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Non-compete clause

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Definition Edit

A non-compete clause or covenant not to compete is a term used in contract law under which one party (usually an employee) agrees not to pursue a similar profession or trade in competition with another party (usually the employer).

Overview Edit

As a contract provision, a non-compete clause is bound by traditional contract requirements including the consideration doctrine. The use of such clauses is premised on the possibility that upon their termination or resignation, an employee might begin working for a competitor or starting a business, and gain competitive advantage by abusing confidential information about their former employer's operations or trade secrets, or sensitive information such as customer/client lists, business practices, upcoming products, and marketing plans.

Conversely, a business might abuse a non-compete covenant to prevent an employee from working elsewhere at all. Most jurisdictions in which such contracts have been examined by the courts have deemed covenants not to compete to be legally binding so long as the clause contains reasonable limitations as to the geographical area and time period in which an employee of a company may not compete. Courts have held that, as a matter of public policy, an individual cannot be barred from carrying out a trade in which (s)he has been trained except to the extent that is necessary to protect the employer. The extent to which non-compete clauses are legally allowed varies from one jurisdiction to another:

Some states refuse to enforce non-competes, or refuse to enforce non-competes that contain any unenforceable provisions ('red-pencil' doctrine), although a majority of states will modify overbroad non-compete contracts to render them enforceable ('blue- pencil' and 'equitable reform' doctrines).[1]

Some jurisdictions, such as the state of California, invalidate non-compete clauses for all but equity stakeholders in businesses.

Justification Edit

The conventional picture of a workplace characterized by non-compete agreements is one that features trade secrets, including sophisticated technical information and business practices that firms have a strong interest in protecting. By preventing a worker from taking such secrets to a firm's competitors, the non-compete essentially solves a "hold-up" problem: ex ante, both worker and firm have an interest in sharing vital information, as this raises the worker's productivity. But ex post, the worker has an incentive to threaten the firm with divulgence of the information, raising his or her compensation by some amount equal to or less than the firm's valuation of the information. Predicting this state of affairs, the firm is unwilling to share the information in the first place unless it has some legal recourse like a non-compete contract.

Occasionally, client relationships are included along with trade secrets in this explanation (and are sometimes treated similarly as a matter of state law). However, it is not clear that relationships with clients constitute a socially valuable investment analogous to trade secrets.

History Edit

Modern interpretations of non-compete agreements are often said to have their origin in 15th and 16th century English common law and are best understood in the context of that period's economic structure. The guild economy largely comprised three types of workers: the apprentice, the journeyman, and the master craftsman. Custom required apprentices to train under master craftsmen for an extended period until graduating to the status of journeyman. Once a journeyman, the individual was free to work wherever he wished while he sought entrance into the inner circle of master craftsmen. Non-compete agreements likely originated in this context as journeymen replaced retiring master craftsmen by purchasing their businesses.[2] However, available case law suggests English courts tended to disfavor restraints on trade — especially restraints initiated by an employer.

The most cited example from this period comes from The Dyer's Case of 1414.[3] This case is perhaps the first known example of a contractual restraint of trade. A London practitioner prohibited his apprentice from pursuing his trade in the same city for six months following his apprenticeship. The court ruled against the covenant.[4] According to some commentators, the result produced two fundamental pillars of employment law.[5]

Over time, some master craftsmen began to take on more apprentices than customary so as to employ a larger staff at low cost.[6] The consequence of this strategy was an influx of journeymen looking for ways to unseat master craftsmen. Some craftsmen addressed the increased levels of competition by requiring apprentices and journeymen to sign non-compete agreements.[7] The English Parliament brought attention to some of these practices in 1536 by authoring the Act for Avoiding of Extracting Taken upon Apprentices.[8] The law attempted to restrain some of the practices of guild masters — including non-compete contracts. In 1563, the Statute of Artificers restricted the privileges of workers while also shifting power from guild masters to the evolving English state.[9] The law established national constraints on maximum wages and the length of apprenticeships.[10]

By the beginning of the 17th century, courts continued to disfavor employment restraints, whether in the form of time or place. An excerpt from Colgate v. Bacheler (1602) notes, "For as well as [employers] may restrain [employees] for one time, or one place, [they] may restrain [them] for longer times, and more places, which is against the benefit of the Common-wealth. . . . For he ought not be abridged of his Trade, and Living."[11] Others worried that non-compete covenants forced young men into "idleness."[12] However, as a new economic system emerged, English courts began to rethink their position on non-compete covenants.

