Please Release Me: Analyzing the Enforceability of Restrictive Covenants in Employment Agreements

Please Release Me: Analyzing the Enforceability of

Restrictive Covenants in Employment Agreements

Mary Anne MasonJustice of the Appellate Court, First

DistrictKathleen Pantle

Judge of the Circuit Court of Cook County

April 25, 2014

Life was so simple then….

Many decades ago, Fred began taking lessons at Arthur Murray Dance Studio in Cleveland, Ohio

Fred progressed from having two left feet to the pinnacle of modern dance becoming Arthur Murray’s most popular instructor

But Fred tired of barely eking out a living and decided to branch out and a loyal clientele followed.

But although Fred was fleet of foot, Arthur Murray took a heavy-handed approach to enforcing Fred’s restrictive covenant.

More than 60 years ago, the court of Common Pleas in Cuyahoga County, Ohio described the law regarding an employee’s covenant not to compete:

“It is a sea – vast and vacillating, overlapping and bewildering. One can fish out of it any kind of strange support for anything, if he lives so long.”

Arthur Murray Dance Studio v. Witter, 105 N.E.2d 685 (1952)

In the more than 6 decades following that observation, that sea has become a legal tsunami, threatening to overwhelm even the most experienced jurist.

If you Google “restrictive covenants in employment”, it generates more than 550,000 results.

In the short time we have here today, Judge Pantle and I will attempt to navigate the treacherous seas of restrictive covenants.

What is a restrictive covenant?A means by which an employer

seeks to limit an employee’s post-employment conduct by imposing restrictions defined by time, geographical area, activity and/or disclosure of confidential information

Those ancillary to the sale of a business

Those ancillary to a valid employment relationship

Today we will be concentrating on those covenants that are ancillary to a valid employment relationship

Two Kinds of Restrictive Covenants

Pre-Reliable Fire enforceability analysis:Restrictions were only justified if

founded upon a “legitimate business interest: consisting of either1. near-permanent customer relationships or

2. trade secrets

In the absence of one or both of these protectable interests, many courts found that efforts to circumscribe an employee’s ability to compete following termination of employment were impermissible, e.g. Office Mates 5 v. Hazen, 234 Ill. App.3d 557 (1992)

"Upset at you for breaching the non-compete? Of

course not."

ALLIGATOR PIT

Plaintiff filed a complaint alleging that Defendants violated restrictive covenants contained in their valid and enforceable employment agreements by engaging in sales activities and providing services to Plaintiff’s customers; soliciting referrals from Plaintiff’s referral sources; and soliciting several named Plaintiff employees to leave their employment with Plaintiff.

Reliable Fire Equipment Co. v. Arredondo, 2011 IL 111871

After trial, the trial court ruled that the restrictive covenants were unenforceable concluding that Plaintiff failed to prove the existence of a legitimate business interest. Reliable Fire, 2011 IL 111871 at ¶8.

A “sharply divided” appellate court affirmed. Id. at ¶9.

The Illinois Supreme Court reversed.

Adhered to well-established Illinois law: Contracts in total and general restraint of trade are void as against public policy…

But, a contract which is only in partial restraint of trade is valid provided, It is reasonable AND It has a consideration attached to it. Reliable Fire, 2011 IL 111871, ¶16,

quoting Hursen v. Gavin, 162 Ill. 377 (1896).

Any covenant must be ancillary to either the sale of a business or a valid employment relationship

A court must consider whether the covenant: Is no greater than is required for the

protection of a legitimate business interest of the employer-promisee;

Does not impose undue hardship on the employee-promisor; AND

Is not injurious to the public

Three-Prong Rule of Reason

Factors include but are not limited to:Near permanence of customer

relationshipsEmployee’s acquisition of

confidential information through his employment

Time and place restrictions

Legitimate Business Interest

The extent of the employer’s legitimate business interest may be limited by:Type of activityGeographic areaTime

In the absence of a legitimate business interest in need of protection, a plaintiff cannot satisfy the three-prong rule of reasonableness necessary to entitle it to judicial enforcement of a restrictive covenant contained in an employment agreement.

