Many employees take for granted that they have the ability to leave their old job for perceived greener pastures. Perhaps unbeknownst to them, some employees are contractually prevented from simply choosing a new employer at their discretion without significant legal hurdles. The freedom to move from employer to employer is not universal and may be a difficult proposition for employees such as captive insurance agents and securities brokers whose employment agreements typically contain a section known as the "covenant not to compete."
In simplest terms, a covenant not to compete is a contract between employee and employer whereby an employee promises not to work for the employer's competitor for a specified time, in a particular geographic area, after termination of employment. Such covenants are usually included as a clause in an employment agreement or sometimes drafted as a separate contract. The use of such clauses is intended to prevent an employee upon termination or resignation, from working for a competitor or starting a competitive business. Thereby, the subsequent employer could gain a competitive advantage by using knowledge of the former employer's operations such as trade secrets or other sensitive propriety information such as customer/client lists, business practices, and marketing plans. For these reasons, covenants not to compete are becoming more popular among companies within the United States and abroad.
Various state and federal courts have examined the enforceability of covenants not to compete. One of the major concerns of the courts has been that a business might abuse a non-compete covenant to prevent an employee from working anywhere at all. Generally speaking, such clauses are enforceable assuming that the contract language is not too broad. As such, reasonable limitations to the contract language are crucial to its enforceability. For example, Pennsylvania courts have stated that covenants not to compete must be: 1. incident to an employment relation between the parties to the covenants; 2. reasonably necessary for the protection of the employer; and 3. reasonably limited in duration and geographic extent. Plate Fabrication v. Beiler, 2006 U.S. Dist. LEXIS 52 (E.D. Pa. 2006). The law regarding the enforceability of a covenant not to compete varies from state to state and is by no means universal. Some states such as California, consider any non-compete agreement to be illegal and against public policy. However, the Pennsylvania standard will be discussed hereafter as a general starting point to understand covenants not to compete.
The first element, "incident to an employment relation" means that the employee agrees to the covenant not to compete as part of the employment contract. Many courts merely describe this requirement as the typical contractual term of "consideration." In other words, this element is satisfied if the employee receives something in exchange for the covenant not to compete which is generally employment and compensation.
As to the second element, restrictions are generally considered to be "reasonably necessary" as to an employer's propriety and trade secret information. Typically, covenants not to compete include language which specially enumerates what types of information are considered propriety and confidential. In addition, many states, such as Pennsylvania, recognize information such as customer lists as being a protected trade secret. It should be noted that courts will normally carve out an exception allowing employees to retain customer information for clients that the employee knew before he commenced employment such as friends and relatives.
The final element as to "reasonable limitations" on geographic scope and time duration has arguably generated the most controversy in terms of the enforceability of covenants not to compete. Covenants not to compete are more likely to be upheld if the geographic scope is smaller and the duration is shorter. However, Pennsylvania courts have enforced covenants not to compete for periods up to two years and covering multiple states in certain circumstances. For example, Jacobson & Company v. International Environment Corporation, 427 Pa. 439 (1967), affirmed the enforcement of a covenant not to compete wherein a Plaintiff corporation engaged in the business of selling and installing building materials in Pennsylvania. The Defendant was initially employed as a salesman and within ten years became a substantial shareholder in the corporation. As part of his employment agreement, the Defendant agreed to a covenant not to compete for a period of two years after termination which included Pennsylvania, New York, Connecticut, Delaware and New Jersey. The Court enforced this covenant not to compete as being, "reasonably necessary for the protection of the employer . . . without imposing undue hardship on the employee." Id. at 452.
Covenants not to compete are common in employment agreements for captive insurance agents and securities brokers. Most jurisdictions in which such contracts have been examined by the courts have deemed them to be legally binding if there are reasonable limitations as to the geographic area and time period in which a former employee may not compete. As such, employees and employers who have agreed to covenants not to compete would be wise to carefully review and understand its terms and their enforceability. Ideally, covenants not to compete must strike a balance between not restricting the employee's right to earn a living and enabling the employer to protect its business interests. However, a perceived violation of a covenant not to compete opens a veritable Pandora's Box of potential legal issues.