Alternative asset managers know that today’s valued employee may become tomorrow’s competitor. You may suddenly find yourself competing against a person who, after having years of access to your strategies, processes, confidential information, and clients, learned the business at your side and knows everything about your firm and its customers. How do you stop departing employees from usurping your confidential information and goodwill? A wise employer will prepare in advance for the eventual departure of employees that may be in a position to do competitive harm when they leave. Restrictive covenants such as non-competition and non-solicitation agreements can help to ameliorate the risks and damage of such competition.
The Basis For An Enforceable Restrictive Covenant
Unlike typical commercial agreements, which generally are enforced in accordance with their terms, restrictive covenants will be enforced only where there is a legitimate business justification for doing so. Restrictive covenants are viewed as anti-competitive arrangements that limit employees’ ability to freely market their services and earn a living in their chosen profession, and accordingly are enforced only when the court finds a legitimate business justification for doing so. Two typical bases that can support a restrictive covenant are the protection of confidential information and the protection of goodwill arising out of client relationships.
Protection of confidential information can serve as a proper basis supporting the enforcement of a restrictive covenant where the employee had access to proprietary or confidential information belonging to the employer that could readily be used by the employee or a successor employer to unfairly compete against the employer after his departure. In the financial services industry, confidential trading strategies, software programs for high-speed trading, and black box strategies may be sufficiently confidential to support the enforcement of restrictive covenants.
Alternatively, an employee’s contact with clients may support the enforcement of a non-competition or non-solicitation covenant restricting that employee from contacting or doing business with those clients following termination of his employment. Because the employee was able to develop these relationships only through the introduction of, or at the expense of, the employer, case law supports the proposition that an employer should be afforded a reasonable amount of time to substitute another individual in that relationship before the employee may seek to compete.
Note that generalized knowledge of industry information does not justify the enforcement of restrictive covenants. Nor does the fact that the employee knew nothing about the industry before working for a particular employer and is in a position to obtain alternative employment and compete against the employer only because of the knowledge that was imparted to her during her employment. Conduct that seems disloyal is simply not enough, unless the employee engages in other truly wrongful conduct, such as theft of confidential information or other property.
Even where supported by a legitimate business justification, a restrictive covenant will be enforced only to the extent it is narrowly tailored – in terms of geography, duration, and the activities prohibited – to protect the interests identified as the legitimate business justification underlying the covenant. The less restrictive a provision is, the more likely it is to be enforced.
While courts will sometimes enforce longer restrictions, one-year restrictions are most common. Indeed, even where a legitimate business justification exists, some courts have severely curtailed the duration of restrictions, particularly where the confidential information at issue quickly becomes stale (e.g., short-term trading positions and strategies); in such circumstances, an outside limit of six months often is enforced. With respect to geographical restrictions, broad prohibitions commonly are enforced in the financial services industry in recognition of the fact that such work typically can be performed anywhere in the country or, indeed, the world.
Types Of Restrictions To Consider
The broadest type of restriction is a true noncompete – a restriction by which the employee agrees not to compete with the employer following termination of his employment for some defined period of time. Even here, however, the scope of the restriction must carefully be considered. Is “competition” to be defined as working in the financial services industry? Or being associated with any hedge fund? Such a restriction runs the significant risk of being found to be too broad in most circumstances. Consider instead whether the restriction can be tailored to address the particular strategies pursued by the employer, or a particular product or industry focus.
Alternatively, a customer restriction may be used. Thus, for example, the employee may agree to forego engaging in business with certain specified clients of the firm, or with any clients of the firm with whom she communicated on behalf of the firm, or some other formulation that protects some or all of the client relationships of the employer. Such restrictions are often viewed as more reasonable than full non-competition covenants because they allow the employee to continue working in her profession and use her expertise and merely prohibit the employee from doing so on behalf of a limited number of clients. This type of restriction is most appropriate for employees in marketing roles and portfolio managers who have become known to a firm’s clients.
Finally, most employers will want to restrict employees’ ability to solicit, hire or otherwise engage their coworkers and the consultants, referral sources and vendors of their employer. Because such provisions are often viewed as less anti-competitive than the other restrictions discussed above, they are more easily enforced by courts and more commonly complied with by departing employees.
Do You Have To Pay The Employee During The Restricted Period?
In determining whether to enforce restrictive covenants, a court undertakes a balancing of the equities. From the employee’s perspective, one of the key questions revolves around the extent to which enforcement of the noncompete will inhibit the employee’s ability to earn a living. In this regard, the employee’s level of compensation is important – an employee who was highly compensated by his former employer is far less likely to get sympathy from a court than a low-paid administrative or just-out-of-school employee.
When assessing the effect enforcement will have on the employee’s ability to earn a living, courts will of course consider whether the employer will continue to pay the employee during the period of the restriction. To be clear, the law does not require that the employer provide such compensation, but doing so reduces the financial impact on the employee and thus enhances the likelihood of enforcement of the restrictions.
Note that employers in the financial services industry typically do not pay incentive compensation during a restricted period (although they may permit continued vesting of previously awarded deferred compensation if the individual is otherwise a “good leaver”). Nonetheless, because incentive compensation tends to be a large portion of total compensation, paying only base salary during the period of restriction typically has only a limited benefit as compared to other industries in which incentive compensation is a far smaller percentage of total compensation.
Using A Carrot Instead Of A Stick
One alternative to using traditional restrictive covenants is to embed such restrictions in deferred compensation arrangements. A deferred compensation plan or agreement may provide that the departing employee will be entitled to receive continued payment of previously deferred compensation only if she complies with specified restrictions. Here, the restrictions are not affirmative in nature – they cannot be separately enforced – but instead affect a forfeiture of the deferred compensation if the former employee engages in prohibited competition or solicitation. Not incidentally, such provisions are more readily enforced by courts under the “employee choice” doctrine, as the employee is empowered to choose to comply with the restrictions and be paid the deferred compensation or compete and forgo the payments.
Using Restrictive Covenants To Protect Your Business
Restrictive covenants are part of an employer’s arsenal of weapons to protect against the loss of confidential information and client relationships that may ensue in the wake of the departure of valued employees. While restrictive covenants may not be appropriate for the most junior employees in an organization, particularly non-professionals, firms should consider using restrictive covenants to ensure the protection of confidential information and client relationships. When combined with nondisclosure agreements and deferred compensation arrangements, such agreements can go a long way toward avoiding – or at least reducing the damage from – unfair competition by departing employees.
Restrictive covenants must be contained in a written agreement, whether a broader employment agreement that addresses other terms and conditions of employment or a stand-alone document that addresses only these issues. If not entered into in connection with the commencement of an employment relationship, in some jurisdictions the restrictive covenants must be supported by additional consideration beyond mere continued employment. In Connecticut, for example, a restrictive covenant that was not entered into at the commencement of employment must be supported by separate and independent consideration. In New York, however, continued employment of an at-will employee typically is adequate consideration to support restrictive covenants.
As a final note, restrictive covenants generally must comply with the law of the state in which the employee works. There is significant variation among states in terms of their approach to restrictive covenants. Thus, for example, in New York, reasonable restrictive covenants are enforceable to the extent they are supported by a legitimate business justification, while California has a specific statutory provision that prohibits the enforcement of restrictive covenants in the employment context (although it does permit the use of restrictive covenants in connection with the sale of a business). Employers must be cognizant of the particular jurisdiction(s) in which they operate and ensure that their use of restrictive covenants is in compliance with local law.
Published May 23, 2012.
