Restrictive Covenants

Restrictive covenants (also known as "covenants not to compete") generally arise in two different situations - an employment contract or an agreement for the purchase of a business. Employers often want to protect their business from unfair competition by former employees. Therefore, in the employment contract, the employer includes a provision - the restrictive covenant - that restricts what the employee may do after the employment relationship has ended. When a person or entity purchases a going business, usually one of the significant items being purchased is the "goodwill" of the business. Therefore, the purchaser of the going business often wants to be certain that the seller will not promptly resume a similar business in competition with the purchaser. This is accomplished by including a provision in the purchase agreement that restricts the former owner from engaging in competition with the purchaser's business. In both instances - the employment contract and the agreement for the purchase of a business - the person is restricted from competing directly - on her or his own - and is usually also restricted from competing indirectly - as an employee, employer, partner, investor, consultant, corporate officer, etc. The specific language and terms of the restriction vary from contract to contract.

Where they are properly drafted, restrictive covenants are generally enforced by the courts of Pennsylvania. In other words, if the former employer or business purchaser goes to court, an injunction can be obtained, prohibiting the former employee or former business owner from continuing to compete in violation of the restrictive covenant. Many people are under the impression that these types of contract provisions are mere "scare tactics" and that the courts will not honor them. That is simply incorrect. Although it has been said that "restrictive covenants are not favored in the law," today in Pennsylvania this merely means that courts will not enforce them if all the legal requirements have not been met. Pennsylvania courts will examine the restrictions carefully, will interpret the restrictions narrowly and will make certain that the legal requirements have been met. However, if those requirements have been met, generally the restrictions will be enforced.

Contracts generally must meet certain criteria to be valid and enforceable. In order for an ordinary business contract to be enforceable there must be (a) a meeting of the minds, (b) some legal consideration flowing between the parties (generally each side gets something and gives up something in return), (c) sufficiently definite contract terms and (d) a purpose the law recognizes as legal or legitimate. Contracts that contain restrictive covenants must also meet certain additional criteria to be enforceable. In Pennsylvania, the criteria are somewhat different depending upon whether the restrictive covenant is contained in an employment contract or a business purchase agreement.

In order for a restrictive covenant in an employment contract to be enforceable in Pennsylvania, the contract must be "incident" to employment, the restrictions must be reasonably necessary for the protection of the employer, and the restrictions must be "reasonable."

A contract is considered to be "incident" to employment in two situations. The first is where the parties enter into the contract at the inception of the employment relationship - when the employee is first hired and before the employer-employee relationship has been formed. The second is where an existing employee is given a bona fide significant benefit or change in position, for example a significant raise or a promotion. If it is not bona fide - if the raise is nominal or simply the customary annual raise or if the promotion is a sham - the court probably will find that the criteria was not met and the restrictive covenant will not be enforced. In either of those legitimate situations - employment inception or bona fide change in position - the contract will be considered "incident" to employment.

The second test is that the restriction is reasonably necessary for the protection of the former employer. The former employer does not have the right merely to eliminate competition by the former employee. Rather, there must be a legitimate business interest in need of protection and the restriction must not be greater than is necessary to protect that interest. The courts will balance this interest, if it exists, against the former employee's interest in earning a living.

The third test for a restrictive covenant contained in an employment contract is if it is "reasonable". The restrictions must be reasonable regarding the period - not longer than is reasonably necessary for the employer fairly to protect against competition with the former employee. The restrictions must also be reasonable regarding the geographic scope - the restricted territory must not be larger than is reasonably necessary for the protection of the business of the former employer. What time period and what geographic scope are "reasonable" is different for every employment situation and depends upon the particular facts and circumstances. There is no "one size fits all" restrictive covenant. In one case, a restriction of one year and ten miles might be the outside limits of a reasonable restriction while in another case, three years and the entire United States east of the Mississippi River might be considered reasonable. Courts will sometimes reduce the geographic area set forth in the contract and enforce the restrictive covenant with the more narrow geographic area.

A restrictive covenant in a business purchase agreement is enforceable if it is designed to protect the legitimate interests of the purchaser. Where the restrictive covenant is contained in an agreement for the purchase of a going business, the "incident to employment" requirement is eliminated. It would be clearly  unfair for someone to sell her or his business to another, agree not to compete with the purchaser and, in fact, engage in competition to the detriment of the purchaser. The purchaser clearly would be deprived of the benefit of what he or she had bargained for. Therefore, restrictive covenants are generally enforced in the business purchase situation with a less rigorous test than in the employment contract situation. Similarly, the length of time and scope of territory are items that have been negotiated and if there was an arm's-length bargain, particularly where the seller had the benefit of advice from his or her lawyer, generally the courts will allow the parties to make their own bargains and hold them to their agreements.

A related area of the law is the enforcement of restrictions against the disclosure or unfair use of the trade secrets of a former employer. Trade secrets might include list of customers, customer routes, methods of doing business and many other things. The right to prevent the use of trade secrets might arise from a contractual provision or may exist independent of any contract, under the common law of "unfair competition." A discussion of the law concerning trade secrets is beyond the scope of this article.

It is important for an employer to obtain proper legal advice before hiring a new employee so that the employer will be properly protected in the employment contract from unfair competition if the employee leaves - both through the use of a restrictive covenant and through express protections against the use of trade secrets. This advice would be helpful to the employer both in negotiating the terms of employment and in drafting the employment contract. Similarly, in negotiating the purchase of a business and the terms of the related agreement, proper legal advice is critical for the protection of the purchaser. Where there has been a possible violation of a restrictive covenant, the failure to obtain proper legal advice in attempting to enforce the restrictions could result in the complete inability to obtain the benefit of an enforceable restrictive covenant. Where a former employee is considering taking action that might  violate an existing restrictive covenant, the former employee also needs to seek timely legal advice - before taking the action - to know what potential adverse consequences he or she might face. A potential new employer also needs proper legal advice to measure the risks to the new employer if the new employer hires an employee in violation or in possible violation of the restrictive covenant in the employee's employment agreement with the former employer. In summary, in creating restrictive covenants, in attempting to enforce them and in considering if to violate them, adequate legal advice is very important to all the parties involved.

 

Copyright 2011 Marc H. Jaffe and Fromhold Jaffe & Adams

Notes:

Information for this article was obtained from, among other sources, the 2002 opinion of the Supreme Court of Pennsylvania in Hess v. Gebhard & Co. Inc., 570 Pa. 148, 808 A.2d 912 (2002).

The information set forth in this article is for general information purposes only and is not intended as legal advice. There are many additional factors that must be considered in determining the rights, obligations and potential legal consequences of the people involved. You should consult a lawyer in the state where the contract is made or intended to be enforced, and rely on the advice of that lawyer rather than upon anything set forth in this article.