temporary restraining orders and preliminary injunctions may require the employer to post a bond to cover the employees’ damages in case the employee ultimately prevails in the litigation. The Plaintiff in Elelis, supra, does not seem to be pressing hard for a temporary restraining order or preliminary injunction.

[7] Because of the procedural posture of the case as it appeared before the Court in Tradesman, supra, that Court did not address Tradesman’s claims regarding breach of confidentiality. However, by analyzing the non-compete claims in part upon the confidentiality of the subject information, the Court in Tradesman, supra, indicates its view of the relationship between the two. In Fifield, supra, the restrictive covenant (like the one in Tradesman, supra) applied throughout the U.S.; however, due to the way the Court decided that case, it did not have to address that lack of geographic limitations. In Exelis, supra, the subject Non-Compete Agreement contains time and geographic limitations upon the restrictions, whereas the subject Assignment of Inventions and Non-Disclosure Agreement does not. It remains to be seen how, if at all, that distinction plays out in that case. I suspect that, in most cases, the employee did not take the confidential information merely for the purpose of possessing it without using it for competitive (or, not relevant for the purposes of this article, espionage or political) purposes. Thus, it seems to me that (a) non-competes and confidentiality agreements are closely related and should be analyzed together as part of one total agreement, even though they are often documented as separate agreements; and (b) as a practical matter (as distinguished from a legal one), geographical restrictions are not generally relevant with respect to supplying software or technical services that can be ordered and downloaded, remotely over the internet, internationally. It seems to me that, for technology companies, the types of potential customers or uses are more relevant criteria, including whether the departing employee is seeking to apply the subject technology to uses not contemplated by the former employer.