Gastroenterology Consultants of the North Shore, S.C. v. Meiselman, 2013 IL App (1st) 123692.

Factors the courts used to hold as conclusive are now only non-conclusive aids in determining the promisor’s legitimate business interest, which is but one component in the three-prong rule of reason, grounded in the totality of the circumstances

Vast body of case law establishing factors that a court can consider in determining the employer’s legitimate interest remains intact EXCEPT

Sunbelt Rentals, Inc. v. Ehlers, 394 Ill. App.3d 421 (4th Dist. 2009) was expressly overruled; and

The two-factor test established in Nationwide Advertising Service, Inc. v. Kolar, 28 Ill. App.3d 671 (1st Dist. 1975) is no longer conclusive.

After being laid off Jack, Larry, and Stan decide to form their own competing company.

All three had signed agreements with their former employer which contained restrictive covenants.

Their employment agreements were not identical.

They did not receive stock options, bonuses, or a higher salary for agreeing to the restrictive covenants.

Jack, Larry, and Stan worked in the automotive industry for a company named “Rustbucket, Inc.”.

Jack is an engineer with detailed knowledge of patented manufacturing processes.

Larry was a salesperson with no specialized knowledge, but lots of customer contact.

Stan was an executive vice-president who negotiated his non-compete prior to accepting the job.

Rustbucket, Inc. sues all three men alleging violations of their restrictive covenants.

Stan, the executive vice-president, worked for the Plaintiff for eight months. He now moves for declaratory relief on the grounds of inadequate consideration.

Scenario

A.YesB.No

Should Stan’s motion for declaratory relief be granted?

A. B.

0%0%

Continued employment for a substantial period of time beyond the threat of discharge is sufficient consideration to support a restrictive covenant in an employment agreement.

Fifield v. Premier Dealer Services, Inc., 2013 IL App (1st) 120327, ¶ 14.

Adequate Consideration

“Generally, Illinois courts have held that continued employment for two years or more constitutes adequate consideration.”

Fifield, 2013 IL App (1st) 120237, ¶ 14.

Jack’s (the engineer) employment agreement contains a provision that prohibits Jack from competing for a five-year period anywhere in the United States in the area of the “manufacture, sale, distribution, or servicing of computer equipment found in or on any automobile”.

Jack moves to dismiss under section 2-615 on the grounds that the temporal and geographic restrictions are overbroad.

Rustbucket, Inc. argues that the restrictive covenant is not overbroad because it manufactures cars that are sold in every State and therefore Jack would be competing anywhere he worked in the United States. Also, the temporal restriction is valid because its employees usually work for them for more than five years.

A.GrantedB.Denied

The Motion to Dismiss is

A. B.

0%0%

“At the outset, we question whether a section 2-615 motion to dismiss is an appropriate vehicle to decide issues that are essentially very fact-intensive, since section 2-615 restricts the trial court to the ‘four corners’ of the complaint.”

Baird & Warner Residential Sales, Inc. v. Mazzone, 384 Ill. App.3d 586, 591 (1st Dist. 2008).

Larry’s (the salesperson) employment agreement prohibits him from soliciting existing customers, including but not limited to customers with whom he had personal contact, and potential customers, including prospects, anywhere in the United States for a period of two years following termination of his employment.

Larry moves to dismiss on the grounds that the covenant is vague and overbroad.

A.GrantedB.DeniedC.Granted in

part, denied in part

The Motion to Dismiss is

A. B. C.

0% 0%0%

As a matter of law, an employer cannot have a protectible interest in future customers who do not yet exist.

Eichmann v. Nat’l Hospital & Health Care Services, Inc., 308 Ill. App.3d 337, 346 (1st Dist. 1998).

BEWARE! (However) If the employer is operating in a niche

market and devotes substantial time and resources to the development of prospects, the employee could be enjoined from utilizing the prospect list for his own benefit after termination.

In addition, the covenant prohibits Larry from soliciting other salespeople to leave Rustbucket’s employ.

After Larry is terminated, he promptly asks others in the sales department to join him in the new firm and proceeds to contact his five largest customers.

