Employers commonly require employees to sign agreements containing restrictive covenants. These include non-competition agreements, in which the employee promises not to work for a competing venture after departure. Many employers require non-disclosure agreements, which prevent a former employee from divulging or utilizing the employer’s confidential information. Finally, employers often require non-solicitation agreements, in which the former employee is prohibited from contacting clients and/or co-employees with the intention of diverting them away from the company.
Employers often draft these agreements intending to protect customer relationships. Because employees often work closely with customers, they naturally develop relationships that enhance business opportunities for the employer. This is commonly thought of as goodwill, and it is recognized as a valuable commodity for employers. In appropriate circumstances, employers may restrain former employees from utilizing this goodwill on behalf of another employer. The law does not favor restrictive covenants, and courts are less likely to enforce restrictive covenants based on goodwill as opposed to bona fide trade secrets.[1] Still, courts are receptive to appropriate restrictions designed to protect goodwill.
In practical application, the concept of goodwill can be elusive, which leads to litigation and ensuing risk and cost for all parties. For example, can an employer prevent a former employee from soliciting a customer with whom the employer has established goodwill if that former employee had no contact with the customer? Certainly it would harm the employer to lose such a customer. Can an employer protect goodwill with a mere prospect with whom the former employee had significant contact? Losing that lead would potentially harm the employer, but how much contact is required to make the prospect worthy of legal protection?
Last month, the New Hampshire Supreme Court reviewed a salesman’s restrictive covenant and narrowed employers’ ability to protect customer goodwill. Construing New Hampshire law, the Court found that the employer’s restrictive covenants exceeded the permissible scope under the law and required the employer to pay its departed employee money damages to remedy its overreaching. Employers should learn two lessons from this important decision: (1) employers need to understand the legal landscape of restrictive covenants, especially when they are intended to protect the company’s goodwill, which, over time, comes to reside in employees who have client contact; and (2) employers should be cautious about overreaching when requiring employees to sign restrictive agreements.
Prior Case Law
In Technical Aid Corp. v. Allen (1991), Allen, a salesman, signed several restrictive covenants at the outset of his employment. Allen eventually left TechAid and formed his own temporary staffing company, but he did not solicit or service his former customers.
TechAid sued to prohibit Allen from competing within 100 miles of his former office and from soliciting any accounts, including actual and potential customers (leads) within that 100-mile area. Further, TechAid sought to prevent Allen from soliciting not just his own former customers, but also any customers with whom TechAid did business in the year prior to Allen’s departure. TechAid also asserted that Allen could not compete for accounts that became known to him during his employment or divert away any of TechAid’s accounts.
The Court began its analysis by emphasizing that post-employment restrictive covenants are not favored in the law. The Court used a three-part test, requiring that such employment restrictions: (1) are no greater than necessary to protect a legitimate interests of the employer; (2) do not impose an undue hardship on the employee; and (3) do not injure the public interest.
Because Allen had generated valuable goodwill on behalf of TechAid, the Court concluded that TechAid had a legitimate interest in preventing Allen from contacting former customers. The Court, however, struck down the broad prohibition against competing within 100 miles. Note that this restriction would prevent Allen from competing for TechAid’s actual clients as well as potential clients (or leads) located within 100 miles. The Court reasoned that because Allen could not have generated any measurable goodwill outside his sales territory, the restriction was too broad. The Court did not grapple with the distinction between preventing Allen from contacting actual and potentialclients, or those with whom TechAid arguably had little (if any) goodwill.
Focused on goodwill, the Court struck down the restriction against servicing customers, regardless of their location, with whom TechAid did business in the year prior to Allen’s departure (actual clients). The Court reasoned that Allen’s departure and subsequent competition did not threaten TechAid’s goodwill outside of Allen’s sales territory. As the Court put it, Allen had “no advantage over any other complete stranger” for customers outside his territory.
Interestingly, the Court enforced Allen’s promise not to solicit actual clients that became “known to him” while employed at TechAid. The Court held that “known to” meant having significant knowledge or understanding of the account beyond its mere existence. The Court posited, without analysis, that clients “known to” Allen would most often include those clients with whom Allen had actual contact, but could also include those with whom he never communicated but about whom he gained significant knowledge in some other manner. In either case, the Court found it permissible to prevent Allen from exploiting that knowledge to TechAid’s detriment.
This aspect of the TechAid decision was particularly confusing because it suggested that Allen could be prohibited from contacting those customers with whom he had no direct contact, which seems antithetical to the concept of goodwill. The ability to restrict an employee from soliciting customers with whom he had no contact but who were otherwise “known to him” seemed to rest not on goodwill, but instead on the employee’s access to confidential information about that client, which might be more properly analyzed under New Hampshire’s Trade Secret law than an employment agreement. Moreover, the clients “known to” Allen would presumably include some clients outside his sales territory, which seemed at odds with earlier parts of the opinion.
