In the May 17, 2024 edition of The Legal Intelligencer, Edward T. Kang wrote, “FTC Ban on Noncompetes: Antitrust Implications of Agreements.”

Massachusetts’s Route 128 high-tech corridor was supposed to be America’s high-tech capital. In the 1970s, armed with talents from Harvard and MIT and home to computer companies like Digital Equipment Corp. and Wang Laboratories, the Boston metro area was leading the charge for minicomputer innovation. Back then, the total technology employment in the area was roughly triple that of Silicon Valley, and the notion of Silicon Valley outshining Boston as the high-tech capital seemed implausible. Fast forward to 1995. Silicon Valley saw the highest increase in export sales among U.S. metro areas, while Boston did not make the top five. What explains Silicon Valley’s rise and Boston’s decline? Legal scholars have identified one key reason: while most states, including Massachusetts, enforce noncompete agreements, California does not. The result was a strikingly open culture in Silicon Valley where employees are free to go from one company to another or start their own, enabling and sustaining more successful regional development. In the last decade, there has been a surge in public initiatives including new legislations and regulatory initiatives aiming to reign in employers’ use of noncompetes, with the most recent example being the FTC’s issuance of its final rule banning nearly all noncompete agreements. The final rule has yet to take effect, however, and legal challenges are already looming. Rather than just describing the new FTC rule, we should examine noncompetes’ anticompetitive effects, a critical aspect of the rule’s underlying rationale. As a growing body of academic literature asserts, noncompetes are restraints against competition, and they are harmful to both employees and the economy. As one of the major levers that the federal government has over the economy, antitrust laws can provide significant deterrence to abuse of noncompetes by employers.

The Spectrum of State Laws on Noncompetes

The legal system has historically addressed noncompetes almost entirely under state common law. Nowadays, the treatment of noncompete provisions varies significantly from state to state. On one end of the spectrum, five states completely prohibit almost all noncompete agreements. These states include California, Colorado, Minnesota, North Dakota and Oklahoma. On the opposite end of the spectrum regarding enforceability, numerous states rely on common-law development to assess non-compete agreements and generally uphold noncompete agreements. However, all states subject such agreements to closer scrutiny than typical contracts by applying a balancing test that requires employers to show a “protectable interest,” or requires more than minimal consideration. Generally, under the balancing test, a court must consider whether the restraint is greater than is needed to protect the employer’s legitimate interest; the hardship to the employee; and (3) the likely injury to the public. See Modern Environments v. Stinnett, 561 S.E.2d 694 (Va. 2002).

On the enforceability of noncompete agreements containing unenforceable provisions, courts in these jurisdictions are split among three approaches: the “all or nothing” approach, which voids the agreement entirely if any part is unenforceable, the “blue pencil” approach, which enables the court to enforce the reasonable terms provided the agreement remains grammatically coherent once its unreasonable provisions are excised, and the “partial enforcement” approach, which reforms and enforces the restrictive covenant to the extent it is reasonable, unless the “circumstances indicate bad faith or deliberate overreaching” on the part of the employer. See Ferrofluidics v. Advanced Vacuum Components, 968 F.2d 1463 (1st Cir. 1992).

The Anticompetitive Effects of Noncompetes

By imposing outright limits on employees’ ability to engage in competitive work, noncompetes can deter employees from leaving their employers and impede their access to economic opportunities. Moreover, noncompetes, in the aggregate, can cause broader harm to society when they impede free trade and open competition.

An example is helpful to illustrate the threat to competition posed by noncompetes. Imagine a hospital in a rural area with a fixed number of trained nurses. Suppose the hospital owner is worried that another hospital might be established in the area and bring in competition, both in the product market for medical services and the labor market for skilled medical professionals. In that case, the hospital can hire additional unneeded nurses out of the pool of trained nurses and subject all nurses to noncompetes of three years. The noncompetes would be a significant entry barrier for any new hospital that wants to enter the market. Even if a new hospital is willing to pay a significant wage premium to hire the nurses employed by the incumbent hospital, the new hospital will have to wait three years while the nurses remain unemployed. Furthermore, this entry barrier will harm not only the labor market for nurses, but also all the other labor markets, such as the markets for doctors and hospital administrators, from which the new hospital would have drawn, and the product market for medical services because there are fewer consumer choices. In summary, in addition to employees subject to the noncompete, a non-compete can harm the labor markets from which the employer draws, and the product market in which the employer operates.

