Protect Your Assets: Covenants Not to Compete and Nondisclosure Agreements
August 23, 2007
Business owners often take many different precautions to protect their tangible assets, such as purchasing liability insurance and installing security systems. Part of protecting your business interests and securing a profitable future is hiring trusted employees. Unfortunately, old-fashioned trustworthiness only goes so far in protecting confidential information and maintaining a competitive edge that is often crucial to the survival of a small business.
Hence, many business owners take advantage of certain contractual arrangements that ensure promises by employees not to unfairly compete with the employer and not to disclose or use confidential information gained while working for the employer. These contracts can be effective tools for protecting one’s business interests. Thus, when business owners consider how best to protect their tangible assets, they would do well to consider using covenants not to compete (also called non-compete agreements) and nondisclosure agreements.
Non-compete Agreements: Preventing Unfair CompetitionA non-compete agreement can be an effective tool to prevent your managers from stealing your customers after they leave your employ. Covenants not to compete customarily require an employee not to work or compete in the same type of business in a certain area for a specified period of time. Non-compete agreements apply to post-employment behavior. Most states recognize the common law duty of loyalty, which requires employees to act in their employer’s best interests while they are employed.
Covenants not to compete are typically used with those employees who have significant responsibilities, customer contacts and/or the ability to compete after separation of employment, such as managers or salespeople. Most states will reject these contracts if they are used in an attempt to prevent competition by lower-level employees. In Colorado, the legislature has restricted the use of non-compete agreements to executive and management personnel and officers of a business (with some exceptions).
As an example, a non-compete agreement might provide that a manager at a cleaning and restoration business cannot compete with the employer in the same type of business for a period of two years and within 100 miles of the employer’s business after the employment relationship has ended. This means that, when the manager leaves, he or she cannot engage in competition with the former employer – as an employee of a competitor or in a start-up business of his or her own – for two years and within the provided geographic area. The former manager would instead have to work in a different type of business, work outside the stated geographic boundary or wait two years before competing.
Covenants not to compete are considered restraints on trade, and their enforceability varies widely from state to state. Therefore, it is important for a business owner to seek the advice of legal counsel before introducing these agreements into his or her business. Indeed, in some states, such as California, courts invalidate almost all non-compete agreements except in narrow circumstances established by the legislature (e.g., purchasing a business and the goodwill that comes with it). Many states, like Colorado, generally disfavor these types of contracts in employment situations, but the courts will usually enforce them if the terms are reasonable and they fall within certain statutory exceptions. Other states, such as New Mexico, readily enforce covenants not to compete – again, as long as the terms are reasonable.
So, what is reasonable? There are general guidelines that most state courts follow when determining whether a non-compete agreement is reasonable and enforceable against the former employee: covenants not to compete must contain an exchange of consideration between the employer and the employee; the limitations should be no broader or longer than is reasonably necessary for the protection of the employer’s business; the restrictions should not impose undue hardship on the employee, and they should not harm the public interest.
First, a covenant not to compete is a contract, and thus the parties must exchange consideration. In other words, there must be some sort of benefit or promise flowing to the employee who is agreeing not to compete. Some states allow the promise of at-will employment to qualify as consideration to support a non-compete agreement. Most employees do not have employment contracts and are not members of a union, and thus are considered at-will employees. Under at-will employment, either the employer or the employee may terminate the employment relationship at any time with or without cause. Nevertheless, some states allow a job offer or a promise of continued at-will employment to supply the necessary consideration.
Other states find, however, that continued at-will employment is an illusory promise and not sufficient consideration to support a covenant not to compete. The rationale is that any promise dependent on a continued interval of employment in an at-will situation is illusory-unless the consideration for any promise is enforceable even if the employee resigns or is fired. For example, a promise to give a raise in two months is illusory because the employment relationship could be terminated before that time.
In these states, the employer will usually have to provide some sort of monetary compensation in exchange for the employee’s signature on a covenant not to compete. A one-time bonus will often be effective. In some states, even $1 will suffice, although in others the consideration must bear a rational relationship to what the employee is giving up and how important the agreement is to the business owner (i.e., a court might find that it must not be very important to the employer if it’s only worth $1 to prevent the employee from competing for a year or two). In the latter jurisdictions, a more substantial bonus would be required.
