United States: Restrictive Covenants

General Principles

In the United States, employers generally use four types of restrictive covenants: (1) covenants not to compete for a certain period of time following the employee’s termination from employment (or following a business transaction such as a sale, merger, etc.); (2) covenants not to solicit customers or clients for a period of time following the employee’s termination from employment; (3) covenants not to recruit, solicit or hire away employees for a period of time following the employee’s termination from employment; and (4) covenants not to use or disclose the employer’s confidential or proprietary business information.

Certain states prohibit employers from entering into non-competition and/or non-solicitation covenants. Other states impose specific limitations on the types of employees who can be covered by such restrictions, such as prohibitions on employees whose compensation level is below a specified statutory threshold. Further, some states impose advance notice and other requirements on employers as a condition of entering into restrictive covenants with employees.

In most states, restrictive covenants are enforceable only if they serve a legitimate business purpose and are reasonable in duration, geographic scope and with respect to the substantive nature of the activity being restricted. Courts often recognize that an employer’s legitimate business interests include, for example, preserving confidential or proprietary information or trade secrets, protecting customer relationships, and preserving the company’s goodwill.

The reasonableness of the duration of the restriction often depends on whether the agreement is entered into in connection with the sale of a business. If not, a duration of 1-2 years is normally the outer range of reasonableness for most non-competition and non-solicitation restrictions. Accordingly, if, for example, a restrictive covenant between employer and employee includes a five-year term, the covenant is unlikely to be deemed enforceable by a court. In the sale of business context, courts typically are more willing to enforce covenants lasting longer than 1-2 years.

The reasonableness of the geographic scope of the restriction generally must be tied to where the company does business, and, depending on the circumstances, where the employee worked or had responsibility. Accordingly, if the restriction is overly broad (i.e., broader than the geographic scope of the employer’s business), the geographic scope is unlikely to be enforced as written. The same is true as to the substantive scope of the restriction, which should only be as broad as necessary to protect the company’s legitimate business interests. If the substantive nature of the business activity being restricted is broader than the one in which the employer operates, it is unlikely to be enforced. For example, with respect to a non-solicitation covenant, the scope of the restriction generally should be limited to clients, customers or personnel with whom the restricted employee had contact or responsibility, rather than extending to all clients, customers or employees of the company.

Non-competition

Some states, such as California, Minnesota, North Dakota and Oklahoma, generally prohibit employers from entering into non-competition agreements with employees, subject to very limited exceptions (such as in connection with the sale of a business). Other states have limited non-competes to certain categories of employees. For example, in Illinois, only employees whose annual compensation exceeds certain minimum thresholds may be subject to non-compete or non-solicitation covenants. Similarly, many states, including Colorado, Illinois, Maine, Massachusetts, New Hampshire, Oregon, and Washington and the District of Columbia, have enacted laws that require employers to provide the employee with prior notice of the restrictive covenant in advance of being hired, or with minimum notice in advance of continued employment. For example, in Colorado, employers must provide prospective employees with a separate notice setting forth the terms of a non-compete before they accept any offer of employment. Other states (such as Illinois and Massachusetts) impose additional requirements on employers, such as an obligation to notify employees in writing of their right to consult with independent counsel before signing the restrictive covenant agreement.

As noted above, in analyzing restrictive covenants, most states look at the reasonableness of the restriction in terms of three elements:

• The duration of the restriction;

• The geographic scope of the restriction; and

• The substantive scope of the restriction.

With regard to the duration of the restriction, the shorter the restriction, the more likely it will be found reasonable. With regard to geography, if the employer carries on the type of activity being restricted in a particular geographic region, then the restriction is expected to be coextensive with that geographic region, but not broader. Finally, courts often enforce a covenant that seeks to limit competition only in the same aspect or segment of the business as the one in which the employer operates, and only insofar as the employee worked in such a segment.

Non-Solicitation or Non-Service of Clients/Customers

Some jurisdictions treat covenants not to solicit customers/clients as covenants not to compete, and apply the same reasonableness analysis to either type of covenant. In the minority of jurisdictions, like California, courts will likewise disregard the fact that something is labelled as a covenant not to solicit customers and/or clients, and may instead deem it akin to a covenant not to compete and treat it as such. However, the majority of jurisdictions treat non-solicitation covenants of clients/customers differently than true non-compete covenants, which are often more restrictive on one’s ability to earn a livelihood.

Non-Solicitation of Personnel

With regard to covenants not to solicit other employees, most US jurisdictions consider several factors in the assessment of whether the restriction is necessary to protect the employer’s legitimate business interests and not unduly burdensome to the employee. Such factors often include whether there was actual solicitation by the employee, as opposed to the target employee having initiated the contact through their own volition. Generally, covenants not to solicit other employees are permitted in California, provided that the employer seeking to enforce the covenant can meet the reasonableness criteria above and can show that the solicitation caused business disruption or had other significant negative impacts on its business.

On the Horizon

In recent years, an increasing number of states have enacted laws limiting restrictive covenants. On April 23, 2024, the US Federal Trade Commission (FTC) issued a final Non-Compete Clause Rule (FTC Rule) which is scheduled to take effect on September 4, 2024. If effective, the FTC Rule will invalidate non-compete agreements nationwide by making an employer’s enforcement (or attempted enforcement) of a non-compete clause with an employee or independent contractor per se unlawful. Litigation was filed shortly after the FTC Rule was issued. To date, one Texas federal court has enjoined the implementation and enforcement of the Final Rule, at least as to the plaintiffs in that case, while a Pennsylvania federal court has preliminarily determined that the FTC Rule is lawful. We expect additional rulings regarding the enforceability of the FTC Rule will be issued before its effective date on September 4, 2024, with appeals surely to follow by the end of July 2024. Given the pending legal challenges to the FTC Rule, it is unclear if it will ever become effective.

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