(Note: the following is adapted from materials prepared for Litigating the Business Divorce (BNA, 2016), co-edited and co-authored by Brian Gottesman).
It is fairly common for members or partners (particularly those in managerial positions who contribute intangible benefits, such as know-how or intellectual property) to be bound by restrictive covenants against competition. These contractual provisions may be found in the operating agreement or other governing document itself, or in a separate document such as a contract for employment or shareholders’ agreement. A non-compete provision may be invoked in the context of a business divorce, either as the basis for injunctive relief and monetary damages or as leverage in settlement negotiations. For example, members may offer to declare a non-compete agreement null and void in exchange for monetary or other concessions. However, non-compete provisions are enforceable only within certain equitable and policy-based limitations, which can vary widely from jurisdiction to jurisdiction.
Most states permit covenants not to compete, but “[c]ovenants not to compete when contained in employment agreements are not mechanically enforced.”[1] The majority of states apply a standard that considers whether: (1) the non-compete is valid under ordinary contract principles (i.e., given in exchange for consideration); (2) the economic interest purportedly protected by the covenant is legitimate and genuine, and the non-compete is not broader than necessary to protect that interest; (3) the non-compete is limited to a reasonable geographic and temporal scope; and (4) the non-compete provision implicates or injures the public interest.[2]
Whether a non-compete can be enforced under this standard is a highly fact-specific analysis. A reasonable temporal scope for a particular employee, with a particular set of skills and knowledge, may be entirely unreasonable for an employee with less access to proprietary information or whose company’s information quickly becomes obsolete. Most courts recognize that two years, as a default rule, is a reasonable temporal scope, but this is no guarantee that a shorter period may be mandated in specific cases.[3] Reasonable geographic scope is also highly dependent on factors specific to the industry and the nature of the services provided by the person encumbered by the covenant. In fields where services may be provided remotely from anywhere in the world, a worldwide restriction is generally regarded as enforceable and reasonable.[4]
Similarly, the nature of a “legitimate business interest” may vary widely depending on the specific circumstances. Florida offers guidance with a non-exhaustive statutory catalogue of possible “legitimate business interests”:
1. Trade secrets, as defined in § 688.002(4).
2. Valuable confidential business or professional information that otherwise does not qualify as trade secrets.
3. Substantial relationships with specific prospective or existing customers, patients, or clients.
4. Customer, patient, or client goodwill associated with:
a. An ongoing business or professional practice, by way of trade name, trademark, service mark, or “trade dress”;
b. A specific geographic location; or
c. A specific marketing or trade area.[5]
Many states identify specific industries or fields in which non-compete agreements cannot be enforced because their enforcement would per se be unduly injurious to the public interest. For example, most jurisdictions will not enforce non-compete agreements between attorneys.[6] Moreover, many jurisdictions have enacted statutes that prohibit the enforcement of restrictions on the right of physicians to compete.[7]
California is a notable exception to the general rule as it prohibits by statute the enforcement of non-compete agreements. Subject to a few exceptions set forth in the statute, “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.”[8] Non-compete agreements are enforceable if entered into in connection with the sale or dissolution of a business entity:
Any person who sells the goodwill of a business, or any owner of a business entity selling or otherwise disposing of all of his or her ownership interest in the business entity, or any owner of a business entity that sells (a) all or substantially all of its operating assets together with the goodwill of the business entity, (b) all or substantially all of the operating assets of a division or a subsidiary of the business entity together with the goodwill of that division or subsidiary, or (c) all of the ownership interest of any subsidiary, may agree with the buyer to refrain from carrying on a similar business within a specified geographic area in which the business so sold, or that of the business entity, division, or subsidiary has been carried on, so long as the buyer, or any person deriving title to the goodwill or ownership interest from the buyer, carries on a like business therein.[9]
Thus, while cases in which California courts are willing to enforce non-compete agreements are vanishingly rare,[10] a properly-limited non-compete provision agreed upon in the context of a business divorce may be enforceable even under the state’s restrictive standard:
The purchaser of a business is entitled to negotiate and enforce an agreement by the seller(s) of the business imposing a reasonable restriction on competition by the seller(s) on the theory that such competition would diminish the value of the business which had been purchased. “In order to protect the buyer from that type of ‘unfair’ competition, a covenant not to compete will be enforced to the extent that it is reasonable and necessary in terms of time, activity and territory to protect the buyer's interest.[11]
Traditionally, courts in many states were authorized to “blue-pencil,” or modify the geographic or temporal scope of a restrictive covenant, in the event they found it to be overly broad. In such cases the court would, for example, reduce an unreasonably long period to a more reasonable one, or reduce the geographic scope to accurately reflect the company’s operations.[12] In some states, such as Texas, the right of courts to “blue-pencil” is codified in the statute.[13] However, in recent years this doctrine has come under increasing fire. As one legal scholar put it:
The blue pencil places too heavy of a burden on employees. The blue pencil doctrine permits employers to overreach, and in so doing, harms employees. In many jurisdictions, employers may safely execute contracts that contain unenforceable agreements. The employer then receives what amounts to a free ride on a contractual provision that the employer is well aware would never be enforced. In the words of one commentator, “[t]his smacks of having one's employee's cake, and eating it too.”
The problem is commonly referred to as the in terrorem effect. Blue-penciling of the contract permits an “in terrorem effect on an employee, who must try to interpret the ambiguous provision to decide whether it is prudent, from a standpoint of possible legal liability, to accept a particular job or whether it might be necessary to resist plaintiff's efforts to assert that the provision covers a particular job.” It is true that an employer may try to limit the in terrorem effect of an ambiguous non-compete clause by interpreting it narrowly, but such a “request for limited relief cannot cure what is otherwise a defective non-competition agreement.”