Empirical studies have highlighted the harmful effects of noncompetes in the aggregate on competition and entrepreneurial activities. Enforcing noncompetes reduces the formation of “spinout” firms, which are new firms founded by employees leaving their previous employer. A one standard deviation increases in state law enforceability of noncompetes leads to a 28.7% decrease in new spinout firm formation. Venture capital is more effective at generating firms and jobs in states without noncompete enforcement than states that enforce noncompetes.

The prevalence of noncompetes and the labor markets being highly concentrated exacerbate the anticompetitive effects caused by noncompetes, creating a vicious cycle. If a labor market is competitive and many employers exist, the employers are more likely to free ride on each other rather than to pay the wage premiums for employees to sign noncompetes. However, most labor markets are highly concentrated. One study found that 60% of labor markets have a Herfindahl-Hirschman Index (HHI) exceeding 2,500, a threshold considered “highly concentrated” by the Justice Department and FTC. If employers use noncompetes infrequently, their adverse effect of deterring entry and causing market concentration might only be seen in the long term. Noncompetes are common, however. Approximately one in five American workers, which amounts to approximately 30 million people, are restricted by non-compete clauses. As a result, non-competes in aggregate are harmful to labor markets.

Using the Sherman Act to Challenge Noncompetes

As agreements in restraint of trade, noncompetes fall within the ambit of the Sherman Act. But, lawsuits challenging noncompetes under antitrust law are almost nonexistent. In earlier cases, courts dismissed plaintiffs’ challenges because they found that noncompetes involved de minimis effects on competitions and did not harm the public interest, as shown by the plaintiffs’ failure to show non-competes effects on the market. See e.g., Bradford v. New York Times, 501 F.2d 51 (2d Cir. 1974). Courts also evaluated noncompetes under the deferential rule of reason standard rather than the per se illegal or quick look standard. Under the rule of reason standard, a plaintiff cannot prevail unless she can prove that the defendant has market power, that is, the power to force the employee to do something that she would not do in a competitive market; and that the noncompete measurably reduces competition. See United States v. Topco Associates, 405 U.S. 596 (1972). Proving that a single noncompete can harm an entire labor market is difficult. Given that such challenges usually involve a single plaintiff defending against the enforcement of one non-compete, the effect of the noncompete on wages and the employee’s mobility in the labor market is likely to be lost in statistical noise. Moreover, while various versions of the rule of reason require considerations of the agreements’ potential impact on the public interest, most courts do not engage in this inquiry, and the process for making such factual determinations remains unclear. As a result, a restraint deemed reasonable in scope typically will not be invalidated due to public interest alone.

Scholars have long critiqued the application of the rule of reason to noncompetes. In the late 1970s, Prof. Charles Sullivan published “Revisiting the ‘Neglected Stepchild’: Antitrust Treatment of Postemployment Restraints of Trade,” where he argued that otherwise “reasonable” noncompetes could violate Section 1 of the Sherman Act. To remedy this problem, he asserted, “courts should look to the general use of noncompetes in the industry to determine whether the collective effect of such practices is to lock-in classes of key employees so as to create a general barrier to competition.” In reaching this conclusion, Sullivan made two factual assumptions: first, that the prevalence of non-competes is much broader than could be surmised from reported caselaw; and second, that as a consequence, non-competes were likely to have broader effects in aggregate beyond what courts would typically discern when examining the specific circumstances of individual cases.

