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.” 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.
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. 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.
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.
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.” 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.
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.
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.”
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.
 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).