What Is a Covenant not to Compete?
Generally, by signing a covenant not to compete, an employee agrees that they will not go to work for the employer’s direct competitors if they leave the employer. The employee will occasionally accept compensation for signing the agreement. Covenants not to compete are also known as “non-compete clauses.”
Businesses that typically use covenants not to compete include those dealing with:
- Highly confidential materials
- Client demographic or information databases that an employee can access
- Companies with a direct competitor
- Trade secrets
- Trademarks and copyrights
Are Covenants Not to Compete Enforceable?
It is hard to determine whether a judge will enforce a non-competition agreement. While the secrets of an employer are useful, the legal system also places importance on an individual’s freedom to pursue other employment. To be enforceable, courts usually require that a covenant not to compete be reasonable.
A covenant not to compete will be considered unreasonable (i.e., not enforceable) when:
- It lasts for too long: Depending on the employer’s trade, a court will decide how much time is appropriate
- The geographic area it covers is too large
- The types of business it covers are too far-reaching
- The covenant usually restricts employment in companies related to the employer’s industry.
- The employer does not have a legitimate business interest in enforcing the covenant not to compete
It is important to note that there will be a new law that governs non-compete agreements that is scheduled to go into effect in 2024 that will be discussed at the end of this article.
What Is an Employment Contract?
An employment contract is an agreement formed between an employer and employee regarding an employment situation. The employer and worker are the parties to the contract. An employment contract includes terms and provisions regarding the employment relationship. For instance, it might state that the employee will work for the employer for a certain number of hours for an hourly wage or yearly salary.
An employment contract might determine benefits, such as paid time off or the provision of health insurance. The contract might state the grounds for termination and how much notice each party must give if they want to terminate the contract.
Employment contracts are not entered into in every employment situation. However, if the employment is not informal, it is usually good to have one. Employment contracts do not have to be written. They can be oral. However, if the parties are serious about the contract, it should probably be in written form. If a conflict occurs between an employer and worker, the contract is available to help resolve it.
Some courts have held that an employee must have time to contemplate the employment contract terms before starting the job. Handing the employee the contract to sign after the employee has begun working or on the first day of the job is probably not a suitable practice. Further, as with any contract, the agreement may not be signed due to duress, coercion, misrepresentation, or undue influence.
A sales representative is a kind of employee who is likely to have a formal written employment contract. The contract might specify the key accounts where the sales representative will sell the employer’s products or services. The contract might also specify other obligations, such as attendance at sales meetings and training sessions. The contract will determine the salary and the commission that the sales representative will be paid. The commission will probably be a percentage of the number of sales the representative completes. The contract is also likely to include sales goals.
Once an employment contract is made, it is binding on both the employer and the worker. This means that if either party fails to perform as promised in the contract, that party can be held legally accountable in court.
Do I Need a Non-Compete Covenant?
Most courts require a “legitimate business interest” for a non-compete covenant. The agreement must not simply punish the worker for leaving or aim to stop normal competition. Non-compete agreements are standard in the technology and sales industries, where protecting secret information and customer relationships is key.
What Criteria Must Be Present in a Non-Compete Covenant?
For a non-compete covenant to be enforced, the agreement must be reasonable.
Several criteria should be present to make it more straightforward for courts to enforce a covenant not to compete:
- Reasonable time restrictions: The period the worker must abstain from competing with their former employer must be reasonable. Reasonableness will vary depending on the industry. In manufacturing and marketing industries, courts have found two-year restrictions reasonable;
- In technology-based industries, courts have held covenants of even one year unreasonable.
- Reasonable geographic scope: Most non-compete covenants will be restricted to the location where the employee worked. National non-compete covenants may be deemed reasonable for industries that operate worldwide;
- Nevertheless, a state that disfavors non-compete covenants, like California, may decline to enforce an out-of-state covenant.
- Narrow class of customers and competitors: The more specific a covenant, the more likely it will be upheld. For instance, restricting the covenant to customers with whom the worker had close contact or positions with substantially comparable duties increases the chances of the covenant being found reasonable.
