Restrictive Covenants

Restrictive covenants in employment contracts are aimed at preventing an employee from competing unfairly with their former employer when they leave. If they go and work for a competitor, or set up a rival business, they may be able to use “inside” information about their former’s employer’s business including its commercial and strategic plans, its customer and supplier connections, plus other confidential insights, to gain an unfair advantage in the market.

Employees are generally subject to implied duties not to compete with their employer during employment, but these do not usually extend beyond the end of the employment relationship. Restrictive covenants are therefore a means of binding an employee via contract not to do certain things when they depart which would be likely to harm the former employer’s business.

Because the operation of restrictive covenants impairs an individual’s freedom to earn a living and use their skills (i.e. amounting to a “restraint of trade”), as a matter of public policy such provisions will only be enforceable where (a) a former employer has a legitimate interest that it is appropriate to protect and (b) the protection sought is no more than is reasonable considering the interests of the parties and the public. This will involve limiting not only the restricted activities themselves, but also the period and (if appropriate) the geographical extent of the restriction. Failure to do so may result in the covenant being treated as void for being too wide.

The types of interest which the courts have recognised as capable of protection include:

• trade connections (with customers, clients and suppliers) and, more generally, goodwill
• trade secrets and other confidential information
• stability of the workforce

Commonly, restrictive covenants fall into the following main categories:

Non-solicitation covenants which prohibit the employee making (generally speaking) active approaches to the former employer’s clients and customers – what amounts to a reasonable restriction is likely to depend on the seniority of the employee, their role, loyalty of the client base, the time it would take a successor of the employee to develop customer rapport and what is standard in the industry as regards the scope and/or length of restrictions.

Non-poaching and non-employment covenants which protect the stability of the former employer’s workforce but, again, need to be reasonable to be enforceable – a non-poaching restriction (i.e. soliciting former colleagues to go and work elsewhere) is more likely to be enforced than a non-employment restriction which amounts to a general prohibition on employing such people. It may also be relevant how senior (and/or critical) the relevant employee(s) are to the business and the size of the workforce – e.g. if there is a small employee cohort, a court may be prepared to enforce a non-poaching covenant that applies to all staff.

Non-dealing covenants restrict the employee from providing goods or services (of the same or a similar kind) to the former employer’s customers and clients – this type of covenant has the advantage over a non-solicitation covenant that you do not need to prove active steps were taken by the departing employee, but due to its wider nature, courts are generally more reluctant to enforce such provisions.

Non-competition covenants which prevent an employee from joining a rival employer for a defined period after termination, which makes them wider than a restriction on solicitation and, for this reason, less likely to be enforceable unless they can be justified. A non-compete provision may be upheld, however, where it is difficult to “police” a non-solicitation covenant, practically speaking, or where the employee’s influence over customers or suppliers is so great that the only effective protection is to ensure that they are not engaged in a competing business in any way.

Key points to remember about drafting and enforcing restrictive covenants in employment agreements:

• if a dispute arises, the covenants will be construed (and reasonableness assessed) as at the date of the contract – this makes it desirable to revisit and, potentially, amend them if an employee is subsequently promoted and they become more senior/influential in the business;
• if a covenant is held by a court to go beyond the minimum restraint reasonably necessary to protect a legitimate interest of the employer, it will be void and unenforceable (the courts will not generally lend assistance by modifying an excessive covenant), hence the stakes are high if an employer “overshoots”;
• the reasonableness of a restrictive covenant is generally fact sensitive and can depend on a number of factors including the industry sector and what is “market practice”, the seniority and level of influence the employee has plus the loyalty of the customer/client base and the frequency with which the relevant goods or services are purchased;
• if the employer commits a repudiatory (fundamental) breach of the employment contract – for example, they dismiss an employee without giving due notice – the restrictive covenants may fall away and have no effect, so employers should beware and handle termination correctly (see also wrongful dismissal).

Enforcement of restrictive covenants is usually via an injunction (as interim relief pending a trial and/or on conclusion of a case in the court by way of final remedy). An injunction is a court order requiring a party to proceedings to do, or to refrain from doing, something. In the context of restrictive covenants, a prohibitory injunction may be granted requiring an employee not to work in competition with their former employer and/or not to solicit the former employer’s customers or staff, for instance. Damages may also be awarded for breach of restrictive covenants – usually as an alternative to an injunction. An injunction would only tend to be granted where damages are not an adequate remedy for the employee’s breach(es).

Garden leave can often serve a similar purpose to post-termination non-competes by keeping the employee out of the marketplace for a period, though a key difference is that the employee remains bound by the express and implied terms of their contract during garden leave, conferring greater protection on the employer than after termination. It is not uncommon for employment contracts to contain both a garden leave clause and post-termination restraints which kick-in on termination.

The combined effect of garden leave and then a post-termination restraint (or restraints) means that an employee can be prevented from working with a competitor or on their own account in a related business/industry sector for a long time. As a consequence, the restrictive covenants may ultimately be considered to exceed what is reasonably necessary and thus be unenforceable. For this reason, it is common for an employment contract to include a set-off provision, reducing the length of time a restrictive covenant operates by the length of time they spend on garden leave.

Alternatives to restrictive covenants

Post-termination restrictive covenants have come under scrutiny recently given the obvious public policy objections and the potential for them to hamper innovation and stifle movement within the labour market. Consultations have taken place in the UK (notably leading to Government proposals to cap non-competes at 3 months, though this has not yet been brought into effect). Elsewhere, the US Federal Trade Commission passed a regulation banning the use of non-competes nationally in the USA subject to some limited exceptions for senior executives with existing covenants. Before the ban came into effect, it was blocked and there are further legal proceedings currently underway to see whether it ultimately gets anywhere. However, it does underline that there is a potential sea change against the indiscriminate and sometimes over-zealous use of restrictive covenants.

Whether or not restrictive covenants are banned or subject in future to legal limits on their scope remains to be seen (and there are no Isle of Man plans in this regard of which we are aware), there are other strategies employers can use to protect their legitimate interests and strengthen their legal protection including:

• providing for longer notice periods
• use of garden leave in appropriate cases
• bolstering intellectual property and confidentiality provisions in employment agreements
• putting in place social media policies (relating to ownership and use of customer contacts when an employee leaves)
• adopting positive customer retention strategies and protecting the “brand” rather than leaving relationships in the hands of “key players” – know your business and know your customers!

Did you know: Cains’ employment specialists can assist with drafting restrictive covenants and advising on enforceability, dealing with disputes (including protecting the employer’s confidential information and tackling potential misuse) plus obtaining – where appropriate – legal remedies (interim and final) in the case of actual or anticipated breaches of post-termination restraints. Contact us for further information or to discuss any concerns in this area.