Second, the restraints contained in a covenant not to compete must be reasonable. Typically, restraints are unreasonable if they are broader than necessary to protect the legitimate interests of the employer. For example, a restraint on customer solicitation is usually overbroad and unreasonable when it extends to customers with whom the employee had no dealings during his employment. The risk of unfair competition is greatest when it involves customers with whom the former employee had significant contact.
Accordingly, geographic restraints usually should be limited to the territory or areas in which the employee made contacts with customers during employment. States and the individual cases therein vary widely, but generally, covenants not to compete within a 100-mile radius or within a specific county or metropolitan area have been enforced. Some courts have allowed more expansive restrictions if there are large areas where the employer’s customers are located and the employee had extensive contact with those customers. Temporal restraints usually should be limited to 1-3 years depending on the circumstances, such as the nature of the employer’s business, the subject matter, the people served and the situation of the parties.
Third, if the covenant not to compete places an undue restriction on the ability of the employee to earn a living, it will usually be found unreasonable. Some courts ask whether the agreement prevents the employee from simply accepting employment in a competing business and there is no real risk of competition in violation of the agreement (i.e., the former employee accepts a position with a competitor that involves a different type of work so the employee is not actually competing).
A former employee who has to move to a different city or state to continue working in the same type of business might claim that the non-compete agreement creates an undue burden. Uprooting a family and forcing them to relocate sounds burdensome, but the former employee is obligated to abide by his or her contractual obligations. However, if the employee’s skills are so specialized that he or she cannot find a job anywhere else, a court would probably invalidate the covenant not to compete.
Fourth, state courts have held that the public has an interest in seeing that competition is not unreasonably limited or restricted, but it also has an interest in protecting the freedom of persons to contract and in enforcing contractual rights and obligations. In this vein, some courts consider whether the public is unfairly deprived of the employee’s special skills or services. Overall, equity may dictate that a court refuse to enforce a covenant not to compete if great hardships will be imposed on the employee and relatively small benefits will accrue to the employer.
If you choose to make use of covenants not to compete in your business, you can start by requiring newly hired managers to sign them as a condition of the offer of employment. If monetary consideration is required by the laws of your state, you can provide a sign-on bonus in exchange for the employee’s agreement not to compete. Introducing these agreements to current employees involves more difficult
considerations, especially with managers who have been a part of the business for several years. This can require a business owner to walk a fine line. Treading lightly with respect and helping the employee to understand that the contract is a legal necessity and not a sign of distrust is important. A bonus usually doesn’t hurt either. But a trusted employee who has been with the company for many years can often do the most damage if the employment relationship ever sours in the future.
If a manager refuses to sign, you’ll have to decide the consequences of such a refusal. Your reaction – whether you drop it or discipline the employee or even terminate employment – depends on the importance of getting the manager to sign the non-compete agreement, whether the employee is easily replaceable, the effect on the bottom line and other considerations. Of course, the laws of your state will also play a role (e.g., in California, you cannot terminate an employee for failing to enter into a covenant not to compete because such contracts are against public policy).
Despite the varied treatment of these contracts in employment situations, covenants not to compete can be an effective tool to protect your business interests and maintain a level playing field. Even if a non-compete agreement will not be enforced by a court, it might serve as a sufficient deterrent to prevent a former manager from partaking in unfair competition in the first place. And it places your managers and executive employees on notice of what behavior embarks on unfair competition in violation of their contractual responsibilities. It also places future employers on notice that they cannot unfairly profit from your former employee’s inside knowledge at the expense of your business.
If you utilize covenants not to compete in your business and a former employee subject to such a contract engages in activity in violation of the agreement, you should contact your attorney as soon as possible. The first step is usually to send a cease-and-desist letter to the former employee and, if the person is employed by a competitor, the new employer. This letter will usually demand that the competitive actions in violation of the contract must stop immediately. If the demand letter fails to accomplish its task, you will likely have to file for a preliminary injunction in court to bring an end to the former employee’s breaches of the contract.