Numerous courts have noted the possible harmful effect of the overly broad covenant. In the case of Reddy v. Community Health Foundation of Man, the Court decried the use of overly broad provisions, “where savage covenants are included in employment contracts so that their overbreadth operates, by in terrorem effect, to subjugate employees unaware of the tentative nature of such a covenant.” Likewise, in Valley Medical Specialists v. Farber, the Court noted that “[f]or every agreement that makes its way to court, many more do not.”[14]
A number of courts have adopted this reasoning in rejecting the “blue-pencil” doctrine and refusing to enforce restrictive covenants with overly broad temporal or geographic scopes. As the Delaware Court of Chancery has held:
It is trite and naive to suggest that low to mid-level employees freely agree to restrictive covenants. Disparities in resources, bargaining power, and access to information undercut that overly simplistic notion—except for senior managers and top-dog executives where the shoe is on the other foot and different agency concerns arise. The employer is a repeat player with strong incentives to invest in legal services, to devise an advantageous non-compete, and to insist that employees sign. For the employer, the marginal costs of imposing a non-compete are low.[15]
Disputes between partners or co-members on more or less even footing are not the same as disputes between the “low to mid-level employees” for whom the Court of Chancery expressed concern. Where there is no evidence of a disparity in bargaining power, non-compete agreements will likely be enforced. Even if the provisions are arguably unreasonable in scope, parties seeking to enforce the non-compete have a reasonable expectation that most courts will be inclined to “blue-pencil” the offending provisions and render them enforceable. However, such parties may expect (and should be prepared to respond to) arguments that the court should not rescue a party from carelessly (or intentionally) overly broad language.
[1] Delaware Exp. Shuttle, Inc. v. Older, 2002 WL 31458243, at *11 (citing McCann Surveyors, Inc. v. Evans, 611 A.2d 1, 3 (Del. Ch. 1987)).
[2] Id., see also, e.g., Analogic Corp. v. Data Translation, Inc., 358 N.E.2d 804, 807 (Mass. 1976); Insulation Corp. of America v. Brobston, 667 A.2d 729,733 (Pa. Super. 1995); Supinsky v. Omni Healthcare, P.A., 856 So.2d 526, 528 (Fla. 5th DCA 2003); Tex. Bus. & C. Code § 15.50; Light v. Central Cellular Co. of Texas, 883 S.W.2d 622,647 (Tex. 1994). Some states substitute an “undue hardship” factor that essentially duplicates the inquiry into reasonableness of temporal and geographic scope. Maw v. Advanced Clinical Comm’n, Inc., 846 A.2d 604, 609 (N.J. 2004); Reliable Fire Equip. Co. v. Arrendondo, 965 N.E.2d 393, 396-97 (Ill. 2011).
[3] See, e.g., Community Hosp. Group, Inc. v. More, 838 A.2d 4721, 484 (N.J. App. 2003), rev’d, 183 N.J. 36 (2005).
[4] Mansol Indus., Inc. v. Singh, 1996 U.S. Dist. LEXIS 22823, at *33 (D.N.J. Sept. 25, 1996).
[5] Fla. Stat. § 542.335.
[6] E.g., Pettingell v. Morrison, Mahoney & Miller, 687 N.E.2d 253, 256-57 (Mass. 1997).
[7] E.g., 6 Del. C. § 2707 (declaring non-compete provisions against physicians and other health care workers void as against public policy, but allowing the enforcement of limited monetary penalties for competition); Mass. Stat. 112 § 12(x); but see Tex. Bus. & C. Code § 15.50(b) (allowing enforcement of non-compete against physicians, subject to requirements of access to patient records and requiring provision allowing buyout at a reasonable price by the physician). Massachusetts and Illinois have additionally declared void restrictive covenant against certain media and broadcasting personnel. Mass. Stat. 149 § 186; 820 Ill. Comp. Stat. § 17/21.
[8] Cal. Bus. & Prof. Code § 16600.
[9] Cal. Bus. & Prof. Code § 16601. See also Id. § 16602-16602.5 (permitting non-compete agreements associated with the sale of partnership or limited liability company interests).
[10] See, e.g., Edwards v. Arthur Andersen LLP, 189 P.3d 285 (Cal. 2008).
[11] Vacco Indus., Inc. v. Van Den Berg, 6 Cal. Rptr. 2d 602, 609 (Cal. App. 4th 1992).
[12] E.g., John Roane, Inc. v. Tweed, 89 A.2d 548, 556 (Del. 1958) (quoting Am. Weekly, Inc. v. Patterson, 16 A.2d 912, 915 (Md. 1940) (“Where the covenant as originally drawn has been found too broad, courts have had no difficulty in restricting it to its proper sphere and enforcing it only to that extent”).
[13] Tex. Bus. & C. Code § 15.51.
[14] Griffin Toronjo Pivateau, “Putting the Blue Pencil Down: An Argument for Specificity in Noncompete Agreements,” 86 Neb. L. Rev. 672, 689-90 (2008) (internal citations omitted).
[15] Delaware Elevator, Inc. v. Williams, 2011 WL 1005181, at *11 (Del. Ch. Mar. 16, 2011) (further holding that “when a restrictive covenant is unreasonable, the court [applying Delaware law] should strike the provision in its entirety”). It is noteworthy that the Court of Chancery found that it had to apply Maryland law to the non-compete at issue in Delaware Elevator, and accordingly that it was compelled to apply the “blue pencil” as mandated by Maryland law.