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illINOIS STATE BAR TM ASSOCIATION

ILLINOIS BAR

November 2013 Volume 101

Number 11

Page 568

The Maj

noisLawyers

Employment Law
Non-Traditional Non-Competes: Designing Non-Competition Agreements to Hold Up in Court
By Kenneth J. Vanko

Non-competition agreements are famously difficult for employers to enforce. That means lawyers for businesses seeking to restrict competition by ex-employees should consider more arms-length alternatives that stand up better to judicial scrutiny. Here are some options.
Business attorneys love contract templates. Though form contracts save transaction costs and are highly efficient,they dont always work for non-compete arrangements. Traditional non-competes that is, outright restrictions on certain business activity triggered post-termination may not be the best fit for a business owner. Depending on the particular employees circumstances, alternative contract choices can achieve the same goals and solve enforceability problems.
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This article reviews some contract options available to business owners and emphasizes the need for business attorneys to consider non-traditional options that may avoid problems endemic to enforcing non-compete agreements in litigation.a

Recent Developments in Non-Compete Law and Enforcement Problems

Non-competition agreements typically are reserved for employees who are most likely to have significant access to company secrets or the ability to appropriate customer goodwill. The problem with using traditional non-compete s is that their enforceability often is in question. Unlike other contract disputes where the central disputed questions almost always are breach and damages, non-compete cases require courts to consider whether the contract is reasonable or an invalid restraint of trade Recent developments in Illinois law have crystallized the need for employers to examine non-traditional alternatives to protect business assets. Reliable Fire and the totality of the circumstances test. In 2011, the Illinois Supreme Court reaffirmed the long standing, three-part rule of reason test courts use to determine the enforceability of an employment-based noncompete. In Reliable Fire Equipment Co. v. Arredondo, the court held a restrictive covenant is reasonable if (1) it: is not greater than is required for the protection of a legitimate business interest of the promisee (usually an employer), (2) does not impose an undue hardship on the promisor (usually an employee), and (3) does not injure the public.a

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In determining the extent of the legitimate business interest a company must show as support for the non-compete, the court held the traditional business interests use of confidential business information and the existence of nearpermanent customer relationships were non-conclusive aids in determining the [employer]s legitimate business interest, which in turn is but one component of the three-prong rule of reason, grounded in the totality of the circumstances
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This flexible test creates a significant practical problem non-compete suits are exceedingly expensive to pursue, defend, and resolve. Taking Reliable Fire literally, the scope of discovery in a non-compete case is virtually unbounded, as courts will feel constrained to limit areas of inquiry an employee believes will assist him or her in demonstrating the employers lack of a legitimate business interest This totality-of-the-circumstances test arguably undermines a courts ability to condUct an expedited hearing and address issues central to whether an employer can enforce a non-compete clause Aside from problems of efficiency, the outcome of any non-compete case is usually far from certain. In the wake of Reliable Fire, the Illinois Appellate Court has struggled to advance a coherent approach to resolving non-compete disputes. Fifield and the at-will employee problem More recently, one district of the appellate court has added another layer of complexity to the enforcement of non-competes. this time as it pertains to at-will employees In Fifield v Prernter Dealer Seiv,ces. Inc., the First District created a prophylactic rule of contract consideration, which only allows an employer to enforce a non-compete agreement against an at-will employee if that employee remains employed for at least two years The opinion is broad enough to apply to employees who signed a covenant in connection with the start of employment and even if its the employee who chooses to end the relationship. As a result of F/field, at-will employees effectively have a two-year option to void a non-compete. Although Reliable Fire makes litigating noncompete cases expensive, F/field means an employer may not be able to enforce its contracts at all Enforcing generic non-compete agreements in Illinois is, simply put, a step fraught with uncertainty. Contract law functions best when it creates economic efficiency, but that rarely happens in non-compete enforcement cases. Litigation costs are high. Results are uncertain. And customers often leave regardless of a companys success in court. So this matrix of practical problems begs the question: What alternatives do businesses have to protect trade secrets and customer goodwill?

