Covenants Not to Compete

A covenant not to compete, also called a non-competitive clause, is a formal agreement prohibiting one party from performing similar work or business within a designated area for a specified amount of time.  This type of clause is generally included in contracts between employer and employee and contract between buyer and seller of business.

Many workers sign a covenant not to compete as part of the paperwork required for employment.  It may be a separate document similar to a non-disclosure agreement, or buried within a number of other clauses in a contract.  A covenant not to compete is generally legal and enforceable, although there are some exceptions.

Whenever a company recruits skilled employees, it invests a significant amount of time and training.  It often takes years before a research chemist or a design engineer develops a workable knowledge of a company’s product line, including trade secrets and highly sensitive information.  Once an employee gains this knowledge and experience, however, all sorts of things can happen.  The employee could work for the company until retirement, accept a better offer from a competing company or start up his or her own business.  This is why companies encourage the signing of a covenant not to compete.  Without something in writing, there would be few legal ways to prevent an employee from starting a new company across town and competing with his/her former employee.

A covenant not to compete may cover a number of potential issues between employers and former employees.  Many companies spend years developing a local base of customers or clients.  It is important that this customer base not fall into the hands of local competitors.  When an employee signs a covenant not to compete, he or she usually agrees not to use insider knowledge of the company’s customer base to disadvantage the company.  The covenant not to compete often defines a broad geographical area considered off-limits to former employees, possibly tens or hundreds of miles.

Another area of concern covered by a covenant not to compete is a potential ‘brain drain’. Some high-level former employees may seek to recruit others from the same company to create new competition.  Retention of employees, especially those with unique skills or proprietary knowledge, is vital for most companies, so a covenant not to compete may spell out definite restrictions on the hiring or recruiting of employees.

A covenant not to compete may also define a specific amount of time before a former employee can seek employment in a similar field. Many companies offer a substantial severance package to make sure former employees are financially solvent until the terms of the covenant not to compete have been met.

Because the use of a covenant not to compete can be controversial, a handful of states have already banned this type of contractual language.  The legal enforcement of these agreements falls on individual states, and many have sided with the employee during arbitration. A covenant not to compete must be reasonable and specific, with defined time periods and coverage areas. If the agreement gives the company too much power over former employees or is ambiguous, state courts may declare it to be overbroad and therefore unenforceable.  In such case, the employee would be free to pursue any employment opportunity, including working for a direct competitor or starting up a new company of his or her own.

It has been held that an employee’s covenant not to compete is assignable where one business is transferred to another, that a merger does not constitute an assignment of a covenant not to compete, and that a covenant not to compete is enforceable by a successor to the employer where the assignment does not create an added burden of employment or other disadvantage to the employee.  However, it has also been held that a covenant not to compete is not assignable[i] and under various statutes for various reasons that such covenants are not enforceable against an employee by a successor to the employer.

Further, in a covenant by the seller of a business that he or she will not engage in a similar business, when valid, is assignable by the original purchaser upon a subsequent sale of the business.  An express assignment of the covenant to the subsequent purchaser is unnecessary. Upon a subsequent sale of the business, the covenant passes as an incident of the business, even when it is not expressly assigned.  The covenant not to compete is treated as essentially part of the goodwill of the business sold.[ii]

[i] Hawaii v. Gannett Pac. Corp., 99 F. Supp. 2d 1241 (D. Haw. 1999)

[ii] J. L. Davis, Inc. v. Christopher, 219 Ala. 346 (Ala. 1929)


Inside Covenants Not to Compete