Full-fledged litigation might ensue, which can be costly. How far you proceed through the legal system usually depends on a cost-benefit analysis, considering the potential loss of revenue due to the former employee’s actions against the time and expense to achieve court enforcement of the covenant not to compete. If litigation is not worth it, then unfortunately the covenant not to compete did not serve as a sufficient deterrent to prevent that employee from competing unfairly. But at least with the non-compete agreement you were able to make that decision. And in most cases, a covenant not to compete will effectively deter unfair competitive behavior because the former employee will respect his or her contractual obligations.
As noted above, some states have strong public policies that militate against enforcing covenants not to compete, while others readily enforce such agreements. Some state courts will revise the terms or scope of an unreasonable covenant not to compete so that it is no longer unreasonable in its application. There are no hard and fast rules to predict what restrictions a particular court will find reasonable. These issues are decided on a case-by-case basis. Therefore, if you decide to use non-compete agreements in your business, you should consult an attorney.
Nondisclosure Agreements: Protection of Trade SecretsBusinesses large and small rely heavily on customer lists and confidential information. It is imperative that business owners take steps to secure these important assets. Covenants not to compete can be used to protect trade secrets, but due to the questions about their enforceability in many jurisdictions and their usual application to management personnel only, they are not the most effective tool for this purpose. A restriction on competition will usually not be upheld where an agreement prohibiting disclosure of trade secrets will adequately protect the employer. Therefore, a nondisclosure agreement is better suited to protect your confidential information and can be used with all of your employees.
Employers have a vested interest in protecting their confidential information and trade secrets. Many states have adopted a version of the Uniform Trade Secrets Act. These laws generally prohibit a person from acquiring a trade secret by improper means, disclosing a trade secret without consent or using it without consent (also known as misappropriation of a trade secret). Trade secrets can include scientific or technical information; a design, process, procedure, formula, improvement, business strategy, confidential business or financial information; listings of names, addresses, or telephone numbers, or other information relating to the business that is secret and of value. A trade secret is information that gives a business an opportunity to obtain an advantage over competitors who do not know it or use it.
What constitutes a trade secret depends on several factors, including the extent to which the information is known outside the business; the extent to which it is known to those inside the business (i.e., amongst employees); the precautions taken by the business to guard the secrecy of the information; the savings effected and the value to the business in having the information as compared to competitors; the amount of effort or money expended in obtaining and developing the information and the amount of time and expense it would take for others to acquire and duplicate the information. Most courts look at the totality of the factors.
Confidential information acquired by an employee during the course of employment may be protected as a trade secret, but general knowledge of business operations usually does not qualify for trade secret status. The general ability and know-how an employee brings to an employer and the skill and experience acquired during employment are not the employer’s property. Information about special training provided to an employee can often be protected.
Something as basic as a bid on a contract can be protected as a trade secret if the above-mentioned factors are met. The most common trade secret is a customer list, although such lists don’t necessarily constitute a trade secret or confidential information, especially where the identities of the customers are common knowledge in the industry or easily accessible to competitors.
A business must take measures to maintain secrecy and prevent confidential information from becoming available to persons other than those selected by the employer to have access to it. For example, a business can protect the trade secret status of a customer list by keeping the customer contact information in a locked cabinet accessible to only a select few employees, or in a file on a computer that requires a password known only by a limited number of employees. Customer lists that are readily obtainable from other sources, such as the white pages of a telephone book, are not trade secrets.
Most trade secret statutes provide for the ability to obtain temporary injunctive relief because the protection of a trade secret may require immediate action. In addition to stopping the misappropriation of a trade secret through a civil action, some states provide for criminal prosecution for misappropriation of a trade secret as theft.
Today, most employers use employee or personnel handbooks. A copy should be provided to every employee. The best way to use nondisclosure agreements in your business is to include them in your employee handbooks. Every employee should sign the nondisclosure agreement and the acknowledgment form (acknowledging receipt of the handbook and an understanding of its content). Some businesses include the employee’s acceptance of his or her trade secret nondisclosure obligations on the handbook acknowledgment form.
However it is provided to employees, use of a nondisclosure agreement imparts to every employee the knowledge that your business uses confidential information and that it is important to protect that information. Such agreements also explain the employee’s responsibilities when using trade secrets. Without the use of nondisclosure agreements, what you consider confidential information may not be afforded the protection of your state’s trade secret laws. As with any contract, you should consult with legal counsel before using nondisclosure agreements.