Restrictions On Post-Employment Behavior: Noncompetition, Nondisclosure, And Work-For-Hire
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
The legal literature on occasion deals with certain promises between an employer and its employees–noncompetition, nondisclosure, and ownership of inventions–as if they were entirely separate arrangements, involving discrete legal principles and policy considerations. In fact, the usual case has all three closely related; one might even say variations on a single theme. And, at the risk of some confusion for those accustomed to separate presentations, the discussion in the text will frequently treat them as if they were part of one whole.
The critical issues arise generally after the employment relationship is terminated. That is to say, if an individual is in fact a current employee, there is little controversy about an obligation, either expressly or by implication, not to compete and to maintain his employer's secrets in confidence. Once the employee is out on his own–either fired or by his voluntary act–how far can the employer impose restrictions on his subsequent behavior? Can the employer prevent him from joining or organizing a competitive firm and/or disclosing confidential information? Can a non-compete clause be considered a permissible surrogate for a nondisclosure obligation, on the theory that a ban on competition is the only effective way to police the confidentiality undertaking? Can the employer assert ownership rights to inventions the employee comes up with, even those invented (at least ostensibly) after the relationship has been severed? Does it make a difference whether the employer is relying on common-law principles of unfair competition, a state statute (perhaps a version of the Uniform Trade Secrets Act), or express contractual provisions?
Labels: "Non-compete" versus "Nondisclosure"
Depending on the state laws obtaining, it may be a bad idea to style any term of the employment arrangement baldly as a "covenant not to compete" (unless, as discussed below, the covenant is imposed in connection with the sale of a business or a significant stock position). Competition is the American way; labeling a restraint as anticompetitive is simply asking for some court to find a way around it in the clutch. The most prominent state weighing in on the issue is California, state law banning non-competes entirely. Careful legal work, therefore, should start with the title of the section in the employment agreement, denoting what it is precisely the company is trying to accomplish: a "covenant not to misappropriate proprietary information," perhaps, in which case the non-compete restriction is structured as a buttress, a way to enforce a nondisclosure obligation which cannot otherwise be realistically patrolled.
Indeed, there are multiple reasons why courts and legislatures are hostile to noncompetition agreements. Strictly enforced, the provisions could mean that the former employee cannot make a living in his field. Moreover, many of the most glamorous start-ups were the brainchildren of free spirits, who left giant oaks to plant little acorns. If Hewlett Packard had elected to impose, and been allowed to enforce, noncompetitive clauses in every possible instance, one wonders what the computer industry in this country would look like today. Prudent counsel should start, therefore, with the presumption that a covenant not to compete may be unenforceable (pending, of course, a thorough review of state law). Instead of drafting language without substantive impact, the search should be for provisions that will survive, which have a fighting chance of accomplishing some corporate purpose when a valued employee leaves.
The issue, of course, can be serious. The flight of the scientific brains of the company into the arms of a competitor can be a death sentence. If a choice has to be made, the investors are well advised to let the provisions of, say, the registration rights agreement pass without negotiation, directing their counsel to focus in on this area. Given the high level of judicial and legislative hostility, it is sensible to frame each contract individually, tailor-made to the particular employee and the threat he poses, once on the loose, to his former employer's prosperity. If he is to serve as the marketing manager, the agreement should zero in on avoiding the harm that an individual in that post can do; perhaps a prohibition on the former employee aiding another firm in contacting customers he cultivated while in the plaintiff's employment. A court is much more likely to enforce a restraint if it is carefully limited to the potential injury facing the employer; this requires that thought be given to each individual case. It should be noted that emotions run extremely high in these disputes. The work atmosphere in a high-tech firm is often intense; the key officers work so feverishly and such killing hours in the development of a new technology that their bond is as close as the marriage sacrament. When one of them decides he owes it to himself to strike out on his own, the emotions can be extremely bitter, the investors and officers of the earlier firm viewing the defection as hideously unfair if the defector is able to parlay his knowledge and experience into the building of a competitor, as is so often the case. Tying employees to a firm for life may be good and accepted practice in Japan, but it conflicts with the mobility built into U.S. society. On the other hand, for investors and employees of a given firm to see their hard-earned secrets walk out the door and form the basis for a clone across the street is unfair competition of the most exasperating kind.
