Teaching entrepreneurship: the importance of noncompete agreements to the viability of the enterprise.

Geho, Patrick R. ; Lewis, Stephen D.

INTRODUCTION

Entrepreneurs face a myriad of challenges, not the least of which is hiring, training and managing employees who may one day become competitors. Business owners must prevent their trade secrets, customer lists, and other proprietary information from being used by a current or former employee to the detriment of the enterprise. Employees, especially those who have worked for a business for several years, may become particularly familiar with day-to-day business operations. Having learned the trade and its processes, these individuals may sense an opportunity to venture out on their own and establish a competing business. The entrepreneur's recourse is to utilize a noncompete contract to protect the firm's interests.

Entrepreneurs of all types must be vigilant in protecting their business interests. Even those engaged in franchise contracts frequently find themselves compelled to enter into a noncompete agreement with their franchisor. Likewise, a buyer of an existing business also has a compelling interest in securing a noncompete agreement with the seller to ensure that the newly acquired business is protected from possible competing interests of the seller.

Potential for economic harm as a result of the misappropriation of a firm's proprietary information by an employee or former employee should be an integral part of the discussion in entrepreneurship courses. Student exposure to this facet of business operation should occur from an approach that does not overwhelm with too much legalese. The objective should be to impart an understanding of the critical importance noncompete agreements play in relation to the wellbeing of the enterprise. Various scenarios and actual legal cases will be cited throughout the following sections to illustrate this importance.

NONCOMPETE CONTRACTS

A contract is "an agreement between two or more parties creating obligations that are enforceable or otherwise recognizable at law" (Garner, 2004, p. 341). Its essentials are competent parties, subject matter, a legal consideration, mutuality of agreement, and mutuality of obligation. When entrepreneurs perceive a need to prevent misuse of proprietary information, they may require employees to sign a noncompete contract, sometimes called a noncompetition covenant. A noncompetition covenant is "a promise, usually in a sale-of-business, partnership, or employment contract, not to engage in the same type of business for a stated time in the same market as the buyer, partner, or employer" (p. 392).

Entrepreneurial ventures frequently increase during poor economic times or recessions. Victims of downsizing or rightsizing seek opportunities wherever they can find them. Thus, the need for a noncompete contract may increase.

As many executives are taking extra measures to protect their companies during the economic downturn, employment attorneys are seeing an increase in litigation around trade secrets. Specifically, employers are being more aggressive about suing former employees regarding noncompete agreements, attorneys say (Marquez, 2008).

ENFORCING NONCOMPETE CONTRACTS

Suing former employees over a noncompete agreement is seldom easy. Because entrepreneurship studies students are typically not exposed to noncompete agreements in their entrepreneurial studies curriculum, it is important to first explain that within the four corners of a noncompete agreement, there is much to be taken into account to draft an enforceable contract. Enforceability is based upon the prevention of "unfair" competition. "In brief, at common law a restraint against competition was valid to the extent it reasonably provided for the protection of a valid interest of the covenantee" (Monogram Indus., Inc. v. Sar Indus., Inc., 1976). Common law is defined as "the body of law derived from judicial decisions, rather than from statutes or constitution" (Garner, 2004, p. 293). However, a number of states are moving away from the common law in relation to the enforceability of covenants not to compete, which is disconcerting to business owners.

Unfortunately, there is no uniform federal statute that gives states a roadmap to follow concerning noncompete agreement enforceability per se with the narrow exception of the Uniform Trade Secrets Act. This act itself is not intended to establish uniform federal standards regarding trade secrets, but rather is the codification of existing states' interpretation of trade secrets based upon existing common law. So other than the issue of trade secrets in relation to noncompete agreements, there is much variability in states' laws in the level of protections afforded to businesses in enforcing noncompete agreements.

Some states look at noncompete agreements as creating an undue restraint of trade, and therefore against public policy. Other states consider noncompete agreements enforceable in relation to a condition of employment and where limited in scope, typically referring to time and geography language in the agreement.

Although courts recognize that enforcing a restrictive covenant may result in the loss of an individual's livelihood, most courts across the country today will enforce the agreement if it meets certain tests. California and a dozen or so other states generally do not uphold restrictive covenants (Shapiro, 1993).

