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Covenants Not to Compete Essentials

by Jim Slaughter

Originally published as "The Essentials of Covenants Not to Compete" in The Litigator of the N.C. Bar Association

arrow When John was hired, he agreed orally not to compete against his employer for one year after he left the company. John leaves the company several years later. Is John’s covenant not to compete enforceable?
arrow Three months after joining her new firm, Mary’s employer asks her to sign a covenant not to compete. The terms provide that Mary will not compete against the company for one year within 10 miles of the home office and is based on the "valuable consideration that Employee is willing to accept continuation of employment on the terms agreed upon." Mary signs the document. Is the agreement enforceable?
arrow Ruth signs a covenant not to compete as part of her employment agreement. The terms of the agreement provide that Ruth will not be employed in a competing business within a radius of 350 miles for two years following employment. Mary quits and joins a competitor 100 miles away. What recourse does Ruth’s former employer have?

Covenants not to compete, or anti-competitive agreements, are contracts that an employee will not compete against an employer following termination of employment.  A former employee violating such a contract can be ordered by a court to pay damages as well as to stop the competing enterprise.

Historically, such agreements were prohibited in early common law as being against public policy.  In those days, individuals were apprenticed to certain trades and could only work in the field of their apprenticeship.  To restrain a person from practicing in his apprenticed profession could prevent the person from making a living.  As a result, covenants not to compete were unenforceable for several centuries.

Covenants not to compete are now enforceable in many states, including North Carolina.  Early decisions on anti-competitive agreements reflect the common law reluctance to enforce such covenants, noting that "[c]ontracts restraining employment are looked upon with disfavor in modern law." Kadis v. Britt, 224 N.C. 154, 160, 29 S.E.2d 543, 546 (1944).  More recent decisions, however, have been willing to uphold anti-competitive agreements: "While the law frowns upon unreasonable restrictions, it favors the enforcement of contracts intended to protect legitimate interests. It is as much a matter of public concern to see that valid engagements are observed as it is to frustrate oppressive ones." Sonotone Corp. V. Baldwin, 227 N.C. 387, 390, 42 S.E.2d 352, 355 (1947).

Courts today will enforce a covenant not to compete if it meets certain requirements, including that it is

arrow in writing,
arrow part of a contract of employment,
arrow based on valuable consideration,
arrow reasonable as to time and territory,
arrow fair to the parties and
arrow not against public policy.

See Forrest Paschal Machinery Co. v. Milholen, 27 N.C. App. 678, 220 S.E.2d 190 (1975); Whitaker General Medical Corp. v. Daniel, 324 N.C. 523, 379 S.E.2d 824 (1989).

Writing

Covenants not to compete must be in writing. Manpower of Guilford County v. Hedgecock, 42 N.C. App. 515, 257 S.E.2d 109 (1979).  N.C.G.S. § 75-4 provides that no contract "limiting the right of any person to do business anywhere in the state of North Carolina shall be enforceable unless such agreement is in writing duly signed by the party who agrees not to enter into any such business within such territory."

Like other statutes of frauds provisions, only the party against whom enforcement is sought (usually the employee) needs to have signed the document.  The party seeking enforcement of the anti-competitive agreement (usually the employer) does not need to have signed the writing. See Lumber Co. v. Koury, 140 N.C. 462, 53 S.E. 300 (1906).

Consideration

A covenant not to compete, like any other contract, must be supported by consideration to be valid.  Anti-competitive agreements are generally entered into at the time and as a part of the contract of employment.  This promise of new employment is valuable consideration that will support an otherwise valid covenant not to compete contained in the employment contract. Wilmar, Inc. v. Corsillo, 24 N.C. App. 271, 210 S.E.2d 427 (1974), cert. denied, 286 N.C. 421, 211 S.E.2d 802 (1975).  In other words, if the covenant is part of the original employment offer, the job itself is valid consideration.

If an anti-competitive agreement is signed following employment, there must be new consideration to support the agreement, such as a change in compensation, duties or nature of the employment. Whittaker General Medical Corp. v. Daniel, 324 N.C. 523, 379 S.E.2d 824 (1989), cert. denied, 325 N.C. 277, 384 S.E.2d 531 (1989).

For example, in Young v. Mastrom, 99 N.C. App. 120, 392 S.E.2d 446 (1990), disc. review denied, 327 N.C. 488, 397 S.E.2d 239 (1990), an employee never saw an employment contract or anti-competitive agreement before being asked to sign them after three days of work.  The Court of Appeals affirmed a finding that the covenants were unenforceable for lack of consideration. Young, 99 N.C. App. at 124, 392 S.E.2d at 449.

Furthermore, forcing an employee to sign a covenant not to compete under threat of being fired is not sufficient consideration.  In Henley Paper Co. v. McAllister, 253 N.C. 529, 117 S.E.2d 431 (1960), an employee was presented with an anti-competitive agreement after several months of work and told that "trainees sign this thing or they don’t keep their job."  The Supreme Court affirmed a finding that the covenant lacked consideration. Henley, 253 N.C. 533, 117 S.E.2d at 433.

