United States: Court Ruling May Herald Next Step In Evolution Of Restraint Of Trade Law

The recent federal district court decision in EarthWeb, Inc. v. Schlack¹ has generated a great deal of attention and discussion, and its impact may be broad. Judge William Pauley’s opinion, emphasizing more than once the rapid changing character of Internet industries² suggests that E-commerce industries, and probably other high technology fields as well, may be on the verge of an evolutionary shift (if it has not already taken place)³ for purposes of the law relating to the maximum duration of enforceable noncompete agreements. This change may also reach into other aspects of competition law where the dimension of time is an important factor. One example might be merger analysis, where otherwise problematic mergers will be approved if entry of new competitors is likely to restore competitive conditions in a reasonable period of time. In this respect, the federal government’s horizontal merger guidelines generally define a two-year entry process as timely. But is two years the appropriate benchmark in E-commerce industries? If not, the presumptive two-year time period may require some rethinking.⁴

The EarthWeb case is likely to have important and immediate practical ramifications for agreements of companies operating in E-commerce. These businesses will have to reevaluate the nature and scope of covenants not to compete both in employment agreements and in restraints ancillary to the sale of a business. Given the rapidity of change in their world, they may have to reduce the time limits involved in those restrictions to have a reliable expectation of having them enforced. For non-compete clauses in employment agreements, the message from the judicial system seems clear: rapid changes in an industry may mean that former employees can do less harm to their former employers, but employees who are locked out of work for even a few months may suffer acutely.

These and other businesses also may be affected if antitrust enforcers and courts focus on the ability of the Internet to foment rapid changes in competitive conditions and limit their intervention in appropriate cases in favor of allowing the quickly adaptable marketplace (or, to use Judge Pauley’s words, the "fluid," "evolving," and "dynamic" marketplace) to correct itself. As regulators recognize that market entrants may rapidly change industries when they begin to compete, the regulators may entertain making fewer challenges to mergers, acquisitions, and other arrangements in E-commerce industries. But analysis in this regard will be a good deal more complex than simply identifying the industry in question as "Internet-related." Most industries today have some Internet facets, but face entry and other competitive conditions no different than they were before the Internet revolution began. The question in each case will be the likelihood of rapid change and the degree of its probable impact on competitive conditions in the affected market. In some industries, and in some contexts — such as that in EarthWeb — that may have a decisive impact on the result. In others it will not.

The law relating to restraints of trade has always evolved with the times. Nearly six hundred years ago, a British court rejected a plaintiff’s attempts to enforce a dyer’s agreement not to "use his art of a dyer’s craft" for six months, concluding that the covenant was "against the common law, and per Dieu, if the plaintiff were here, he should go to prison till he paid a fine to the King."⁵ This decision was rendered at a time when the guild system was in place, limiting the mobility of workers to move from job to job. Travel itself was difficult, too, which compounded the problem. In the language of 1999, barriers to entry were high. The treatment of covenants not to compete was correspondingly harsh.

As the restrictive guild system broke down and travel became more commonplace, courts evidenced a willingness to enforce these kinds of non-compete agreements, at least in circumstances where the agreement was associated with the sale of a business or incorporated into an employment contract. In other words, as barriers to entry relaxed, courts became more lenient toward restraints on trade. Thus, in the early 1700s, courts recognized that these types of "partial" restraints could be upheld if they were geographically limited and supported by adequate consideration.⁶

Adam Smith’s advocacy, and the general adoption in practice, of laissez-faire economics in the United States and Great Britain had similar repercussions on restraint of trade law. For example, British courts, in what may seem remarkable decisions today, upheld horizontal price fixing and market division agreements.⁷ Courts in the United States may not have been so easygoing, but they did seem willing to enforce "ancillary" restraints, including non-compete agreements tied to the merger or acquisition of ongoing operations, provided they were reasonably limited in time and scope.⁸ This common law analysis of ancillary covenants in restraint of trade eventually became the foundation of antitrust law as we know it today.⁹ EarthWeb is the latest step in this evolution.

The EarthWeb case was brought against Mark Schlack by EarthWeb, Inc., a publicly traded company that provides on-line products and services to business professionals in the information technology (IT) industry. EarthWeb operates through a family of Web sites offering IT professionals information, products, and services to use for facilitating tasks and solving technology problems in a business setting. Some of EarthWeb’s Web sites are free to users, while others require a subscription fee. EarthWeb obtains the content for its sites primarily through licensing agreements with third parties. Its primary source of revenue is advertising.