More often than not the courts construe noncompete agreements in favor of the employee rather than the employer, so the employer must include meticulous details when preparing a noncompete agreement.

PUBLIC POLICY

Public policy may be considered as a basis for not enforcing or limiting the enforceability of noncompete agreements. This may be troublesome to business owners who are trying to protect their business interests. California courts are often cited as the example of a state that as a matter of public policy generally deems noncompete agreements unenforceable, with the narrow exception of when it relates to an employer's trade secrets. The California Supreme Court has held that provisions in employment contracts prohibiting employees from working for a competitor after completion of their employment or imposing a penalty if they do so is to that extent void, unless those provisions are necessary to protect the employer's trade secrets (Muggill v. Reuben H. Donnelley Corp., 1965).

A District Court in Arizona held that the restrictive covenant a physician (employee) entered into with a medical group (employer) was too broad and against public policy, because (1) the covenant not to compete for three years is unreasonable, (2) the prohibited geographic area encompassed 235 square miles and was thus unreasonable, and (3) the covenant did not provide an exception for emergency care. The court of appeals reversed, holding that a modified version of the covenant was reasonable because there were eight hospitals outside the restricted area where the former employee could practice. Furthermore, the severability clause allowed him to perform emergency services within the area; and the employer was allowed to stipulate that the employee could treat certain cases within the prohibited area. The employee appealed to the Supreme Court. At issue, can a restrictive covenant prohibiting a doctor from competing within a certain geographic area for three years after the termination of the employment agreement be enforced?

In the same case the Arizona Supreme Court held that a restrictive covenant restraining competition between the employer and employee cannot be enforced for two reasons: (1) the restraint is greater than necessary to protect the employer's legitimate economic interests, and (2) even if the restraint was not overly broad, the competing interests of the patients and the public in general outweigh the economic interests of the employer. In addition, the court said the three-year restriction was unreasonable, given the nature of the profession and pointing to the patients' needs. Thus, a reduction of the noncompete period to six months would be sufficient to protect the employer. The covenant was too broad in scope and precluded any type of practice by the former employee. Legitimate economic interests of the employer in this case could not withstand the interests of public policy. The negative impact the covenant not to compete had on the patients' right to see the departing physician came into play and outweighed the employer's interests. The general rule in Arizona is that restrictive covenants restraining competition or commerce are unenforceable. However, such a restraint can be enforced if it is reasonable and is not against public policy (Valley Medical Specialists v. Farber, 1999).

To be valid and enforceable and not in violation of public policy, a noncompetition covenant must be reasonable from both the employer and employee's standpoints. A recent case involved plaintiffs who produced and distributed trade publications relating to homeland security. The defendant in the case, which sold advertising space for the plaintiffs' publications, agreed not to compete with the plaintiffs by selling or promoting publications that competed with the plaintiffs' publications. The defendant argued that the lack of any geographic limitation rendered the noncompetition agreement unenforceable as a matter of law because it essentially imposed a worldwide restriction. The court stated that while there was no geographic limitation, the agreement had a duration of one year and limited the prohibited activities to those in direct competition with one journal. Thus, the mere fact that there was no geographical limitation was not fatal to the enforceability of the agreement. The terms of the noncompetition agreement were narrowly tailored to protect the plaintiffs' legitimate business interests while not prohibiting the defendant from competing in the chosen field. The agreement also appeared to be narrowly tailored so that it did not offend public policy. This case successfully upheld a noncompete agreement without a geographic limitation, reversing long-standing Virginia precedent (Market Access Intern. Inc. v. KMD Media LLC, 2006).

THE BLUE-PENCIL DOCTRINE

The Blue Pencil Doctrine is a legal concept in common law that enables amending a contract. This doctrine is defined as

a judicial standard for deciding whether to invalidate the whole contract or only the offending words. Under this standard, only the offending words are invalidated if it would be possible to delete them simply by running a blue pencil through them, as opposed to changing, adding, or rearranging words, (Garner, 2004, p. 183).

