Good Company

Noncompetition Agreements with a Twist

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Recently, a state Supreme Court confirmed the enforceability of a different type of "non-competition agreement." This agreement, however, did not provide for the usual post-employment restriction on competition. Instead, the agreement permitted competition, but at a substantial price to the departing employee. This alternative, described below, may be suitable for some businesses and not for others. 

For many years, New Hampshire and Massachusetts courts have only grudgingly enforced post-employment covenants not to compete, under a test that regards these clauses with deep suspicion and enforces them under a strict reasonableness test. This test consists of three sub-tests. A covenant not to compete, supported by reasonable consideration and imposed in good faith, is reasonable only if it: (1) is no greater than is necessary for the protection of the employer's legitimate interests; (2) does not impose undue hardship on the employee; and (3) is not injurious to the public interest. Failure to pass any one of the sub-tests renders the covenant unenforceable. Ancillary issues relating to, for example, the employer's good faith in seeking and presenting the agreement to an incoming employee, and whether the employer consistently enforces the agreements sometimes make enforcement difficult and unpredictable.

True non-competition clauses are intended to protect against the loss of goodwill, trade secrets, and important customer contacts. Under certain circumstances, an employer may want to consider a new approach to the overall question of protecting against competition by the former employee or officer. In this approach, the employer and employee enter into an agreement under which an employee can compete upon the termination of employment, but only if the employee agrees to pay a reasonable amount of liquidated damages. 

A recent case decided by the North Carolina Supreme Court is illustrative. The parties — a medical practice and an individual physician — entered into an agreement with a so-called "Cost Sharing" provision. Under this provision, the employee acknowledged the significant financial commitment and risks taken by the practice in hiring and training her, and that her departure would cause significant harm to the business. The parties agreed that the Employer was entitled to "an equitable reimbursement" of the economic harm flowing from the hiring, training and termination of the employee physician's employment. The agreement provided that, in the event that the physician employee competed in certain specified counties, within one year following her termination of employment with Employer for any reason, she would pay a liquidated "Cost Share" calculated pursuant to a formula in the contract. After she gave notice of her termination, and after negotiations to resolve the dispute over her competition failed, the practice brought an action for breach of the agreement, seeking $109,000 in Cost Share reimbursement.

The employee argued that the Cost Sharing provision: (1) was actually a covenant not to compete, which was unenforceable as a matter of North Carolina public policy; and (2) was an unenforceable penalty rather than a proper liquidated damages clause. The state Supreme Court disagreed.

Importantly, the Court rejected the assertion that the clause was a non-competition agreement. The court held that a forfeiture of rights upon an employee's decision to compete — such as the right to deferred compensation — was not a prohibition on an employee's right to engage in a profession. "The contract does not prohibit [the employee] from engaging in the practice of her profession, but only provides that if she does so within the described three-county area, she will pay a certain sum for making this choice." Rather than subject the contract to the "strict scrutiny as to reasonableness and public policy required with a covenant not to compete," the question was whether the Cost Sharing provision constituted a penalty, rendering it unenforceable, or a proper sum of liquidated damages. The court then held that the amount of "equitable reimbursement" was reasonable and enforceable. Importantly, the court's test for determining whether this liquidated damages provision was enforceable is identical to New Hampshire and Massachusetts law. 

Although it is not clear that these sorts of agreements would be enforceable in New Hampshire and Massachusetts, this case bodes well for an alternative to the traditional non-competition agreement. At the same time, these types of contracts are not right for every business. The business in this case, a medical practice, made a deliberate decision not to curtail competition as such. Instead, the business weighed the competing interests carefully, and determined that the Cost Sharing and liquidated damages provisions provided a significant incentive for the employee to remain with the practice, and that eventual competition would not unduly harm its goodwill and client contacts. Rather than take the standard approach to employee departure and create restrictions on the employee's future employment, businesses need to think a little outside of the norm. The type of decision-making made in the case discussed here may work for your business. Your counsel can help you come to the right choice for your business.