State of the Law: Noncompetition
The precedents are hard to align into a body of black-letter rules because the states have adopted quite different approaches to the issues involved, either through the common law of unfair competition and trade-secret protection as interpreted by judges and/or because, as in California, legislation has been enacted. The rights of the two contesting parties–employer and former employee–will often depend on where the action is brought and which state law the court elects to apply. Without attempting to review the authorities, certain general propositions can be extracted, with the caveat that they are general in nature and subject to local exceptions.
First, an obvious point: if the employer, the boss, breaches the employment contract, the employee is released from at least his noncompetition and probably his nondisclosure promises. (In a given context, the obligation to respect trade secrets may exist independent of contract.) The situation dealt with in this section is termination of the relationship because the employee quits, either in breach of his agreement or because the agreement no longer requires him to stay on.
Secondly, if a post-employment constraint is connected with the sale of a business, courts are more likely to enforce a noncompetition provision. Assume Smith, the sole owner of Widget, Inc., sells all his stock to Jones. Smith agrees to stay on for a period as a consultant and, for two years thereafter, to stay out of the widget business. If Smith attempts to violate his promise, a court will justify intervention by construing the restraint as protection for the goodwill that Jones has just bought. In this instance, the noncompetition covenant need not be tied to the unfair use of information. The investor has bargained for certain assets from the issuer, including the issuer's promise to stay out of the business. (It is not clear why investors purchasing a partial interest in Smith's company are entitled to any less consideration if Smith elects to quit. The goodwill is dissipated in either event.)
Allied to the "sale of the business" concept is the notion that, if the noncompetition restraint is created in connection with the resale of a significant equity position back to the company, the liveliness of the restraint is enhanced. As a planning point, therefore, it makes sense from the issuer's vantage point to tie the restraint to a buy/sell arrangement respecting the employee's equity. (If the repurchase is at a penalty price–e.g., the employee's cost–or for a de minimis amount of stock, common sense would suggest that the stock transaction should lend little help to the restraint's validity.) The two provisions should be expressly tied together, maybe even contained in the same numbered paragraph. The linkage device is not, of course, foolproof. As is the case generally in this area, courts in various states and at various stages approach the issues variously. Some will invent ways to ignore the equity side of the transactions and invalidate the restraint, reasoning that, for example, the price does not reflect a sale of goodwill.
The repurchase-of-equity provisions create a further opportunity for the firm to escape the negative implications of a "covenant not to compete." If the employer is located in a state hostile to post-employment restraints, one possibility is to string out certain benefits for the employee–for example, payment for the stock or deferred salary–and then provide for forfeiture if the employee winds up working for a competitor.
Alternatively, the former employer can sue the new employer, not the employee, for tortious interference, coupled with an allegation of wrongful misappropriation of proprietary information; the remedy sought in such a case is damages, but the object of the exercise is equitable in nature, to intimidate the competitor and/or the potential investors so that they refrain from infringing on the former employer's domain. To repeat a prior point, the plaintiff's claim is that noncompetition restraints are generally justified as necessary to enforce in the real world the underlying obligation not to misappropriate the employer's rights to its proprietary information. The idea is that once the employee has been allowed to join a rival firm, the damage has been done; the horse is out of the barn.
The gloss of "reasonableness" colors the discussion and holdings, meaning that the judges are consulting what they perceive to be the equities and common sense of the situation. Thus, the longer the employee has been employed and/or the higher his station in the company, the more likely a restraint will be enforced. A narrowly focused restraint will be more successful than one that bars the employee from working in "any competitive job anywhere in the world." The more sensitive the data to which the employee is privy, the likelier an injunction becomes. Indeed, injunctive relief is possible even in the absence of a contract if the secrets are particularly critical, but the failure of the employer to insist on a contract can be highly dangerous; the employer's lassitude cheapens its later assertions that the information is vital, and may, in fact, constitute a lack of vigilance which negates the employer's rights under the law of trade secrets. To comply with the reasonableness standard employment agreements are quite elaborately drafted to the effect that if, the time or geography is too severe the judge should act the terms back but enforce the same as modified.