Teaching entrepreneurship: the importance of noncompete agreements to the viability of the enterprise.

Teaching entrepreneurship: the importance of noncompete agreements to the viability of the enterprise. INTRODUCTION Entrepreneurs face a myriad of challenges, not the least of whichis hiring, training and managing employees who may one day becomecompetitors. Business owners must prevent their trade secrets, customerlists, and other proprietary information from being used by a current orformer employee to the detriment of the enterprise. Employees,especially those who have worked for a business for several years, maybecome particularly familiar with day-to-day business operations. Havinglearned the trade and its processes, these individuals may sense anopportunity to venture out on their own and establish a competingbusiness. The entrepreneur's recourse is to utilize a noncompetecontract to protect the firm's interests. Entrepreneurs of all types must be vigilant in protecting theirbusiness interests. Even those engaged in franchise contracts frequentlyfind themselves compelled to enter into a noncompete agreement withtheir franchisor. Likewise, a buyer of an existing business also has acompelling interest in securing a noncompete agreement with the sellerto ensure that the newly acquired business is protected from possiblecompeting interests of the seller. Potential for economic harm as a result of the misappropriation ofa firm's proprietary information by an employee or former employeeshould be an integral part of the discussion in entrepreneurshipcourses. Student exposure to this facet of business operation shouldoccur from an approach that does not overwhelm with too much legalese.The objective should be to impart an understanding of the criticalimportance noncompete agreements play in relation to the wellbeing ofthe enterprise. Various scenarios and actual legal cases will be citedthroughout the following sections to illustrate this importance. NONCOMPETE CONTRACTS A contract is "an agreement between two or more partiescreating obligations that are enforceable or otherwise recognizable atlaw" (Garner, 2004, p. 341). Its essentials are competent parties,subject matter, a legal consideration, mutuality of agreement, andmutuality of obligation. When entrepreneurs perceive a need to preventmisuse of proprietary information, they may require employees to sign anoncompete contract, sometimes called a noncompetition covenant. Anoncompetition covenant is "a promise, usually in asale-of-business, partnership, or employment contract, not to engage inthe same type of business for a stated time in the same market as thebuyer, partner, or employer" (p. 392). Entrepreneurial ventures frequently increase during poor economictimes or recessions. Victims of downsizing or rightsizing seekopportunities wherever they can find them. Thus, the need for anoncompete contract may increase. As many executives are taking extra measures to protect theircompanies during the economic downturn, employment attorneys are seeingan increase in litigation around trade secrets. Specifically, employersare being more aggressive about suing former employees regardingnoncompete agreements, attorneys say (Marquez, 2008). ENFORCING NONCOMPETE CONTRACTS Suing former employees over a noncompete agreement is seldom easy.Because entrepreneurship studies students are typically not exposed tononcompete agreements in their entrepreneurial studies curriculum, it isimportant to first explain that within the four corners of a noncompeteagreement, there is much to be taken into account to draft anenforceable contract. Enforceability is based upon the prevention of"unfair" competition. "In brief, at common law arestraint against competition was valid to the extent it reasonablyprovided for the protection of a valid interest of the covenantee"(Monogram Indus., Inc. v. Sar Indus., Inc., 1976). Common law is definedas "the body of law derived from judicial decisions, rather thanfrom statutes or constitution" (Garner, 2004, p. 293). However, anumber of states are moving away from the common law in relation to theenforceability of covenants not to compete, which is disconcerting tobusiness owners. Unfortunately, there is no uniform federal statute that givesstates a roadmap to follow concerning noncompete agreementenforceability per se with the narrow exception of the Uniform TradeSecrets Act. This act itself is not intended to establish uniformfederal standards regarding trade secrets, but rather is thecodification of existing states' interpretation of trade secretsbased upon existing common law. So other than the issue of trade secretsin relation to noncompete agreements, there is much variability instates' laws in the level of protections afforded to businesses inenforcing noncompete agreements. Some states look at noncompete agreements as creating an unduerestraint of trade, and therefore against public policy. Other statesconsider noncompete agreements enforceable in relation