It Appears That These Contracts May Be Here to Stay

By PETER VICKERY, Esq.

Peter Vickery

It did not go well for the employer, John Dyer. He was asking the court to enforce the agreement against his former apprentice, a young man who (in exchange for Dyer forgiving a loan) had promised to refrain from setting up his own shop for six months after the end of the apprenticeship. Not only did the judge rule for the young apprentice, he added that Dyer himself ought to go to prison for trying to stifle competition.

While Massachusetts Gov. Deval Patrick has no plans to jail employers who draft them, he would nevertheless like to make non-competes a thing of the past.

Six centuries after Dyer’s Case, the goal of non-competes remains the same: to help employers protect their businesses by temporarily preventing ex-employees from aiding, or becoming, the local competition. As in 47 other states, these contracts are legal in Massachusetts (with a few exceptions for particular professions, discussed below) so long as they are reasonable in terms of time and territory. Patrick wants to change that, but so far the Legislature has refused to go along. At the end of the last session — after legislators passed his economic-growth bill, minus the section that would have banned non-competes and rewritten the trade-secrets law — the governor said he would try again. What is at stake, and how would victory for the governor affect businesses in Massachusetts? Read on.

What Are Non-compete Agreements?

Non-competes have survived because creating intellectual property is like training an apprentice: it takes time and money. In business, our motive for investing such resources is profit, and most of us would not invest if other people could simply walk off with our profits.

Patent, copyright, and trademark law harness the profit motive by protecting most — but not all — forms of intellectual property. Trade-secrets law helps plug the gaps. Even after revealing a trade secret to an employee, an employer can retain some of the secret’s value via contracts, such as agreements not to disclose and not to compete.

If an employee with access to your trade secrets (e.g. customer data, expansion plans, and marketing strategy) quits and walks straight into a job with your nearest rival, you have reason to worry. Mindful of this possibility, some employers use non-disclosure agreements to prevent their trade secrets from falling into the hands of the competition. By signing non-disclosure agreements, your employees promise not to divulge confidential information to their new employer.

But how can you, the former employer, looking across the street at your ex-employees happily chatting away with your nemesis, be absolutely sure that they are abiding by this commitment and not using your information against you? As a practical matter, you cannot, at least not without resorting to electronic surveillance, which would likely generate many more difficulties — big ones, involving lawyers and judges — than it would solve. This is why non-competes are helpful.

Compliance with a non-compete agreement is easier to verify than compliance with a non-disclosure agreement. Although you may not be able to find out what your ex-employees are saying, you will find it comparatively easy to find out where they are working. So, to borrow a theological term, the purpose of the non-compete is to ensure that your employees avoid the occasion of sin, i.e. circumstances that entice or incite wrongdoing on their part.

Waiting for the harm to occur and then suing for damages would make little sense. After all, the most effective way to protect commercially valuable confidential information is to stop the harm from happening in the first place. Therefore, the typical non-compete allows the employer to ask a judge for an injunction prohibiting ex-employees from going to work for the local competitors or setting up a rival enterprise of their own.

But non-competes cannot go as far as some employers might wish. To imagine an extreme example, if the law allowed permanent, worldwide non-competes, ex-employees would be unable to pursue their livelihoods or start new businesses, commerce would stagnate, and the consumer would suffer. So to balance the employer’s interests against those of both the employee and society as a whole, the Massachusetts courts have gradually narrowed the purpose, geographic reach, and duration of non-competes.

This is how the Supreme Judicial Court has summed up the law: “a covenant not to compete is enforceable only if it is necessary to protect a legitimate business interest, reasonably limited in time and space, and consonant with the public interest.” In addition, the court will not enforce an agreement if, after signing it, the employee’s job undergoes substantial changes.

Each case is different, and the reasonableness of time and territory will depend on the particular facts, as will what sort of job changes are substantial, but one universal principle applies: if the agreement’s purpose is merely to prevent ordinary competition, the court will not enforce it.