The new empirical literature on noncompetes supports both assumptions and has revealed non-competes’ pernicious effects on labor markets. Antitrust law applies equally to labor markets as to markets for other services and products. The Supreme Court has made clear that antitrust law does “not confine its protection to consumers, or to purchasers, or to competitors, or to sellers” but that the law is instead “comprehensive in its terms and coverage, protecting all who are made victims of the forbidden practices by whomever they may be perpetrated.” See Mandeville Island Farms v. American Crystal Sugar, 334 U.S. 219 (1948). The antitrust regime should incorporate these findings and treat noncompetes as presumptively anticompetitive. Under this approach, courts will not demand proof of market power, and an employee subject to a noncompete would nearly always have a prima facie Section 1 claim. The burden will shift to the employer to rebut the presumption. Suppose the common law standard is imported into the antitrust law. In that case, the plaintiff will only have a prima facie claim when a noncompete is excessive under the common law, and the employer will have the burden of providing a business justification.

The Takeaways

There are limited situations where noncompetes are used to protect legitimate business interest. No one would buy a business, for instance, unless the seller agrees to refrain from competing with the business from the relevant market for a limited period. Most noncompetes are not designed to protect legitimate business interest, however (e.g., an employer requiring a noncompete from every employee). In the latter category, emerging evidence suggests that noncompetes create barriers to competition. Treating noncompetes as presumptively illegal under the Sherman Act will allow the courts to hold employers accountable under antitrust laws if noncompetes undermine market competition.

Edward T. Kang is the managing member of Kang Haggerty. He devotes the majority of his practice to business litigation and other litigation involving business entities. Contact him at ekang@kanghaggerty.com.

Reprinted with permission from the May 17, 2024 edition of “The Legal Intelligencer” © 2024 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.

The determination of whether a restrictive covenant is reasonable is a factual one that is assessed on a case-by-case basis: courts weigh the competing interests of the employee versus the employer, and typically the burden is on the employer to demonstrate that the restrictive covenant protects the employer’s interests without posing an undue hardship on the employee.

In Pennsylvania, restrictive covenants are enforceable if they are incident to an employment relationship between the parties, the restrictions imposed by the covenant are reasonably necessary for the protection of the employer, and the restrictions imposed are reasonably limited in duration and geographic extent.  Hess v. Gebhard & Co. Inc., 808 A.2d 912 (Pa. 2002).

When Mid-Atlantic hired Socko as a salesman in March 2007, Socko signed an employment agreement with a two-year covenant not to compete.  He resigned in February 2009, but was rehired in June 2009 and signed a new employment agreement with a similar two-year covenant not to compete.  Subsequently, he signed a third employment agreement on December 28, 2010 containing a two year non-compete covering eight named states, including Pennsylvania, and anywhere else that Mid-Atlantic did business.   In January 2012, Socko resigned and took a position with a competitor basement waterproofing company located in Camp Hill, Pennsylvania.  Mid-Atlantic wrote the new employer enclosing the third employment letter and threatening litigation.  The new employer terminated Socko, who sued for declaratory judgment seeking a determination that the non-compete provision of the employment agreement was unenforceable for lack of sufficient consideration.

Mid-Atlantic argued that the employment agreement satisfied the requirement of adequate consideration by containing language stating the parties “intending to be legally bound” and therefore under Pennsylvania’s Uniform Written Obligations Act, 33 P.S. § 6 (“UWOA”), the contract could not be avoided for lack of consideration.  The trial court granted partial summary judgment to Socko, and Mid-Atlantic appealed contending the court erred in failing to give effect to UWOA as satisfying the requirement of consideration sufficient to support the employment agreement and its restrictive covenant.

UWOA states, “[a] written release or promise, hereafter made and signed by the person releasing or promising, shall not be invalid or unenforceable for lack of consideration, if the writing also contains an additional express statement, in any form of language, that the signer intends to be legally bound.”  Essentially, UWOA acts as a “consideration substitute” in forming a valid contract – i.e., so long as the written agreement contains the language the signer “intends to be legally bound” by the agreement, the agreement is valid even without any other consideration (like money or other property).  As of now, Pennsylvania appears to be the only state in the country with this law.