to a condition ofemployment and where limited in scope, typically referring to time andgeography language in the agreement. Although courts recognize that enforcing a restrictive covenant mayresult in the loss of an individual's livelihood, most courtsacross the country today will enforce the agreement if it meets certaintests. California and a dozen or so other states generally do not upholdrestrictive covenants (Shapiro, 1993). More often than not the courts construe noncompete agreements infavor of the employee rather than the employer, so the employer mustinclude meticulous details when preparing a noncompete agreement. PUBLIC POLICY Public policy may be considered as a basis for not enforcing orlimiting the enforceability of noncompete agreements. This may betroublesome to business owners who are trying to protect their businessinterests. California courts are often cited as the example of a statethat as a matter of public policy generally deems noncompete agreementsunenforceable, with the narrow exception of when it relates to anemployer's trade secrets. The California Supreme Court has heldthat provisions in employment contracts prohibiting employees fromworking for a competitor after completion of their employment orimposing a penalty if they do so is to that extent void, unless thoseprovisions are necessary to protect the employer's trade secrets(Muggill v. Reuben H. Donnelley Corp., 1965). A District Court in Arizona held that the restrictive covenant aphysician (employee) entered into with a medical group (employer) wastoo broad and against public policy, because (1) the covenant not tocompete for three years is unreasonable, (2) the prohibited geographicarea encompassed 235 square miles and was thus unreasonable, and (3) thecovenant did not provide an exception for emergency care. The court ofappeals reversed, holding that a modified version of the covenant wasreasonable because there were eight hospitals outside the restrictedarea where the former employee could practice. Furthermore, theseverability clause allowed him to perform emergency services within thearea; and the employer was allowed to stipulate that the employee couldtreat certain cases within the prohibited area. The employee appealed tothe Supreme Court. At issue, can a restrictive covenant prohibiting adoctor from competing within a certain geographic area for three yearsafter the termination of the employment agreement be enforced? In the same case the Arizona Supreme Court held that a restrictivecovenant restraining competition between the employer and employeecannot be enforced for two reasons: (1) the restraint is greater thannecessary to protect the employer's legitimate economic interests,and (2) even if the restraint was not overly broad, the competinginterests of the patients and the public in general outweigh theeconomic interests of the employer. In addition, the court said thethree-year restriction was unreasonable, given the nature of theprofession and pointing to the patients' needs. Thus, a reductionof the noncompete period to six months would be sufficient to protectthe employer. The covenant was too broad in scope and precluded any typeof practice by the former employee. Legitimate economic interests of theemployer in this case could not withstand the interests of publicpolicy. The negative impact the covenant not to compete had on thepatients' right to see the departing physician came into play andoutweighed the employer's interests. The general rule in Arizona isthat restrictive covenants restraining competition or commerce areunenforceable. However, such a restraint can be enforced if it isreasonable and is not against public policy (Valley Medical Specialistsv. Farber, 1999). To be valid and enforceable and not in violation of public policy,a noncompetition covenant must be reasonable from both the employer andemployee's standpoints. A recent case involved plaintiffs whoproduced and distributed trade publications relating to homelandsecurity. The defendant in the case, which sold advertising space forthe plaintiffs' publications, agreed not to compete with theplaintiffs by selling or promoting publications that competed with theplaintiffs' publications. The defendant argued that the lack of anygeographic limitation rendered the noncompetition agreementunenforceable as a matter of law because it essentially imposed aworldwide restriction. The court stated that while there was nogeographic limitation, the agreement had a duration of one year andlimited the prohibited activities to those in direct competition withone journal. Thus, the mere fact that there was no geographicallimitation was not fatal to the enforceability of the agreement. Theterms of the noncompetition agreement were narrowly tailored to protectthe plaintiffs' legitimate business interests while not prohibitingthe defendant from competing in the chosen field. The agreement alsoappeared to be narrowly tailored so that it did not offend publicpolicy. This case