Garden leave and term contracts

The concept. The idea of garden leave is not unique, but it has found very little traction in the United States as an alternative to a traditional non-compete arrangement. Under a true garden-leave provision, an employee promises to give a certain amount of notice to the employer before resigning. In exchange, the employer does not require the departing employee to perform any work during the garden-leave period and pays the employee full salary and benefits.Z Garden-leave provisions have two primary benefits over non-competes First, if an employee violates the garden-leave clause and competes during the contract term, he or she violates not only the contract provision, but also the common law duty of loyalty. This is an obvious, built-in deterrent to unfair competition. A fiduciary breach allows an employer to recover salary paid during garden leave and (possibly) punitive damages. Second, a garden-leave provision undercuts one of the departing employees strongest arguments under Reliable Fire undue hardship. The most persuasive argument an employee often has is that an injunction will impair his or her ability to earn a living. Enforcing a garden-leave clause, in which a court not only orders the employee to stop
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competing, but also conditions that relief on an employers continued payment of salary, significantly undercuts the hardship defense. American courts, for the most part. have not addressed the enforceability of garden-leave clauses. The leading modern case actually comes from the English Court of Appeal, in Evening Standard Co. Ltd. v. Henderson Hendersons contract with the Evening Standard (a major London-area evening paper) prohibited him from working for another employer during the term of his contract The contract, though, required one-years notice of termination Henderson resigned, but indicated he would leave before the notice period expired After the lower court denied the Evening Standards injunction request the court of appeal allowed it when the Evening Standard offered to pay Henderson during the entire term of the notice period whether he actually performed work or not.-

Example in practice financial services employees. In the United States. garden-leave clauses have become
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popular in the financial services industry But the case law remains sparse. Bear Stearns & Co., Inc (before its sale to JPMorgan) used garden-leave clauses with brokers and managing directors, It ran into enforcement problems, primarily because the 90-day notice clause specifically provided that Bear Stearns could ask the employee to perform all, some or none of your work duties in Bear Stearnss sole discretion.U Another early case (also in the financial services sector), though, reached a different result. A New York trial court enforced a six-month, garden-leave clause in Maitby v. Harlow Meyer Savage Inc.ia The court enforced the covenants through a preliminary injunction on condition that plaintiffs continue to receive their salaries for the notice period. The term garden leave never appears in the case, but its clear the court was persuaded that the payment of full salary helped ensure the employees continued to maintain their livelihood.

Drafting considerations. Employers who deem garden leave a sound substitute for more traditional non-compete
arrangements must include some key contract provisions: (1) specify the precise notice period, (2) ensure the employee remains an active employee during this period; (3) prohibit employment for any other employer during the garden-leave term; and (4) confirm the employee need not perform any actual services for the employer once the notice period starts. The garden-leave period must be reasonable to avoid the appearance of overreaching. Finally, though employers could try to reduce garden-leave pay to a percentage of base income or salary, material changes may invite a court to apply higher scrutiny to a garden-leave clause.

Safety nets and covenant payments

The concept. Safety-net payments are similar to garden-leave arrangements with one key difference The covenant applies after complete termination of the relationship, so the agents duty of loyalty is not implicated. In a typical contractual arrangement, payment of some reasonable consideration at or around the time of termination triggers the covenant. Once payment is made, the promisor must refrain from engaging in specified conduct, such as contacting customers. But, importantly, the parties have no continuing relationship.

Example in practice captive insurance agents. The relationship between Farmers Insurance Exchange and its
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agents provides a clear example of how such a safety-net provision works in actual practice. Farmers has a contract with its captive insurance agents (each of whom is an independent contractor) that provides them a payment of contract value upon termination of the agency relationship. An insurance agents acceptance of this contract value payment then triggers a non-compete obligation, limited to insurance customers in the district to which that agent was assigned.

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Contract value roughly equates to one-years renewal commissions for the agents book of business existing at the time of termination. Importantly, the ex-Farmers agent must accept tender of contract value payment, meaning he or she is not free to elect whether to forego the money in exchange for the right to compete for former customers. Farmers has been successful in enforcing this safety-net clause Although courts have not specifically relied on the safety-net payment as an enforceability factor, the fact the agent was being paid contract value logically would influence a courts decision when assessing the impact or hardship the restriction has on an agent There is a better way to look at safety-net covenants like the one Farmers uses. It is, in effect, a sale-of-business restrictive covenant, which is subject to a much lower degree of scrutiny in Illinois courts.L Put another way, if an agent receives reasonable consideration for his book of clients and in turn agrees not to compete for those clients, this is tantamount to a sale back to Farmers of the business the agent developed and serviced And there is no analytical way to distinguish the enforcement-friendly sale-of-business cases in Illinois. except (perhaps) for the fact that the sale was preordained when the agent and Farmers began their relationship A similar type of safety-net payment may be more appropriate for employees who develop intellectual property, as opposed to independent sales agents who cultivate client relationships For instance, high-frequency trading (HFT) firms often have contracts requiring the company to make payments to ex-employees during a restricted period the employer selects at the time of termination. HFT firms use these contracts not only to attract talented, highly skilled employees in the first place, but also to ensure the enforceability of their contractual restrictions when those employees leave. Since an ex-employee receives pay during the non-compete period, courts presumably would be less troubled by the burden the restraint poses.

