Unpacking the Business Arguments For And Against Noncompetes
Regular readers here at Suits by Suits know that we’ve continued to monitor the status of proposed changes to the law governing the enforceability of covenants not to compete in Massachusetts, from the state legislature’s proposal to restrict such covenants to six months in length to more recent pronouncements by Gov. Deval Patrick (D) that his administration would like to ban the enforcement of all such clauses, moving Massachusetts into the same space currently occupied by the state of California.
One question we get here pretty frequently regards the political and business implications of states that are moving in this direction. Certainly, it is generally regarded as an article of faith that enforcing non-competes is pro-business, and states that are considering restricting or outright banning such clauses are prioritizing fairness concerns above economic growth. (This intuition is undoubtedly reinforced by the fact that the most high-profile discussions are coming from one of the most liberal states in the union, Massachusetts.) But is this intuition correct? Many would argue that the case for and against non-competes is considerably more complex; read on.
On face, the argument that enforcement of noncompetes is pro-business (and therefore, pro-growth) is pretty straightforward: noncompete clauses are drafted by the employer and enforced by the employer against a former employee. Therefore, the argument goes, if a jurisdiction wants to be perceived as pro-business, it will uphold the enforceability of such clauses. Thus, the “to-enforce-or-not-to-enforce” argument seems, at first glimpse, to break down along traditional liberal-versus-conservative lines: do you value fairness considerations or economic growth?
I think the case for and against noncompetes is considerably more subtle than that, however. Indeed, when I was interviewed by Crain’s Chicago Business in connection with a recent decision by the Illinois appellate courts in Fifield v. Premier Dealer Services, I tried to articulate the pro-business argument for curtailing the enforcement of covenants not to compete being made by supporters in places like Massachusetts. That argument goes something like this: small businesses are the primary engines of economic growth, particularly on the state level. As a result, a state has a compelling interest in encouraging entrepreneurs to start up, and investors to continue to fund and develop, new businesses within that state. Those new businesses, in turn, prize highly an educated and mobile workforce willing to leave their existing jobs to support the risk (and rewards) of a startup. Moreover – and particularly in the technology industry – that argument appears to derive considerable empirical support from the fact that California (which, as you all know, effectively bans the enforcement of covenants not to compete) continues to outpace the rest of the country in terms of tech startups.
In The Daily Journal, syndicated columnist and radio host Cliff Ennico tackles a question from a small business owner that helps highlight this argument:
I run a small service business that's been around for 30 years.
As I get older, I'm getting tired of running this business alone. I want to hire and train a general manager to run the business day to day, with the understanding that when it comes time to retire, I will pass ownership of the business on to this person.
I have found the absolutely perfect person to hire as manager. He works for a competing company and is absolutely miserable there (the owners are real SOBs). I can offer this young man a better future, and he recognizes that.
The problem is that earlier this year, his employer made him sign a noncompete agreement— they threatened to fire him if he didn't sign.
I'm not a lawyer, but the agreement looks pretty bad. It says he cannot 'own (other than ownership in a publicly traded company), operate, manage or participate in the ownership of any company or control of any person, company or entity which is in competition with' his current employer for two years after he leaves the company.
I would like to hire this person — he has amazing skills our company needs — but I don't want to get sued. I've heard that noncompete agreements are often not enforceable in the courts. Is that true?
In other words, for this questioner, his business would be much better served by a regime that was less likely to enforce covenants not to compete. In the online journal Xconomy, Rob Stevens, vice-president of Sales & Marketing for GrabCAD, makes a similar point:
I’ve worked at four startups in my career, and I can tell you that non-competes are a factor in hiring decisions. I’ve been part of hiring close to one thousand people across the four companies. Some of the roles we were hiring for required industry expertise. In those cases we sometimes hired someone from “the industry”—someone who had worked at one of the big companies in the space. We didn’t hire this person because they worked at Big Company, we hired them because they knew the industry and were a great fit for us. In many cases Big Company wasn’t even really a competitor.
But more than once the employee in question received a threatening letter from Big Company’s lawyers, warning the person that he was at risk of violating his non-compete agreement. The employee would call us up and say, essentially, “what the heck?” And now we’re both worried—the employee is worried about getting sued, or being out of a job (since he already quit his job at Big Company). And we’re worried about losing a great employee, and also about being sued.
“But companies get sued all the time,” you point out. True, but startups can’t afford to engage in legal battles that aren’t life and death—a lawsuit is a huge distraction for a company that is struggling to create a new product and a new market. Lawsuits over an employee are hard to justify. We would probably win the suit, but we’d still have the cost and distraction of the battle—so maybe we should just let that person go and save ourselves the trouble. Maybe we should avoid hiring people with experience in the industry. Maybe we should grow a little slower and lower our goals.
And that’s how non-competes kill innovation and growth.
Neither Stevens nor our anonymous small business owner make the further point, which is that the current LBI (legitimate business interest) test used in most states to evaluate the enforceability of covenants not to compete involves balancing multiple, subjective factors. (See our most recent discussions of the LBI test here (Missouri) and here (Connecticut)). As any lawyer will tell you, the more subjective a standard is, the greater the likelihood that such a standard will result in increased litigation over the contours of the component factors. In other words: if the law is that a covenant not to compete is enforceable so long as the duration is “reasonable,” there is inherently more uncertainly involved than if the law is that a covenant not to compete is enforceable so long as it is for six months or less; an employer whose employee signs on with a competitor after seven months might bring a lawsuit in the first jurisdiction but almost certainly won’t in the second.
Let me be clear: I don’t think all of the evidence is in, or that what evidence we do have is sufficient to conclude that the Massachusetts and California folks definitely have it right, and that eliminating noncompetes will always foster economic growth. But I do think it is worth fully understanding and evaluating the arguments being made by both sides as we try to weather out the storm that is this State-By-State Smackdown.