Restrictive Covenants in an Expired Term Contract: Roy’s Analysis of Quirky Question # 179

Quirky Question # 179:

Our company has a sales force composed of individuals located throughout the U.S.  When we hire sales employees, we use a term employment agreement, typically of three years’ duration.  Our employment contracts include post-employment restrictive covenants, the most important of which are non-competes and non-solicits with respect to our customers.  Each restrictive covenant last two years.

We try to negotiate new agreements for the sales employees who are doing a good job.  Our goal is to get the new agreements in place at least one month before the existing agreements expire.  Sometimes, however, things fall through the cracks and we find ourselves negotiating a new agreement following the expiration of the former contract.  In the interim, the employees usually just keep working for us under the terms of the prior agreement. Then, if there are compensation changes, we make them retroactive to the date the prior contract expired.

One of our best salespeople recently advised us she was resigning to join a competitor.  Her contract apparently expired about three months ago but we failed to notice and did not negotiate with her regarding a new agreement.  Nevertheless, she continued working under the terms of her old contract and did not raise any concerns.

When she told us she was leaving, we tried to sweeten the offer to persuade her to stay.  We were not successful. We then told her we expected her to abide by the two-year non-compete and the two-year non-solicit.  Her response was that those provisions expired with the contract’s expiration.  That can’t be right, can it?  The contract specifically provides that the restrictive covenants continue for two years after the contract’s termination.

Roy’s Analysis:

There are a number of interesting aspects to your question.  But, let’s start with the basics.

First, as you noted in the first sentence of your question, your employees are located throughout the U.S.  As I’ve remarked in many prior Blog posts, it is critical to understand that post-employment restrictive covenants are governed by state law.  Moreover, state laws vary widely with respect to the these covenants – some states repudiate the restrictive covenants except in very limited circumstances, some states enforce them but only where they are justified by a legitimate corporate interest, and some states largely enforce the contracts as written.  Thus, your first task is to ensure you understand the law of the state where the issue you identified has arisen.

Second, perhaps I belabor the obvious to state that in any question involving contract interpretation, it is crucial to carefully parse through the language of the contract.  What did the parties intend?  Were the parties’ intentions accurately represented in the contract?  More specifically here, did the contract differentiate between termination and expiration?  Did the contract address the question of whether the post-employment restrictive covenants would survive the expiration of the contract?

Third, as you acknowledged, your employee’s contract “expired about three months ago but [you] failed to notice.”  As you seemingly understand, this is not a helpful fact.  Although your employee continued working without a contract for the last several months, her continued employment following the expiration of her contract likely has little impact on the legal issue you now confront.

Turning then to the specifics of your question, let’s start with the first issue I referenced above – what state’s law applies to the contract interpretation issue.  Where does this employee work?  Where was the contract executed? Is there an enforceable choice of law provision in the contract (i.e., a provision specifying that the law of a certain state will govern the enforcement of the contract)?  (It’s beyond the scope of this Blog analysis for me to provide you a state-by-state survey of this issue. For the purposes of your question, in a moment I’ll reference a couple of Minnesota cases that shed some light on this issue.) Read more

Non-Competes, Unsigned Agreement; Quirky Question # 126

Quirky Question # 126:

We have a non-compete issue.  Several years ago, we provided our employees with an employment agreement that contained various post-employment restrictive covenants.  When one of our employees left a couple of years later and started competing with us, we took a careful look at the non-compete language in the employment agreement.  Simply put, it was not brilliantly drafted.  Therefore, we had our lawyers draft a new version of the employment agreement that contained a more carefully crafted (and more comprehensive) non-compete.  Because our company also was having some financial difficulties at that time, we also used that opportunity to change everyone’s compensation formula, reducing their compensation.

Most of our employees signed off on the new agreement.  Several, however, did not.  Nevertheless, we started compensating those employees on the basis of the new compensation system and they continued to work.  After another year or so, due to ongoing financial problems at our company, we reduced everyone’s compensation yet again.  We presented the employees with a new employment agreement, containing the new compensation formula.  We also changed some other terms and conditions of their employment, and significantly enhanced the non-solicitation agreements (both with regard to co-employees and customers) contained in the agreement.  Again, some employees did not sign.  But, we started compensating them on the basis of the new agreement and they continued to work for us.