The Superior Court forcefully rejected Mid-Atlantic’s argument and stressed that since the Pennsylvania Supreme Court’s decision in Kistler v. O’Brien, 347 A. 2d 311 (Pa 1975), decisions of the Superior Court have “consistently and without exception” held that when an employee signs an employment agreement containing a covenant not to compete subsequent to initial employment, the restrictive covenant “ ‘must be supported by new consideration . . .in the form of a corresponding benefit to the employee or a beneficial change in his employment status’”(cited case omitted).  Adequate new consideration is required because “restrictive covenants are disfavored in Pennsylvania because they are in restraint of trade and may work significant hardships on employees.”  Viewed in this context, the Pennsylvania Supreme Court has held that continued at-will employment, contracts under seal and other nominal consideration do not satisfy the requirement of valuable new consideration.  The Superior Court explained that while a contract under seal and the UWOA both import consideration into a contract, thereby eliminating the need for proof of the existence of consideration, neither constitutes adequate consideration to support a covenant not to compete.  At the inception of employment, the job itself is sufficient to satisfy this requirement, but when a restrictive covenant is added to an existing employment relationship, “the employee must receive a corresponding benefit or a change in job status.”

This Superior Court decision is a clear reminder to employers that new restrictive covenants obtained from employees during the course of their employment, need to be based upon some form of clearly stated valuable consideration described with specificity in the agreement containing the restrictive covenant.  Promoting an employee to a more senior position with substantial additional compensation, making the employee eligible for a new bonus or incentive compensation plan, or the payment of a one-time meaningful bonus, are examples of the types of valuable consideration that may satisfy the requirement of new consideration.

Kang Haggerty LLC represents employers and employees in disputes involving non-competes and other restrictive covenants.

Employers have legitimate interests in protecting their confidential business information and key customer relationships developed at significant expense. Consequently, many employers require new employers to agree to contractual employment and post-employment restrictions on their activities and conduct. Such restrictive covenants may be a part of an employment agreement or set forth in a separate non-compete and non-disclosure agreement. New employees eager to start out on the right footing are inclined to sign whatever documents are presented to them in connection with the hiring process. Later, if the relationship ends questions arise as to the enforceability of the restrictions. Understanding the basic legal principles applicable to enforcement of restrictive covenants can help both parties.

Courts in most states that enforce post employment restrictive covenants recognize employers have legitimate protectable interests in (i) trade secrets and other confidential information; (ii) unique skills and knowledge developed at the employer’s expense and (iii) customer relationships and goodwill. Ultimately the enforceability of a restrictive covenant will be determined by courts on a case by case basis balancing the employer’s right to protect a legitimate interest against the former employer’s right to pursue a livelihood and the general public interest in unfair restrictions on free and open competition.

Confidential Information Restrictions
Restrictive covenants with confidentiality provisions prevent disclosure or use of the employer’s trade secrets and other confidential, proprietary information. Most states including Pennsylvania, have provided statutory protection to trade secrets by adopting a variation of the Uniform Trade Secrets Act. In Pennsylvania, a trade secret is any information that “[d]erives independent economic value … from not being generally known to … other persons who can obtain economic value from its disclosure or use.” 12 Pa. Cons. Stat. Ann. § 5302 (2005). A trade secret may consist of any formula, pattern, device or compilation of information that is used in one’s business, and gives that person an opportunity to obtain an advantage over competitors who do not know or use it. Felmlee v. Lockett, 466 Pa. 1, 351 A.2d 273, 277 (Pa.1976). On the other hand, information that can be obtained from sources outside of the business or are generally known within the industry are not considered trade secret or protectable as proprietary information of the employer. A customer list is a classic example of business information that may or may not be considered proprietary.

Non-solicitation Restrictions
Non-solicitation provisions prohibit a former employee from soliciting or doing business with customers of the former employer. To be reasonable, the restriction must be limited in duration, geographical scope and no broader than necessary to protect the employer’s legitimate interest. For example, if the employer has invested substantial resources in the development of the employee’s skills and expertise such that the employee has acquired unique talents at the employer’s expense, then limiting that person’s ability to exploit those relationships to the detriment of the former employer has been recognized as reasonable by courts. On the other hand, if the individual established customer relationships before becoming an employee, then the employer cannot legally prevent the former employee from soliciting such customers after his employment ends.