Mitchel v. Reynolds (1711) marked a distinct shift away from the practice of completely banning non-competes.[13] Reynolds, a baker, agreed to rent his bakery for five years. In return, Mitchel pledged Reynolds a bond worth 50 pounds on the condition that Reynolds would not resume his trade within St. Andrew Holborn Parish for 5 years. The latter failed to keep the agreement and Mitchel sued. Chief Justice Parker ruled in favor of the agreement.[14] He reasoned that while general restraints on trade were unlawful, as they benefited neither party, some partial restraints were reasonable.[15] Effectively, the ruling permitted individuals to enter agreements even if they restricted one's ability to work in a particular location or for a certain period, as long as both parties and the affected communities benefited from the arrangement. However, employers were required to demonstrate the economic necessity of any such agreement.

The economic significance of non-competes evolved as new technology accompanied the Industrial Revolution.[16] Once limited to local markets, companies began expanding into national and international markets, exposing themselves to new rivals.[17] Moreover, corporations were increasingly concerned with worker mobility. Leaving one's town no longer carried the same economic and physical risks. Homer v. Ashford (1825) describes the logic applied by English courts on matters of non-compete covenants:

A merchant or manufacture would soon find a rival in every one of his servants if he could not prevent them from using to his prejudice the knowledge they acquired in his employ. Engagements of this sort between masters and servants are not injurious restraints of trade, but securities necessary for those who engage in it. The effect of such contracts is to encourage rather than cramp the employment of capital in trade and the promotion of industry.[18]

Some took the argument of the court to suggest that non-compete clauses were permissible in most circumstances. Six years later, the court clarified that while employers should have access to protection, Mitchel's test-of-reason still applied. In Horner v. Graves (1831), a dentist's assistant contracted to not practice independently within 100 miles of the original employer.[19] Soon after parting with his employer, the assistant broke the agreement, prompting the dentist to sue. In response, the court sided with the defendant, explaining that a reasonable restraint must also account for the interests of the public. From the public's perspective, the dentist had sought to withhold a valuable service within the 100 mile radius of his practice in order to protect himself. The court determined that the burden placed on the public was greater than the need to protect the interests of the previous employer and that the requirement was unreasonably broad.[20]

The intermittent reweighting of employer, worker, and public interests continued as the 19th century wore on. By 1841, although most English courts still rejected general restraints, some began to enforce them as businesses globalized.[21] A trend toward pro-employer policy continued in 1853 when the Queen's Bench ruled that the burden of showing unreasonableness rested on the employee rather than employer.[22] In 1875, the court ruled that while contracts must remain reasonable, a central value of the liberal economic philosophy permitted men of sound mind to enter arrangements as they saw fit.[23] Increasing emphasis on freedom of contract was evident in Rousillon v. Rousillon (1880), where the court allowed covenantal protection to extend beyond national borders. The court reasoned that if the contract was reasonable in scope at the negotiation, changing economic circumstances should not bar enforcement.[24]

As English courts were moving toward pro-employer policies, American courts started developing their own body of common law. In 1851, Lawrence v. Kidder, a case before the New York Supreme Court, established a precedent that the state's priority was to deter monopolies.[25] The court reasoned that as far as possible, the state must ensure that all citizens be permitted to work.[26] As such, the court viewed agreements which barred individuals from practicing their occupations based on state or territory boundaries as unlawful.

