Should employers pay for restrictive covenants?
In some countries, clauses that restrict employees from working for a competitor or setting up their own business after they leave are not enforceable unless the ex-employee is paid. But would this work in the UK? Justin T Tarka, employment lawyer at Ogletree Deakins, looks at the pros and cons.
Typically found in senior employment contracts or director service agreements, restrictive covenants (also referred to as post-termination restrictions) are clauses which restrain the actions of individuals when they leave an organisation.
There are three commonly used types of restrictive covenants:
- Non-compete: this aims to stop individuals from working for competitors or starting their own competing business for a period following termination, usually 6-12 months.
- Non-solicit/non-deal: this aims to restrict or prohibit contact with clients, suppliers, contacts or customers of the individual's former employer for a period following termination, usually 3-12 months.
- Non-poach: this aims to prevent departing individuals from taking other employees with them to their new organisation.
Employers who seek to enforce a restrictive covenant may seek an injunction to stop an individual from breaching an agreement. For example, if an ex-employee with a six-month non-compete is set to join a competitor a week after their termination date, the ex-employer may seek an injunction to enforce the restrictive covenant against the individual and the new employer.
However, restrictive covenants are not automatically enforceable. As we've seen, they can impose powerful restrictions on someone post-termination which may be unjustified. The courts recognise this, therefore companies must show that they are being used to protect a "legitimate business interest". The legal test is made up of four stages:
- The court must decide what the covenant means when properly construed.
- The court will consider whether the ex-employer has shown they have legitimate business interests requiring protection in relation to the employee's employment.
- The covenant must be no wider than is necessary for the protection of those interests (assessed from the perspective of reasonable persons in the position of the parties).
- If the restrictive covenant is reasonable, the court will decide whether, as a matter of discretion, the injunctive relief sought should in all the circumstances be granted, having regard to its reasonableness at the time of trial.
Accordingly, enforceability will be dependent on the facts of each scenario. Nevertheless, in the UK, the threat of litigation is the only incentive for individuals to comply with restrictive covenants. This is expensive, time-consuming, and success for the employer is not guaranteed. So is there another way to encourage compliance?
In many jurisdictions, restrictive covenants are not enforceable unless the enforcing party (employer) pays the party against whom they wish to enforce the covenant (ex-employee). This generally applies to non-competes, partly as it directly limits an individual's earning potential.
For example, to enforce a non-compete in Belgium, ex-employees must be compensated 50% of their salary for the duration of the non-compete which cannot exceed 12 months. However, the covenant can be waived on termination so that no money is due and the ex-employee can disregard the restrictions.
In Germany however, the remuneration level is the same but the maximum duration is two years - this is payable even if the company decide to waive the covenant on termination.
The UK government has been taking the temperature on restrictive covenant practices. A consultation was opened for contributors to offer their thoughts on proposals to make compensation a requirement for enforceability, place a statutory limit on the length of restrictive covenants, or ban them altogether like in California in a bid to "encourage innovation". The consultation ended in February 2021 and no response has been published yet.
Pros of paying for restrictive covenants
A clear benefit is that it would likely deter individuals from acting in breach of covenant. For example, a non-compete can limit someone's job options or delay plans to establish a business of their own. Rather than risk breaching the covenant and tempting litigation, individuals who receive some payment will have less pressure to immediately find a role at the same level.
This in turn reduces the risk on both parties of litigation, which can be expensive. If ex-employees are incentivised to comply with covenants, litigation budgets may shrink and resources can in part be re-allocated to cover the costs of the covenants.
Alternatively, requiring payment may prompt discussion around whether the covenants are truly necessary in the first place. Paying half the salary of a high-earning senior employee for 12 months is a significant financial commitment, and the costs may not be proportionate to the protection of company interests. It may reduce the use of restrictive covenants across the board and thus level out the power imbalance between companies and individuals.
Employers will be paying more money from the start of the process. Currently, if the ex-employee complies, there is no need to pursue them legally and costs are nil if the covenants remain unchallenged. The changing cost considerations will cause employers to re-evaluate, particularly if the reason for termination is budget-related.
Paid restrictive covenants are not automatically enforceable - this remains the case in countries such as Belgium and Germany mentioned above. It is not clear whether the current legal test would remain or be replaced by a statutory provision, but the requirement for them to be well-defined and justified will very likely remain, as a matter of public policy.
Furthermore, the risk of litigation is not erased. The covenants can still be examined by the courts to determine their validity if challenged.
It may be preferable to place the employee on garden leave. During this time, the individual remains technically an "employee" and paid their usual salary for their notice period. However, unless requested to do so they are typically not permitted to be involved in work in any form, including contacting clients and colleagues. Therefore, they can't work elsewhere, and their company knowledge may become out of date upon termination of the employment.
Deferred remuneration (such as share option grants) may be an alternative way of protecting business interests. This is where part of an employee's remuneration is delayed and paid out upon certain conditions being achieved. Employees who depart for non-approved reasons (such as to join a competitor) will forfeit the deferred remuneration.
Not all employment contracts will have restrictive covenants as there are other legal provisions which protect misuse of private company information. It's a well-established principle in employment law that all employees are under a duty of confidentiality to their employer following termination. A confidentiality clause is typically included into an employment contract to define this, along with clauses protecting a company's intellectual property. As such, if the financial burden of enforcing restrictive covenants becomes commercially unviable, these protections can provide employers with a right of action against ex-employees.