What Are Restrictive Covenants? Restrictive Covenants 101

April 27th, 2015

Litigation arising out of employment contracts that contain non-compete, non-disclosure/trade secret, no employee raiding or non-solicitation of customer provisions often involve high stakes, including the protection of trade secrets, the ability to practice one’s trade, the elimination of a competitor, or maintaining key client relationships. Businesses have long sought to guard against unfair competition and to protect their trade secrets and market share. Regardless of whether it was in 1414 in Dyer’s Case, where, in the first recorded restrictive covenant case, an English court refused a master’s request to preclude his apprentice from practicing his trade in London for 2 years following the end of his apprenticeship or today in New York where courts are willing to enforce a restrictive covenant agreement if reasonable in time and geographic scope, and necessary to protect the employer’s legitimate interests.

The litigation is fast and furious for the parties often get one bite at the apple to quickly secure an emergency injunction or to prevent its issuance. This, before a judge who may

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appreciate the necessity for such relief , but nevertheless looks upon restrictive covenants, just as courts did in the 1400’s, with great skepticism because they can act as a restraint on trade and the free flow of ideas. Crafting and arguing a restrictive covenant case requires skill and experience, as failure can mean a loss of employment. On the employer side, decades of hard work and financial investment can be quickly undone by misappropriation of a database or the raiding of a company’s staff by a knowledgeable ex-employee.

THE BASICS

Purpose

Generally restrictive covenants are designed to protect against a company’s “legitimate business interests” including its proprietary information, trade secrets, and client relationships from unfair competition or misappropriation. Enforcement may lie in a claim for breach of contract, tort or both.

Protectable Interests:

Enforceable

Factors:

Process:

Generally, time is of the essence in order to bring an immediate halt to the dissemination of trade secret or the loss of a client, thus a complaint and a motion for emergency injunctive relief, with or without notice to the other side is filed in a court of competent jurisdiction. In time, a complaint is often preceded by a cease and desist letter to the offending party.

Brief History of Restrictive Covenant Law

July 25th, 2013

The history of restrictive covenant law begins with the apprenticeship system in pre-industrial England. In the earliest cases, masters had attempted to prevent competition from their apprentices following the apprenticeship period, through the use of agreements not to practice for a set period of time. British courts uniformly struck down such agreements as against public policy, arguing that enforced idleness is detrimental to both the individual apprentice and to society. In the most famous such case, The Dyer’s Case (1414), the court held that the apprentice’s covenant not to practice his trade in London for 2 years following his apprenticeship was void regardless of its terms. Given that the apprentice was trained only in a single particular skill and had limited mobility, the court determined that a restrictive covenant violated his right to livelihood and constituted a wrongful attempt to prolong subservience.

The current legal framework for enforcing restrictive covenants finds its origins in a case a few centuries later, Mitchel v. Reynolds (1711), in which a London baker leased his bakery and agreed not to compete locally but later broke that promise. At trial, the baker argued that this covenant was an illegal restraint on his livelihood that could not be enforced. Despite declaring that restrictive covenants are disfavored (“the law presumes them bad”), the court applied a rule of reason to uphold the agreement. The court based its reasonableness determination on a few factors, particularly (1) that the covenant was supported by adequate consideration, (2) that the restraint was limited rather than general in nature, and (3) that the public was not unduly injured by the restraint. Furthermore, the court distinguished this covenant for the transfer of business from covenants between employers and employees, noting that in a business transfer the parties are more likely to negotiate as equals and mutually benefit from the restraint. In making this distinction, the court reaffirmed judicial skepticism of covenants between an employer/master and an employee/apprentice, which may be prone to “great abuses . . . from masters, who are apt to give their apprentices much vexation on this account, and to use many indirect practices to procure such bonds from them, lest they should prejudice them in their custom, when they come up to set up for themselves.”

American courts adopted this precedent and almost universally rejected restrictive covenants throughout the 1800s. Employer attempts to restrain competition in New York were denied without regard to circumstance. Unlike 19th century British courts, which placed an increasing emphasis on freedom of contract to eliminate the traditional presumption against restrictive covenants, U.S. courts emphasized employee protection from exploitation, safeguarding the right to earn a living, and defending the public from loss of a free market. Their rejection of restrictive covenants applied not only to labor constraints but also to constraints on the flow of information. If an employee acquired knowledge on the job, the employer could not limit any subsequent use of that knowledge, in the absence of protection by patent.

This broad rejection of restrictive covenants began to wane around 1900 as courts started recognizing internal business information such as knowledge of particular customers and strategies as warranting legal protection. For the first time, U.S. courts identified a legitimate employer interest in restricting employee competition in order to prevent the abuse of confidences and protect employer investments. Quickly the American and British approaches became largely aligned. The rule of reason set forth in Mitchel v. Reynolds was adapted for modern times, with the British House of Lords and the American Restatement of Contracts (1932) espousing similar standards to enforce restrictive covenants, including most importantly that the restraint be no greater than necessary to reasonably protect the employer’s legitimate interests. As expressed in the 1932 Restatement of Contracts and then echoed by the 1979 edition, a restrictive covenant is reasonable if it (1) is no greater than required for protection of the employer, (2) imposes no undue hardship on the employee, and (3) tends not to substantially harm the public interest. Though courts continue to refine and revise conceptions of the permissible duration and scope of a restrictive covenant to afford reasonable protection, the essential standard for enforceability remains unchanged.

The above information is based on the following articles:

Catherine L. Fisk, Working Knowledge: Trade Secrets, Restrictive Covenants in Employment, and the Rise of Corporate Intellectual Property, 1800-1920, 52 Hastings L.J. 441, 442 (2001).

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 & Ent. L.J. 711 (2001).
Harlan M. Blake, Employee Agreements Not to Compete, 73 Harv. L. Rev. 625 (1960).