United States: Employers Should Revisit Their Non-Compete Agreements For 2023

Key Takeaways:

• Given recent legal and legislative trends, employers should narrowly tailor non-compete provisions to protect essential business needs. Employers cannot rely on the courts to repair or reform overly broad restrictive covenants.
• A more serious challenge: the FTC's proposed rule could ban non-compete agreements nationwide for all workers and require employers to rescind all existing non-compete agreements. Employers should strengthen Confidentiality and Inventions Assignment Agreements and non-solicitation clauses to maximize this alternate protection should the proposed rule become law.

In recent years, there has been a shift across the U.S. to restrict the use of non-compete agreements. In fact, on January 5, 2023, the Federal Trade Commission ("FTC") proposed a new rule that would effectively ban the use of non-compete agreements. The FTC's notice of proposed rulemaking details the suggested five-part regulation that would eliminate the use of non-competes nationwide for all workers. The proposed rule defines the use of non-compete clauses as an unfair method of competition,¹ prohibiting employers from entering non-competes with their workers.

The FTC's proposed rule is a dramatic crescendo in the growing chorus to restrict or eliminate non-competes. Many states make up this chorus, and we have provided a few examples from key jurisdictions.

New York

In New York, while non-competes are enforceable, they are generally disfavored by the courts.² New York courts will only enforce a non-compete when the employer can establish: (1) the restriction is reasonable in time and geographic scope; (2) the restriction is necessary to protect a legitimate interest of the employer; (3) the restriction is not unreasonably burdensome to the employee; and (4) the restriction is not harmful to the general public.³ New York courts may blue-pencil a non-compete (i.e., sever and grant partial enforcement of an overbroad employee restrictive covenant) when the unenforceable portion of the agreement is not essential.⁴

A recent decision by the U.S. District Court for the Southern District of New York, however, saw the court decline to blue-pencil a former employee's allegedly overly broad restrictive covenant. In Flatiron Health, Inc. v. Carson, 2020 U.S. Dist. LEXIS 48699 (S.D.N.Y. March 20, 2020), the employer sued its former employee to enforce its non-compete that prohibited competitive activity and solicitation of Flatiron clients and employees for one year following the employee's separation from employment. While the Flatiron court acknowledged the "judicial power to sever and grant partial enforcement for an overbroad employee restrictive covenant" (i.e., the judicial power to blue-pencil), it found that the employer did not demonstrate its entitlement to partial enforcement.⁵ Ultimately, the Flatiron court held that the non-compete was broader than necessary to protect the employer's business interests, and in turn unenforceable.⁶ According to the court, the Flatiron non-compete broadly prohibited the defendant from working for any company that was marginally similar to Flatiron.⁷ Thus, the court held that Flatiron's non-compete impermissibly prohibited competition in areas where Flatiron had no legitimate business interest.⁸

This decision illustrates the willingness of New York judges to forgo partial enforcement of non-competes – leading to an increase in unenforceable non-competes in New York.

Massachusetts

In 2018, Massachusetts enacted the Massachusetts Non-Competition Act (the "Non-compete Act" or "Act"), which governs the enforceability of non-competes that were entered into on or after October 1, 2018.⁹ The Act prohibits employers from enforcing non-competes against certain employees, including (a) employees who are classified as non-exempt under the Fair Labor Standards Act; (b) undergraduate or graduate students participating in an internship or other short-term employment; (c) employees terminated without cause or laid off; or (d) employees under the age of 18.

The Act also includes other restrictions for valid non-competes. For instance, it provides that non-competes must be: in writing; signed by both the employer and employee; and supported by either a "garden leave" clause (i.e., the employee is allowed to remain on payroll during the time they are prohibited from commencing other employment) or some other mutually-agreed upon consideration. Moreover, the Act establishes that non-competes entered into in connection with the start of employment must expressly state that the employee has the right to consult with counsel prior to signing.

The Non-compete Act also prohibits employers from using continued employment as consideration when entering a non-compete after a worker has commenced employment. This forces Massachusetts employers to provide its employees with some sort of consideration aside from the continuation of employment if the employer wants the current employee to enter a non-compete. This may mean additional pay or benefits.

Finally, the Act imposes certain time restrictions on the use of non-competes. For example, the Act establishes that any valid non-compete agreement can remain effective for a maximum of one (1) year after the employee's departure, unless the employee has breached his/her fiduciary duty to the employer or the employee has unlawfully taken the employer's property, in which case the non-compete would remain effective for a maximum of two (2) years from the date of separation. Additionally, the Act requires employers that seek to enter a new hire into a non-compete to provide said non-compete: (1) at or before the time of a formal offer of employment; or (2) ten business days before the commencement of employment.

In sum, the Non-compete Act necessitates a new manner of drafting, implementing, and enforcing non-competes in Massachusetts.

