Restrictive Covenants: One Size Does Not Fit All
October 16, 2020 | Categories: Firm News | Topics:
KMK is pleased to announce that an article by KMK Shareholder Ryan M. Billings was recently published in the American Bar Association Business Torts & Unfair Competition Committee Journal. The article compares non-compete law in New York, California, Illinois and Wisconsin, and argues that new rules should be created for non-disclosure and non-solicitation agreements, which are more targeted and less burdensome than traditional non-compete agreements.
A courtesy copy of the article is enclosed below. If you have any questions about non-compete law or an issue involving any non-compete agreement, feel free contact Ryan M. Billings at firstname.lastname@example.org or call (414) 962-5110.
Founded in 1937, Kohner, Mann & Kailas, S.C. (KMK) is a leading law firm with a global reputation for success and a rich tradition of results, providing legal expertise in business and financial services, business litigation, and commercial collections. Recognized by U.S. News & World Report as one of the nation’s Best Law Firms, KMK is headquartered in Milwaukee, WI. For more information, visit www.kmksc.com.
Restrictive Covenants: One Size Does Not Fit All
An analysis of how employee non-compete enforceability tests are ill-suited to govern the enforceability of non-solicitation and nondisclosure agreements.
By Ryan M. Billings
Restrictive covenant law largely developed in the context of non-compete contracts, where an employee was prohibited from working within X miles of a company’s location for Y years after termination. Courts were generally hostile toward such agreements, as they flatly barred departing employees from working in their chosen profession in the location where they worked and therefore likely lived (at least at the time the common law on this issue developed). More recently, these kinds of “classic” non-compete contracts have become less common, replaced by
- non-solicitation covenants, prohibiting a departing employee from soliciting a company’s customers, vendors, or other employees; and
- nondisclosure agreements, barring a terminated employee from disclosing a company’s confidential information and trade secrets.
These kinds of covenants generally have a different impact on the terminated employee in that the employee can still practice his or her given profession in his or her home city; the employee just cannot target the company’s customers or use the company’s secrets in the employee’s new job. Yet, many states still apply the traditional employee non-compete enforceability tests to non-solicitation and nondisclosure agreements. Arguably, this can create perverse results, allowing a departing employee free rein to use a company’s proprietary information or assume the company’s goodwill, based simply on a perceived overbreadth of the employment contract.
This article examines the interplay between non-compete, non-solicitation, and nondisclosure enforceability tests for employer-employee agreements across four different states (California, Wisconsin, New York, and Illinois) that are fairly representative of the different approaches state laws take on restrictive covenants, and this article points out cases in which the non-compete enforceability paradigm may not be a good fit for more targeted non-solicitation and nondisclosure agreements.
California represents the high-water mark of hostility toward employee non-compete agreements; non-compete covenants for ordinary employees are unenforceable across the board under California law. Cal. Bus. & Prof. Code § 16600. While the law is not entirely settled, California courts generally apply this same prohibition to non-solicitation agreements, although they have left room for the possibility that a non-solicitation covenant that bars a departing employee from using a company’s confidential information or trade secrets to solicit other company employees or customers may be enforceable. See, e.g., Thompson v. Impaxx, Inc., 7 Cal. Rptr. 3d 427, 429 (Cal. Ct. App. 2003); D’Sa v. Playhut, Inc., 102 Cal. Rptr. 2d 495, 501 (Cal. Ct. App. 2000). Under California law, nondisclosure agreements that protect a company’s confidential information and trade secrets are generally enforceable, and a specific duration limit is not necessarily required for the nondisclosure covenant to be enforceable. See Loral Corp. v. Moyes, 219 Cal. Rptr. 836, 840–41 (Cal. Ct. App. 1985). Not surprisingly, given California’s overt hostility to employee restrictive covenants, California courts will generally refuse to “blue-pencil” an overbroad agreement to reform it to comply with the restrictions of California law. Strategix, Ltd. v. Infocrossing W., Inc., 48 Cal. Rptr. 3d 614, 617 (Cal. Ct. App. 2006).