After working as senior editor and/or editor-in-chief of several print magazines, such as BYTE and Web Builder, Schlack joined EarthWeb in its New York City office on Oct. 19, 1998. His title at EarthWeb was vice president, Worldwide Content, and as the name suggests, Schlack was primarily responsible for determining what content EarthWeb licensed or acquired for its Web sites. In that capacity, Schlack was privy to information concerning a wide range of matters. Schlack often worked collaboratively with other department heads and employees on technology issues, marketing, and advertising. Although such matters may have been handled principally by other departments, Schlack’s decisions concerning content directly impacted these aspects of EarthWeb’s business.

Schlack tendered his resignation on Sept. 22, 1999. At that time, EarthWeb discovered that Schlack had accepted a position with ITworld.com, a subsidiary of International Data Group, Inc. (IDG) that was scheduled to launch in the year 2000. IDG generates over $1 billion in annual revenues and publishes more than 280 monthly periodicals. IDG intended that ITworld.com, when operational, would become a single Web site for IT professionals containing news, product information, and editorial opinions written primarily by an internal staff of more than 275 journalists.

In contrast to EarthWeb’s emphasis on obtaining the products and services of third parties through acquisitions and licensing agreements and then making those materials readily accessible on its Web sites, IDG expected that ITworld.com would rely on original content for over 70% of its website’s material; content such as product reviews and technical research would be created in-house by It.world’s staff.

In an effort to block Schlack from working for ITworld.com, EarthWeb filed suit against him, alleging that he breached his employment contract and that he had misappropriated EarthWeb’s trade secrets.

After finding that the case did not involve any actual misappropriation or theft of trade secrets, and after rejecting EarthWeb’s request for an injunction on "inevitable disclosure" grounds,¹⁰ the court turned its attention to the provisions of the employment agreement between EarthWeb and Schlack.

The court noted that one section of the agreement, entitled "Limited Agreement Not To Compete," provided in part that "[f]or a period of twelve (12) months after the termination of Schlack’s employment with EarthWeb, Schlack shall not, directly or indirectly: (1) work as an employee, employer, consultant, agent, principal, partner, manager, officer, director, or in any other individual or representative capacity for any person or entity that directly competes with EarthWeb."

According to the agreement, a company would directly compete with EarthWeb if it was "(i) an on-line service for Information Professionals whose primary business is to provide Information Technology Professionals with a directory of third party technology, software, and/or developer resources; and/or an online reference library, and or (ii) an on-line store, the primary purpose of which is to sell or distribute third party software or products used for Internet site or software development[.]"

EarthWeb argued that under the non-compete provision of the employment agreement, Schlack should be enjoined from commencing employment with ITworld.com because that company would "directly compete" with EarthWeb. In contrast, Schlack argued that by its terms, the "limited" non-compete provision to which he agreed did not apply to his employment with ITworld.com because that company’s "primary business" would not involve offering a "directory of third party technology," an "online reference library" or an "online store."

The court determined that it should strictly construe the employment agreement "based on its rather onerous terms." The court noted that the agreement provided that Schlack’s employment was at will and said that although it contained a restrictive covenant, it made no provision for the payment of severance to Schlack in the event that EarthWeb terminated his employment. Moreover, the court continued, EarthWeb purported to reserve the right to modify the terms of this Agreement on a quarterly basis, subject to notice and acknowledgment by the Employee of such modifications." In the court’s view, read collectively, the effect of these provisions was "to indenture the employee to EarthWeb."

The court found that because EarthWeb’s restrictive covenant only proscribed Schlack from working for companies whose "primary business" fell within a specified category, the de minimis aspects of ITworld.com’s content did not fall within the scope of the provision. Indeed, the court said that EarthWeb’s argument that ITworld.com’s "primary business" could change in the months before its website was launched only served to highlight a fundamental weakness in EarthWeb’s position: as the moving party, EarthWeb had the heavy burden of demonstrating that it was entitled to preliminary injunctive relief, which burden it did not meet.

