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Article - Nexus Between Non-Competition Agreements and Trade Secrets (LegalEra, India)
The Nexus between Non Competition Agreements and Trade Secrets
In the United States, enforcement of covenants against competition, whereby an employer seeks to restrict the right of an employee to compete against it for a period of time after severance of the relationship, is philosophically conflicted by two fundamental tenets: (1) society's support of freedom of contract and (2) discouragement of restrictions on employment, or bluntly the barter of an employee's freedom.
State courts in each of the 50 states approach the tension between these tenets, both resting on foundations of freedom as derived constitutionally and culturally, by applying a reasoned analysis as to the legitimate needs of each, the parties to the covenant against competition. Reasonableness is an ever- recurring theme in the enforceability of a covenant against competition. Construction of the anti competition covenants in a contract will be parsed from beginning to end, so that the court effectively becomes the third party to the contract, construing whether the restrictions are gratuitous or reasonable.
However this analysis is not totally balanced. It starts by weighing most heavily, society's abhorrence and economic fear of restricting an employee's gainful employment; this results in an analysis, which is presumptively aligned against a covenant against competition. Simply put, public policy in the United States militates against enforcement of any provision that will cause loss of a person's ability to work. To shift this balance one can and should incorporate the legitimate economic concern of the employer to protect its trade secrets from misappropriation by an employee, or a third party such as a future employer of the employee. Therein falls the shadow, the nexus between what otherwise might be a problematic covenant against competition into a fully enforceable restraint on the employee.
Drafting the Covenant
Being aware of the philosophical tensions as well as the process by which a court will interpret and enforce what are otherwise problematic restrictions on freedom, permits the lawyer qua draftsmen to anticipate the strongest scope and language which a court will enforce.
(1) Employer's Compliance is the sine qua non of enforcement. The agreement containing the covenant against competition, whether it is in an employment agreement or part of a buy sell contract, should first ensure that employer cannot be hoisted by his own petard. Any provision, which is ambiguous or structured to give an employee certain vague rights, such as official titles, supervisory authority, nature of duties and such are traps. Since courts are reluctant to enforce covenants restricting liberty, if an employer is deemed to have breached the agreement, the enforceability of the entire contract, let alone the covenant, becomes problematic.
Only if the employer seeks enforcement of the contract with clean hands will the court engage in a reasonableness analysis to see if the covenant against competition should be enforceable. If the party seeking enforcement of the covenant against completion is the proximate cause of the breach of the contract, the courts will not enforce an otherwise perfectly fine restrictive covenant.
Other theories whereby a court will not enforce the covenant against competition include waiver and estoppels. For example advising, aiding or abetting an employee to interview with potential competitors, failure to enforce other restrictive covenants with other employees may be deemed waivers and estoppels by the employer. Thus an employer would be barred from seeking enforcement of the covenant against competition.
The fundamental rules applied to covenants against competition are those of strict construction against the employer/draftsman. The court will infer any ambiguity in favor of the employee. So it behooves the draftsman as counselor to advise the employer that non-essential terms be omitted from any contract dealing with covenant against competition. The employee's counsel, whether as existing employee or an employee to be hired on an earn out after the sale of the company, should in contradistinction seek to embellish the terms, anticipating clauses and provisions which although non material may be grounds to allege an employer breach. For example the failure to provide "timely" written notice of a breach, even though employer had otherwise crafted a totally reasonable agreement has been the basis for a court to decline enforceability.
(2) TEP Elements Must Be Factually Reasonable. How does one draft an agreement protecting the employer with an enforceable restrictive covenant once it is established the employer is in full compliance? There are two forks to the reasonableness analysis. The first fork is factual and deals with the conventional triumvirate of TEP: TEMPORAL, how long is the restriction against competition, EXTENT, what performance duties does the restriction cover and PLACE, is the geographic area reasonable. TEP restrictions must be limited to what is factually reasonable to protect the legitimate interests of the employer and may not be used to disguise a restraint of trade.
