Non-Competition Agreements – How Strong Are They?

After years of litigation in Pennsylvania, the courts have made it clear that non-competition agreements between an employer and an employee are generally enforceable. Requirements of enforceability, however, contain additional conditions: the contract which contains the covenant must be supported by adequate consideration rendered at the time it is entered into, and the covenant must be reasonably limited in both geographical distance and length of time.

In almost every agreement to sell a business the buyer asks the seller/employee or other employees of the business being sold to agree not to compete with the business being purchased, disclose any proprietary information of the business, or solicit any of the employees or customers of the business. These three concepts are often termed “covenants” – a covenant not to compete, a covenant not to disclose, and a covenant not to solicit, respectively. In addition, many employers ask one or more of their key employees to enter into similar agreements.

The rationale for the existence of these types of covenants is obvious. The buyer or the employer is desirous of protecting the business, employees and confidential and proprietary information, and does not want the seller or the terminated employee to start a competing business.

Covenants of these varieties generally run for a certain term (such as three or five years), are limited to a defined geographical area (such as 50 miles from the office of the business), and are applicable to a specified type of product or service. In the sale of business context, the courts in Pennsylvania generally uphold a covenant not to compete, solicit or disclose that is supported by adequate consideration, and if the restrictions are reasonable in time, distance, and scope of business.

Many employers ask employees to enter into agreements containing these types of covenants, unrelated to the sale or the purchase of a business. For example, a covenant not to compete between an employer and an employee beginning upon termination of employment and extending for three years in a 50-mile radius of the business of the employer is an effective way to protect customer goodwill and proprietary business information.

In the employee context, the first and most critical issue is: was there adequate consideration in money or value provided to the employee at the time the employee entered into the covenant (and for this purpose we will group the covenant not to compete, the covenant not to solicit, and the covenant not to disclose together)? In the event the agreement is entered into at the time the employee commences employment, the offer and acceptance of employment constitutes adequate consideration, generally minimizing a defense of inadequate consideration. However, if the employer approaches an existing employee and requests the employee to enter into a non-competition agreement, there must be adequate consideration rendered at that time. In Pennsylvania, a majority of the courts have held that an offer of continued employment, conditioned upon the execution of a restricted covenant by the employee constitutes adequate consideration provided the previously existing employer-employee relationship is terminable at will by either party. The minority view in Pennsylvania is that an offer of continued employment does not constitute adequate consideration.

Because the best defense to enforcement of a covenant is lack of adequate consideration, an employer must document and precisely express consideration which is being offered and accepted at the time the covenant is requested. One way is to raise the pay of the employee and to document that the agreement not to compete is the reason for the bonus. The employee’s defense in this instance is that the raise or bonus was insignificant and was simply a means of justifying the agreement. Adequacy cannot be precisely defined, and the raise or bonus should be meaningful.

A change in an employee’s status from part-time to full-time is generally considered adequate consideration, and likewise a change in an employee’s status to that of an independent contractor has been held to be adequate consideration.

Promoting an employee to a higher level of employment or office, electing an employee a director, or granting an option to purchase stock in employer’s business are all recognized forms of consideration that will support the enforcement of a covenant. Other forms of adequate consideration may be the award of severance pay if terminated, or a non-qualified or retirement benefit. Substance must prevail, and fairness must exist for the employer to defend a covenant successfully. From an employee standpoint, the reverse is obvious. The employee’s attack is the lack of adequacy, or claim that the employer without notice demanded that all key employees immediately execute a covenant not to compete. Be careful about window-dressing. A nominal raise, a meaningless title, or any form of illusory consideration is not sufficient.

The element of time is of lesser importance. The time during which the covenant is applicable should be a reasonable length of time, that which is necessary to protect the interest of the employer. The test of reasonableness is subjective. However, the courts in Pennsylvania have routinely upheld covenants of one, two and three years as being reasonable. The difference in time relates to an analysis of the interests of employer being protected. The time period of the covenant generally commences upon termination of employment, and not upon the date of the execution of the employment agreement which contains the covenant.

As an overview, an employer should treat each employee separately, and look at the adequacy of consideration on an individual basis. An employer should not suddenly adopt a company-wide covenant not to compete program and attempt to coerce its employees into signing en masse. Each agreement should be in writing and clearly outline the covenants and restrictions that are being entered into by the employee. In addition, the particular industry to which the covenant relates should be examined; recent litigation in Pennsylvania indicates that there is a stricter scrutiny. For example, in the case of healthcare providers, the Pennsylvania courts will give closer scrutiny to the potential impact upon the public, if the application of critical health services is being terminated as a result of the terms of the covenant.

While a covenant not to compete generally requires a reasonable geographical restriction in order to be valid, a covenant not to solicit and a covenant not to disclose generally are upheld as being valid, even without a geographical restriction. Presumably, the length of time of a covenant not to solicit or disclose is not as important as the length of time for the covenant not to compete. Courts have held that a covenant not to compete for three and possibly five years is generally a reasonable period of time.

Geographic restrictions are to protect the legitimate interest of the employer. Courts will enforce geographic limitations in the employer’s primary business area and in the area where the employee performs services. The geographic limitation depends upon the facts and circumstances; one court in Pennsylvania upheld a covenant involving six northeastern states.

— Michael Beausang