Courts in states that recognize the blue pencil doctrine may attempt to reform the noncompete agreement to create an enforceable agreement from what otherwise would violate the law in that state. "If it is clear from its terms that a contract was intended to be severable, the court can enforce the lawful part and ignore the unlawful part." To the contrary, "where the severability of the agreement is not evident from the contract itself, the court cannot create a new agreement for the parties to uphold the contract" (Olliver/Pilcher Ins. v. Daniels, 1986).

Arizona courts have adopted the blue pencil doctrine in order to reform covenants that are not unreasonable but apply it only in cases where severability was the original intent and the agreement is not against public policy. "Arizona courts will 'blue-pencil' restrictive covenants, eliminating grammatically severable, unreasonable provisions" (Valley Medical Specialists v. Farber). States are less inclined to apply the blue pencil doctrine approach to modifying a noncompete agreement when it appears that employers are over-reaching in the "terms and conditions language" of the noncompete agreement and when employers use the agreement's broad language as a firewall and a deterrent to employees competing.

In Indiana the courts adopt the "strict" interpretation of the blue pencil doctrine which permits a court to strike out only the overbroad language. "Apart from the 'blue pencil' doctrine ..., if the agreement as drafted is unreasonably broad, it cannot be enforced in part on the theory that the parties could have agreed to some more reasonable terms" (Product Action Intern'l, Inc. v. Mero, 2003).

REASONABLE MODIFICATION DOCTRINE

Some states apply reasonable modification to noncompete contracts where there is a compelling reason to modify the agreement in order to permit enforcement. Illinois is one such state. In supporting the contention that defendants have a protectable interest in enforcing the restrictive covenant, the court upheld a restrictive covenant contained in an employment agreement between a departing ophthalmologist and an eye clinic, prohibiting the ophthalmologist from practicing within a 50-mile radius of the eye clinic's branches at which he previously practiced. The court found that

Restrictive covenants between medical doctors are not detrimental to the public interest because the restricted doctor can be just as useful to the public in another location outside the restricted area; and the physician can always resume his practice in the restricted zone once the time duration of the covenant not to compete has expired (Gillespie v. Carbondale & Marion Eye Centers, Ltd., 1993).

However, the Gillespie court did recognize "the possible adverse effects that enforcement of this restrictive covenant could have on the public," but it felt compelled to follow an earlier Illinois Supreme Court case (Canfield v. Spear, 1969), which held that restrictive covenants between medical doctors are not detrimental to the public interest for the previously noted reasons.

REASONABLENESS OF THE AGREEMENT

Many states apply a test of reasonableness in determining whether to enforce a noncompete agreement. In employment cases, reasonableness breaks down into three issues:

1. Is the restraint reasonable in the sense that it is no greater than necessary to protect the employer in some legitimate interest?

2. Is the restraint reasonable in the sense that it is not unduly harsh and oppressive on the employee?

3. Is the restraint reasonable in the sense that it is not injurious to the public?

So the question might be posed: Is it reasonable to ask an employee to sign a noncompete agreement well after being employed with no additional consideration given to the employee? At issue is whether additional consideration is required in order to enforce a noncompete agreement entered into after employment has begun. The trial court found that there does not have to be any new consideration for a noncompete agreement even though it is entered into after an employee has been employed for a period of time (CentralMonitoring Service, Inc. v. Zakinski, 1996).

Standard contract law governs the enforceability of a noncompete agreement. South Dakota statutes state that an employee may agree with an employer at the time of employment or at any time during his employment not to engage directly or indirectly in the same business or profession as that of his employer "as long as the noncompetition agreements comport with the statutory language" (American Rim & Brake, Inc. v. Zoellner, 1986).

Many courts will not enforce an overly broad noncompete agreement or will enforce it only in the state in which the cause of action arose allowing the noncompete agreement to stand in other states in which the business also had a presence. The general rule is that the local law of the state that "has the most significant relationship to the transaction" will govern (Restatement [Second] of Conflict of Laws [section] 188). Contract law is for the most part intended to facilitate the interests of the parties to the agreement. Where there is an issue of multiple jurisdictions involved, many states will follow the reasonable test and enforce the agreement as it pertains to that state's law while deferring on the matter of enforceability on the same issue as applicable in another state. For example, an employer's noncompete agreement that prohibited a former employee from working for a competitor anywhere in the world and prohibited solicitation of any of the employer's customers was overly broad and unenforceable under Georgia law (Keener v. Convergys Corp, 2003). However, the Georgia appeals court would not support the trial court's ruling that the noncompete agreement was unenforceable in another state where the employer also had operations.