Larry’s covenant also prohibits him from disclosing any of Rustbucket’s “confidential information” defined in the agreement as “all information in whatever form, relating to the company’s business, including, but not limited to customer lists, customer contact information, customer ordering history, customer pricing, automotive equipment specifications, the company’s suppliers, and employee training manuals.”

Larry moves to dismiss, asserting that, as a matter of law, his restrictive covenant is overbroad in that its non-disclosure provisions cover virtually every aspect of the company’s business and encompasses information that is clearly not confidential or a trade secret.

Rustbucket responds contending the covenant is valid and further responds that, if the court finds that only some parts of the covenant are valid, it should enforce those provisions.

Consider: Are the provisions clearly reasonable in

time and activity restrictions? Has Larry violated those provisions? Do the non-disclosure provisions work

a hardship on Larry? Would denying enforcement of the

covenant because of the over-breadth of a portion of it deprive the employer of bargained-for protections?

What are the relevant factors?

Is there a severability clause in the parties’ agreement?

“Blue-pencilling “= Editing in order to carve out certain unenforceable provisions while preserving reasonable restraints, i.e. enforceable provisions.

Does “blue-pencilling” result in significant alteration of the agreement?

Blue-Pencilling

“Slight” modifications have been upheld where the balance of the restrictions were reasonable and necessary to protect the employer’s interests.

Arpac Corp. v. Murray, 226 Ill. App.3d 65, 80 (1992) (Court found covenant restricting ex-employee from competing in the shrink-wrap industry “in any capacity” overbroad, but enforced other reasonable restrictions.

But, even if the parties include a “reformation clause”, rewriting an overbroad covenant is inadvisable.

Cambridge Engineering, Inc. v. Mercury Partners, 378 Ill. App.3d 437 (2007).

Assume that the motions to dismiss have been denied.

After discovery, Jack, Larry, & Stan move for summary judgment because they claim that the evidence does not establish “near permanence of customer relationships.”

Plaintiff argues that it has established near-permanence becauseThe Defendants would not have

come into contact with the customers but for their employment with Plaintiff.

There is a limited number of customers.

Plaintiff makes sure it contacts its customers at least once a month to make sure the customer is satisfied.

It takes about 6 months to develop a relationship whereby the customer decides to hire Plaintiff.

A. Granted B. Denied

The Motion for Summary Judgment is

A. B.

0%0%

Marsha Smith has been employed by ABC Insurance Company as a commercial lines insurance salesperson for 10 years.

The market for commercial lines insurance is highly competitive. Policies come up for renewal every year.

Marsha’s employment agreement with ABC prohibits her, for a period of one year after the termination of her employment from soliciting or accepting commercial lines insurance business from clients whose accounts she serviced within two years preceding the termination of her employment.

During her tenure at ABC, Marsha developed relationships with several longstanding clients. Marsha is the “go to” person for all issues and questions relating to these accounts. She has entertained clients (at ABC’s expense) and has socialized with them on non-business occasions. All of her clients have Marsha’s cell phone number.

Marsha has decided to accept an offer from one of ABC’s competitors. In an exit interview, she affirms her understanding of her restrictive covenant and indicates her intention to honor it.

On her last day, Marsha sends the following email to each of her ABC clients:

“After 10 rewarding years at ABC, I have decided to accept another opportunity in the insurance industry. I have derived great professional satisfaction from the business you have entrusted to me and I value my relationship with both you and your employees on a professional and personal level.

“My contract with ABC prohibits me, for a period of one year, from soliciting or accepting business from ABC clients that I have serviced in the past two years and I intend to honor that agreement. I hope again to be in a position to meet your insurance needs in the not-too-distant future.”

Marsha does not send a copy of her email to anyone at ABC.

Following Marsha’s departure, several large ABC clients whose accounts Marsha serviced move their business to Marsha’s new agency. When ABC’s president calls one of the clients to introduce ABC’s new salesperson, that client provides him with a copy of the email.

A.YesB.NoC.Maybe

Has Marsha violated her restrictive covenant?

