Many companies negotiate post-contractual non- compete clauses with their management and other key personnel in order to protect their business interests. This is an issue that is also of relevance in the context of M&A.Compared to the U.S. and a number of other European countries, the legal requirements in Germany for such covenants are rather strict. In particular, employers must be aware that compensation amounting to at least 50% of an individual’s most recent total remuneration must be agreed upon for the term of the post-contractual non-compete restriction and that the term of such restrictions must not extend beyond a period of two years. As employers run the risk that the non- compete agreements will not be enforceable if these requirements are not met, restrictive covenants must be carefully drafted. Furthermore, given the remarkable costs of a post-contractual non-compete covenant, employers should evaluate in every case whether non-compete restrictions are necessary to safeguard the interests of the firm.
Under German law, the legitimate scope of non- compete covenants varies slightly depending on the individual who is to be restricted by the covenant.If the restrictions apply to employees (including executive employees), the statutory requirements set forth by Sec. 74 et seq German Commercial Code (Handelsgesetzbuch) apply. In contrast, these provisions do not apply to board members and managing directors, as those individuals are generally not considered to be “employees.”
Non-Compete Agreements With Employees
The requirements for non-compete agreements with employees are essentially as follows:
- The agreement must be made in writing.
- Non-compete clauses must reflect legitimate business interests of the company (e.g., protection of company know-how, customer details and other sensitive information), and these clauses must not unreasonably hinder the employee in his or her professional advancement.
- The prohibition may not be extended beyond a period of two years following the termination of the employment relationship.
- The covenant must not extend beyond the geographic area in which the employee is active.
- The employer needs to provide compensation equivalent to at least 50% of the employee’s most recent overall remuneration (including fixed salary, variable compensation and fringe benefits) to be paid during the term of the covenant.
For practical reasons, non-compete covenants should be negotiated by the parties when entering into the respective employment relationship, e.g., by including a corresponding clause in the employment agreement. Although it is legally possible to negotiate post-contractual restrictions during an ongoing employment relationship, it is often difficult to obtain the employee’s consent once it becomes important for the company to have the employee sign a non- compete clause.
Regarding the scope of the covenant, there is – unfortunately – no “one-size-fits-all” solution. Instead, each covenant, in particular its factual and geographical scope, must be tailored to the circumstances of the individual case at hand. As a general rule, a close link between an employee’s position and professional activities, and the scope of the post-contractual non-compete restriction is required. Therefore, if an employee only serves a certain part or division of a company or only within a certain territory, it may be unlawful to extend the scope of the non-compete clause to the entire business of the firm or to competing activities worldwide, while in the case of executive employees, the legitimate scope may be broader. Similarly, a term less than two years must be agreed upon if the maximum period of two years is not necessary to protect legitimate business interests or if the maximum term would unreasonably impede the employee’s professional career and ability to earn a living. Employers should note that the scope of any covenant is only binding and enforceable against the employee to the extent the statutory requirements are met. If non-compete restrictions exceed the permitted scope, the scope of the covenant, by operation of law, is, in general, automatically reduced to the scope permitted by law in maximum.
When calculating the compensation, all elements of the employee’s remuneration, including bonus payments, allowances and non-cash benefits (e.g., a company car available for private use), must be taken into account, not just the most recent fixed salary amounts. On the other hand, the mere reimbursement of expenses or payments made with respect to employee inventions do not have to be considered. Where the contractual remuneration consists of variable payments, the average of such remuneration received over the last three years shall be the basis of the calculation of the non-compete compensation. However, the employee must allow any sums that he or she earns through capitalization of his or her work capacity elsewhere or that he or she maliciously fails to earn to be deducted from the compensation due if the non-compete compensation plus these earnings would exceed the most recent contractual remuneration by more than 10% (or more than 25% if the employee was forced to change his or her residence to find work). In case the amount of compensation agreed by the parties is too low, the covenant will be non-binding for the employee. As a consequence, in this case, the employee may choose to adhere to the covenant and claim the compensation (it is controversial whether the amount illegally agreed upon between the parties or the statutory minimum amount can be claimed) or to compete. In any case, the employer is bound by the decision of the employee and can, in particular, not enforce the post-contractual non-compete obligation against the will of the employee.