For a complete definition of reasonableness as it applies to noncompete agreements, see Unreasonableness of Covenant Not To Compete, 20 AmJur Proof of Facts 3d 705, [section] 3:

CONCLUSION

When teaching entrepreneurship, consideration should be given in curriculum development to aspects of contract law and more specifically noncompete agreements that could have an impact on nascent enterprises. Students need to be made aware of the possible need for a noncompete agreement in developing a business plan, the essential elements to create a legally enforceable agreement, and the potential pitfalls inherent in enforceability from one state to another. As students assimilate into the work force, they may find themselves on either end of a noncompete contract. As employees, they should be acutely aware of what limitations might be imposed by their signature on a contract. Likewise, their familiarity with noncompete contracts may mitigate future anguish when they hire staff for their own businesses.

Although there are a few states that hold noncompete agreements as prima facie void, most state courts will rule for partial enforcement. Thus, a promise in a noncompete agreement should be enforceable by and large when public policy issues are not in conflict and where the agreement is in severable terms. There is much case law on the subject of noncompete agreements, and while it is not easy to reconcile because the law is far from being settled, entrepreneurship students should be exposed to the subject matter since there is a high probability that they will be faced with the issue sometime during their business careers.

REFERENCES

20 AmJur Proof of Facts 3d 705, [section] 3: (1993 and Supp. 2001). American Rim & Brake, Inc. v. Zoellner, 382 N.W. 2d 421, 424 (S.D. 1986).

Canfield v. Spear, 44 Ill. 2d 49, 254 N.E.2d 433 (1969).

Central Monitoring Service, Inc. v. Zakinski, 1996 SD 116, from South Dakota Unified Judicial System. Retrieved February 6, 2009 from http://www.sdjudicial.com/index.asp? category=opinions&nav=5319&year=1996&month=9 &record=916.

Garner, B. (Ed.). (2004). Black's law dictionary (8th ed.). St. Paul, MN: Thomson West.

Gillespie v. Carbondale & Marion Eye Centers, Ltd., 251 Ill. App. 3d 625, 622 N.E.2d 1267 (1993).

Keener v. Convergys Corp (2003) 11th US Circuit Court of Appeals Keener v. Convergys Corp (2003).

Market Access Intern., Inc. v. KMD Media, LLC, 2006 WL 3775935 4 (Va. Cir. Ct., Dec. 14, 2006) Retrieved August 10, 2009, from http://www.frithlawfirm.com/Articles/BusinessNonCompeteArticles/ NonCompetitionAgreementsinVirginia/tabid/136/Default.aspx

Marquez, J. (2008, November). Litigation over noncompete pacts on rise. Workforce Management, 87(18), 11-12. Retrieved February 6, 2009 from ABI/INFORM Global database. (Document ID: 1597305511).

Monogram Indus., Inc. v. Sar Indus., Inc., 64 Cal.App.3d 692, 697-98 (1976).

Muggill v. Reuben H. Donnelley Corp., 62 Cal.2d 239, 242 (1965).

Olliver/Pilcher Ins. v. Daniels, 715 P.2d 1218, 1221 (Ariz. 1986).

Product Action Intern'l, Inc. v. Mero, 277 F. Supp. 2d 919 (D. Ind. Aug. 5, 2003).

Restatement [Second] of Conflict of Laws [section] 188 (1971).

Restatement (Second) Contracts [section] 518 (1977).

Shapiro, B. R. (1993). The enforceability of non-compete agreements. Marketing Management, 2(1), 70. Retrieved February 10, 2009, from ABI/INFORM Global database. (Document ID: 1214342).

Valley Medical Specialists v. Farber, 982 P.2d 1277 (1999). Retrieved February 10, 2009, from http://www.law.unlv.edu/faculty/bam/k2002/briefs/valley.html.

Patrick R. Geho, Middle Tennessee State University

Stephen D. Lewis, Middle Tennessee State University