Legally enforceable restrictive covenants provide significant advantages to employers, protecting against the loss of employees and clients and the unauthorised disclosure of confidential information. In fact, such covenants have become essential to employers operating in jurisdictions where attracting and retaining talent is difficult due to economic conditions or mobility rights or where the organisation operates primarily as a result of information or processes that are proprietary to it. Reputation risks may also be minimised through the use of restrictive covenants, protecting organisations from the disclosure of information that could harm its public reputation or give rise to legal liability.
This global employment and labour law update considers the approaches that have been taken internationally to the use of restrictive covenants, including whether such clauses are upheld when challenged by departing employees and their new employers. The existing approaches and experiences in Canada, England and Wales, The People’s Republic of China (Mainland China), Hong Kong, France, Australia, Germany and South Africa are all discussed.
A brief overview
Restrictive covenants generally take one of three forms: a non-solicitation provision; a non-competition provision or a provision guarding against the disclosure of confidential information to third parties.
The importance of the distinction between the first two types of restrictive covenant is important: a non-solicitation provision prevents a current or former employee from approaching co-workers or clients of the organisation for the purpose of securing their employment or business; a non-competition provision prevents a current or former employee from working for competing employers or for an employer engaged in a similar industry to the one in which the employee is currently employed.
In some jurisdictions, Canada as an example, non-solicitation provisions are more favourably perceived by the courts than are non-competition clauses. The rationale generally employed by the Canadian courts is that the employer’s legitimate business interests are adequately protected by prohibitions on the solicitation of employees and clients of the former employer, rendering the need for a non-competition clause unnecessary. By contrast, in Australia, courts have expressly recognised that non-solicitation clauses may be insufficient to protect an employer’s legitimate business interests.
Clarity in drafting is important in all jurisdictions. For example, in Canada, the United Kingdom and South Africa, courts will generally not re-draft an improperly written restrictive covenant. Rather, the court will strike out the covenant as broader than necessary to protect an employer’s legitimate business interests and therefore unenforceable.
The concept of legitimate business interests is an important one across jurisdictions. Restrictive covenants are often described as covenants “in restraint of trade” and therefore prima facie unenforceable. As a result, when called upon to evaluate the enforceability of restrictive covenants, courts will generally weigh the extent of the restriction imposed upon the employee (e.g. to accept other employment opportunities) as against the business interest that the covenant is meant to protect. Where the covenant is found to restrict the employee’s economic interests beyond what is necessary to protect the employer’s interests, the risk that the covenant will be struck down is increased significantly. However, in South Africa the courts take a decidedly different approach. There, restrictive covenants are prima facie enforceable with the onus on the party seeking to challenge the covenant to prove that it is unenforceable
Trends in the enforcement of restrictive covenants
To be enforceable, restrictive covenants should be contained in the employment contract or other legally enforceable agreement and, in most jurisdictions, signed prior to the commencement of employment. On occasion an employee will become bound to a restrictive covenant during the course of an agreement to purchase an organisation in which the employee was a shareholder or executive. In this latter case, the employee generally has agreed to be bound by the restrictive covenant in exchange for the consideration provided to them in the sale transaction.
It appears that the use of restrictive covenants has increased given the recent downturn in global financial conditions. Employers are more attuned to the need to retain top talent in order to forestall the negative effects of the global economic environment within their organisations. The loss of key employees can be detrimental to the ability of the organisation to do that. For example, departing employees may take valuable business contacts with them to their new employers, resulting in a loss of market presence for the former employer. In jurisdictions where there are a lack of qualified young professionals, restrictive covenants can stem the loss of a key demographic to competitor organisations.
The use and enforcement of restrictive covenants can be driven by local and cultural norms. For example in Japan, employment is often characterised by lifelong employment with a single employer and high levels of employee loyalty and commitment to the organisation. Given the culture of the Japanese workplace, restraints of trade in employment contracts have typically only been found in the contracts of senior executives, although, keeping with global trends, they are becoming increasingly common with lower level employees in sensitive positions.
