- Tools Employers Need to Protect Trade Secrets -- Part 1: Restrictive Covenants
- May 5, 2003
- Law Firm: Fox Rothschild LLP - Exton Office
Litigation concerning restrictive covenants, trade secrets and confidential information has generated so much attention from the courts and commentators that the standards to be extracted from these sources can be confusing to lawyers and nonlawyers alike. Enforcement of restrictive covenants and trade secret protection is perhaps most troubling for the courts because it involves tension between two significant and countervailing policies: on the one hand, the encouragement of free trade and competition in the marketplace and an individual's right to earn a living, and on the other hand, an employer's interest in protecting trade secrets and, more generally, its time and expenditures in training and imparting skills and knowledge to its paid work force.
The following will provide employers with an overview of the techniques available for protecting your company's trade secrets and other business interests.
What are restrictive covenants?
A restrictive covenant is an agreement between the employer and an employee which limits the employee's activities after termination of employment. Generally, the covenant restricts the former employee's ability to work with a competitor, although it can also restrict the former employee's ability to solicit the employer's customers and employees.
Why are restrictive covenants important?
Restrictive covenants provide an adequate, timely and flexible remedy often not otherwise provided by law. They extend beyond trade secret protection, filling in gaps left by unfair competition and other business torts by providing increased protection for the employer's business interests. Restrictive covenants not only provide adequate remedies, but timely ones through the availability of injunctive relief to prevent or minimize competitive injury.
When should employers use restrictive covenants?
Courts will enforce restrictive covenants only when they are necessary to protect an employer's legitimate business interests. Courts strictly construe restrictive covenants because of their restraint on the free exercise of trade, and because of the courts' reluctance to prevent an individual from earning a living. Pennsylvania is a "blue pencil" state, meaning that the courts will modify restrictive covenants to reflect what they deem to be reasonable and necessary under the circumstances. For example, a covenant restricting a former employee from working in the same line of business "within Pennsylvania for five years" may be modified to "within Bucks County for two years."
What are the elements of typical restrictive covenants?
Restrictive covenants should contain a description of the circumstances surrounding entry into the agreement, including the employment relationship or other relationship of the parties and the consideration for the agreement. They should also contain a detailed, specific description of the restrictions imposed, and the limitations on those restrictions in terms of their duration and geographic scope. When delineating the restrictions, employers should consider the area in which the employee does business, as well as the geographic reach of the employer. Although employers usually like to extend the restrictions as far as their customer base extends, courts often curtail the scope to the territory in which the employee did business. Agreements may also extend the duration of the restrictions in the event that the employee breaches the agreement, or postpone commencement until the employee's violation ceases or a court enforces the restrictions.
Agreements may also contain enforcement tools, which may help in the event of litigation. Provisions such as choice of law, choice of forum and consent to personal jurisdiction, if upheld, allow the employer to effectively choose the court in which he or she will enforce the covenant and the law that will apply. Agreements should also contain assignment clauses, allowing them to be assigned by the employer in situations such as a subsequent merger. Assignment clauses are significant, as Pennsylvania courts have refused to enforce restrictive covenants where the party seeking enforcement was a successor by merger to the employer who entered into the restrictive covenant with the employee.
What are the requirements of enforceable restrictive covenants? Consideration must be given for restrictive covenants. Essentially, in the employment context, this means that Pennsylvania law prohibits employers from foisting restrictive covenants upon employees without giving them something in return. Typically, restrictive covenants are part of the terms of new employment, with the offer of employment being the consideration for the covenant. That is not, however, always the case. Examples of situations where Pennsylvania courts have found valid consideration include:
- Covenant that was part of initial terms of employment
- Oral covenant that was agreed to at the outset of employment, embodied in a written contract executed soon thereafter
- Covenant entered into in exchange for a change of employee tenure from at-will to a specific term
- Covenant entered into in exchange for a conversion from provisional employment to regular employment
- Covenant entered into in exchange for an agreement by the employer to pay the employee commissions
- Covenant entered into in exchange for a promotion and eligibility for profit sharing
- Covenant entered into in exchange for a monetary payment, the promise of two weeks' notice before termination, the promise of two weeks' severance pay, and increased benefits and reimbursements
- Covenant entered into in exchange for the issuance of stock or rights to stock
Examples of situations where Pennsylvania courts have found that valid consideration did not exist for the covenant include:
- Covenant that was first disclosed on the first day of work, rather than on an earlier date when the parties agreed on employment terms
- Covenant that was not presented to or discussed with the employee until after the employee had worked for several weeks
- Covenant entered into in exchange for continuation of employment under earlier agreement, plus one dollar
- Covenant entered into upon the threat of loss of employment upon refusal to sign
- Covenant entered into in exchange for the conversion from an oral to a written employment contract, without any change in the terms of employment
- Covenant entered into in exchange for a regular, scheduled salary increase
- Covenant entered into in exchange for an agreement by the employer to provide notice of termination
- Covenant entered into in exchange for the payment of $1000 (without more)
When would covenants be enforced?
