Legal

Courts Take Closer Look at Noncompete Clauses

By Peter A. Steinmeyer, Scarlett L. Freeman

Jul. 18, 2016

Companies seeking to enforce post-employment restrictive covenants — agreements restricting an individual’s ability to compete with their former employer or solicit its customers or employees — should be aware of current litigation trends surrounding what constitutes “adequate consideration” for a restrictive covenant.

Consideration — the mutual exchange of something of value — is an essential element of an enforceable contract. As with all other contracts, restrictive covenants must be supported by “adequate consideration” to be enforceable.

In the past few years, courts have been re-examining what constitutes adequate consideration for a restrictive covenant. In 2013, the Illinois Court of Appeals held, contrary to longstanding precedent, that in the absence of other considerations, mere employment constitutes adequate consideration for a restrictive covenant only if the employee remains employed for at least two years after signing the restrictive covenant.

This two-year rule applies regardless of whether the employee signed the restrictive covenant as a new or existing employee and regardless of whether the employee voluntarily resigned or was fired. Notably, multiple federal district courts in Illinois subsequently declined to apply the bright-line rule, instead considering other factors such as compensation, raises and bonuses, and the terms of the employee’s termination.

Similarly, since 2014, Kentucky, North Carolina and Pennsylvania courts have each issued decisions requiring some consideration beyond mere continued employment to enforce a noncompete. For example, in Employment Staffing Group v. Little, the North Carolina Court of Appeals upheld as adequate a $100 payment made to the defendant employee in conjunction with signing a midemployment noncompete. The court upheld the $100 direct deposit payment to the employee in exchange for signing the restrictive covenant, even where the payment was not directly referenced in the agreement terms.

On the other hand, in 2015, the Wisconsin Supreme Court held in Runzheimer International v. Friedlen that employers may require existing at-will employees to sign noncompete agreements without offering additional consideration beyond continued employment, although the court did not provide clear guidance as to the period of time that the employment must continue after the noncompete is signed. The court reasoned that although an employer could theoretically terminate an employee’s employment shortly after having the employee sign a restrictive covenant, the employee could challenge the enforcement of the restrictive covenant through other contract formation principles such as fraudulent inducement or good faith and fair dealing.

All of these decisions demonstrate the recent willingness of parties to challenge existing notions of consideration when it comes to restrictive covenants; additional challenges are anticipated nationwide.

What then should an employer do to ensure that a restrictive covenant is supported by adequate consideration?

First, depending on the state of employment, employers may want to provide consideration in addition to an offer of initial or continued employment. Examples of possible “additional consideration” include a cash payment; stock options; training; education; a raise; additional paid time off; guaranteed severance; or a promotion. In the absence of judicial guidance, it would be prudent to be as generous as possible and to provide consideration that is more than de minimis. Regardless of the “additional consideration” ultimately decided upon, the restrictive covenant itself should both explicitly recite the consideration provided to the employee for signing it and further provide that the employee acknowledges the consideration and its adequacy.

Second, the employer may agree to continue the employee’s salary during any restricted period, thereby alleviating concern about consideration being illusory.

Third, employers may consider trying to evade consideration concerns entirely by having employees agree to a “garden leave” or “required notice” clause, rather than a traditional noncompete or nonsolicit clause. Under such a provision, an employee is required to give advance notice of their resignation (e.g., 30 to 90 days) and, during the notice period, the employee remains on the payroll and owes the employer a fiduciary duty of loyalty (and therefore cannot work for a competitor during that period). Because the employee remains on the payroll and because garden leave provisions tend to be shorter in duration than traditional restrictive covenants, they are less onerous to the individual and thus more likely to be enforced.

Fourth, when drafting a restrictive covenant, employers should include a contractual choice-of-law provision that specifies which state’s laws will govern the agreement. Ideally, there will be a reasonable connection to a state with favorable laws regarding the enforceability of restrictive covenants, and that state’s laws can be designated as the governing laws.

Examples of possible states to be chosen include the state where the employer’s headquarters is located or where the employee actually works. Unless the choice-of-law provision violates the fundamental public policy of a state with a materially greater interest in the situation, or the parties and contract do not have a substantial relationship with the chosen state, courts will generally enforce such provisions.

Finally, on an annual basis, employers should have their restrictive covenants reviewed by a knowledgeable attorney to make sure they are still up-to-date and fully compliant with current court decisions and state statutes.

As courts increasingly address challenges to the adequacy of consideration in restrictive covenants, employers can take measures to ensure that a restrictive covenant will be enforced. By simply remaining aware of fluctuating state laws, employers can structure employment agreements to incorporate adequate consideration under applicable state law.

Peter A. Steinmeyer is a member of the law firm Epstein Becker & Green, P.C. in the Employment, Labor & Workforce Management practice. He co-leads the firm’s non-competes, unfair competition and trade secrets strategic initiative. Scarlett L. Freeman is an associate in Epstein Becker & Green, P.C.’s litigation practice and a member of the firm’s non-competes, unfair competition and trade secrets strategic initiative.

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