Using Non-Competes When Greater Employee Responsibility = Greater Protectable Interest

by Foley & Lardner LLP

Many employers require new hires to sign non-compete agreements and we have advised previously about best practices for employers to refresh their non-compete terms on a regular basis. A recent decision by a Maryland federal court illustrates a terrific, practical application of one practice to tighten up restrictions on employees after their employment has begun. Though not applicable in all non-complete situations, the case is certainly helpful in the circumstance of a pre-employment non-compete and a second non-compete entered into later as part of an employee incentive compensation plan or some other development providing benefits to the employee.

In the case, the defendant’s former employees held senior positions such as regional vice president, national account manager and director of strategic sales with a company subsidiary. The subsidiary was a national professional staffing company that focused on placing people with high tech and IT skills to government agencies and large government contractors. Each employee signed a non-compete/non-solicitation agreement when hired which prohibited certain post-employment activities relating to the subsidiary’s business and clients. Some of the agreements had 2-year restriction periods, others 18 months. Later on, the employees were selected to participate in an incentive compensation plan offered by the parent company. Each time they were awarded an incentive payment, the employees were required to confirm that they would comply with a 30-month restrictive covenant that was actually broader than their pre-employment restrictive covenant. For example, the incentive plan was designed to promote the interests and economic growth of the parent company and its subsidiaries so the restrictions prohibited soliciting certain clients, staff, “trade, business or goodwill” of the parent and subsidiaries. On the other hand, the earlier covenant only restricted activity related to the subsidiary.

In an example of remarkably bad timing, one of the former employees violated the incentive plan covenant in the final month of the 30-month restricted period. The other defendants engaged in prohibited conduct too, so they defended by asserting that the pre-employment and incentive plan covenants were unenforceable.

In upholding the non-compete and non-solicitation provisions, the court assessed four factors: (1) did that employer have a legally protected interest; (2) were the geographic scope and duration of the covenant broader than reasonably necessary to protect the employer’s interest; (3) did the covenant impose an undue hardship on the employee; and (4) did the covenant violate public policy? The court had no trouble enforcing the geographic scope, which applied to all of the U.S. and Canada, because the companies competed nationally and internationally for business and the former employees’ jobs also had national and international focus.

However, the former employees’ main challenge to the incentive plan’s non-compete was based on the fact that they only worked for the subsidiary, yet the restriction applied to the business and clients of the parent company and its other subsidiaries as well. They argued that the scope of the restriction was too broad to protect the legitimate business interests of the subsidiary. The court disagreed, however, in part because the former employees could still exploit their goodwill from having worked with large customers of the subsidiary years before to compete against the parent and its other subsidiaries because those companies specialized in filling positions in different but related skill areas with the same large government agencies and contractors. In other words, the market and target clients of subsidiary and its related companies overlapped. The court noted that the incentive payment plan was designed to promote the interests of all of the related companies, not just the relevant subsidiary. As such, the legitimate, protectable business interest supporting the incentive plan restrictive covenant was much broader than the legitimate, protectable business interest of the subsidiary.

The case serves as a reminder that courts will scrutinize the business interests that employers seek to protect through the use of restrictive covenants and will test whether the scope of each covenant exceeds the protectable interest. The court’s analysis also shows that an employer can structure a covenant to restrict a departing employee’s ability to compete with subsidiaries and related companies of their employer if appropriately drafted. This strategy can be a powerful tool for employers.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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