Drafting considerations. Companies considering the use of safety-net payments must be wary of several potential traps. The first concerns how to trigger the covenant. As with the Farmers example, the governing contract must require the employee to accept payment in exchange for the competitive restriction.
The company also should provide a mechanism to coerce compliance. Farmers achieves this by staggering payments over the restricted term and holding back subsequent installments if the agent violates the non-compete restriction. Because prior versions of its agent agreement were not clear, Farmers has run into problems when holding back installment payments after discovering an agents breach. Refusing to pay the agreed-upon consideration is a contract forfeiture; under Illinois law, forfeiture clauses are disfavored and will be strictly construed by courts. Therefore, the contract ought to provide in unambiguous terms that subsequent installment payments will be forfeited if the agent does not comply with the competitive restriction.

Client purchase agreements

The concept. Client purchase arrangements are de facto non-competes in that they do not prohibit competition, but unquestionably discourage it. Simply put, the parties contract contains an agreed-upon price the ex-employee will pay if he or she chooses to service restricted accounts. In effect, client purchase covenants are similar to true noncompetes with liquidated damages clauses, except they do not carry with them the specter of injunctive relief 42 Why would a company choose this option? The reason is pretty intuitive. In many professional services firms, the relationship between the client and the employee is highly personal and based on a significant degree of trust Without the employee, the firm inevitably may lose the business and face a strong defense in any enforcement action that the interests of third-parties would be impaired by an injunction. Organizations may opt to secure some fair value for clients who are likely to leave Because the employee can continue the relationship at a price enforcement
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should not adversely affect third-party interests, except for the fact that an employee bound by a client payment covenant may charge a higher price to the customer to compensate for increased marginal sales costs. Example in practice accounting firms. Public accounting firms frequently use client purchase agreements Many courts still assess the overall reasonableness of client purchase agreements but they have been willing to enforce them
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For instance, the Supreme Court of Montana has determined that a client purchase covenant in a public accounting firms agreement did not constitute a restraint of trade to be analyzed under a traditional non-compete test The agreement in that case required the former employees to purchase restricted clients by paying their old firm 100 percent of gross fees billed to a particular client over the one-year period immediately preceding termination. The Court of Appeals of Oregon reached a similar result in Isler v. Slitick, finding a client purchase agreement was not a liquidated damages clause and analogous to the purchase of a customer list That court even went so far as to downplay the parade of horribles advanced by the employee and stated that a bad employment bargain does

not become a restraint of trade because it is onerous In Illinois, it is clear courts will apply some degree of scrutiny to client purchase covenants, even if it is not the exacting or strict scrutiny reserved for traditional employee non-compete arrangements. As a practical matter, though, courts would be far less likely to invalidate a client purchase agreement (which permits competition) than they would an outright non-competition covenant (which doesnt). Drafting considerations. Once again, clear drafting is essential to enforcement. Client purchase agreements must address several unique issues The firm must account for: (1) the purchase price, which usually is expressed as a percentage of trailing sales (or a multiple of trailing profits) per customer; (2) the accounts covered by the arrangement; (3) over what period of time the employee must pay the purchase amount; (4) the interest rate applicable on the declining balance; and (5) a means for the employee to determine how the purchase amount is calculated.

FIfield revisited: Consideration for the at-will employee

Whats clear from these examples of non-traditional contract restrictions is that firms have to pay a price for enforceability. While safety-net payments and garden-leave clauses resemble a form of severance, allowing an employee to buy a client list may result in the erosion of goodwill over time The alternative, though. may be less palatable: the inability to enforce a contractual restriction in court. Even so, for many businesses, the right play still may be a traditional non-compete. In light of Fifield (and assuming it remains good law), what to do? Although Fifield provides no guidance at all on what consideration will suffice for atwill employees, a company has several potential options that it otherwise may not be inclined to consider: (1) pay the employee a signing bonus; (2) provide some other monetary consideration. such as a higher commission or bonus structure. (3) guarantee employment for a certain term; or (4) condition the non-compete on payment of severance. When granting monetary consideration, businesses should document carefully either in the agreement itself or in an offer letter how the consideration is tied specifically to the non-compete clause. Otherwise, an employee could argue the consideration is illusory in that the company would have provided the benefit regardless of the employees agreement to the restriction.
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Conclusion
There is great debate concerning courts skepticism of modern non-compete agreements. Pro-enforcement advocates stress that judicial hostility towards covenants can depress wages and incent employers to forego valuable