successfully upheld a noncompete agreement without ageographic limitation, reversing long-standing Virginia precedent(Market Access Intern. Inc. v. KMD Media LLC, 2006). THE BLUE-PENCIL DOCTRINE The Blue Pencil Doctrine is a legal concept in common law thatenables amending a contract. This doctrine is defined as a judicial standard for deciding whether to invalidate the wholecontract or only the offending words. Under this standard, only theoffending words are invalidated if it would be possible to delete themsimply by running a blue pencil through them, as opposed to changing,adding, or rearranging words, (Garner, 2004, p. 183). Courts in states that recognize the blue pencil doctrine mayattempt to reform the noncompete agreement to create an enforceableagreement from what otherwise would violate the law in that state."If it is clear from its terms that a contract was intended to beseverable, the court can enforce the lawful part and ignore the unlawfulpart." To the contrary, "where the severability of theagreement is not evident from the contract itself, the court cannotcreate a new agreement for the parties to uphold the contract"(Olliver/Pilcher Ins. v. Daniels, 1986). Arizona courts have adopted the blue pencil doctrine in order toreform covenants that are not unreasonable but apply it only in caseswhere severability was the original intent and the agreement is notagainst public policy. "Arizona courts will 'blue-pencil'restrictive covenants, eliminating grammatically severable, unreasonableprovisions" (Valley Medical Specialists v. Farber). States are lessinclined to apply the blue pencil doctrine approach to modifying anoncompete agreement when it appears that employers are over-reaching inthe "terms and conditions language" of the noncompeteagreement and when employers use the agreement's broad language asa firewall and a deterrent to employees competing. In Indiana the courts adopt the "strict" interpretationof the blue pencil doctrine which permits a court to strike out only theoverbroad language. "Apart from the 'blue pencil'doctrine ..., if the agreement as drafted is unreasonably broad, itcannot be enforced in part on the theory that the parties could haveagreed to some more reasonable terms" (Product ActionIntern'l, Inc. v. Mero, 2003). REASONABLE MODIFICATION DOCTRINE Some states apply reasonable modification to noncompete contractswhere there is a compelling reason to modify the agreement in order topermit enforcement. Illinois is one such state. In supporting thecontention that defendants have a protectable interest in enforcing therestrictive covenant, the court upheld a restrictive covenant containedin an employment agreement between a departing ophthalmologist and aneye clinic, prohibiting the ophthalmologist from practicing within a50-mile radius of the eye clinic's branches at which he previouslypracticed. The court found that Restrictive covenants between medical doctors are not detrimentalto the public interest because the restricted doctor can be just asuseful to the public in another location outside the restricted area;and the physician can always resume his practice in the restricted zoneonce the time duration of the covenant not to compete has expired(Gillespie v. Carbondale & Marion Eye Centers, Ltd., 1993). However, the Gillespie court did recognize "the possibleadverse effects that enforcement of this restrictive covenant could haveon the public," but it felt compelled to follow an earlier IllinoisSupreme Court case (Canfield v. Spear, 1969), which held thatrestrictive covenants between medical doctors are not detrimental to thepublic interest for the previously noted reasons. REASONABLENESS OF THE AGREEMENT Many states apply a test of reasonableness in determining whetherto enforce a noncompete agreement. In employment cases, reasonablenessbreaks down into three issues: 1. Is the restraint reasonable in the sense that it is no greaterthan necessary to protect the employer in some legitimate interest? 2. Is the restraint reasonable in the sense that it is not undulyharsh and oppressive on the employee? 3. Is the restraint reasonable in the sense that it is notinjurious to the public? So the question might be posed: Is it reasonable to ask an employeeto sign a noncompete agreement well after being employed with noadditional consideration given to the employee? At issue is whetheradditional consideration is required in order to enforce a noncompeteagreement entered into after employment has begun. The trial court foundthat there does not have to be any new consideration for a noncompeteagreement even though it is entered into after an employee has beenemployed for a period of time (CentralMonitoring Service, Inc. v.Zakinski, 1996). Standard contract law governs the enforceability of a noncompeteagreement. South Dakota statutes state that an employee may agree withan employer at the time of employment or at any time during hisemployment not to engage directly or indirectly in the same business