Seven years later, in Concord Orthopaedics P.A. v. Forbes, the Court reviewed an agreement in which a doctor signed an employment agreement prohibiting him from practicing orthopaedic medicine within 25 miles of the clinic. In that case, the Court drew a distinction between actual and potential patients of the clinic. The Court prohibited Forbes from contacting any clients of the clinic, including those clients Forbes did not service personally. The decision implied that Forbes was free to treat people located within 25 miles of the clinic but who had not been patients at the clinic. If the agreement rested on goodwill, it seemed illogical to hold that Forbes had any measurable goodwill with clients he never met. Unlike in TechAid, the Forbes decision did not rely on a restriction preventing Forbes from contacting clients that became “known to him” during his employment.
Recent Developments in the Law of Restrictive Covenants
Several important questions remained unresolved from the Court’s TechAid and Forbes decisions. Last month, the Supreme Court addressed some of these questions in the case of Merrimack Valley Wood Prods., Inc. v. Near. In that case, Near was a salesman whose duties included soliciting new customers and servicing existing customers. Six months after he began his employment, Merrimack Valley presented Near with an employment agreement containing restrictive covenants. In the agreement, Near promised not to sell any materials to customers to whom Merrimack Valley sold materials within the twelve months prior to his termination. (This is similar to the covenant struck down in TechAid described above). Near left Merrimack Valley, joined a competing company, and solicited sales from the customer base he developed while at Merrimack Valley.
Merrimack Valley obtained a preliminary injunction preventing Near from soliciting or servicing any of Merrimack Valley’s clients, including those who were not Near’s personal accounts. When the case went to trial, however, the trial court held that the restrictive covenants were overly broad and unenforceable. The trial court awarded Near damages for the income he lost while under the preliminary injunction order as well as his attorneys’ fees.
In many ways, Merrimack Valley narrows the permissive scope of restrictive covenants. The Supreme Court applied the TechAid three-part test to determine whether the agreement was enforceable. Merrimack Valley argued that Near’s contact with its clients was a legitimate business interest on which to base the noncompetition agreement. The Court acknowledged that “[when an employee is put in a position involving client contact, it is natural that some of the goodwill emanating from the client is directed to the employee rather than to the employer. The employer has a legitimate interest in preventing its employees from appropriating its goodwill to its detriment].” The Supreme Court held, however, that Merrimack Valley’s attempt to prohibit Near from contacting any of its 1200 customers was overbroad because Near himself serviced only sixty regular customers: “[Near was] in no better position than a stranger” when it came to soliciting business from accounts that were not his accounts. The agreement was therefore unreasonable to the extent that it prevented Near from soliciting customers with whom he had no actual, direct contact while employed at Merrimack Valley. Had this logic been strictly applied in the Forbes case, Forbes would have been prevented from servicing his patients, as opposed to all patients of the clinic. If this logic were applied in the Tech Aid case, it would have prevented Allen from contacting his clients, but not all of TechAid’s clients known to him.
It is unclear how today’s Court would view a “known to” clause such as the one in TechAid, because it would include clients about whom the employee learned while employed, but with whom the employee had no contact. In those situations, the employer’s legitimate interest might be protecting its confidential information (e.g. customer identities) and not any customer goodwill residing in the departing employee. In most cases, the employer could rely on the trade secret law to protect that information. However, in some cases, the information might not rise to the level of a trade secret if, for example, the employer failed to take all the steps necessary to protect such information. In some cases, the employer may need to rely on the “known to” language in a restrictive agreement to prevent the employee from pirating customers he learned about while employed, but with whom he never had contact.Merrimack Valley casts some doubt on the enforceability of “known to” clauses, but because the issue was not squarely before the Court, it remains unsettled.
The holding of Merrimack Valley serves as a cautionary tale for employers who force their employees to sign agreements that contain restrictive covenants, which are later proved to be invalid. Employers who do so can, in some instances, be held financially responsible for the former employee’s (a) damages suffered while complying with the otherwise unenforceable agreement, and (b) attorneys’ fees incurred in defending an action based on an invalid agreement. Merrimack Valley also cautions against presenting restrictive covenants to employers after the inception of the employment relationship. The Court found that Merrimack Valley acted in bad faith when it waited until six months into Near’s tenure to present him with the agreement and forced him to sign or lose his job. These facts persuaded the Court to strike down the agreement and find the employer liable for damages and attorneys’ fees.
Merrimack Valley should not scare employers away from requiring restrictive covenants, but should highlight the importance of carefully implementing a plan to protect the company’s most important assets: its customers. Those steps may include (a) crafting narrowly tailored restrictive agreements; and (b) utilizing New Hampshire’s Uniform Trade Secret Act, which itself requires employers to take appropriate steps to protect proprietary information, including that relating to customers.