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training. Other judges have expressed concern over firms incentives to use patently unenforceable non-competes to discourage employees from leaving in the first place, only to retreat during litigation and ask a court to modify the covenant under equitable principles Putting aside this debate, however, enforcement actions over traditional non-compete agreements often times do not yield efficient economic outcomes for businesses The cost of litigation and the expected return from a favorable settlement or judgment may come nowhere close to the long-term loss of client goodwill Employers who use appropriate non-traditional contractual arrangements that are more reflective of an arms-length business transaction, and not a contract of adhesion, can help reduce litigation expenses, achieve more certainty, and reduce the risk of adverse determinations on enforcement proceedings Kenneth J. Vanko is a pudner at the Whea ton law firm of Clingen Callow & McLean LLC He concentrates his practice in unfair competition litigation His blog, Legal Developments In Non-Competition Agreements, can be atwwvnonjppecoiii. His Twitter page is @KenVanko.

found

Non-competes arent enforceable against employees who leave within two years: the groundbreaking Fifield case
A recent and much-discussed Illinois Appellate Court case, F/field and Enterprise Finance Group. Thc V Premier Dealer Services. Inc., 2013 IL App (1st) 120327, held that a noncompetition agreement is not valid and enforceable if an employee is fired or resigns within two years, as AyIa N. Ellison puts it in the September issue of ISBAs Labor & Employment Law newsletter. Illinois companies can still require newly hired workers to sign noncompetition agreements, but if the employee is employed for less than two years the restrictive covenant will lack the consideration necessary to be enforceable by an employer. There must be two years of continuous employment to be considered adequate consideration to support a postemployment restrictive covenant, she writes. Ellison goes on to summarize the Fifield facts and holding and offer this analysis. By inviting employees to breach restrictive covenants with impunity, Fifield could prove to be troublesome for employers. As long as an employee resigns within two years of their start date, F/field supports the notion that restrictive covenants will not stick to employees Additionally, by viewing at-will employment as an illusory benefit this case also suggests that at-will employment is insufficient to constitute consideration to enforce postemployment restrictive covenants. Read Ellisons article, in the September Labor & Employment Law newsletter.

1. Northwestern National Insurance Co. v Donovan, 916 F2d 372, 377 (7th Cir. 1990). 2 In this article, the term non-competes refers to general market-based restraints, as well as narrower activity restraints that limit the ability of an employee to solicit or service a class of customers. Illinois courts analyze these restaraints under the same framework. See Cambridge Engineering, Inc v. Mercury Partners 90 BI. Inc 378 III. App. 3d 437, 452-55 (1st Dist. 2007) (applying same enforceability test to non-competition and nonsolicitation covenants).

3. Reliable Fire Equipment Co v. Arredondo. 2011111. 111871, 117. 4. Id. 5 See Kairies v. All Line, mc, 2012 IL App (2d) 111027-U, 11 14, 19 (holding that a non-compete was unreasonable on its face and limiting Reliable Fires holding to the legitimate business interest test).

6. Fifield v. Premier Dealer Services, Inc., 2013 IL App (1st) 120327,

17, 19.

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7. Jeffrey S. Klein & Nichols J. Pappas, Garden Leave Clauses in Lieu of Non-Competes, N.Y.L.J., Feb. 5, 2009. 8. See Levy v. Markal Sales Corp., 268 III. App. 3d 355, 373 (1st Dist. 1994) (noting that Illinois law permits complete forfeiture of salary paid during a period of disloyalty and discussing the availability of punitive damages for breach of fiduciary duty) But see Bank of Tokyo-Mitsubishi. Ltd v. Ma/hotra. 131 F. Supp. 2d 959, 961-62 (N D III. 2000) (describing salary forfeiture remedy as discretionary and declining to impose remedy even in the case of fraudulent activity). 9 10 Evening Standard Co Ltd. v Henderson. [19871 I C R 588 (C.A 1986) Id at 594

11. Bear, Stearns & Co. Inc v Sha,on, 550 F. .2d 174. 177-79 (D. Mass 2008) (denying temporary restraining order in aid of FINRA arbitration and noting Bear Stearns could force Sharon to submit to Bear Stearnss whim regarding his employment activity in the near future) 12 13 Ma/thy v. Harlow Meyer Savage, Inc., 166 Misc. 2d 481 (NY. Sup. Ct 1995) /d.at486

14. Id 15 See Farmers Insurance Exchange v. Sorensen, 99 F. Supp. 2d 1000 (E.D Wis 2000), Farmers Insurance Exchange v. Chamberlain, 712 P.2d 172 (Or. Ct App 1986)

16. Health Professionals, Ltd. v. Johnson, 339 III. App. 3d 1021, 1031 (3d Dist 2003) 17 See Citadel Investment Group, LLC v. Teza Technologies, LLC. 398 II. App. 3d 724, 731 (1st Dist. 2010) (describing contract matrix that allows for employer to select duration of non-compete term and pay a base level of compensation during the term).

