Restrictive Covenants

An Introduction to Restrictive Covenants

Some employers seek from their employees an agreement that limits what an employee can do after the employee has left the employ of the employer. These agreements are referred to as restrictive covenants or non-compete agreements.

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Restrictive covenants are unusual in that most employment agreements focus on what the parties expect out of each other during the period of employment.* As an example agreements customarily lay out what the employee’s work responsibilities are and what the employer’s obligations are with regard to pay and benefits.

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A restrictive covenant in an employment agreement may look like this:

“Dr. X agrees that upon termination of her employment with the Omega 

Dental Center she will not work in Warren County, Kentucky as a 

dentist for a period of 36 months.”

Legislators, courts and professional organizations that draft ethics rules for their respective professions have all struggled with what to do with restrictive covenants. On their face these agreements appear one sided and unfair. Legislatures in some states have outlawed or severely limited restrictive covenants. Many restrictive covenants have been found to be unenforceable by the courts. Some professions, (most notably the legal profession), have made the use of restrictive covenants in professional employment contracts unethical. Having said all of this, the simple fact is that restrictive covenants are legal in most states and will, if they are well drafted, be enforced by the courts.

The tug of war can be summarized as follows: employers want to be protected from having the goodwill they have paid to develop pirated; employees want to be free to practice their chosen career without interference from their former employer. Courts that support

*Unusual only in that they deal with after employment obligations of the employee. In the world of physicians contracts they are not unusual. In 2003 the American Society of Colon and Rectal Surgeons surveyed members who had begun employment in the proceeding 5 years. Of those with written contracts 53% had restrictive covenants. In 2016 the U.S. Treasury Department estimated that 18 percent of American workers were subject to restrictive covenants. This number has been challenged by others who believe that the Treasury Department’s estimate significantly overstates the actual number.

restrictive covenants generally point out that parties should be free to reach whatever contractual arrangements they want to make with each other so long as the terms don’t call for an illegal act. Courts that don’t approve restrictive covenants generally point to the anti-competitive nature of such agreements.

Twenty -six states have some type of legislation regulating restrictive covenants in some way. The other half leave it up to the courts to work out. California, North Dakota, Montana and Oklahoma ban nearly all restrictive covenants. The California statute provides that; “Except as otherwise provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade or business of any kind is to that extent void”. (California business and professional code section 16600). Other states have attempted by statute to create rules and tests for the courts to use in analyzing the enforceability of restrictive covenants. Florida has taken three stabs at it legislatively. The Florida legislature created rules in 1953 which it then amended significantly in 1990 which it then modified again in 1996. Tennessee had a statute that it passed in 2007 that it then modified in 2008, modified again in 2010 and then modified again in 2011. It seems like a sizable number of constituents are never happy with the legislatures’ attempts to codify the rules.

Some states, (Delaware 6 Del Code §2707), Colorado Colo. Rev. Stat. §8-2-113(3))), prohibit restrictive covenants for physicians and other healthcare professionals. Texas has severe restrictions on the ability of employers to restrict post-employment conduct of health care professionals.

Oregon takes the unusual approach, (ORS 653.295), of allowing employers to use restrictive covenants, but it requires the employer to pay the employee the greater of 50% of their wage while they are being restricted, or 50% of the median family income for a family of four as calculated by the US Census Bureau. This sometimes referred to as “garden leave”.

. Most states allow the courts to deal with the issue, with the legislatures staying out of the fray. For a brief period of time Kentucky addressed the question of restrictive covenants for doctors with a statute that made restrictive covenants with a duration of over 364 days unenforceable. That statute remained on the books for less than one year. After its repeal Kentucky reverted to an approach which is like that found in most states—leaving the  issue for the courts rather than the legislature.

When there is no statutory rule, and this is the case in most states, the courts that are asked to enforce restrictive covenants deal with the cases on a case by case basis. This is referred to as the “common law approach. This makes knowing what the rule is in a particular jurisdiction difficult at best. When courts are asked to enforce restrictive covenants there are a variety of factors that the courts consider. By far the two most important are duration and geographic scope. Courts will not enforce covenants that they view as being too broad in geographic scope or too long in duration. Clearly the two are related to each other. The broader the geographic scope the more limited the covenant has to be in terms of time. The longer the duration of the covenant, the more the court is going to want to see a smaller geographic scope. As an example, it may be reasonable to prevent someone from competing on the same city block for a period of 5 years, but that length of time may be unreasonable if geographic scope encompasses the entire state. Kentucky courts reviewing  employment contracts for physicians have found covenants of 3 years and a single county to be reasonable, in another case the courts found a 2 year covenant that covered a 50 mile radius from the former site of employment reasonable.

With the confusion that all of this creates, many states have adopted what is called the “blue pencil rule”. The blue pencil rule allows the courts to simply strike out of contracts provisions which are too broad. More common is the approach taken by Kentucky and at least 25 other states. In these states, the courts review the covenants, and exercise the courts inherent equitable powers to modify or reform the contracts to make them fit within the general rule that covenants may not be overly broad. This may mean reducing the geographic scope or reducing the duration or reducing both.

When courts are asked to enforce restrictive covenants they are ordinarily asked to use what are known as the courts equitable powers. Courts have both legal power and equitable power. In most contract cases we see courts using their legal power; this is what is done when the court reviews a contract case and determines that one party has breached the contract and owes the other party money for the breach. In restrictive covenant cases the plaintiff, (the party that files the suit), will ordinarily ask the court not for money damages, (a legal remedy), but instead will ask the court for an injunction (an equitable remedy). The plaintiff wants an the court to issue an injunction that prohibits the defendant from working in a particular place at a particular time.

All of this makes giving good advice about restrictive covenants extremely difficult. A few simple guidelines are the best I can do.

1. Know what the rules are for the jurisdiction you are in.

2. If you are the employee, try to avoid having a restrictive covenant.

3. If you have to have one try to;

a) make it short in time and short in duration.

b) have a provision that lets you earn it away, –something like if I leave in the first five years there is a restrictive covenant, but if I stay longer it will not be required.

c) have a buy out provision that lets you buy your way out of the restrictive covenant for a set amount. Get the employer who insists on a restrictive covenant to try to create a meaningful value, as an example 3 months pay.

4. If you are the employer remember that courts don’t like restrictive covenants so don’t get greedy by going too big or too long. This will hurt you. In blue pencil jurisdictions, where if you are reasonable or close to reasonable the court will probably leave it alone, but if you are too greedy you run the risk that the entire covenant will be voided. In jurisdictions where the court can re-write the covenant to be reasonable suppose if you will  a judge that believes that a covenant shouldn’t extend more than 50 miles, further suppose that the covenant being reviewed is one calling for a restriction covering the county of employment and adjoining counties. In such a case it is unlikely that court step in to “rewrite” the covenant even if part of some adjoining counties were 60 miles away from the place of business, but if the employer got greedy and had a covenant that called for restrictive covenants of 200 miles the court would in all likelihood step in and cut it back to what the court thought was reasonable, (50 miles). Over reaching invites intervention.

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