There are at least five hurdles an employer has to jump over before a court will enforce a non-compete:

• The agreement must protect a legitimate business interest, e.g. trade secrets and good will;
• It must be reasonable in duration, e.g. up to two years;
• It must be reasonable in geographic scope, which depends on the extent of the employer’s business. The court might uphold a worldwide ban for a genuinely worldwide enterprise, but not for a business whose market extends only 50 miles from its store;
• The competition must be direct, i.e. for the same customers; and
• If the employee’s compensation or responsibilities change, the employee must sign a new agreement.

There is one more hurdle regarding current employees. If an employee is already working for the employer at the time she signs the agreement, the employer will have to provide her with separate consideration, meaning a benefit that is something more than the job itself, such as extra money. Otherwise, the non-compete is unenforceable.

As well as these significant hurdles, Massachusetts law prohibits non-competes for certain professions, namely physicians, nurses, broadcasters, licensed social workers, and attorneys. And the courts are inclined to relax the terms of non-competes that try to restrict the employment of financial advisors and brokers.

Even with all those caveats and provisos, non-competes make obvious sense for established companies. And therein lies the tradeoff dilemma for policymakers. A rule that protects existing businesses is also a barrier to entry, standing in the way of newcomers. If policymakers want to protect current jobs-makers, the environment will be less welcoming to insurgents. Conversely, if they want to create an ideal climate for startups, they will almost certainly hurt existing businesses and the people they employ.

The Case for Banning Non-competes

Patrick would like Massachusetts to follow California, where non-competes are illegal. Much of the lobbying has come from groups that believe the switch would encourage more innovation, making Massachusetts more like Silicon Valley.

Non-competes came into the crosshairs in the 1990s when academics started to blame them for discouraging startups. In 1994, AnnaLee Saxenian, a graduate of Williams College, Harvard, and MIT, credited Silicon Valley’s “culture of mobility” with enabling the rapid transfer of knowledge, and compared it unfavorably with the “buttoned-down” culture of Route 128 in the Boston area. Five years later, Ronald Gilson, a law professor at Stanford Law School, published an article that pointed to non-competes as the explanation for the success of Silicon Valley compared with Route 128. Gilson said that it was the presence of non-competes in Massachusetts and their absence in California that lay at the root of the different cultures.

Several scholars have buttressed this idea, claiming that non-competes impede entrepreneurship and job growth. For example, Matt Marx and Lee Fleming, the authors of Non-compete Agreements: Barriers to Entry… and Exit? (2012), found evidence of a “brain drain,” with talent moving from states that enforce non-competes to states that do not.

Patrick’s proposal is based on this notion. Specifically, he wants the Legislature to repeal Sections 42 and 42A of General Laws Chapter 93 (which allow damages and injunctions for the unlawful taking of trade secrets) and create a new Chapter 93K, a Massachusetts version of the Uniform Trade Secrets Act (UTSA). In a nutshell, the thinking behind the governor’s proposal is that ditching non-competes and adopting UTSA will help make Massachusetts more like California, increasing our allure for new, innovative, hi-tech enterprises.

Who Wants to Keep Non-competes?

Established, larger businesses tend to oppose the governor’s plan. Some report that confidential-information theft is common, not rare, and that abolishing non-competes would make it harder to deter the practice. More fundamentally, these employers sense that the bill threatens existing jobs without guaranteeing new ones. The promised gains are merely possible and general, whereas the losses are highly likely and specific.

Even some people who believe that non-competes impede startups recommend caution. For example, Marx and Fleming agree that non-competes “are responsible for a general exodus of talent [and] are driving away some of the best and brightest.” But they also point out the absence of some important data, and warn that there is still no “definitive answer regarding whether non-compete enforcement is a net positive or negative.” Clearly, when weighing the merits of a far-reaching policy proposal such as banning non-competes and signing up to UTSA, legislators need to bear in mind what we do not know.

But they should also look at what we do know, starting with two simple facts. First, 46 states have adopted UTSA in some form. The exceptions are Massachusetts, New Jersey, New York, and Texas. Second, 47 states enforce non-competes, and those that do not are California, Montana, and North Dakota.