(a) Temporal. Arbitrary and capricious temporal, time restraints will not be enforced. The contract must establish that the time restriction is somehow in the factual context linked to avoidance of post employment injury. An acceptable formulation would be to include language, which notes the parties agree that the time constraint is recognized to be necessary for the dissipation or dispersal of the employer's confidential information or trade secrets into the public domain or by which it becomes stale. Clearly this will be fact driven and by industry.
(b) Extent. The extent of the activity restriction contained in the covenant against competition must be reasonable both as to subject matter and the actual activity. As such it is prudent to limit the reach of the activity restriction to actual services to be rendered pursuant to the agreement. In theory, this could lead to a bleeding of confidential information if the employee works for a competitor but renders services and activities other than rendered to the employer. In this new position, the employee could draw upon his knowledge of the employer's trade secrets to the unfair benefit of the new employer. As such, the agreement should clearly recite that even if the employee is not subject to the covenant against competition, the employer retains full and complete rights to protect its trade secrets and confidential information from misappropriation.
(c) Place. The contractual agreement must state a geographic scope for the covenant against competition. While globalization has weakened, the ability of the employer to argue uniqueness of the employee, it has opened the door to wider and more expansive geographic limitations. A factually driven analysis will lead one to conclude whether or not a simple limitation as to area, such as five (5) miles from corporate headquarters, or dissected to other specified zones where the employer is competitive, will be appropriate, balanced and reasonable in any particular industry. The global reach of an e-commerce company located in Los Angeles, California is substantially different from the local medical practice with five doctors in Bayonne, New Jersey.
(3) What is Reasonable? The second fork is conceptual, giving substance to the concept of reasonableness. TEP must be constructed so that it meets three standards of reasonableness.
(a) Legitimate Interests of the Employer. The first is that the restrictive covenant must be crafted to protect the legitimate interests of the employer. Trade secrets and confidential information are the most persuasive. So language in the contract reciting that the employee will be exposed to trade secrets and confidential information, which is not in the public domain, is the fulcrum of enforcement. The propinquity of the proprietary information to the restrictive covenant will conceptually make the scope more reasonable rather some vague, poorly or mis-identified interest of the employer. The underpinning of this policy is one of preventing unfair competition and loss of good will. The use of certain trade secrets or proprietary information such as customer lists, under any circumstance, could give rise to a cause of action. To mitigate the necessity or risk of a cause of action based on a naked theory of misappropriation of trade secrets, we link the contractual agreement of the covenant against competition to create a prophylactic to avoid accrual of damages for which the employer would seek a remedy in unfair competition.
An exception to the foregoing analysis is when the covenant against competition is part of an employment agreement entered into in connection with an exit vehicle, an earn-out or simply as part of a buy sell agreement. The buyer of a business is more than entitled as part of the evaluation of the value of the business and as payment of consideration to calculate that for a time after the purchase it will not face competition from the seller's principals. In such event, one may say that the test of protecting the legitimate business interests of the employer is ipso facto met by the nature of the purchase of the business.
Thematically, one can also link the unique or extraordinary services of the employee to the legitimate interest of the employer. As with much of this area of law, whether services are unique or extraordinary is fact driven. The recitals in the agreement should expansively establish why the employer and employee view the services to be the antithesis of commonplace.
However, beware, one should not misconstrue "valuable" with "unique." An employee who is easily replaceable, has no special education, training or knowledge is unlikely to be deemed unique or extraordinary. Value to an individual employer does not equate with unique or extraordinary services o society at large.
The ability to interchange employees fluidly in today's globalized employment environment and the use of the Internet is going to create greater burdens on the employer to establish uniqueness of the employee. It is easy to understand why a window washer or even a manger of a window washer will not be deemed to have unique or extraordinary employment, but I query if even the most sophisticated and highly educated financial titans, chemists engineers, doctors or lawyers may not be deemed unique or extraordinary if it can be shown that the same are easily replaceable.