- Adequate consideration: To be reasonable, an employment contract with a non-compete clause must supply adequate consideration for the clause term. This means the employee must obtain compensation in exchange for agreeing not to compete, either via promotion or raise during employment or compensatory pay upon departure from the business.
What Is Consideration in a Contract?
In a contract, the parties must exchange something of value. They must bargain in this exchange for the contract to be valued. “Something of value” can either be goods or services.
For example, one party may offer a $30 gift certificate for the other’s promise to paint a wall in their home. Note that the parties must bargain for the exchange; they must agree upon the terms before exchanging the service or goods.
Lastly, consideration can also include a promise to perform services or deliver a particular property item. It can also commit not to do something.
Why Is Consideration Important in a Contract?
Without contract consideration, the contract is typically not considered to be valid. The exchange of consideration makes the transaction a contract and not a gift. If one party gives an item or service to the other, the courts consider this a gift.
Note that the consideration delivered must be considered “adequate” for the contract to be legal. For instance, if one party is delivering services worth $2,000, the other party must provide consideration equal to or about equal to $2,000. Past services or actions will not be considered; consideration for fake promises that can never be performed (“illusory promises”) is not valid in contract formation.
What Is the Most Recent Law Governing Non-Compete Agreements?
In April of 2024, the Federal Trade Commission (FTC) voted to enact a law governing non-compete agreements called the Final Rule or Non-Compete Clause Rule. This new law places bans on most types of non-compete agreements.
The Non-Compete Clause Rule will not apply until 120 days after the Federal Register is published. This is a government publication which includes rules and regulations in documents that have general applicability and legal effect.
The Final Rule will not go into effect until August of 2024 or after. At this time, all employers will be required to comply with the new law.
It is advisable for an employer to begin preparing as soon as they can for the possible upcoming changes. It is important for employers to consult with attorneys to make sure they are preparing to comply with the new law when it goes into effect.
There is only one exception that has been provided in this law’s ban on non-compete agreements. The exception to the ban on non-compete agreements is agreements made with senior executives.
This exception was provided because non-compete agreements made with these higher level employees were more likely to have been negotiated than those made with other categories of employees. If a worker was not senior level at the time their agreement was signed, the agreement will not be enforceable once the new law takes effect.
The employer will have to provide all of their workers who signed non-compete agreements with notification that the agreement can no longer be enforced. These changes may also require that employers completely rewrite or at least revise the employment agreements they currently use.
How Does this Affect State Laws?
The Non-Compete Clause Rule is a federal law, which preempts any state laws that conflict with it. If a state law does not conflict with the new rule, it will not be affected.
If, however, a state has laws that allow non-compete agreements, those will be preempted by the new law.
What if the Final Rule Is Challenged in Court?
This new rule is likely to be challenged or interpreted by a court or courts in the future. This law includes a severability clause, which means that, if any part of the rule is deemed unenforceable or is invalidated by a court, the remainder of the rule will remain in effect.
It may also be possible that the rule is struck down in the future. Because of these different possibilities, it is very important for all employers who provided non-compete agreements to their employees to consult with attorneys to make sure they are complying with the new law and its changes.
If a party is in a case involving non-compete agreements, it is essential to be aware that changes are likely to occur and the consequences they may have on the case. It is important for parties to prepare for possible changes so that proper arguments are made in court to cover all of the legal possibilities.
All parties should ask their lawyers to keep them updated regarding any changes that are made to the Non-Compete Clause Rule throughout the year 2024 and into the future.
Do I Still Need to Know about the Previous Non-Compete Agreement Laws?
It is essential to be aware of both the previous non-compete agreement laws and the new laws that will take effect. The area of law governing non-compete agreements is currently undergoing changes and will be doing so for the foreseeable future.
Employers need to prepare for every possibility and how the changes may affect their business. Lawyers can help employers draft and edit employment agreements to ensure that they comply with the Final Rule.
Should I Consult an Attorney?
An experienced contract attorney can help draft a covenant not to compete or negotiate the terms of the agreement. An attorney can also advise your right to sue an employee for breaching a covenant not to compete.
