Covenants not to compete, or “noncompetes,” provide an important tool chemical manufacturers can use to protect intellectual property that can otherwise migrate with employees. Personnel to whom a confidential formula or technologies are disclosed, or who receive special training, are frequently required to sign noncompete covenants. These covenants typically prohibit employees from competing with their current employers for a given period into the future.
What employers do not always realize is that their interests may not be sufficiently protected by simply rolling out a covenant not to compete that complies with the legal requirements in the employer’s home state or the employee’s principal state of employment. First, in this day and age, most businesses can be subject to competition from a former employee resident in another state. If business can be conducted via the Internet, a business needs to consider the possible effect of other states’ laws on its noncompetes.
Second, as a long-anticipated decision from the Texas Supreme Court reminds us, different states have very different rules about the enforcement of noncompetes. California, for example, will enforce noncompetes, by statute, only in extremely narrow circumstances. In the great majority of states where the agreements are enforced, the laws vary substantially and, as discussed below, companies and employees cannot simply overcome those variations by agreeing to the law of a particular state. Perhaps the most important variation from state to state is on the subject of what constitutes sufficient contractual consideration to support a noncompete. While the Texas Supreme Court recently reexamined, and to some degree relaxed, the state’s consideration requirement, Texas remains a significant hazard to navigation for many employers seeking to implement noncompete agreements. In Alex Sheshunoff Management Services v. Johnson (Tex. Sup. Ct., Oct. 20, 2006), the court held that a covenant not to compete can become enforceable when an employer provides confidential information or specialized training to an employee, even if that occurs at some point after the employee signs the agreement.
Previously, for a noncompete to be enforceable in Texas, an employer had to unconditionally agree to give the employee confidential information or specialized training, or provide that information or training to the employee at the moment the covenant was signed. Texas courts took the view that a promise to provide confidential information or training in the future was illusory in the context of an atwill relationship because the employer could avoid the obligation by firing the employee at any time.
The Sheshunoff court ruled that in an at-will employment relationship, a noncompete provided in exchange for a promise to provide future confidential information becomes enforceable when the employer actually provides that information to the employee. This modified approach greatly facilitates the creation of covenants that will be enforceable in Texas.
Even now, though, under Texas law any noncompete must be ancillary to the employee’s promise to maintain the information as confidential, and the covenant must be designed to enforce the employee’s consideration or promise not to disclose or use the information. This is still more complicated than the consideration requirements in most states and noncompetes that pass muster in many states may not be enforced in Texas.
In many states, mere continued employment, i.e., the privilege of coming to work the next day, is sufficient consideration for a noncompete, as found, for example, in Lake Land Employment Group of Akron, LLC v. Columber, 101 Ohio St. 3d 242 (2004). In these states, an employer may flatly require employees to sign noncompetes even after many years of employment and the noncompetes will still be enforceable.
In many other states, continuing employment is not sufficient but the commencement of an employment relationship, even an at-will relationship, is. In these states, employers must provide some additional consideration if they seek to enter into a noncompete in the midst of an employment relationship. See, for example, Labriola v. Pollard Group, Inc., 152 Wash. 2d 828 (2004). Another important issue is whether courts will modify overly broad noncompetes, narrowing them to make them enforceable. Such modification is permissible in Michigan under Mich. Comp. Laws §445.744a(1). However, in states where courts may not make such modifications, such as Wisconsin (Wisc. Ann. Stat. §103.465), where a court finds a noncompete to be overly broad, the former employer is left with no noncompete protection at all. Many states fall somewhere in between – they will modify agreements provided that those agreements are at least initially reasonable, but they will not entirely rewrite them. See, for example, Freiburger v. J-U-B Engineers, Inc., 141 Id. 415 (2005). Others will “blue pencil” agreements, i.e., strike offending language but not go so far as to add corrective language, as in Bridgestone/Firestone, Inc. v. Lockhart, 5 F. Supp. 2d 667 (S.D. Ind. 1998).
Thus, it is critical for employers to anticipate the possibility that their agreement might be scrutinized under the law of such a state and consider the likely impact of these various rules. While many companies may assume they can use a choice of law provision to select the state’s law they want applied to a noncompete agreement, thereby avoiding application of unfavorable law, it is not always that simple. Choice of law and forum clauses are indeed critical aspects of noncompete agreements, but if an action is brought in another state, the other state’s court may choose not to enforce the clauses.
One scenario: A former employer in State A sends a letter to a former employee, reminding the former employee of his contractual obligations and threatening to file a lawsuit if he does not cease his new employment in State B with a competitor of the former employer. Believing litigation to be inevitable under the circumstances, the employee and his new employer institute litigation themselves, in State B, seeking a declaratory judgment that the noncompete is not enforceable. Applying choice of law principles, the court in State B finds that the law of State A offends the public policy of State B. Therefore, State B’s courts will not enforce the law and forum selection clauses. The court applies the less favorable (to the former employer) law of State B and declares the noncompete to be unenforceable. See, for example, Frame v. Merrill Lynch, Pierce, Fenner & Smith, 20 Cal. App. 3d 668 (1971) (declining to follow a New York choice of law provision).
In short, if a current or former employee can compete with a company in a particular state, then that company needs to consider how the laws of that state might affect its noncompete agreements. Balancing the variations among many states’ laws with an understandable desire to treat employees consistently across geographic lines can be a delicate task, but, as the somewhat unusual laws of Texas demonstrate, it is a necessary process for employers seeking to properly protect their intellectual assets.
Key practice points for multi-state noncompete programs
Choose law and forum strategically. Since laws vary from state to state, the location of the litigation and the state’s law being applied can be critical. In most cases, these issues should be addressed in the noncompete. Consider every state where you are in competition. There are situations in which the choices of law and forum may not be honored, particularly by out-of-state courts. It is critical to at least know the rules in every state where the company is engaged in competition.
Strive for similarity for similar employees. The scope of a noncompete makes a statement about the company’s determination of its business needs. If a similar employee in another state is subject to fewer restrictions, it can create litigation issues. Often (though not always), particular states’ rules can be incorporated in a “standard” agreement without causing difficulties in other states.
California is different. California and a few other states, with very few exceptions, do not recognize noncompetes. Companies doing business in these states may need different agreements in those states, but in any event should squarely address these issues in the planning stages.
Reasonably tailor restrictions to business needs. Some states will revise restrictions found to be overbroad so as to make them enforceable, but some will not – and the result of an overly broad restriction can mean the enforcing employer is left with nothing. There may be other strategic reasons to take a more aggressive approach to restrictions, but many employers find that narrower restrictions prove most effective in the long run.
Transitions are tricky. Changes to a company’s noncompete program, even if only to enlist current employees who “fell through the cracks,” can raise consideration issues. Some states require something in addition to continuing employment to support a noncompete. This, in turn, can raise fairness questions for current employees or similar employees in other states who did not receive any consideration for their noncompete. Again, anticipating these situations and making informed judgment calls is critical.
Back it up with a strong trade secrets program. While noncompetes can be uniquely effective in protecting a company’s business resources, employers should not consider them a substitute for vigilance over confidential information through limiting access to those with a strict need to know, training and communication on protecting confidential information, proper monitoring, and confidentiality acknowledgements and agreements