Noncompete provisions
The essence of a noncompete provision is that the employee cannot go to work for a competitor of the employer after ending employment, however again, the limitation must be reasonable in duration, geographical area and scope of activity. If the employer operates globally and the employee had very broad responsibilities, then a global noncompete for a reasonable period of time, such as one or two years may be found to be reasonable. On the other hand, where the employee did not have responsibility beyond a limited geographic area, the noncompete should be similarly limited in scope.

Tips for employees
If you are beginning a new job and required to sign a written agreement containing any type of restrictive covenant, you should take the time to carefully read and understand the restrictions. If they seem reasonable in relation to your new job description, then signing the agreement may very well be appropriate. However, if the provisions of the restrictive covenant seem to be one sided, overbroad or unreasonable in any way, then think twice before signing. You have a right to negotiate the terms of a restrictive covenant just as you would negotiate any other term of your employment. If you have concerns, voice them and see whether the new employer understands your concerns and responds in a way that you believe to be fair under the circumstances. Just because the restrictive covenant is “standard” or “customary,” doesn’t mean you should sign even if they don’t fairly reflect your individual circumstances. If your new employer insists you sign the restrictive covenant without addressing the things you believe are unreasonable, then be sure to make a written record that you raised concerns which the employer rejected. After you sign and begin your employment, ask the personnel office to put a note in your file reflecting that you asked for certain changes in the restrictive covenant which were rejected and that you signed without the changes because it was a condition of your employment. At a minimum prepare a written summary of your oral dealings with the employer about the issue because after employment ends, if a dispute arising about the restrictive covenant, you may be able to demonstrate that the employer’s conduct in insisting on overbroad restrictions was unreasonable.

Tips to Employers
While it is always tempting to have your counsel draft restrictive covenants as broadly as possible to maximize your legal protection, increasingly courts are evaluating the fairness of every aspect of restrictive covenants because of the strong public policies favoring the right of everyone to pursue a livelihood and the strong public policy favoring unfettered competition. To be reasonable and enforceable, restrictions must be no broader than necessary to protect your legitimate business interests.

In practical terms this means that a noncompete should be narrowly drawn to prohibit the employee from working for a direct competitor in a position that is the same or similar to the position held with your company. The restriction also should be limited to a confined geographical area and for a reasonably short period of time. In Pennsylvania, for example, a two year limitation had been judicially approved, but one year is more customary. Confidential information restrictions must also be narrowly focused on categories of information that are truly proprietary such as customer purchase histories, marketing plans, projections, and trade secrets. Whatever you consider to be proprietary information, you should be able to show is not readily known within the industry or available from public sources. If it can be “Googled”, it can’t be confidential and proprietary to you and shouldn’t be included in your restrictive covenant. Nonsolicitation provisions also need to be limited to the relationships that you introduced to your employee and that you expended money to develop and maintain.

Understanding and acknowledging the talents and experience a new employee will bring to your organization means, among other things, being willing to negotiate the scope and specific terms of restrictive covenants. For example, if the new employee has developed client or customer relationships that you know about and hope the new employee will capitalize on for the benefit of your organization, then revise your nonsolicitation provision to exclude relationships developed before becoming your employee. If a post-employment dispute arises over enforcing your restrictive covenant, being able to show you negotiated and revised the restrictions to accommodate concerns voiced by the individual and to reflect the realities will greatly strengthen your prospects of enforcing the terms of the restrictions.

Courts increasingly are not sympathetic to enforcing post employment restrictions that are obviously overbroad and appear to reflect overreaching or dominating conduct by the employer at the beginning of the employment relationship. A quirk of Pennsylvania law is that enforcing a noncompete is much more difficult in the case of employees terminated for cause.

As one federal court explained:

Courts are skeptical when an employer seeks to enforce a non-compete agreement for a terminated employee based only on customer goodwill, as the employer’s termination suggests that the employer does not find the employee to be a competent salesperson, and thus, is not a competitive threat.

InterMetro Indust. Corp. v. Kent, 2007 WL 1140637 at *7 (M.D. Pa. April 17, 2007).

Understanding the pitfalls of overbroad restrictive covenants may help employers craft restrictive covenants that can actually be enforced if the need arises.