So we know that (1) most states have a version of UTSA on their statute books and (2) most states enforce non-competes. This makes it difficult to determine how big a factor non-competes and UTSA are in encouraging innovative startups. Complicating matters further, in recent years several states have modified their non-compete rules. Idaho and Louisiana made it easier to enforce them, Oregon and New York made it harder, and Georgia moved closer to the Massachusetts approach. But, keeping these analytical challenges in mind, we can learn something valuable by looking at recent economic indicators and league tables of innovation and competitiveness.

One useful indicator is the unemployment rate. Looking at the states where non-competes are illegal, North Dakota’s rate is 2.8%, Montana’s is 4.7%, and California’s is 7.4%. Our unemployment rate in Massachusetts is 5.6%, higher than North Dakota’s and Montana’s but lower than California’s. The most likely explanation for the lower unemployment rates in Montana and North Dakota is not the absence of non-competes but the presence of a booming energy sector. And the fact that the unemployment rate is higher in California than in Massachusetts suggests that banning non-competes would not, in and of itself, boost our overall job growth.

Most of the states with UTSA — which are most of the states in the U.S. — have higher unemployment than Massachusetts. Of course, so do New Jersey and New York (non-UTSA states), which indicates that UTSA is not a determinative factor either way.

League tables of competitiveness and innovation tell a similar story. The Beacon Hill Institute’s 2013 State Competitiveness Index ranked Massachusetts top of the league, with Texas in ninth place and New York 26th.  California came in 29th and New Jersey 41st. As for the two states (other than California) where non-competes are illegal, the index gave second place to North Dakota and 36th place to Montana. Non-competes do not seem to be outcom-determinative, at least according to the way the Beacon Hill Institute measures competitiveness.

The University of Nebraska-Lincoln’s 2013 State Entrepreneurship Index ranks North Dakota first and California second, which would seem to support the contention that states without non-competes are more entrepreneurial than those with them, until you notice that, only two years before, California placed 11th, which was the ranking Massachusetts received in 2012, while New York held third place throughout. Between 2011 and 2013, the legal status of non-competes remained stable in California, Massachusetts, and New York, so any claim that this index proves non-competes stifle entrepreneurship falls flat.

Another index reinforces the lack of a connection, namely the 2014 State New Economy Index from the Information Technology and Innovation Foundation, which factors innovation capacity into its calculation of economic dynamism. On the one hand, California (where non-competes are illegal) ranks third, ahead of New York and New Jersey (where they are allowed). But, as for the two states other than California where non-competes are illegal, the index ranks North Dakota 36th and Montana 39th. The state winning first place? Massachusetts. Again, the presence or absence of non-competes fails to predict a state’s standing in the innovation rankings.

In summary, the UTSA states include many with high unemployment and low innovation, which suggests that UTSA is not a key ingredient to prosperity. Similarly, the states that enforce non-competes include some that lead the nation in terms of innovation, and some that bring up the rear. What we do know is that, so far, no one has been able to offer clear and convincing proof that banning non-competes and enacting a version of UTSA would lead to greater innovation and more jobs.

The Future of Non-competes

If Patrick or his successor should decide to rejoin the battle, legislators would have to consider the costs to present employers as well as the putative benefits to employers yet to come.

They might also consider some innovations of their own, such as expanding the motley list of vocations where non-competes are forbidden — currently physicians, nurses, broadcasters, social workers, and lawyers. Even though those professions cannot be subject to non-competes, they seem to thrive regardless. For example, nobody is complaining about a lack of lawyers in Massachusetts (or anywhere else).

On the other hand, the amorphous nature of the tech sector makes it difficult to draw lines around. The Legislature learned this lesson last year when it imposed, and then repealed, a tax on “computer-system design services.” Trying to define the kinds of high-tech jobs that would qualify for new exemptions from non-competes could become a legislative drafter’s nightmare.

Unless and until proponents can offer persuasive evidence that banning non-competes would create more jobs than it would destroy, this particular species of contract looks set to celebrate its 601st birthday — and maybe many more.

Peter Vickery practices law in Amherst; (413) 549-9933; www.petervickery.com