Labor: 5 considerations for evaluating restrictive covenant enforceability

Figure out your chances before heading to court.

Companies often seek to protect confidential, proprietary business information, customer and employee relationships and restrict unfair competition by requiring employees to sign restrictive covenants prohibiting certain activities after their employment ends.

Such restrictions may involve: agreements not to compete with the former employer, agreements not to solicit customers, agreements not to solicit or hire employees and agreements not to disclose confidential information. Agreements that limit post-employment competitive activities are typically governed by state law and may or may not be enforced. Many Courts dislike enforcing these agreements unless it is necessary to protect the employer’s legitimate business interests.

In order to determine if a restrictive covenant is enforceable, a company must consider the laws of the state where the employee works and the laws of the state that governs the interpretation of the agreement. Additionally, the company must fully investigate the facts regarding the execution of the agreement containing the restrictive covenant, the circumstances surrounding the employee’s time with and departure from the company, the duties of the employee while with the company and the extent to which the company will be harmed if the former employee does not abide by the restrictive covenant.

What follows is a brief checklist of things to consider in evaluating the enforceability of a restrictive covenant.

1. Locate the agreement

As simple as this sounds, there are times when an agreement cannot be located even though management is convinced  that a departed employee signed one. While there are a variety of other causes of action that may be brought against a former employee who is believed to be competing unfairly with his former employer (e.g., breach of the duty of loyalty, violation of Trade Secrets laws, violation of the Computer Fraud and Abuse Act), a copy of the signed agreement containing the restrictive covenant must be located so that its precise terms can be reviewed, if the employer and appropriate claims based upon the agreement can be asserted.

2. Make sure that the consideration for the agreement is sufficient.

State laws vary in terms of what constitutes adequate consideration for a restrictive covenant. For example, in A.T. Hudson & Co. v. Donovan, the New Jersey Appellate Division held that a covenant executed at the beginning of the employment relationship was supported by adequate consideration. However, in Diederichi Insurance Agency, LLC v. Smith, the Illinois Court of Appeals, Fifth District, held that a covenant signed three months before an employee was terminated was not supported by adequate consideration. Thus, the applicable state law must be reviewed to determine whether there is sufficient consideration for the agreement.

3. Check to see if there are any skeletons in the closet.

When deciding whether or not to institute litigation seeking to enforce a restrictive covenant, a company should be prepared for the possibility of counter-claims from the former employee. If the employee has not been paid all that is due to her or if the employer has otherwise violated the agreement with the employee, the company will likely be unable to enforce the restrictive covenant.

Many courts will consider the circumstances around the employee’s departure from the company when determining whether or not to enforce the restrictive covenant. Courts in New York, unlike courts in many other states, regularly hold that restrictive covenants will not be enforced if the employee is involuntarily terminated without cause. However, even in New York, if the employee is terminated for cause, her termination will not bar enforcement of the covenant. In Gismondi, Paglia, Sherling, M.D., P.C. v. Franco, the United States District Court for the Southern District of New York held that a restrictive covenant signed by a physician was enforceable in a case where a former employee was terminated for cause when, among other things, he failed to turn over payments he received from hospital and misappropriated patient billing records.

4. Examine whether the agreement meets the standards for enforcement in the jurisdiction.

In states where restrictive covenants are considered enforceable, courts will usually review the covenant in question to determine if the restriction is necessary to protect the employer's legitimate business interests, is sufficiently limited in time and geographic scope, does not present an unreasonable burden on the employee and does not violate public policy. An analysis should be conducted to determine if the covenant meets the standards set forth in decisions interpreting the applicable state’s laws.

Additionally, the agreement must be examined to determine if the company is capable of enforcing the restrictive covenant. If the company that hired the former employee has been sold, the new company may not have standing to enforce it. Courts will evaluate the relationship between an employee’s original employer at the time of signing a restrictive covenant and the successor employer to determine whether the successor employer can enforce the restrictive covenant. An analysis of the relevant case law on this topic must be conducted before determining whether a successor employer is entitled to enforce the agreement.

5. Consider alternatives to litigation

Litigation involving restrictive covenants is often expensive and time consuming. Discovery can be voluminous and may involve the production of documents confidential to the former employee and his new employer, who is a competitor of the company. Sometimes compliance with the restrictive covenant can be achieved with a cease and desist letter to the former employee and, if appropriate, the new employer. This option should always be considered before litigation.

However, sometimes such an approach is not warranted by the facts and a strategic decision must be made as to whether an application to the court for an injunction is the best way to achieve compliance. The decision should be made as soon as possible after the relevant facts are gathered. In order to obtain a Temporary Restraining Order in a restrictive covenant case, a company will usually need to show that there is a likelihood of success by the company on the merits of the claim, that irreparable injury will occur in the absence of injunctive relief and that there is a balance of equities in favor of granting injunctive relief. A delay in bringing the case to court undermines the company’s claim that it will suffer irreparable harm if the Court does not issue a restraining order.

author image

Sharon Margello

Sharon Margello is a shareholder in the Morristown, NJ office of Ogletree Deakins and Co-chair of the firm’s Unfair Competition and Trade Secrets Practice...

Bio and more articles

Join the Conversation

Advertisement. Closing in 15 seconds.