A. B. C.

0% 0%0%

Does it make a difference if the evidence shows that when contacted on her cell phone, Marsha informed clients that she could not give them her new office contact information and reiterated her intention to honor her non-compete?

Does it make a difference if the evidence shows that when contacted on her cell phone, Marsha informed clients of her new office contact information, but that she intended to honor her non-compete?

Does it make a difference if at the new agency:

Marsha is screened from contact with her former clients, but shares in the revenue generated by their business?

What if Marsha is screened from contact with former clients, does not share in the revenue generated by their business, but is paid a higher base salary by the new firm for a period of one year?

Does is make a difference if Marsha’s new firm already had accounts with several of the clients for other lines of insurance (but not commercial lines)?

Q # 1: Is the restrictive covenant ancillary to either the sale of a business or a valid employment relationship?

If No, the ex-employee wins. If Yes, then go to the next question.

“How To” Analysis

Q # 2: Is there valid consideration for the restrictive covenant?

If No, the ex-employee wins. If Yes, then go to the next

question.

Q #3: Is the covenant injurious to the public?

Example: Injurious to the public when there’s a limited source of product or services and enforcement of the restrictive covenant would inhibit the public’s access to the product or service.

Q # 4: Does the covenant impose undue hardship on the employee?

Example: If the employee gained knowledge and experience in a particular segment of the industry, but the covenant precludes the employee from working in any capacity, then undue hardship may result.

Q # 5: Is the covenant greater than is required for the protection of a legitimate business interest of the employer? In making these arguments

Keep in mind the factors espoused by the reviewing courts over the years and use them as non-conclusive aids

Totality of the Circumstances

Q. 5 continuedConsider the type of activity being restrained and the temporal and geographic restrictions

The standard is “totality of the circumstances”—no one factor carries any more weight than the others, but its importance will depend on the specific facts and circumstances of the individual case

“If it were possible to make a complete list today [to define an employer’s legitimate business interest], human ingenuity would render the list obsolete tomorrow.”

Reliable Fire, 2011 IL 111871 at ¶ 40, quoting Arthur Murray, 105 N.E.2d at 695.

Is the decision in Reliable Fire pro-business or pro-ex-employee?

Safe answer: It depends.

Burning Question for a Spring Day

The opinion makes it: More difficult for a plaintiff to get

a TRO More difficult for a defendant to

win a Motion to Dismiss More difficult for either side to win

at the summary judgment stage

The following opinion is that of the presenter and not necessarily that of

the producer of Reliable Fire

Almost a certainty the case is going to trial unless:One side feels a “chill wind” coming from the bench after a preliminary injunction hearing.

Cont.

“Garden Leave” covenants Require an at-will employee to provide 90-

180 days’ notice of intent to leave During notice period, employer continues to

pay employee salary and benefits but employee performs little or no services

During notice period, employee still owes employer duty of loyalty and cannot work for another firm

New Developments

Garden leave provisions are pure non-compete

Courts have been divided on their enforceability

1. Bear Stearns & Co. v. Sharon, 550 F. Supp.2d 174 (D. Mass. 2008) Court refused to enforce provision against department managing director reasoning that the employee was forced to remain with the firm despite his “at-will” status

2. Bear Stearns & Co. v. Arnone, No. 103187 (Sup. Ct. N.Y. 2008) Court enjoined broker from communications with clients where she contacted her clients during notice period to tell them where she could be contacted after the period expired.

The ITSA defines a “trade secret” as: Information, including but not limited

to: Technical or non-technical data A formula Pattern Compilation Program Device

Illinois Trade Secrets Act

Method Technique Drawing Process Financial data List of actual or potential customers or

suppliers

That Is sufficiently secret to derive

economic value, actual or potential, from not being generally known to other persons who can obtain economic value from its disclosure or use

AND

Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy or confidentiality

Rustbucket alleges that Larry, the salesperson, stole its trade secrets by downloading a copy of its customer list onto a thumb drive before quitting. The customer list was maintained on a computer and was password protected. The list took a long time to compile and was extremely valuable.