The court then determined that even if the terms of EarthWeb’s restrictive covenant reached Schlack’s prospective employment at ITworld.com, EarthWeb would still have to establish that the restraint was reasonable and necessary to protect its legitimate interests.¹¹ The court stated, in words that are perhaps especially relevant to the Internet industry, that the policy underlying this strict approach rested on notions of employee mobility and free enterprise. It then ruled that EarthWeb’s restrictive covenant was not enforceable, even if Schlack’s position at ITworld.com had fallen within its parameters.

The one-year duration of EarthWeb’s restrictive covenant was too long, the court said, "given the dynamic nature of this industry, its lack of geographical borders, and Schlack’s former cutting-edge position with EarthWeb where his success depended on keeping abreast of daily changes in content on the Internet." It noted that another court in a dispute involving two Internet advertising businesses had enjoined the defendants for only six months, observing that "[g]iven the speed with which the Internet advertising industry apparently changes, defendants’ knowledge of Doubleclick’s operation will likely lose value to such a degree that the purpose of a preliminary injunction will have evaporated before the year is up."¹² In the EarthWeb court’s view, similar considerations predominated in this case, making a one-year restrictive covenant unreasonably long. It stated that "[w]hen measured against the IT industry in the Internet environment, a one-year hiatus from the workforce is several generations, if not an eternity." The court refused to "blue pencil" the covenant to make it shorter and thus enforceable, emphasizing again that the employment agreement as a whole overreached. It therefore ruled that EarthWeb was not entitled to a preliminary injunction.

Certainly, one should not make too much of isolated court decisions. Both history and the special nature of the Internet industry suggest, however, that the repercussions from the EarthWeb ruling are likely to be examined and analyzed for quite some time to come.

1. 99 Civ. 10035 (WHP) S.D.N.Y. (Oct. 27, 1999)
2. At various points in his decision, Judge Pauley referred to the "fluid and ever-expanding world of the Internet"; the "nascent [Internet] industry" that "is evolving and re-inventing itself with breathtaking speed"; and the "dynamic nature" of the Internet industry and "its lack of geographical borders, where success depend[s] on keeping abreast of daily changes in content on the Internet."
3. See, e.g., Doubleclick, Inc. v. Henderson, 1997 WL 731413 (Sup. Ct. N.Y. Co. 1997) (in dispute involving Internet advertising businesses, court refuses to enforce one-year non-compete agreement but issues preliminary injunction for only six months, stating "[g]iven the speed with which the Internet advertising industry apparently changes, defendants’ knowledge of DoubleClick’s operations will likely lose value to such a degree that the purpose of a preliminary injunction will have evaporated before the year is up"); cf. Webcraft Technologies, Inc. v. McCaw, 674 F.Supp. 1039 (S.D.N.Y. 1987) (in dispute between printing companies involving two-year non-compete agreement, preliminary injunction granted).
4. 1992 Horizontal Merger Guidelines 3.2.
5. Anonymous, Y.B., 2 Hen. V., f. 5, pl. 26 (1415).
6. See, e.g., Mitchel v. Reynolds, 1 P. Wms. 181, 24 Eng. Rep. 347 (1711).
7. See, e.g., Hearn v. Griffin, 2 Chitty 407 (1815); Wickens v. Evans, 3 Y. & T. 318, 148 Eng. Rep. 1201 (1829).
8. See, e.g., Oregon Steam Navigation Co. v. Winsor, 87 U.S. (20 Wall.) 64 (1874); Craft v. McConoughy, 79 Ill. 346 (1875).
9. See R. Bork, The Antitrust Paradox 26-30 (1978), citing United States v. Addyston Pipe & Steel Co., 85 F. 271 (6^th Cir. 1898), aff’d, 175 U.S. 211 (1899).
10. See, e.g., Lumex, Inc. v. Highsmith, 919 F.Supp. 624 (E.D.N.Y. 1996)
11. In New York, non-compete covenants will be enforced only if reasonably limited in scope and duration, and only to the extent necessary to prevent an employee’s solicitation or disclosure of trade secrets, to prevent an employee’s release of confidential information regarding the employer’s customers, or in those cases where the employee’s services to the employer are deemed special or unique. See, e.g., Ticor Title Ins. Co. v. Cohen, 173 F.3d 63, 70 (2d Cir. 1999).
12. Doubleclick, 1999 WL 731413, at *8.