Delaware

In Delaware, a recent decision by the Court of Chancery demonstrates the courts' trend of invalidating overly broad non-competes. In Kodiak Bldg. Partners, LLC v. Adams, 2022 Del. Ch. LEXIS 288, 1 (Del Ch. Oct. 6, 2022), the plaintiff-employer, Kodiak — whose business model is to purchase and operate smaller businesses in various sectors of the construction industry — purchased a roofing company. In connection with the acquisition, the defendant, Adams, became the plaintiff's employee and entered into a restrictive covenant agreement that contained non-competition, non-solicitation, and confidentiality provisions. The agreement also contained language requiring the defendant to acknowledge the reasonableness and necessity of the restrictive covenants, and waive any issue of reasonableness as a defense.¹⁰ A few months later, the defendant resigned and went to a nearby competitor. The plaintiff-employer sued the defendant for breach of the restrictive covenant.

The Kodiak court declined to enforce the non-competition provision. First, the court found that Delaware public policy allowed it to review the parties' restrictive covenant for reasonableness despite the restrictive covenant's waiver provision.¹¹ The court refused to disregard its duty to evaluate the reasonableness of restrictive covenants, simply because a party stipulates that the agreement is reasonable. Second, the court held that the restrictive covenant was overbroad and unenforceable because the scope of the non-compete provision was not tailored to protect a legitimate business interest. The court reasoned that in the context of a sale of business, the acquirer has a legitimate economic interest in the assets and information it acquired in the sale but this economic interest should not be extended to unrelated transactions. Ultimately, the Kodiak court denied the plaintiff's motion for preliminary injunction to enforce the restrictive covenant.

The Kodiak court's decision demonstrates that employers should not expect the courts to repair or enforce overly-restrictive non-competes in Delaware. Instead, employers should narrowly tailor their non-compete agreements to protect necessary business interests.

California

The California Business and Professions Code Section 16600 prohibits the use of non-competes in employment contracts. Section 16600 disallows – with limited exceptions --, "...every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind."¹²California courts interpret this statute broadly, reasoning that the statute represents a strong public policy against the restraint of business and an employee's ability to pursue lawful employment.¹³Employers can still use narrow contractual restraints to prevent a departing employee from using the employer's confidential information.¹⁴The restrictive covenants, however, cannot be used to restrict an employee's ability to engage in lawful employment within a profession.¹⁵

Conclusion

Momentum is growing across the United States for limiting (or eliminating) the use of non-competes. Given this heightened scrutiny, employers should revisit their non-compete provisions and other restrictive covenants to ensure that they are in strict compliance with the current state of the law. This generally involves focusing on key needs and limiting restrictions to working in a competitive capacity for the new employer, not simply prohibiting work for a competitor. Employers should also strengthen other contractual protections to prevent the theft and use of trade secrets, in preparation for a world where enforceable non-competes are becoming a rarity.

Footnotes

1.This would apply only to those clauses after the "Compliance Date"—180 days after the regulation is finalized.

2. See, e.g., Columbia Ribbon & Carbon Mfg. Co. v. A1A Corp., 42 N.Y.2d 496, 499 (1977) (stating there are "powerful considerations of public policy which militate against sanctioning the loss of a [person's] livelihood").

3. See Reed, Roberts Assocs., Inc. v. Strauman, 40 N.Y.2d 303, 307–09 (1976); BDO Seidman v. Hirshberg, 93 N.Y.2d 382, 389 (1999).

4. See, e.g., Marsh USA Inc. v. Schuhriemen, 183 F. Supp. 3d 529, 534–36 (S.D.N.Y. 2016); Brown & Brown, Inc. v Johnson, 25 N.Y.3d 364, 370–72 (2015) (citing BDO Seidman v. Hirshberg, 93 N.Y.2d 382, 394 (1999)).

5. See Flatiron Health, Inc., 2020 U.S. Dist. LEXIS 48699 at 63.

6. Id. at 61.

7. Id. at 55-56.

8. Id. at 54-61.

9. Mass. Gen. Laws ch. 149, §24L.

10. Kodiak Bldg. Partners, LLC, 2022 Del. Ch. LEXIS 288 at 5.

11. Id. at 12.

12. Cal. Bus. & Prof. Code §16600.

13. See Edwards v. Arthur Andersen, 44 Cal. 4th 937, 949 (2008); Scott v. Snelling & Snelling, 732 F. Supp. 1034, 1042 (N.D. Cal. 1990

14. See Gordon v. Landau, 49 Cal.2d 690, 694(1958) (distinguished in Kolani v. Gluska, 64 Cal. App. 4th 402 (2d Dist. 1998); International Petroleum Prods. & Additives Co. v. Black Gold, S.A.R.L.,418 F. Supp. 3d 481, 493 (N.D. Cal. 2019).

15. See California Code, Cal. Lab. Code § 432.5 ("No employer...shall require any employee or applicant for employment to agree, in writing, to any term or condition which is known by such employer...thereof to be prohibited by law.")

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.