Courts will only enforce covenants where they are reasonably necessary to protect the employer's legitimate business interests. In ascertaining the reasonableness of restrictions, courts consider the type of restrictions imposed, the geographical and temporal extent of the restrictions, and the relationship between the restrictions and the employer's purported interests being protected. Examples of legitimate business interests include the employer's customer goodwill, the employer's trade secrets or confidential business information, and the employer's investment in specialized training for the employee.
In terms of the temporal reach of restrictions, courts usually enforce restrictions only for so long as necessary for the employer to hire and train a new person to replace the departing employee, and to restore the employer's customer relations and goodwill. One to two year restrictions are usually considered to be reasonable in Pennsylvania.
In terms of the geographic scope, the restrictions may not be broader than necessary. Courts often look to the territory covered by the employer, and in many cases the territory of customers serviced by the employee. Courts can, and often do, modify the scope to extend only to those areas actually served by the employee, or customers who existed when the employment ended.
When is it difficult to enforce restrictive covenants?
Employers who discharge employees for failure to perform have been prevented from enforcing restrictive covenants against them in Pennsylvania, on the theory that the employees have no worth to the employers and are therefore no threat if they compete. Pennsylvania courts have also refused to enforce restrictive covenants where no trade secrets were at issue and the employees were discharged for poor performance. In contrast, courts have enforced restrictive covenants against employees discharged for misconduct.
When should litigation be used to enforce restrictive covenants?
These cases are often brought with a heightened state of urgency. A typical scenario involves a high level employee with knowledge of a formula or method who leaves for a competitor or forms his own competing company, and uses the information to produce a competing product. In a few short weeks, he may appropriate a process that it took the former employer years of research and development and millions of dollars to create.
Employers can proceed by filing either an application for a temporary or special injunction, or a preliminary injunction. These steps are discussed in more detail below.
Temporary / Special Injunction
Because of the urgency, these cases often start with the filing of an application for a temporary or special injunction that is typically heard by the court within a matter of days. The employer must demonstrate that immediate and irreparable harm will result if the relief is not granted, and makes the application with or without notice to the employee. Unless the situation is a dire emergency, where the employer can not afford the time required to give the employee notice of the application, notice should usually be given. Courts are typically hesitant to grant relief at this early stage, although they will where justified by the circumstances. Where the employee has violated the covenant by obtaining competitive employment, courts may be loathe to enforce the covenant and "fire" the employee at this early stage, without an opportunity to fully consider the positions of both sides. If relief is obtained at this stage, it is only of temporary duration, typically lasting until the court conducts a hearing on the preliminary injunction.
If a dire emergency is not presented, the employer usually files an application for a preliminary injunction. Preliminary injunctions are also temporary in nature, and, if granted, typically remain in force throughout the litigation until the court makes a final determination of all claims asserted in the case.
There are different requirements for obtaining a preliminary injunction, depending on whether the action is brought in federal court or in state court. In federal court, an employer moving for a preliminary injunction must show: (1) a strong likelihood of success on the merits; (2) that the injunction is necessary to prevent irreparable harm that can not be compensated by monetary damages; (3) that a greater injury would result by refusing to grant the injunction than by granting it; and (4) that granting the preliminary injunction is in the public interest. In state court, an employer must show: (1) the injunction is necessary to prevent immediate and irreparable harm which could not be compensated by monetary damages; (2) that a greater injury would result by refusing to grant the injunction than by granting it; and (3) that the injunction would restore the parties to their status as it existed immediately prior to the alleged breach of the covenant.
Demonstrating a strong likelihood of success on the merits equates to a showing that the employee agreed to the restrictive covenant and that the covenant is enforceable - i.e., it was ancillary to employment, was supported by adequate consideration, is reasonably necessary to protect the employer's legitimate business interests, and is reasonable in duration and in scope.
The following actions should be taken to increase the likelihood of enforcement.
- Review the restrictive covenant and amend it, if required.
- Restrictive covenants should be reviewed periodically to determine if the restrictions are, or remain, reasonable.
- The covenant should contain an acknowledgment that its purposes were explained to the employee.
- The covenant should state that its breach can not be remedied by money damages and that an injunction is appropriate and necessary.
- The time restriction should state that if an action to enforce the covenant must be brought, the time period commences when the court orders enforcement. It should also state that the duration of the restriction shall be extended by any period of time in which the employee was in violation of its terms.
- The covenant should contain a choice of law and choice of forum provision.
- Require execution of the restrictive covenant by the employee to be witnessed.
- Renew the restrictive covenant periodically and upon change of the employee's position or title.
- Use the restrictive covenant with only those employees who can legitimately harm the employer's interests. Do not overreach and be no more restrictive than absolutely necessary.
- Enforce restrictive covenants consistently.