Yes, You Can Enforce Non-Compete Clauses

By Robin Samuel

Oct. 4, 2007

Employers today face increasing difficulty in the enforcement of covenants not to compete. In recent years, several states have considered or passed legislation limiting the use of employee non-competition agreements. Courts in other jurisdictions have cut back on the ways in which such agreements may be used, often in contradictory and confusing decisions. While the law of most states still is not as draconian as California’s strict prohibition on non-competes, this new trend represents a sea change in the litigation and enforcement of non-competition agreements.

The trend is not only discomforting, but also creates practical problems for multi-state employers. In-house lawyers and HR professionals now must keep abreast of changing legal requirements in all jurisdictions in which their companies do business at the risk of losing the right to protect the company’s assets everywhere.

However, all is not lost, and employers still can use non-compete agreements to protect their business good will from wandering employees and vying competitors. This article explores some lesser-known methods for protecting against competition while avoiding the thicket of contradictory state laws on the subject.

The root of the problem: California’s ban on non-competes
   Because many states are moving toward the California “model” on non-compete agreements, it is helpful to understand the basis for that state’s prohibition, which is found in California Business and 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.”

California courts interpreting Section 16600 strictly construe it to void most types of non-competition covenants in employment contracts. Besides the standard promise not to directly compete with the employer post-employment, courts also have invalidated agreements that prohibit the solicitation of customers, that penalize employees who compete (rather than outright banning competition) and that prohibit the hiring away of other employees.

And when a California court deems a non-compete to be invalid, the court is not likely to simply strike or “blue pencil” the offending language from an otherwise valid employment agreement. Instead, to deter employers from “stretching the boundaries,” California courts historically invalidate an entire agreement if it contains a prohibited non-competition clause.

Even in jurisdictions that allow the enforcement of non-compete agreements, courts usually impose geographic and time limitations on such agreements. Most courts scrutinize non-compete agreements to ensure that they both are reasonably limited to protecting the employer’s legitimate business interests and will not unduly limit the employee’s ability to pursue other work opportunities. Covenants not to compete generally also must be supported by independent consideration.

Nevertheless, employers still have tools available to them to help prevent competition by former employees, regardless of where they work or reside.

Forfeiture clauses
One of the most powerful but least understood methods of restricting post-employment competition is the ERISA pension plan. Congress enacted the Employee Retirement Income Security Act of 1974 to address numerous problems with unregulated employee benefit plans for the growing U.S. workforce. Despite the enormous growth in such plans at the time of ERISA’s enactment, “many employees with long years of employment [were] losing anticipated retirement benefits owing to the lack of vesting provisions in such plans.”

ERISA helped correct this problem, and provided greater mobility to the growing workforce, by mandating minimum benefit vesting schedules for certain pension plans and by harmonizing the regulation of employee benefit and pension plans in all 50 states.

Somewhat ironically, this need for uniform regulation and minimum vesting is the source of ERISA’s power in the non-compete arena; Section 1144(a) of ERISA states that ERISA “shall supersede any and all State laws insofar as they many now or hereafter relate to any employee benefit plan” covered by the statute. By pre-empting state law, ERISA provides employers with an alternate forum in which to litigate and enforce non-compete agreements that are contained in ERISA-covered plans. Because ERISA plans are governed exclusively by federal law, state law prohibitions on non-competes do not apply, regardless of the employer’s, employee’s or transaction’s locale.

Even with respect to California employees, employee non-competes are permissible under ERISA. As long as a non-competition covenant respects the statute’s minimum vesting requirements, employer contributions in excess of those vesting requirements can be tied to a post-employment promise not to compete. In other words, an ERISA plan may lawfully provide that an employee will forfeit employer contributions that exceed ERISA’s minimum vesting rules if the employee competes with the employer after the employment relationship ends. The employee remains free to compete with the employer, just not with her full pension.

Not every pension plan is covered by ERISA, however. To fall within the protective shield of ERISA pre-emption, a pension plan must have an “ongoing administrative scheme” that, in particular, requires the plan administrator to exercise discretion in administering the plan.

Just as important, most ERISA pension plans are subject to a series of vesting requirements. First, an employee’s right to his normal retirement benefit is non-forfeitable upon the attainment of the employee’s normal retirement age. Second, an employee’s rights to accrued benefits derived from his own contributions are non-forfeitable. Finally, an ERISA pension plan must satisfy one of two vesting schedules: Either 100 percent of accrued benefits must vest after five years of service (so-called “cliff vesting”) or accrued benefits must vest over a seven-year period in 20 percent increments beginning no later than the third year of service.

