Restrictive Covenants Tied to Compensation, Quirky Question # 96

Quirky Question # 96:

Our company is considering requiring our existing and future employees to sign non-competition agreements.  To make the agreements more palatable to our employees, we are considering linking the obligations imposed on the employees to an obligation on the company to compensate the employees if they cannot find suitable alternative non-competitive employment.  We are planning to cap the company’s obligation at one year of the employee’s base pay.Our feeling is that if we want to waive the non-compete for certain employees, as well as our payment obligations, we’ll be able to do so.  Moreover, we are planning to insist that the employees provide us monthly written reports of their efforts to find other jobs, detailing precisely what was done in the preceding month to find employment.  To the extent the employees fail to submit such a report in a particular month, or submit a report that in our discretion is inadequate, the company will be relieved of its obligation to provide the compensation.  Frankly, we feel this will provide us sufficient flexibility to withhold payment.  Make sense?

Dorsey’s Analysis:

Your question implicates a number of different issues.  As a prefatory matter, I’ll start with one of my primary mantras – employment law is often state-dependent.  Therefore, the first issue you need to evaluate is where your employees are employed and the law of these states regarding post-employment restrictive covenants.  (A related issue, not addressed here, is how the courts in the jurisdictions where your employees work analyze contractual choice of law provisions, i.e., the contract terms defining which state’s law will govern if a dispute arises between the employer and employee.)

If, for example, your employees work in California or North Dakota, your non-competition agreements will be unenforceable, except in extremely limited circumstances.  Both the legislatures and courts in these jurisdictions have repudiated non-competition agreements.  In short, when crafting your company’s non-competition agreements, you need to be acutely aware of the relevant state law.

My second observation is a question – Why do you feel your company needs to offer your employees a year’s compensation in connection with the non-compete you are asking your employees to execute?  Assuming your employees are not located in a state like California, North Dakota or other jurisdictions that reject non-competes, you do not need to link your non-competition agreements to post-termination compensation.  If you have supported your restrictive covenants with adequate consideration, and the agreements can otherwise withstand judicial scrutiny, you don’t need to offer continued compensation to make the restrictive covenants enforceable.  Non-competition agreements can withstand scrutiny if they are based on a legitimate corporate interest and are substantively, temporally and geographically reasonable.

The third issue you need to assess is one I alluded to above – Are your post-employment restrictive covenants are supported by adequate consideration?  You mentioned that you plan to require your “existing” and “future” employees to execute the new non-competes.  While a job offer generally will constitute sufficient consideration for your new employees, continued employment may or may not constitute sufficient consideration for your existing employees.  Again, this issue is dependent on the law of the state in which your employees work.

A separate question is whether your company’s offer of up to one year’s compensation in the event your former employee cannot find non-competitive employment would constitute adequate consideration.  I can’t offer a definitive opinion on that issue but I’m skeptical.  First, you state that as to some employees, your company may simply waive the non-compete to avoid making any payments.  If that practice is commonplace, your employees may well be able to argue that this contingent consideration is not adequate to support the non-compete.  Second, as you also noted, you intend to reserve the discretion to withhold the payments if, in your company’s opinion, your former employee has not made sufficient efforts to obtain alternative employment.  In a context where the employer has the sole discretion to determine whether payments must be made to the employee, a court may well conclude that no real consideration has been offered.

Lastly, I am somewhat uneasy by the undercurrent of your question.  You observe that if the employees do not submit reports on a monthly basis, or submit reports that the company, in its discretion, does not deem adequate,  you will have “sufficient flexibility to withhold payment.”  I don’t want to read too much into your observation but it sounds as though your company may be considering offering this benefit without really planning to provide your ex-employees with the compensation promised to make the restrictive covenants “more palatable.”  If so, that would be a mistake.

If you are going to enter a contract with your employees that includes restrictive covenants, and if you are going to offer substantial compensation to your employees to induce their agreement, your expectation should be that your company will fulfill its contractual obligations.  My admonition can be illustrated by a recent case from the Eighth Circuit Court of Appeals, Bannister v. Bemis Company, No.08-1634 (February 25, 2009).  The District Court (Judge Kyle from the District of Minnesota, applying Arkansas law due to a choice of law provision), granted summary judgment to the employee, awarding him $81,051 based on the defendant company’s breach of its monthly payment obligations, as set forth in the non-competition agreement.  Despite the de novo standard of review (that is, the appellate court did not defer to the lower court’s determination), the appellate court affirmed.

In Bannister, the non-compete prevented the employee from working for a competitor for 18 months following the termination of employment.  If the employee was “unable to obtain employment consistent with his abilities and education solely because of the [non-compete] . . . [the non-compete would continue to bind the employee] only as long as Bemis, in its sole discretion made payments to him equal to his monthly base salary at the time of his termination.”  Bannister requested his employer to release him from the non-compete so he could obtain employment with a Bemis competitor, but Bemis rejected this request.  Approximately nine months later, Bemis terminated Bannister’s employment, offering a severance package and a release from the non-compete, except as to the competitor Bannister previously sought to join.  Bannister declined the company’s offer.

Not long thereafter, Bannister requested Bemis to start paying his monthly salary pursuant to the company’s payment obligations set forth in the non-compete.  Bemis declined, pointing out that Bannister had been released to work for any company except for the one competitor Bannister previously had sought to join.  Bannister ultimately found employment with another company but there was a nine-month gap between the end of his job with Bemis and the commencement of his new employment.  Bannister then sought compensation under the non-competition agreement for the nine months in which he was not employed.  As the appellate court noted, “Because the [non-competition agreement] does not provide for a partial release, once Bannister provided the required documentation and sought payment from Bemis under the [agreement] . . . Bemis was obligated to pay Bannister his monthly salary.”

The court also examined the issue of whether Bannister’s failure to submit monthly statements regarding his efforts to find alternative employment (like the obligation your company is considering) justified the company’s refusal to pay the compensation required in the contract.  Because Bannister had provided documentation regarding the job offer he had received from Bemis’s competitor, and because Bemis breached its obligations by refusing to pay the required funds, the court found that Bannister did not need to submit the monthly statements that otherwise would have been required.  As the court stated, “the failure of one party to perform its contractual obligations releases the other party from its obligations.  The party who first breaches a contract is no position to take advantage of a later breach by the other party.”  (Citations omitted.)  In sum, both the federal District Court and the Court of Appeals found that the employer was obligated to fulfill its obligation to pay its former employer his base salary as set forth in the non-compete agreement drafted by the company.

If your company elects to include a payment obligation in your restrictive covenants (which, as discussed above, your firm does not need to do), be prepared to fulfill your obligations to your former employees.  Failure to do so would expose your company to risks of of litigation and liability.

Dorsey & Whitney

Dorsey & Whitney

Dorsey is a business law firm, applying a business perspective to clients' needs. We make it our first priority to know the context in which you do business - your market, your competitors, your industry.

You may also like...