A.YesB.No

Has the Plaintiff alleged sufficient facts to survive a 2-615 motion to dismiss for

failure to state a cause of action?

A. B.

0%0%

Customer lists and other customer-related information are confidential if: The information has been developed by

the employer over a number of years at great expense AND

Kept under tight securityA.J. Dralle, Inc. v. Air Technologies, Inc., 255 Ill. App.3d 982 (2d Dist. 1994).

However, where customer information is readily available to competitors through normal competitive means, no protectable interest exists.

Office Mates 5, North Shore, Inc. v. Hazen, 234 Ill. App.3d 557, 575-76 (1st Dist. 1992).

Plaintiff restaurant owner/chef alleges that defendant, her ex-sous chef, stole her recipe for Southern-style biscuits. Plaintiff inherited the recipe from her grandmother twenty years ago, does not share it with anyone, and was the only one at her restaurant who would prepare the the biscuits. Plaintiff kept the recipe in a safe in her office and Plaintiff was the only one with the key to the office and the combination to the safe. Plaintiff’s restaurant is known for its biscuits.

Scenario

Does the biscuit recipe meet the definition of a “trade secret”?

Chef Lagasse would say that the correct answer is “Yes”

There is a difference between a recipe for baking a casserole and a recipe for baking a cake. Essentially, one is a guideline to be followed generally and the other is a formula, that is, “a prescription of ingredients in fixed proportion”.

Don’t be too quick to argue your client's case without knowing something about the industry at issue.

Moral of the Story

Focus on where the the Verified Complaint is lacking in detail e.g.How much did the defendant earn?

(particularly important in a Trade Secrets Act case)

Tips for the TRO

How long has the plaintiff-employer been in business?

How long does it take the plaintiff to develop the clientele?

How much money is invested in developing the clientele?

TRO Tips (cont.)

How are the plaintiff’s trade secrets secured? Telling you that the secrets are “password-protected” tells you nothing as everyone needs a password to log onto his or her employer’s site.

Who has access to the plaintiff’s trade secrets?

How long did the defendant work for the plaintiff?

What is the geographic area in which the plaintiff-company operates?

Assume Marsha's been enjoined from soliciting/accepting business from other ABC clients.

ABC Corp. now seeks money damages for the loss of business that “walked out the door” after she left, but before the injunction was entered.

The lost business consists of 5 major clients, accounting for annual revenues of $1 million. These clients are now clients of Marsha’s new employer.

Money Damages

ABC requests entry of a money judgment in the amount of $1 million because Marsha’s restrictive covenant prohibited her from soliciting or accepting business from these clients.

Marsha and her new employer argue that these clients were longtime, loyal clients who were serviced exclusively by Marsha and would have left ABC in any event, even if they could not have followed Marsha to her new firm.

Several (but not all) of the 5 clients testified to this at trial.

What judgment is ABC entitled to?1. Judgment in the amount of $1

million.2. $0. Judgment for Marsha and her

new employer on the ground that ABC’s damages were not caused by Marsha’s breach.

3. Who the heck knows?

The purpose of damages is to place the injured party in the same position (but not a better position) at the time of judgment than it would have been had the contract been honored.

Nilsson v. NBD Bank, 313 Ill. App.3d 751, 760 (1st Dist. 1999).

Relevant Considerations

Arguably, had Marsha simply left ABC and done nothing to violate her restrictive covenant, the clients that form the basis of ABC’s damages claim would have left anyway.

However, notwithstanding the client’s testimony at trial, the fact is that Marsha’s conduct in accepting the business from them has rendered it difficult, if not impossible, to reconstruct what would have happened had she not breached.

A countervailing consideration to the notion that breach of contract damages should not place the injured party in a better position than if the breach never occurred, is the principle that a breaching party who, by their conduct, renders the calculation of damages difficult or uncertain, should not benefit from that fact.

Belleville Toyota v. Toyota Motor Sales, U.S.A., 199 Ill.2d 325, 361 (2002).

“Breaking Up Is Hard To Do”Starring:

Justice Mary Anne MasonJudge Nancy Arnold (Ret.)Judge Erica Reddick

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