However, ERISA does not prohibit forfeiture of benefits in excess of the minimum vesting requirements. Accordingly, by incorporating a non-competition forfeiture clause into an ERISA pension plan, an employer can penalize former employees who compete—regardless of which state they live in—by requiring them to forfeit their ERISA pension benefits (in excess of the statutory vesting minimums).

For example, the employer in the case Lojek v. Thomas offered a pension plan with a vesting scheme more generous than the minimum ERISA requirements. At the time, ERISA only required cliff vesting after 10 years, not five. The plan provided that all benefits vest after five years, but required employees to forfeit all benefits if they left before 10 years and competed with the employer. Lojek left his job for a competitor before completing 10 years of service, and the employer required him to forfeit his benefits.

The 9th Circuit ruled that because the plan provided a vesting schedule more liberal than the minimum requirements of ERISA, and because no benefits were forfeitable after 10 years, the plan did not affect non-forfeitable interests and the forfeiture clause was an enforceable. Such forfeiture clauses provide a powerful incentive for former employees to refrain from competition.

As a practical matter, ERISA’s minimum vesting requirements create a relatively short “shelf life” for most pension plan non-competition forfeiture clauses, which leads to the next option for multi-state employers: top-hat plans.

Top-hat plans
ERISA top-hat plans are “maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.” Top-hat plans often take the form of pension or deferred compensation plans provided to key executives in a company. To qualify under ERISA, they must be “unfunded,” meaning that benefits are paid solely from the general assets of the employer, and only a small percentage of the employer’s workforce can be eligible for the plan.

While top-hat plans are subject to some ERISA regulations (and therefore benefit from ERISA pre-emption of state law), they are not subject to the strict vesting requirements placed on most ERISA pension plans. For this reason, non-competition forfeiture clauses can be more freely incorporated into top-hot plans, and the effects of such clauses are much longer lived. For example, an employer can include a clause stating that all future benefits payable under a top-hat plan will be forfeited if the employee competes with the employer any time after the employment relationship ends. Note that while courts have not held that forfeiture clauses in ERISA pension plans must be reasonable in geographic scope or duration, good practice dictates that such clauses be reasonably limited.

Overall, forfeiture provisions in ERISA pension and top-hat plans provide a powerful disincentive for post-employment competition, regardless of where employees live or work. However, they are not the only tools available to employers.

Other options to limit competition
Employers have several other options in creating enforceable non-compete agreements. First, even those states that outright ban the use of non-compete agreements do so only with respect to post-employment competition that is conducted fairly and legally. Employers can and should contract against both competition during the term of employment and unfair post-employment competition.

With respect to the latter, employees should be asked to specifically agree in their employment agreement not to use or disclose the employer’s trade secrets or confidential information or otherwise unfairly compete with the employer. While employers already have tort remedies for unfair competition and trade secrets misappropriation in most jurisdictions, including an anti-unfair competition clause in an employment contract also provides employers with contractual remedies, such as attorneys’ fees or liquidated damages. Inclusion of these provisions in employment contracts also makes employees more cognizant of their duties and responsibilities after they leave the company’s employment.

Second, when employers are faced with unfavorable local non-competition laws, they sometimes can take advantage of the more favorable laws of other jurisdictions by incorporating both a choice-of-law clause and a forum selection clause into employment contracts that contain non-compete covenants.

If an employer is able to contractually designate a forum that allows non-competition agreements as the one for the resolution of employment-related disputes, the employer has a better chance of obtaining judicial enforcement of a non-compete provision. While a choice-of-law clause alone generally will not compel courts to enforce non-compete agreements that violate local public policy, the combination of provisions often results in the litigation being transferred out of state. For example, California courts typically will give effect to a contractual forum selection clause—even in cases involving non-compete disputes—unless there is a showing that enforcement would be unreasonable or would contravene a fundamental public policy. And California federal courts have specifically held that enforcing a forum selection clause does not contravene the public policy behind Section 16600 because the employee is free to assert in the designated forum that California law should govern the dispute. Thus, where there is a reasonable connection between the designated forum and the employer, employee or dispute, even California courts often will uphold the parties’ contractual forum selection clause and allow the case to be litigated in the foreign venue.

Finally, employers also can include “anti-raiding provisions” in employment contracts to prohibit former employees from soliciting or encouraging current employees to end their employment. Such clauses can effectively protect an employer’s workforce from being siphoned off by competitors, and may even be indefinite in scope and duration.

Despite increasing legislative dislike of non-compete agreements, employers are not left completely without protection. ERISA pension and top-hat plans, unfair competition clauses, forum selection clauses and anti-raiding provisions all provide avenues for the creation of enforceable non-compete agreements.

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