orprofession as that of his employer "as long as the noncompetitionagreements comport with the statutory language" (American Rim &Brake, Inc. v. Zoellner, 1986). Many courts will not enforce an overly broad noncompete agreementor will enforce it only in the state in which the cause of action aroseallowing the noncompete agreement to stand in other states in which thebusiness also had a presence. The general rule is that the local law ofthe state that "has the most significant relationship to thetransaction" will govern (Restatement [Second] of Conflict of Laws[section] 188). Contract law is for the most part intended to facilitatethe interests of the parties to the agreement. Where there is an issueof multiple jurisdictions involved, many states will follow thereasonable test and enforce the agreement as it pertains to thatstate's law while deferring on the matter of enforceability on thesame issue as applicable in another state. For example, anemployer's noncompete agreement that prohibited a former employeefrom working for a competitor anywhere in the world and prohibitedsolicitation of any of the employer's customers was overly broadand unenforceable under Georgia law (Keener v. Convergys Corp, 2003).However, the Georgia appeals court would not support the trialcourt's ruling that the noncompete agreement was unenforceable inanother state where the employer also had operations. For a complete definition of reasonableness as it applies tononcompete agreements, see Unreasonableness of Covenant Not To Compete,20 AmJur Proof of Facts 3d 705, [section] 3: CONCLUSION When teaching entrepreneurship, consideration should be given incurriculum development to aspects of contract law and more specificallynoncompete agreements that could have an impact on nascent enterprises.Students need to be made aware of the possible need for a noncompeteagreement in developing a business plan, the essential elements tocreate a legally enforceable agreement, and the potential pitfallsinherent in enforceability from one state to another. As studentsassimilate into the work force, they may find themselves on either endof a noncompete contract. As employees, they should be acutely aware ofwhat limitations might be imposed by their signature on a contract.Likewise, their familiarity with noncompete contracts may mitigatefuture anguish when they hire staff for their own businesses. Although there are a few states that hold noncompete agreements asprima facie void, most state courts will rule for partial enforcement.Thus, a promise in a noncompete agreement should be enforceable by andlarge when public policy issues are not in conflict and where theagreement is in severable terms. There is much case law on the subjectof noncompete agreements, and while it is not easy to reconcile becausethe law is far from being settled, entrepreneurship students should beexposed to the subject matter since there is a high probability thatthey will be faced with the issue sometime during their businesscareers. REFERENCES 20 AmJur Proof of Facts 3d 705, [section] 3: (1993 and Supp. 2001).American Rim & Brake, Inc. v. Zoellner, 382 N.W. 2d 421, 424 (S.D.1986). Canfield v. Spear, 44 Ill. 2d 49, 254 N.E.2d 433 (1969). Central Monitoring Service, Inc. v. Zakinski, 1996 SD 116, fromSouth Dakota Unified Judicial System. Retrieved February 6, 2009 fromhttp://www.sdjudicial.com/index.asp?category=opinions&nav=5319&year=1996&month=9&record=916. Garner, B. (Ed.). (2004). Black's law dictionary (8th ed.).St. Paul, MN: Thomson West. Gillespie v. Carbondale & Marion Eye Centers, Ltd., 251 Ill.App. 3d 625, 622 N.E.2d 1267 (1993). Keener v. Convergys Corp (2003) 11th US Circuit Court of AppealsKeener v. Convergys Corp (2003). Market Access Intern., Inc. v. KMD Media, LLC, 2006 WL 3775935 4(Va. Cir. Ct., Dec. 14, 2006) Retrieved August 10, 2009, fromhttp://www.frithlawfirm.com/Articles/BusinessNonCompeteArticles/NonCompetitionAgreementsinVirginia/tabid/136/Default.aspx Marquez, J. (2008, November). Litigation over noncompete pacts onrise. Workforce Management, 87(18), 11-12. Retrieved February 6, 2009from ABI/INFORM Global database. (Document ID: 1597305511). Monogram Indus., Inc. v. Sar Indus., Inc., 64 Cal.App.3d 692,697-98 (1976). Muggill v. Reuben H. Donnelley Corp., 62 Cal.2d 239, 242 (1965). Olliver/Pilcher Ins. v. Daniels, 715 P.2d 1218, 1221 (Ariz. 1986). Product Action Intern'l, Inc. v. Mero, 277 F. Supp. 2d 919 (D.Ind. Aug. 5, 2003). Restatement [Second] of Conflict of Laws [section] 188 (1971). Restatement (Second) Contracts [section] 518 (1977). Shapiro, B. R. (1993). The enforceability of non-competeagreements. Marketing Management, 2(1), 70. Retrieved February 10, 2009,from ABI/INFORM Global database. (Document ID: 1214342). Valley Medical Specialists v. Farber, 982 P.2d 1277 (1999).Retrieved February 10, 2009, fromhttp://www.law.unlv.edu/faculty/bam/k2002/briefs/valley.html. Patrick R. Geho, Middle Tennessee State University Stephen D. Lewis, Middle Tennessee State University