Judicial Hostility Toward Non-Competition Agreements Leaves Form Users Vulnerable to Competition
December, 2004
Non-competition agreements are essential to protect a company’s customer base from unfair competition. To save time and money, many companies have turned to commercial forms and pre-existing agreements in drafting non-competition agreements. However, the law governing non-competition agreements varies dramatically by state, and there is a general judicial hostility toward agreements that restrain trade. As a result, courts may void an overbroad form non-competition agreement entirely if the agreement does not comply strictly with state law. Companies that unwittingly use overbroad commercial forms or pre-existing agreements thus leave themselves vulnerable to competition from former employees, particularly when form agreements are used in foreign states.
A. Differences in State Law on Non-Competition Agreements
The differences in state law concerning non-competition agreements are too numerous to catalog in this article, but must be appreciated by companies that would use commercial forms or pre-existing agreements. All states that enforce non-competition agreements permit only “reasonable” limitations on competition. Courts differ widely in defining what is “reasonable.” Courts in some states uphold four-year unlimited geographic restrictions, while others refuse to uphold restrictions longer than one year and require that geographic restrictions be tailored precisely to an employee’s territory. Many states require that additional consideration support a non-competition agreement, while others hold that continued employment alone is sufficient consideration. Some courts uphold agreements prohibiting employees from soliciting existing clients, but void agreements that prohibit general competition in the same industry. Many states impose strict statutory requirements on non-competition agreements. Others refuse to uphold non-competition agreements altogether.
B. “Blue Pencil” Rules and Choice of Law Provisions Will Not Save an Overbroad Form Agreement from Contrary State Law
When a contract contains an unenforceable provision, courts will generally enforce the remainder of the contract and reform the provision at issue to make it enforceable. The “blue pencil” rule avoids the undesirable result of voiding an entire agreement because of problems isolated to discrete contractual provisions. Companies might be tempted to rely on form or pre-existing non-competition agreements, believing that a court will reform the agreement if it is overbroad.
Many courts refuse to “blue pencil” restrictive covenants, however, to discourage companies from intentionally drafting onerous restrictions. As one court reasoned:
For every covenant that finds its way to court, there are thousands which exercise an in terrorem effect on employees who respect their contractual obligations and on competitors who fear legal complications if they employ a covenantor, or who are anxious to maintain gentlemanly relations with their competitors. Thus, the mobility of untold numbers of employees is restricted by the intimidation of restrictions whose severity no court would sanction. If severance is generally applied employers can fashion truly ominous covenants with confidence that they will be pared down and enforced when the facts of a particular case are not unreasonable. This smacks of having one’s employee’s cake, and eating it too.
Richard P. Rita Personnel Services Intern., Inc. v. Kot, 191 S.E.2d 79 (Ga. 1972).
Because of this judicial hostility, overbroad restrictions can nullify an entire agreement and leave an unsuspecting business with little protection from unfair competition.
Nor can a choice of law provision protect companies from such judicial hostility. Form agreements can and should contain a choice of law provision providing for resolution of claims under the law of a state receptive to non-competition agreements. A choice of law provision is not a panacea, however, and often will not save an overbroad agreement from laws of a forum state that are more restrictive than those of the contractually chosen state.
Courts refuse to enforce the laws of other states that are “contrary to a fundamental policy” of the forum state, despite the presence of a contractual choice of law provision. See Restatement (Second) of Conflict of Laws, § 187 (1971). Nearly every court that has decided the issue has held that enforcement of restrictive covenants is a matter of fundamental public policy. See e.g. DeSantis v. Wackenhut Corporation, 793 S.W.2d 670, 680 (Tex. 1990)(citing seventeen cases from other jurisdictions holding restrictive covenants to involve fundamental public policy). These courts have universally refused to apply choice of law provisions in restrictive covenants and left companies vulnerable to the forum state’s law.
While a choice of law provision may provide added protection when a lawsuit is brought in the contractually chosen state, it provides minimal protection at best when a lawsuit is brought by an employee in another state. A court in a foreign state will, at the very least, refuse to uphold limitations that are impermissible under the state’s law, and, as discussed above, may void the agreement altogether.
C. Effect of Form Agreements: Leaving Companies Unprotected and Minimizing Deterrence
Absent a carefully drafted, enforceable non-competition agreement, companies will be left to rely only on trade secret laws to protect themselves from unfair competition. Trade secret laws provide far less protection than non-competition agreements, however. While trade secret laws can prevent an employee from misappropriating sensitive financial, technical, and sales information, they cannot keep an employee from competing against his or her former employer to the extent that a non-competition agreement can. Additionally, trade secret cases are far more costly to litigate than breach of contract cases.
Unenforceable form agreements will also leave employees undeterred from forming or joining competing enterprises. Companies have long relied on non-competition agreements for their deterrent effect on competitors and potential defector employees. An employee will be less likely to leave a business and form a competing enterprise if he or she faces the prospect of litigation over a restrictive covenant.
However, companies should expect that an existing employee will obtain a legal opinion on the enforceability of their non-competition agreement prior to joining or forming a competing enterprise. The cost of obtaining such an opinion is small compared to the overall cost of starting a new business. An opinion that an agreement is unenforceable will increase the likelihood that an employee will form or join a competing enterprise, while a contrary opinion can decrease this likelihood. An unenforceable form or pre-existing agreement will therefore fail to provide the same level of deterrence that a properly drafted agreement will provide.
D. Avoid the Pitfalls of the Form
Companies must avoid form or pre-existing agreements in drafting non-competition agreements. While the law on many contracts varies little by state, the law on non-competition agreement varies dramatically, perhaps more than in any area of contract law.
Companies must accordingly rely on experienced counsel in drafting non-competition agreements, particularly when the agreement involves employees in foreign states. Each agreement should be drafted only after careful analysis of the law in both the employer’s and employee’s state(s), including analysis of permissible time and geographic restrictions, necessity and sufficiency of separate consideration, enforceability of industry-wide competition restrictions, and treatment of choice of law provisions and overbroad restrictions. Attorneys should tailor the agreement accordingly, and include a choice-of-law provision selecting the state which is the most favorable toward non-competition agreements and most cost-effective in which to litigate. The resulting agreement should provide far more protection from unfair competition than a form or pre-existing agreement.
Back to CM Report of Recent Decisions (2004v4) 2004 Volume 4 Table of Contents