A couple of the employees who never signed the revised agreements recently left our company and joined one of our competitors.  We’d like to enforce the most recent version of the employment agreement, with its better drafted restrictive covenants, even though they did not sign.  Even though they did not sign, they continued working for us.  Short of enforcing that agreement, we’d like to enforce the agreement they did sign.  Do you see any problems with that plan? 

Roy’s Analysis:

Responding specifically to the question you posed at the end of your factual description, “Yes, I see problems with your plan.”  Let me step back, however, to explain why.

First, as a prefatory observation, keep in mind that there is no federal law regulating contracts that include non-competition provisions or other post-employment restrictive covenants.  Like so much of employment law, non-compete issues are dependent on state law.  Moreover, the 50 states are by no means uniform in how they treat post-employment restrictive covenants.  Some states repudiate these anti-competitive restrictions completely, whether by statute or common law; other states enforce them, largely as written.  So, the first challenge you confront is to ensure that you understand where your state falls on the spectrum of repudiation to complete enforcement. Further, you need to understand that if your company is operating in multiple states, you likely will not be able to use a single contract containing identical provisions if you expect to be able to enforce them in all jurisdictions where your company is operating.  In short, you need to tailor these provisions depending on location, considering the statutes and judicial decisions of the states where your employees are working.

Second, in your question you comment that you provided your “employees with an employment agreement that contained various post-employment restrictive covenants.”  This comment implies that you provided this agreement to both applicants and current employees.  If true, you may have a problem with the adequacy of the consideration needed to support these contracts.  For new employees, the provision of the job itself typically constitutes adequate consideration.  For existing employees, however, separate consideration typically is required to support a post-employment restrictive covenant.  Again, however, this varies from state to state, and in some jurisdictions, continued employment may constitute adequate consideration to support the contract, especially when other factors exist.  Unless your company is operating in one of those states, you may have a problem with regard to your current employees, separate and apart from the other issues I will address below.

Third, although it is good that you evaluated the quality of your employment agreements and the restrictive covenants contained in the agreements, you do not have complete latitude to alter those documents and impose the new agreements on existing employees.  Employment agreements, like any other contract, require an offer, acceptance of that offer, and as referenced above, consideration.  Although your company certainly has the right to change the employment agreements it uses, you have to meet the standard requirements needed to establish any contract.  You also noted that at the same time you reviewed the employment agreements, you also reduced your employees’ compensation.  Given that fact, it would appear that there was no consideration sufficient to support the change in the agreements and the restrictive covenants they contained, even for those employees who did sign.

Fourth, you stated that when you modified your employment agreements, some of your employees did not sign the new agreements.  As to these employees, your situation is even more problematic.  In my opinion, there are very few courts that will enforce these unsigned agreements.  By way of example, in Cypress Group, Inc. v. Stride & Associates, Inc., 2004 WL 616302 (Mass. Super. 2004), a Massachusetts court observed, “[E]ach time an employee’s employment relationship with the employer materially changes . . . a new restrictive covenant must be signed.”  Similarly, in Smith-Scharff Paper Co. v. Blum, 813 S.W.2d 27 (Mo. App. 1991), a Missouri court noted that materially altering employee’s salary after employee agreed to a non-competition covenant resulted in unilateral breach by the employer of the employment agreement.  (Remember, this is a state-by-state analysis.)

Contracts reflect an accord, an agreement, (or as law school contract professors like to characterize it), a “meeting of the minds.”  When an employee refuses to sign an agreement offered to him or her, it is pretty clear that he or she is not “agreeing” to the new terms.  At that point, your company had three alternatives: a) the company could have made a greater effort to obtain the signatures of those who balked, offering financial or other incentives to incentivize the employees to sign; b) the company could have made the difficult decision to part ways with the employees who refused to sign; or c) the company could have elected to stick with the original signed agreement.  Unfortunately, as discussed below, your company opted for none of those options.