A Pennsylvania court made an important distinction in 1866 between the sale of "handicraft" and the sale of "property."[27] The Pennsylvania court deemed restrictions on property much more reasonable than restrictions on the use of an employee's skills. This distinction laid the foundation for the landmark Supreme Court decision in Oregon Steam Navigation Co. v. Winsor (1874).[28] The California Steam Navigation Company sold the Oregon Steam Navigation Company a boat under the condition that they would not operate the vessel within California for a period of ten years. The Oregon Steam Navigation Company subsequently sold it to Winsor, who at the time of sale was engaged in the navigation of water in Washington. The sale was subject to a condition (among others) that Winsor would not operate the boat in California for a period of ten years. The court upheld the condition, noting that there was no injury to the public.[29]

The New York Court of Appeals echoed the opinion of the Supreme Court in 1887 when it ruled in favor of a non-compete clause which restricted selling matches in the states of Nevada and Montana.[30] The court found that the condition was a "partial" restraint even though it covered the entire state of New York, while noting that the distinction between "general: and "partial" restraints, while still good law, was weakening.[31]

Non-compete policies began diverging across states by the end of the 19th century. Notably, the California legislature rendered non-competes generally unenforceable.[32] Outside of legal opinions, the most influential American documents on contract law are the Restatement of Contracts of 1932 and its revision in 1979.[33] Though non-binding, these writings, published by the American Law Institute, codify case law. Both versions of the Restatement of Contracts state that restraints are unlawful if they unjustly benefit employers and impose undue hardship on the employee or public — reflecting the opinion in Horner v. Graves.[34] The second Restatement of Contracts protects the employee further by increasing the standard by which an employer must demonstrate legitimate need for non-compete protection.[35]

References Edit

  1. Non-Compete Contracts: Economic Effects and Policy Implications, at 5.
  2. Harlan M. Blake, "Employee Agreements Not to Compete," 73 Harv. L. Rev. 638 (1960)>.
  3. Y.B. Mich. 2 Hen. 5, fol. 5, pl. 26 (1414).
  4. Id.
  5. Dan Messeloff, 'Giving the Green Light to Silicon Alley Employees: No-Compete Agreements between Internet Companies and Employees under New York Law," 11 Fordham Intell. Prop., Media & Entertainment L.J. 710-11 (issue 3, 2001). Much of this section benefits from this article. The first was a policy in favor of retaining skilled labor in the public domain. The second pillar promoted the right of all individuals to seek a livelihood. These principles guided legal precedent for the next century.
  6. Blake, supra at 633.
  7. Id.
  8. Bland, Brown & Tawney, English Economic History–Select Documents 284-86 (1919).
  9. 50 Donald Woodward, "The Background to the Statute of Artificers: The Genesis of Labour Policy, 1558-63, 33 Econ. History Rev. 32-44 (No.1 1980).
  10. Id.
  11. Cro. Eliz. 872, 78 English Report 1097 (Queen's Bench 1602).
  12. Case of Tailors of Ipswich, 77 English Rep. 1218, 1219 (King's Bench 1614).
  13. 24 English Rep. 347 (Queen's Bench 1711).
  14. Dan Messeloff, supra.
  15. "General" restraints were defined as those with unlimited scope in either time or space, while "partial: restrains were those limited in both dimensions.
  16. See Messeloff, supra at 712-13.
  17. Blake, supra at 638.
  18. 3 Bing. 322, 327 (1825).
  19. 7 Bing. 735, 131 English Rep. 284 (C.P. 1831).
  20. Id. at 743.
  21. Blake, supra at 624.
  22. Tallis v. Tallis, I El. & B. 391, 118 English Rep. 482 (Queen's Bench 1853).
  23. Printing & Numerical Registering Co. v. Sampson, L.R. 19 Eq. 462 (1875).
  24. 14 Ch. D. 351 (1880). See Blake, supra at 641.
  25. 10 Barb. 641 (N.Y. Supreme Court 1851). See Blake, supra at 644.
  26. Id.
  27. Keeler v. Taylor, 53 Pa. 467, 470 (1866).
  28. Messeloff, supra at 720-21.
  29. Id.
  30. Diamond Match v. Roeber 106 N.Y. 473 (1887).
  31. Messeloff, supra at 722.
  32. Id. at 714.
  33. Ibid. at 723-24.
  34. Id.
  35. Id.

Sources Edit

See also Edit

External resources Edit

  • Beck Reed Riden LLP, "50 State Non-compete Chart" (Feb. 21, 2016) (full-text).
  • Fenwick and West LLP, "Summary of Covenants Not to Compete: A Global Perspective" (full-text).


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