Wisconsin has traditionally shared much of California’s hostility to employee non-compete agreements, but Wisconsin law provides that non-compete covenants are enforceable if they are reasonable and support a legitimate business interest of the company. Runzheimer Int’l, Ltd. v. Friedlen, 862 N.W.2d 879, 889 (Wis. 2015). Wisconsin courts have identified two generally acceptable business interests that support enforceability: (1) preventing an employee from exploiting the goodwill developed with customers at the company’s expense (which the customers may associate with the employee personally rather than the company); and (2) preventing an employee from using the company’s confidential information and trade secrets to compete unfairly with his or her former employer. Star Direct, Inc. v. Dal Pra, 767 N.W.2d 898, 906–7 (Wis. 2009).
The same employee non-compete enforceability test applies to non-solicitation and nondisclosure agreements, with the exception that non-solicitation and nondisclosure covenants may sometimes be enforceable without an express geographic scope, a requirement for enforceable non-compete agreements. See Manitowoc Co., Inc. v. Lanning, 906 N.W.2d 130, 133–34, 210 (Wis. 2018); Rollins Burdick Hunter of Wis., Inc. v. Hamilton, 304 N.W.2d 752, 755 (Wis. 1981). Nondisclosure agreements under Wisconsin law, unlike California law, must have a reasonable time limit, unless the nondisclosure covenant targets a company’s trade secrets. Gary Van Zeeland Talent, Inc. v. Sandas, 267 N.W.2d 242, 250 (Wis. 1978). Wisconsin courts are prohibited from blue-penciling a restrictive covenant by the governing statute, which provides that a restrictive covenant that is overbroad in any respect is totally unenforceable. Wis. Stat. § 103.465.
New York presents a more lenient example of restrictive covenant jurisprudence than California or Wisconsin. Under New York law, reasonable employee non-compete agreements are enforceable. BDO Seidman v. Hirshberg, 712 N.E.2d 1220, 1223 (N.Y. 1999). Legitimate reasons for a company to require a non-compete under New York law include protecting the company’s goodwill, preventing an employee from using special or unique services developed at the company’s expense to compete with the company, and barring an employee from using a company’s confidential information or trade secrets to compete unfairly with the company. Id. at 1223, 1225.
The same standard for the enforceability of employee non-compete agreements is applied to non-solicitation agreements, but the test tends to be applied more flexibly by New York courts. See, e.g., Greenwich Mills Co. v. Barrie House Coffee Co., 459 N.Y.S.2d 454, 457 (N.Y. App. Div. 1983). Generally speaking, the employee non-compete tests apply to nondisclosure agreements as well, but nondisclosure agreements do not need to have a time limit. Ashland Mgmt. Inc. v. Altair Invs. NA, LLC, 869 N.Y.S.2d 465, 471 (N.Y. App. Div. 2008), aff’d as modified, 925 N.E.2d 581 (N.Y. 2010). New York courts can also blue-pencil an overbroad agreement, unless it was signed under coercive conditions or the employer had dominant bargaining power. BDO Seidman, 712 N.E.2d at 1226.
Illinois also takes a more permissive approach to restrictive covenants, arguably even more lenient than New York’s. Under Illinois law, a reasonable employee non-compete agreement supported by a legitimate business interest is enforceable, as long as the employee makes more than $13 per hour. 820 Ill. Comp. Stat. 90/5; 820 Ill. Comp. Stat. 90/10. Whether a company has a legitimate business interest is viewed through a totality of the circumstances test, which involves, among other things, consideration of whether the employee possesses confidential information about the company, whether the company has “near-permanent” relationships with its customers, and whether the agreement has a reasonable geographic scope and duration. Reliable Fire Equip. Co. v. Arredondo, 2011 IL 111871, ¶ 43.