Fifth, you also inquired whether you could enforce the original, signed agreement.  Here, your later actions have significantly diminished the likelihood that your initial agreement has any continuing validity.  The combination of your alteration of material terms of the original agreement, which you unilaterally imposed on your employees, coupled with your presentation of subsequent employment agreements to your employees vitiates your initial agreement.  The fact that you offered your employees new employment agreements presents several problems, especially because you also reduced your employees’ compensation in a manner consistent with the later agreements.  This action certainly suggests that your company has abandoned the initial agreement.  Alternatively, your decision to begin compensating your employees consistently with the later agreements would appear to be a breach of your original agreement and the compensation terms it contained.

Courts that have examined the enforceability of the original agreement when other agreements were subsequently presented have uniformly found the initial agreement to be unenforceable.  For example, in another Massachusetts case, AFC Cable Sys. v. Clisham, 62 F. Supp. 2d 167, 173 (D. Mass. 1999), the court found that a change in the employee’s title from “sales consultant” to “sales manager” and the accompanying modification of his pay structure, as well as the employer’s subsequent efforts to have him sign a new non-competition agreement, indicated that employee had entered into a new employment relationship with employer, thereby voiding the original non-compete agreement he had signed at the outset of his employment.  Similarly, in F.A. Bartlett Tree Expert Co. v. Barrington, 353 Mass. 585 (1968), the court held that changes in the employee’s compensation plan, title, responsibility, and territorial assignment, together with the employer’s requests that he sign a new agreement containing restrictive covenants, rendered the restrictive covenants in the agreement signed at the outset of employment unenforceable.  As these illustrative cases demonstrate, particularly when an employer changes material terms of an employee’s contract and presents the employee with a new agreement (or multiple new agreements), there is compelling case law that the original agreement is unenforceable. 

In sum, your company is confronting a number of serious problems with respect to any attempt to enforce either the later-presented, unsigned employment agreements, or the original signed agreement.  In my view, it would not be worth your time or energy or resources to seek to enforce any of these agreements as to the employees who left your organization and who are now competing with your company. 

Quirky Question # 104, Restrictive Covenants in Acquisition Context

In Minnesota, for example, courts will enforce reasonable post-employment restrictive covenants when linked to a legitimate corporate interest.  Recognizing that restrictive covenants are anti-competitive, restrain trade and restrict employee mobility, however, courts examine these agreements carefully.  As the Minnesota Supreme Court stressed more than 40 years ago, non-competes are “looked upon with disfavor, cautiously considered, and carefully scrutinized.”  Bennett v. Storz Broadcasting Co., 134 N.W.2d 892 (Minn. 1965).  Minnesota courts evaluate post-employment restrictive covenants to ensure that they are supported by adequate consideration, and are geographically, temporally and substantively reasonable.

In light of these general principles, even before turning to your specific question about the assignability of the restrictive covenants used by your firm, I recommend you evaluate the following key issues. 

First, where do your employees who have restrictive covenants work?  Do they all work in one state or are you confronting a situation where various states’ laws might apply?  Do the states where your affected employees work accept or reject restrictive covenants?  Are there important statutory or common law limitations that will govern the interpretation of these contract provisions?  If, for example, as alluded to above, some of these employees live and work in California, you may not need to consider the question of whether the covenants would be enforceable by a successor corporation because they probably would not be enforceable by your company.  (A corollary inquiry is whether, even for your hypothetical California employees, your employment agreements have choice of law provisions, i.e., contract terms that specify which state’s law will govern the interpretation of the contracts.  I’ll reserve the issues surrounding the validity of these provisions for another day, but note that it is important to your analysis.)

Second, assuming your employees are working in a state that does not repudiate post-employment restrictive covenants, the next fundamental inquiry for your consideration is what important corporate interests support your company’s restrictive covenants?  Based on the facts you set forth, it would appear that your company considers carefully whether particular employees should be asked to execute the restrictive covenants.  As you noted, your company only asks your “engineers, senior managers, and other select employees” to execute the restrictive covenants.  This suggests to me that you should be able to articulate the reasons why your company considers it important for these individuals to sign agreements with these types of post-employment restrictions.  But give some thought to how you would express these ideas.