Should the company wish to withdraw from the covenant, it may agree with the employee to annul the mutual obligations under the non-compete clause. In practice, such an agreement may be part of a termination agreement or a court settlement for instance. Alternatively, if an agreement with the employee cannot be reached, the employer, prior to the end of the employment relationship, may also unilaterally waive the prohibition in writing. The downside of a waiver, however, is that the employer will only be released from the obligation to compensate the employee as of one year following the date of the declaration, while the employee will be free to engage in competing activities immediately(however, not before the end of the employment relationship). As a consequence, in case an employer realizes that post-contractual competition by the employee is not likely to harm the company’s interests, the non-compete covenant should be waived as soon as possible.
In case of non-compliance with the non-compete restrictions, the employer may seek injunctive relief. In addition, damages that arise from any violation of the covenant may be claimed. However, since in practice it is often difficult to provide evidence for the occurrence of specific damage, non-compete covenants should generally be backed up by a contractual penalty. Like the non-compete covenant itself, a penalty clause should be drafted carefully to avoid the risk that the clause cannot be enforced against the employee. There is the potential, for instance, that a court may consider contractual penalties equal to more than three months’ salary invalid (in practice, penalties in the amount of one month’s salary are often agreed upon). In addition, according to the German Federal Labor Court, penalty clauses must clearly define the circumstances under which a (new) breach of the non-compete clause occurs (which is particularly relevant in the context of repeated and permanent breaches of the covenant).
Non-Compete Restrictions for Board Members and Managing Directors
Unless a board member or managing director expressly agrees with the company on the applicability of the statutory provisions for employees, the following differences in comparison to non-compete covenants with employees should be observed:
- While it is still recommended to agree on non- compete restrictions in writing, there is no legal requirement to do so.
- The term of the non-compete restriction is typically restricted to two years. Under special circumstances, however, non-compete restrictions may be even longer.
- Whether companies may compensate managers with the equivalent of 50% or less of the manager’s fixed salary only is controversial. However,given that there is no (uniform) case law so far, companies should agree with managers (especially with managers whose variable remuneration is rather high) on compensation in the amount of at least 50% of the overall remuneration, including possible bonus payments, allowances and non- cash benefits, to be on the safe side.
- Earnings relating to other professional activities of the manager are not automatically set off against the non-compete compensation.
- If the agreed scope of the post-contractual non-compete covenant is too broad, it will not automatically be reduced to the maximum scope permitted by law. Instead, the whole clause will be considered null and void unless expressly agreed otherwise.
- The company may waive non-compete restrictions at any time, in general even after the end of the service relationship. The parties may agree that the company shall be released from the obligation to compensate the manager within three to six months (rather than one year) after the date of the waiver, subject to the circumstances of the case.
Non-Compete Restrictions for Shareholders
Non-compete restrictions may finally also apply to the shareholders of a company. Since non-compete restrictions arising out of a shareholder’s fiduciary duty generally end once the shareholder leaves the company, post-contractual non-compete restrictions must expressly be provided for in the articles of association or in the shareholders’ agreement. Under German antitrust law, non-compete restrictions for shareholders are only permissible to the extent necessary to prevent a post-contractual weakening of the company due to the loss of valuable information and know-how. As a consequence, according to German case law, post-contractual non-compete covenants may only be negotiated with (i) majority shareholders and (ii) minority shareholders with a certain degree of control over management or with access to sensitive information and know-how. In other cases, a legitimate interest of the company in non-compete restrictions is regularly denied. In addition, in terms of both the factual and geographical scope and the term of the non-compete prohibition, the covenant must not unreasonably hinder the shareholder in his or her freedom of action. In particular, the non-compete prohibition must not extend beyond the business of the enterprise or its territorial extension. With board members and managing directors, the term of the prohibition may generally not exceed a period of two years. Finally, while it is generally recognized that shareholders must be compensated for refraining from competition with the company, the amount of compensation due is still unclear.
In Germany, post-contractual non-compete restrictions may be negotiated with employees as well as with managers and shareholders. While the legal requirements for non-compete restrictions vary, the non-compete clause must always reflect legitimate business interests of the company and not unreasonably hinder the individual in his or her professional advancement. Rather strict requirements regarding the term and scope of the covenant must be observed. In particular, non-compete compensation should be agreed upon, and in the case of employees, the compensation must be at least 50% of the employee’s most recent overall remuneration to comply with statutory requirements. Furthermore, in general, the term of the post-contractual non-compete restriction must not extend beyond two years.