The clear cutting edge to establishing the legitimate interests of the employer to the employee is by linking trade secrets and confidential information with the services of the employee. The more unique the employee is, the greater his exposure should be to the employer's confidential information. This nexus is the bridge to laying a firm foundation for the enforceability of a covenant against competition. By arguing the employee has or will have access to confidential, proprietary information we almost beg the question of uniqueness and thereby obviate an increasingly factually complex hurdle.
Since trade secrets are such an important component to enforceability of the covenant against competition, it is worthwhile to briefly digress and address the status of trade secrets in the United States. While covenants against competition are generally reliant upon separate interpretation by the courts of each separate state, trade secrets have and are evolving. The Uniform Trade Secrets Act ("UTSA") was drafted the National Conference of Commissioners on Uniform State Laws, which has been adopted in 46 states; Massachusetts, New York, New Jersey and Texas have not adopted the UTSA.
Under the UTSA, a trade secret is defined as information, including a formula, pattern, compilation, program, device, method, technique, or process, that:
(i) derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use, and
(ii) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.
A cursory reading shows how broadly trade secrets are defined; note especially the language regarding "actual or potential" economic value. In the context of disclosures to an employee, inevitably a key employee who would be subject to a covenant against competition is more likely than not to have been exposed to the employer's trade secrets as defined under the UTSA.
Once we have linked trade secrets and the covenant against competition, we can use the UTSA to prove misappropriation of trade secrets. Misappropriation is linked to several incidents but the most important proviso is that improper means of acquisition of the trade secret includes "breach or inducement of a breach of a duty to maintain secrecy." The duty to maintain secrecy is the linkage created by the covenant against competition.
(b) The Public Weal Factor. The courts will further examine whether or not the restriction is harmful to the public. If it is harmful to the public weal, it will be deemed unreasonable. The restraint on a person being able to work to be gainfully employed leads down that slippery slope of the employee becoming a public charge. Ethereally, the public also has a call on the employee's service. Removing a unique or extraordinary individual from the coliseum of economic engagement denies society the fruits of competitive battle. Society benefits from the rendezvous of uncommon minds for the benefit of all. Covenants against competition are therefore frowned upon as restraints of trade denying the public the greater good of the employee's contribution to its economic success.
(c) Employee Harm. Finally the courts will ask: are these restraints unduly harmful to the employee? Mitigating factors in terms of harshness to the employee include structuring severance payments, which correlate to the duration of the covenant against competition. As such, if pre-signing bonuses are a factor in the relationship, one may wish to structure the pre-signing bonus as a payment for the covenant against competition.
Another mode to show the restraint to be reasonable to is to carve out those activities, the Extent factor, to which the covenant will apply. If possible, prohibiting the engagement in specified activities on behalf of competitors, as opposed to the broad-brush prohibition against competing with any and all competitors, will more likely be enforced.
A Patina of Protection
What is clear in this area is what is not clear. Each covenant will be subject to construction and a reasonableness interpretation. Applying the principles discussed above, the draftsman would be well advised to follow three guidelines. First, do not exceed reasonable mandates as to any element of TEP. The "hero" will secure absolutely what is necessary for the employer; an attempt to "punish" or entrap the employee will not succeed.
Second, assume even if you are being reasonable, a court for public policy reasons may be loathe to enforce particular elements of the agreement. Do not put the court in an all or nothing position. It is prudent to include severability and/or savings clauses, which permit the court to re-cast the agreement to be enforceable, in other words permit the court to re-write the contract to be reasonable.
Finally, make the case for reasonableness in the agreement. Make it clear that "but for" employee's acknowledgement of employer's legitimate concerns, it would not have entered into the agreement. State the employer's legitimate zone of interests, namely protecting its confidential and proprietary information. Combining these principles along with an understanding of the policies behind the courts' reluctance to enforce covenants against competition will more likely result in the employer at the very least have a patina if not a panoply of protection.
Published in LegalEra (India), September 2010, Volume 1, Issue VII. www.legalera.in
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