Employers in South Africa have recently adopted a more cautious approach to the enforcement of restrictive covenants. Employers will strictly scrutinise whether they can establish a protectable or proprietary interest given that the significant legal costs incurred in bringing an urgent application may only be justifiable where there is an imminent threat that the business will suffer irreparable harm if the restraint is not enforced.
Enforcing employee restraints of trade
Across jurisdictions, employees are prohibited from competing against their employer, soliciting opportunities away from their employer and disclosing confidential information about their employer during the course of employment. In Mainland China, where the legislation is more general and less clear, employers tend to stipulate restrictions and requirements on competition, confidentiality and solicitation in employment related contracts. Note as well, in Mainland China, an employee can be terminated without notice or pay in lieu thereof if he or she refuses to terminate an outside employment relationship that seriously impacts upon his or her performance to the primary employer or that competes with the primary employer.
In order to be permitted to enforce covenants prohibiting the disclosure of confidential information or restricting competition or solicitation after employment, employers must generally adhere to the following key principles:
- restrictive covenants must be agreed to prior to the commencement of the employment relationship, either as a term of the employment agreement or by virtue of a legally enforceable separate written agreement;
- restrictive covenants must be of limited duration, generally only existing as long as is required to protect the business interest of the employer;
- non-competition covenants must be of limited geographic scope and should generally preclude re-employment only in respect of the former employer’s industry or specialised enterprise;
- restrictive covenants must protect a legitimate business interest, such as: trade secrets and confidential information; connections with customers, prospective customers and suppliers; and the stability of the workforce, especially where an employee has a significant role within the organisation.
Some regional anomalies do exist. For example, in Germany, an employee must be given an original signed copy of the agreement containing the restrictive covenant in order for it to be enforceable. In both Germany and France, payments to the employee must be made during the period of restraint in order to maintain the enforceability of the prohibition against competition or solicitation. In Germany such payments must amount to at least 50% of the employee’s compensation immediately prior to the end of the employment relationship (including all fixed and variable payments and benefits in kind), must be made during the restraint period and must also be explicitly addressed in the agreement evidencing the restrictive covenant. In France and Germany, when these conditions are not met, the employee can claim the payment of damages for the loss suffered due to being held by an invalid restrictive covenant. The exception in Germany arises when the employee chooses not to be bound by the restrictive covenant after employment ends. In such a case, the employee forfeits the payments that would otherwise be made during the restraint period. In Australia, the United Kingdom and in Canada, a restrictive covenant can be entered into during the employment relationship but consideration will have to be provided in exchange for the agreement to be binding, for example, by offering a promotion or a salary increase. In Mainland China, the non-competition period must not extend more than two years after employment terminates and the restriction may only be binding on the employee if the employer pays compensation to the employee on a monthly basis during this restricted period. Lump sum payments or payments in-kind may also be recognised by the courts.
Employer and employee strategies when enforcing restraints of trade
Without a restrictive covenant, an employee can better bargain for improved terms and conditions of employment, the threat being that the employee will depart the organisation without increased compensation or perquisites. To that end, employees continue to resist the imposition of restrictive covenants on the basis that they wish to maximise their mobility rights and their ability to seek out and accept new employment on improved terms.
Where disputes arise, there are two primary methods of enforcing restrictive covenants:
- obtaining an injunction against a departing employee; and
- instituting legal proceedings for breach of contract against the departing employee and his or her new employer.
Creative employers have taken other approaches to preventing competition and solicitation post-employment. These strategies have in some cases avoided the potential for legal disputes about the enforceability of restrictive covenants.
For example, in Germany, employers will often provide employees with extended working notice periods on termination. This approach avoids the complexity of introducing a non-solicitation or non-competition covenant into the employment agreement (and avoids the problems arising where no such covenants exist) because employees are obligated at law not to act against the interests of their employer during employment. This approach also gives the employer the practical and financial flexibility to negotiate working notice periods that correspond to the business needs of the organisation on a case by case basis. A variation of this approach, commonly known as “gardening leave” exists in Australia and the United Kingdom where employers are increasingly providing employees with notice periods during which the employee is not required to attend the workplace. The employee is paid their normal salary and continues to be bound by the terms of the contract for the notice period.
