Restricting Restrictive Covenants

Earlier this week I heard a news story on the radio about non-competition agreements. These go by other names, including the one I am most familiar with, “restrictive covenants.” Whatever you call them, they are agreements between an employer and an employee, always demanded by the employer, which prevents the employee from doing certain things after the employment relationship has ended. Generally, those “certain things” involve actions that are directly competitive with the former employer.

I was licensed to practice law in Tennessee for two years, and the only time I was called upon to address a restrictive covenant, I was advised by a colleague “Oh, that’s in front of Judge So-and-So, and I’ve seen him on other cases like that. He said right from the bench ‘I don’t enforce those.'” Now, that wasn’t every judge in Tennessee, but it was certainly Judge So-and-So, and a little more asking around told me that everyone knew it. My client and I negotiated accordingly.

This should give you some insight on just how unpopular these kinds of contracts are.

Not that I didn’t already know it. I had already been admitted to practice in California for many years during that time, and I was well familiar with California’s Business & Professions Code section 16600: “Except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” That’s a blanket ban on non-compete agreements in California.

Now, it’s not quite as simple as that, of course. There is a significant exception, in B&P Code section 16601, which carves out an exception (in a much more long-winded way) — if you own a business, in whole or in part, and you sell its goodwill, you may agree as a term of the sale to be bound to a restrictive covenant, one that is temporary (it needs to expire within a reasonable time) and local (to where the business is actually being done) to allow the buyer of that goodwill to begin using it. Similarly, if you withdraw from or are part of a dissolved partnership or LLC, and the other people who you used to be in business with choose to carry on the same business activities, you may agree be bound to a non-compete covenant in the same area as the surviving business.

What’s “goodwill”? In a nutshell, it’s good relationships with third parties. It’s a business’ reputation, as the business is personified by the person representing it. It’s the degree to which a business is well-known in the community, its brand recognition, and most of all, the willingness of other people to do business with it. This is sometimes tied up with salespeople individually, and in a goodwill sale, the person who holds the goodwill needs to do what is necessary to transfer customer loyalty to the purchaser of that goodwill.

California is known for a long tradition of judicial hostility to non-competition agreements — the case law is very clear that there is a strong public policy against interpreting any such agreement to be enforceable. People have to be free to make a living for themselves, the thinking goes. Your typical California judge is going to have the attitude that Judge So-and-So from Tennessee did.

If you fit into the “sale/separation” exception to California’s blanket ban on non-competes, the restrictive covenant still needs to be reasonably limited in terms of time and geographic scope. It has to protect the realistic, reasonable interest of the former employer or associated business, and only for as long as is necessary. That’s why it is associated with the sale of goodwill. And that’s why California’s tradition of hostility to non-competition covenants is so powerful — if the company demanding that agreement overreaches, and asks for enforcement in areas where it doesn’t really do business or for longer than the judge thinks is needed to establish goodwill, the court will generally not modify the contract to allow it to be enforceable. Sometimes, in a sale-of-business situation, it will, but generally, the contract has to get it right from the get-go. In the terms of the trade, a court will not take out the “blue pencil” and save the agreement from itself.

Oregon law is slightly more amenable to non-competition agreements than California’s. But not a lot. They are generally banned here, too, unless three conditions are met: first, the employee must be a “professional” as defined by ORS 653.020(3) (which roughly mirrors the “professional exemption” for Federal exemption from minimum wage and maximum hour laws); the employee is presented with the agreement not less than two weeks before employment begins or comes along with a bona fide promotion from some previous position; the employee is paid above the national median family income (currently $94,593); and the employer has a “protectable interest.” One “protectable interest” is when the employee is employed as on-air talent for a broadcaster, but mainly it comes down to access to trade secrets or other confidential information. We’ll get back to that in a moment. The agreement cannot be longer than 18 months under any circumstance.

But unlike California, Oregon law does permit a judge to “blue pencil” an otherwise-overbroad restrictive covenant. And the culture here is a bit more varied than California’s, so some judges will permit enforcement of a non-competition agreement (if it otherwise falls into the statutory exception) within the area that, if you will, “should have been” the proper geographic limitations.

Also unlike California, an employer can “buy out” of the ban against enforcement if they want to enforce an agreement on a professional former employees, or former employees who made less than the median income, by paying that person the greater of at least half of the former salary at the time of termination or half of the median income amount (a bit above $47,000 per year). ORS 653.295(6).

Which brings us to the last point: confidential information. Leaving aside spite, the real thing a legitimate, good-faith employer wants to protect when a critical employee departs are its trade secrets. Trade secrets are pieces of information that are not generally known to the rest of the world, which have value because they aren’t generally known to the rest of the world. The classic trade secret is a customer list. None of these states where I’ve practiced put unreasonable restrictions on the ability of an employer to protect its trade secrets from former employees. Technically, they don’t even have to secure the employee’s signature on a confidentiality agreement (although that’s still a really good idea). An employer can use the courts to prevent a former employee from using knowledge acquired during employment to poach that employer’s customers or use proprietary methods to gain advantages to doing business (like the way routes are drawn, secret recipes for foods, and so on).

So that’s what the law really is. The news article is chilling, though, in that it describes what I think is a real abuse of the legal system: making blue-collar workers, people for whom there really isn’t any legitimate reason to protect against trade secret abuse, or who can’t really make use of the employer’s goodwill, sign these agreements. People who aren’t sophisticated in the law will fear the agreement, especially if they don’t know it’s unenforceable. It’s scary to be told “We’re going to sue you.”

Employers sometimes try to get around judicial hostility to these bans on non-competition agreements through choice-of-law and venue clauses in employment contracts, and that’s a fertile ground for litigation as well. In other words, the employer says “Yes, we know you’re employed in California, but you signed a contract saying that Texas law would govern your employment with us, and Texas law allows for enforcement. So we’re going to sue you, in Texas, for work you’re doing in California.” I can think of at least three reasons why this wouldn’t work if put to the legal test, but the point is that you’d have to go to Texas and hire a lawyer there to deal with it, and that’s expensive at best.

Why do employers do this? In a word: retention. They are quite simply scaring their employees into staying. That makes a degree of sense — recruiting, hiring, and training workers (“on-boarding” them, in HR terms) is expensive. Off-boarding them is also expensive, and sets in motion a whole new cycle of on-boarding. But wow, what an awful way to treat your people to have to scare them into not quitting.

If you have any doubt at all about whether you are party to an agreement like this, and whether it’s enforceable, it behooves you to get educated and get a lawyer. And if you think you need to scare your employees into continuing to work for you, maybe, on a moral level, you need to reconsider your retention strategy.