Can You Enforce an Unreasonable Restrictive Covenant? Maybe, But Don’t Bet on It.
The Connecticut Law Tribune
May 28, 2013
Normally, a court will not question the reasonableness of a contract in determining its enforceability. If you enter into a contract to sell your Mercedes for a dollar, so be it. Covenants not to compete are an exception to this rule. If the contract places unreasonable restrictions on the employee, it will be unenforceable as against public policy. Our analysis today is whether this exception applies only when the employer seeks injunctive relief for a breach, or also in cases for money damages. Common wisdom says it applies in both situations. A New York judge, however, recently stated from the bench that since there was no request for injunctive relief, there was no need to determine reasonableness in order to award money damages. The restrictive covenants in that case included a non-competition clause, a non-solicitation (of employees and clients) clause, and confidentiality requirements. Could this provide an opportunity for employers to maintain “unreasonably restrictive” covenants, as long as they do not seek injunctive relief?
A Loophole for Employers?
Typically, if an employee or former employee breaches a restrictive covenant, such as by starting a competing business, the employer will seek an injunction to prevent the irreparable harm that would occur if clients are taken or goodwill is destroyed. In some cases an injunction is not practical, or damages are more important. For example, an employer who discovers the competition only after its top clients have left may be more interested in damages than injunctive relief. Based on the judge’s comment mentioned above, it would seem the employer could even choose to maintain an overly broad restrictive covenant as a deterrent, provided it will only seek damages in the event of breach.
While the specific judicial standards vary among states, the normal judicial approach involves assessing the restriction for reasonableness on three dimensions: time, scope, and geography. It is up to the employer to demonstrate the reasonableness of the restriction and this is usually a highly litigated point. Often, reasonableness is assessed on the three factors together, allowing an employer to balance a wide geographic restriction with a short timeframe and/or a narrow scope. On top of all this, the employer must have some kind of “protectable interest,” such as confidential proprietary information at stake or client relationships developed at the employer’s expense.
There is a certain appeal to the idea that reasonableness matters only when an injunction is sought. It may be “against public policy” to wield the court’s power to restrict someone from working when the restriction is unreasonable as a matter of law. But it does not necessarily follow that it violates public policy for the court to make the employee pay a monetary price for violating that restriction and denying the employer the benefit of its bargain. Yet, case law to support this distinction is lacking and the concept is virtually unknown on a national level.
Employers should proceed with caution before intentionally adopting an overbroad restrictive covenant, particularly in states where judicial modification of the employment contract is not permitted. However, if an employer has already adopted an overbroad restrictive covenant, it may be possible to have the contract enforced for damages if not for injunctive relief.
Non-Competition Provisions Versus Non-Solicitation Provisions
Another possibility, although not articulated by this judge, perhaps due to the stage of the proceedings, was the judge’s apparent willingness to enforce the non-solicitation provisions (as opposed to the non-compete provisions) and award its attendant damages. In our case, a former employee successfully lured another employee and several top clients away from the company. Perhaps this is what swayed the judge to suggest that the only real issue before the court was the amount of damages. Provisions limiting solicitation of employees and clients are generally enforceable since they are viewed as narrowly tailored and therefore reasonable, although the nature of the industry is an important consideration in this analysis.
For this reason, non-solicitation clauses can be a useful addition to or substitute for a non-compete clause. However, a non-solicitation clause often does not restrict former employees from working with a client who approaches them. If this is a concern, employers can consider a non-compete that restricts former employees from working with or for the company’s employees and clients. It may be appropriate to set this kind of restriction in lieu of using a geographic area to limit competition. An employer is likely to have an easier time proving the reasonableness of this kind of restriction.
Given the current economic climate, it is difficult to prove what is reasonable. Judges may be inclined to be more lenient toward employees in these tough times when getting a job that does not violate the restrictive covenants may be nearly impossible. Employers may find themselves paying a very high cost for industry experts to try to establish the reasonableness of restrictive covenants. Narrowly tailoring the restrictions to protect existing client and employee relationships rather than restricting the employee from competing in the area altogether may be the wiser strategy.
Additional Points to Consider
Seeking damages rather than injunctive relief has its own costs. It can be difficult to prove the amount of lost profits or that the lost profits are attributable to the breach of restrictive covenants. Establishing lost profits will almost certainly require the use of an expert which can be costly and time-consuming. A liquidated damages clause can avoid this, but may preclude injunctive relief (because the breach can be fully remedied through money damages). In addition, a liquidated damages amount must not be so high as to function as an unenforceable “penalty,” nor should the amount be so low as to afford full relief without acting as a deterrent. The choice of whether to use a liquidated damages provision involves tradeoffs; you and your counsel should decide.
Another drafting consideration is to explicitly extend the restrictive covenant period by the length of a breach. For example, if there is a 12-month non-compete and the employee breaches for three months before an injunction is entered, the non-compete can be extended until the end of the fifteenth month. This provides an additional incentive not to breach – even in secret. States take different approaches to this issue, with some courts extending the non-compete period without language in the contract to that effect, some requiring it to be provided for in the contract, and some refusing to enforce contract terms providing for extension as the contract becomes unreasonably long. Connecticut has not said which approach it follows.
A final drafting consideration is an attorneys’ fees provision. Such a provision can provide the most powerful deterrent to competition and a powerful incentive to settle as trial gets closer and fees mount. Even with such a clause, it is unlikely for a court to award full attorneys’ fees to the company if it wins, the prospect of an award of even a significant portion of the attorneys fees incurred can scare the employee (and counsel) into compliance.
Given the uncertainty in how restrictive covenants will be analyzed and enforced, it is best to draft contract terms that are well within the parameters accepted by your local courts. However, if you are a gambler, reasonableness may be irrelevant if only money damages are sought and you may therefore be more aggressive in setting your terms. It is important to be aware of your state’s rules regarding judicial modification of overbroad restrictive covenants to determine how conservative to be in setting parameters. Drafting employment contracts with these litigation hurdles in mind can ensure that restrictive covenants provide real value for the company.