Third, again as referenced above, did you provide your employees consideration for executing the restrictive covenants?  If they were informed of the restrictions when they first sought employment, the job offer and subsequent employment can constitute sufficient consideration.  If, however, the request to one or more of your employees was an afterthought, and your company did not present them with the employment agreements containing the restrictions until after their employment commenced, you need to assess whether sufficient consideration was provided to support these contract provisions.  If not, again you may not have an agreement that your company, let alone a corporate successor, could enforce. 

Fourth, are the terms of the restrictive covenants reasonable?  What is their geographic scope?  What is their duration?  What types of jobs would the restrictions prevent your employees from taking?  The more onerous the burdens imposed on your employees, the more skeptical courts are likely to be about their enforceability.  Once again, these issues should be evaluated before you even consider the impact of the potential acquisition on your employees’ restrictive covenants.

If, after exploring each of the issues addressed briefly above, you have concluded that the post-employment restrictive covenants would be enforceable by your company, the next part of the analysis is the one on which your question focused – Would the restrictions be enforceable by the successor company?  Like other aspects of contract analysis, the first place to begin the evaluation is the contract itself.  What specifically does the contract state about successors, if anything?  What specifically does the contract state about the rights of your company to assign the agreements?  What language was used in the contract regarding the nature of these “personal services” agreements?  Looking at the specific contract language is the starting point for your analysis. 

Here, you stated that “there is nothing in the agreements themselves that addresses the [acquisition context].”  This could be problematic.  Courts that have rejected enforcement of restrictive covenants when the underlying contract lacked an assignment provision focus on various factors to justify their decisions. 

First, they point to the personal nature of the contractual obligations set forth in the agreement.  For example, in Cary Corp. v. Linder, 2002 WL 31667316 (Ohio Court App. Nov. 27, 2002), the court observed, “The strong policy considerations in All-Pak [an earlier decision] recognize that the employment relationship is a personal matter between an employee and the company who hired him and for whom he chose to work.  Unless an employee explicitly agreed to an assignability provision, an employer may not treat him as some chattel to be conveyed, like a filing cabinet, to a successor firm.” 

Second, courts have pointed to the fact that the employers typically draft the employment agreement, with no input from the employees.  In this context, courts are reluctant to read terms into the agreement that the employer failed to include.  This is a factor that likely will militate against the enforcement of your agreements by a successor company.

Third, courts look to the specific underlying facts to evaluate the equities of the situation.  For example, you stated that your firm is a software company.  Let’s assume (arbitrarily) that your start-up has 75 employees and operates in just one state.  Your employees may have been willing to sign a restrictive covenant that restricted their employment options in that state.  Let’s assume further that the acquiring company is a national software firm that does business in all 50 states and internationally.  In that context, the language of your geographic restriction may take on far greater implications and be far more limiting for your employees.  In this context, a court may be far more reluctant to enforce a geographic restriction linked to the locations where your company’s potential successor does business.

Fourth, as referenced above, restrictive covenants constitute a partial restraint of trade and are anti-competitive.  Courts often look for reasons not to enforce these restrictions.  The absence of a clear assignment provision, included as part of the agreement at the inception of an employee’s employment, is an easy way for a court to reject enforcement of the agreement by a successor company.

In short, given the absence of an assignment provision in your employment agreements, it would be imprudent for your company to represent to the potential acquirer of your firm that the restrictive covenants will bind your key employees.  This is not likely to be true. 

But, don’t despair.  There should be multiple ways to assuage the concerns of your company’s suitors on these issues.  Regardless of the absence of contract assignment language, there remain a number of legal protections for any acquiring company.  For one thing, your employees have fiduciary duties to your company, primarily linked to their duty of loyalty and their duty of confidentiality.  For another, most (though not all) states have adopted the Uniform Trade Secrets Act, that justifiably restricts your employees’ ability to share your proprietary and confidential trade secret information with others.  To the extent that the potential acquiring companies are concerned about protecting your company’s proprietary information, these interests should be protected. 

Finally, there is no reason why the acquiring company should not be able to prepare new post-employment restrictive covenants for your existing employees.  This will enable them to create contracts that are consistent with any agreements currently in place at the acquiring company for similarly situated employees.  And, in these agreements, suggest that they include an assignment provision.