In other jurisdictions, and specifically the United Kingdom, the financial crisis has precluded the movement of some employees as a result of stagnant employment markets. The result has been that employees remain in their employment for longer periods of time and, therefore, there has been less focus on restraint of trade provisions for individual employees and fewer disputes about their enforceability. However, especially within the financial services sector, there has been a trend towards protecting against “team moves”. In this respect, employers have been reviewing restrictive covenants carefully and have been including “team move” provisions in their senior employees’ contracts. These provisions usually place an obligation on the employee to report to their employer if they are planning to coordinate or participate in a team move or if they are aware of any other senior employees who are planning to do so.
Controversially, there has also been a trend in employers inserting “no show” provisions into contracts of employment for newly hired employees. These clauses usually place an obligation on the new recruit to pay liquidated damages to the employer if he or she subsequently reneges on the employment contract post-signature. These provisions have mainly been used for senior executives in the financial services sector where poaching has proved to be a problem. The English courts have held that, subject to certain requirements, restrictions of this type are enforceable against employees. It bears noting that any judgment obtained against a “no show” employee would still have to be collected after trial.
In some jurisdictions, employers are inserting provisions into contracts of employment that provide for the reduction or return of retirement allowances from former employees who breach their restrictive covenants after departing the organisation. These contractual provisions act as a means of enforcing the restrictive covenant by the imposition of financial penalties, although conceivably, legal recourse would be required if there was a dispute as to whether the restrictive covenant was actually breached or in the event that an employee was unwilling or unable to return the retirement allowance. Again, any judgement obtained against the employee would have to be collected after trial.
Depending upon the financial resources of the former employee, collection proceedings may be difficult. Notably, it would be unlawful to undertake this approach in France and may be unlawful in other jurisdictions where statute or the courts preclude such an approach. For example, in Australia, retirement benefits are facilitated through statutorily recognised third-party trust arrangements; therefore, repayment by the employee of those benefits is not possible.
The Courts’ approach to enforcing employee restraints of trade
Across jurisdictions, courts have generally been very strict in their enforcement of restrictive covenants, strictly interpreting what constitutes a “legitimate business interest” and what is reasonably necessary to protect such an interest. In this regard, the courts largely consider whether a restrictive covenant is sufficiently limited in respect of its duration and the geographic jurisdiction across which prohibited behaviour is restrained. Somewhat uniquely, in France, non-competition and non-solicitation of client clauses will only be found to be enforceable where monetary consideration accompanies the agreement of the employee to be bound by such provisions.
In some jurisdictions, the United Kingdom and Canada notably, the courts have relaxed their strict approach toward the enforcement of restrictive covenants where the departing employees have been determined to be more senior and sophisticated employees who have had strong bargaining positions in employment negotiations.
In Australia, there have been some cases where the courts have enforced restraints against less senior or sophisticated employees where the individual has had a significant connection with the customers or is recognised as the “face” of the business.
In Canada, recent decisions of the courts have found that employers who breach the employment contract by terminating an employee without cause and without reasonable notice of the termination may not be entitled to rely on restrictive covenants. This has been the case even where the covenants have otherwise been properly drafted. Canadian employers are well served to review the terms and conditions of contracts of employment prior to terminating their employees should they wish. Likewise, in the United Kingdom, where an employer terminates the employment contract in breach of its terms, he or she will not be able to rely on any restrictive covenants contained in it after termination.
The courts of Mainland China are generally protective of the interests of employees, requiring employers to clearly document any restrictions on solicitation or competition in compliance with applicable laws and regulations and to have clear evidence proving breaches of their obligations.
Although regional differences in the application and enforceability of restrictive covenants exist, globally, restrictive covenants have been recognised as providing significant business and economic advantages to employers. This is especially the case in jurisdictions where personnel may be difficult to attract or retain. While it bears noting that legal requirements vary between jurisdictions and careful analysis of the local business and legal requirements must be considered to ensure enforceability, where properly drafted, such clauses can result in definable benefits for business.