18. See Sensabaugh v Farmers Insurance Exchange, 420 F. Supp. 2d 980, 988-89 (E.D Ark 2006) (refusing to imply forfeiture of remaining Contract Value when agents agreement did not provide for one) 19 Allabastro v. Wheaton National Bank, 77 III. App. 3d 359, 364 (2d Dist. 1979). 20. See Kenneth J. Vanko, Liquidated Damages: The Forgotten Remedy in Noncomnpete Disputes, 95 Ill. B.J 254, 254-57 (2007). 21. See Cud/s 1000, Inc. v. Suess, 24 F.3d 941, 948 (7th Cir. 1994) (discussing rationale for allowing enforcement of non-competes when employee provides professional service). 22. Dobbins, DeGuire & Tucker, P.C. v. Rutherford, MacDonald & Olson, 708 P.2d 577, 580 (Mont. 1985). 23. Id. at 577. 24. Is/er v. Shuck, 589 P.2d 1180 (Ore. Ct. App. 1979). 25 Id at 1182.

26. Id. at1183. 27 H&M Commercial Driver Leasing. Inc v. Fox Valley Containers. Inc., 209 III. 2d 52, 63-64 (2004) (holding that liquidated damages provision in agreement between companies requiring payment for hiring of leased drivers was a restraint of trade and not a non-compete; ostensibly applying traditional non-compete test of reasonableness to facts of case)

28. See Outsource International, Inc. v. Barton, 192 F.3d 662, 670 (7th Cir. 1999) (Posner, J., dissenting) (discussing function of non-competes as an investment in training or earning potential, stating that [iJf covenants not to compete are forbidden, the employer will pay a lower wage, in effect charging the employee for the training).

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29. See Tradesmen International, Inc. v. Black, 724 F.3d 1004 (7th Cii. 2013) (Hamilton, J., concurring).

Member Comments
The reaction to the Fifield ruling is much ado about nothing While the Court did address a restrictive covenant in the context of a company ownership change, Fifield otherwise reminds all of us working in the area of trade secrets and/or non-competes that if the only consideration received in exchange for signing a noncompete is at-will employment, then that employment must be continuous for two years in order for that lone consideration to be considered reasonable and therefore enforceable under Illinois law This is nothing new. As the Fifield Court itself noted, Illinois courts have repeatedly held that there must be at least two years or more of continued employment to constitute adequate consideration in support of a restrictive covenant Fifield atlfl9, citing Diederich Insurance Agency, LLC, v. Smith, 2011 IL App (5th) 100048, Lawrence v Allen 292 Ill. App 3d, 131, 138 Brown & Brown, Inc v Mudron 379 III. Apo. 3d 724, 728-29 (2008) More importantly, the Fifield holding is specifically made in the context where at-will employment is the sole consideration, as it was in the cases cited by Fifield and Fifield itself. See Fifield at 2, Diederich at J8; Lawrence at 1 34 and Brown at 726 Expanding the Fifleld holding to assume no other consideration will do, only serves to swallow the general rule that an Illinois Court insure a restrictive covenant is reasonable in order to enforce it under Illinois law. Fifield, at 13. Assume, arguendo, Defendant Fifield was a vice president of sales with access to highly valuable trade secrets at a large firm. The employer provides an equivalent of two years salary as specific consideration for an otherwise reasonable restrictive covenant The idea that Fifield stands for the proposition that two years of continuous employment would be necessary, in addition to two years of salary, in order for the restrictive covenant to be reasonable, and therefore enforceable, is a nonsensical and unwarranted interpretation of the Fifield holding. The real problem is that employers (particularly small to mid-sized businesses) too many times make everyone from the Janitor to the CEO sign the same boilerplate non-compete with no compensation other than at-will employment Employers need to partner with their lawyer to conduct a confidential information audit Determine what information is valuable and put a rational monetary value on it. Then decide who needs access to this information and put in place reasonable protections under the circumstances to allow only access to this information on a need-to-know basis. (See, e.g., Jackson v. Hammer, 274 III. ADO. 3d 59, 67 (4th Dist. 1995) in the context of a trade secret.) Only then can an employer make a prudent business decision regarding the compensation of a key employee beyond mere employment. And doing so can provide more certainty that its restrictive covenant is legally enforceable, whether the employee is employed there for 20 years or 20 minutes.

Dennis Esford on November 20, 2013

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