Illinois applies the same test for enforceability to nondisclosure and non-solicitation agreements (except that the under-$13-per-hour limit does not apply) but views nondisclosure agreements as substantively different and less burdensome. Reliable Fire Equipment, 2011 IL 111871, ¶¶ 4, 17; Coady v. Harpo, Inc., 719 N.E.2d 244, 250 (Ill. App. Ct. 1999). Nondisclosure agreements do not require a time limit, and Illinois courts can blue-pencil non-compete, non-solicitation, and nondisclosure agreements, but should consider the overall fairness of the agreement in determining whether to do so. 765 Ill. Comp. Stat. 1065/8; Arpac Corp. v. Murray, 589 N.E.2d 640, 652 (Ill. App. Ct. 1992).
Analysis of Fit
The laws of each of these four states have important differences that emerge in the interplay among the enforceability tests for employee non-compete, non-solicitation, and nondisclosure agreements, arguably creating perverse results. Under California law, for instance, applying the non-compete ban to non-solicitation of customers covenants means that a departing employee has the legal right to use the company’s goodwill with its customers, developed at the company’s own expense, to compete against the company. In other words, in California, a company does not fully own its goodwill, as its employees in many circumstances have the legal right to take it and provide its benefits to a competitor. If the purpose of a ban on non-compete agreements is to allow a terminated employee to work in his or her chosen profession in the area in which he or she lives, applying that ban to allow an employee to take a company’s goodwill is arguably perverse because enforcing a targeted non-solicitation agreement will only bar an employee from soliciting certain customers, not stop the employee from working in his or her trade in his or her home town.
In Wisconsin, an employee nondisclosure agreement must expire after a reasonable time, unless it is targeted at trade secrets (which an employee is independently barred from using or disclosing under trade secret law). This means that, after a certain point, a Wisconsin employee has the right to use, disclose, or sell his or her former company’s confidential information, even if the information would otherwise remain a proprietary asset of the company and unknown to competitors. It is arguably a vestige of “non-compete thinking” to allow a departing employee to use or disclose a company’s confidential information in this fashion. If the information in question is truly confidential and not used by competitors, an employee does not need to use the information to continue working in his or her profession. Yet, Wisconsin law essentially puts a cap on how long a company can keep its own information confidential, if the company has any employee turnover.
New York law seems implicitly to recognize that employee non-solicitation and nondisclosure agreements raise different concerns than non-compete covenants, but this difference is neither formally nor universally recognized. Further, whether a company had a dominant bargaining position is arguably irrelevant to whether a New York court should, through the mechanism of blue-penciling, allow a company to protect its goodwill and confidential information to the full extent permissible under the law. Again, it seems that the coercion and dominance tests were developed with non-compete agreements in mind, as the concern that a company acted from an unequal bargaining position or asked the employee to sign a non-compete agreement under duress is more pressing when the agreement prevents the employee from working in his or her field in the place where he or she lives, and less so if the agreement merely prevents the employee from targeting certain customers or using the company’s confidential information after termination.
Even under the looser standard in Illinois, application of law developed for non-competition agreements to non-solicitation agreements could also give a departing employee license to take a company’s goodwill, if the company cannot convince a court ex post that the reasons it required the employee to sign a non-solicitation agreement ex ante fit within the amorphous set of acceptable justifications recognized by Illinois law (albeit with the possible benefit of an Illinois court’s blue pencil). One can ask why a departing employee should ever be able to take a company’s goodwill and use it to compete with the company, and why the language of and historical reasons for the non-solicitation agreement should be the litmus test for whether a company owns its goodwill with its customers. Even if this calculus involves some weighing of the social good associated with employment mobility against the harm to businesses associated with only partial ownership of their goodwill, the less restrictive nature of employee non-solicitation agreements should arguably be calculated on a different scale than more restrictive non-compete agreements.
All of these points are debatable, and lurking in the background is a concern that powerful companies wield restrictive covenant agreements as a club to prevent ordinary competition, but at minimum courts developing the common law and legislatures enacting statutory laws that govern employee restrictive covenants should consider whether the same or similar employee non-compete enforceability tests and non-compete thinking should apply to non-solicitation and nondisclosure agreements.
Ryan M. Billings is a shareholder and deputy chair of litigation with Kohner, Mann & Kailas, S.C., in Milwaukee, Wisconsin.
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