Reasonableness and Fairness

A covenant not to compete must be reasonable, both as to the time and the territory embraced in the restrictions. Forrest Paschal, 220 S.E.2d at 195.  No bright-line rules, however, specify the degree of reasonableness or fairness required for enforceable anti-competitive agreements. Instead, the question is whether the restraint is reasonable under the specific facts.

Courts will enforce such agreements so long as they are no broader than reasonably necessary to protect the employer’s business and so long as they do not impose undue hardship on the employee. Electrical South v. Lewis, 96 N.C. App. 160, 385 S.E.2d 352 (1989), disc. review denied, 326 N.C. 595, 393 S.E.2d 876 (1990).

Courts consider several elements when determining the reasonableness of a covenant not to compete, including (1) the time and territory encompassed by the covenant, (2) the territory in which the employee worked, (3) the area in which the employer operated, (4) the nature of the business and (5) the nature of the employee’s duties. Clyde Rudd & Assoc. v. Taylor, 29 N.C. App. 679, 225 S.E.2d 602 (1976).

These various factors are not independent and unrelated aspects of a covenant not to compete.  On the contrary, each factor is considered together in determining the reasonableness of the other factors. See Jewel Box Stores Corp. v. Murrow, 272 N.C. 659, 158 S.E.2d 840(1968).  For instance, a covenant not to compete for a long period of time might be reasonable if the territorial restraint is small; however, the same covenant might be unreasonable if the territorial restraint is broad.

Because of the many interrelated factors, determining the reasonableness of an anti-competitive agreement is not a precise science.  Indeed, no hard and fast rules apply to every situation, but several appellate court decisions can give guidance as to how courts may evaluate reasonableness under specific facts.

A covenant not to compete will be enforced if the court deems all factors reasonable.  In Forrest Paschal Machinery Co. v. Milholen, 27 N.C. App. 678, 220 S.E.2d 190 (1975), the Court of Appeals upheld a rather broad covenant not to compete.  The Paschal employee agreed not to compete with his former employer or to be employed by a competitor within 350 miles of the employer’s place of business for two years following employment.  The Court affirmed the trial court’s finding that the restrictions were not unreasonable as to time or territory. According to the Court, the trial "record is replete with evidence of the fact that Plaintiff does business over almost all the United States and even beyond its boundaries." Forrest Paschal, 27 N.C. App. at 687, 220 S.E.2d at 190.

On the other hand, an anti-competitive agreement may be found unreasonable if the contract is broader than necessary to protect the legitimate interests of the employer.  In Henley Paper Co. v. McAllister, 253 N.C. 529, 117 S.E.2d 431 (1960), an employee agreed not to compete for three years "within a radius of 300 miles of any office or branch of the Henley Paper Company or its subsidiary divisions."  The employee was prohibited from, among other things, the "manufacture, sale or distribution of paper or paper products" within the restricted territory.

The Supreme Court of North Carolina affirmed the trial court’s ruling dismissing the action to enforce the covenant. According to the Court, the agreement "excludes the defendant from too much territory and from too many activities." Henley, 253 N.C. at 534, 117 S.E.2d at 434.  The Court explained that the employee had no connection with industrial paper; yet the covenant excluded him from the field of industrial paper.

Although the employer was a distributor and not a manufacturer, the anti-competitive agreement prohibited the employee from the manufacture of paper or paper products.  Finally, the territory in which the employee was prevented from competing extended from Delaware to Alabama and from Indiana to the Atlantic Ocean. All factors together made the covenant void and unreasonable.

The use of a form anti-competitive agreement may also lead to a finding of unreasonableness.  In Manpower of Guilford County v. Hedgecock, 42 N.C. App. 515, 257 S.E.2d 109 (1979), an employee signed a covenant not to engage directly or indirectly in competition with his employer within "a 25-mile radius of any city where there was a Manpower office or Manpower licensed business."  The Court held the restriction unreasonable in that the direct employer was a franchisee with offices only in Greensboro, High Point and Winston-Salem.  Enforcing the covenant as to any franchise "potentially covers a 25-mile radius of any city in the country."  As the local franchisee had no legitimate interest in preventing the employee from competing with any franchise in the country, the agreement was held invalid.

Finally, a covenant not to compete may be deemed unreasonable if its practical effect is merely to stifle normal competition.  In Electrical South v. Lewis, 96 N.C. App. 160, 385 S.E.2d 352 (1989), disc. review denied, 326 N.C. 595, 393 S.E.2d 876 (1990), the employee signed an anti-competitive agreement not to compete for two years with a competitor located anywhere in the world doing business within 200 miles of the company’s office in Greensboro.

The Court of Appeals noted that this language prohibited the employee from associating with any competitor of the company wherever located.  The language might even prohibit the employee from working within 200 miles of a company which created advertising for the former employer.  According to the Court, "[this] ‘shotgun’ approach to drafting this provision produces oppressive results, which violate both the public’s and Employee’s interest in his earning a living."  Electrical South, 96 N.C. App. 168, 385 S.E.2d at 357.  The trial judge’s denial of a preliminary injunction enforcing the anti-competitive agreement was affirmed.

In evaluating the reasonableness of a covenant not to compete, a trial court must either find the covenant valid or the entire document void and unreasonable.  Usually, a court cannot divide the territory in an anti-competitive agreement to make a new contract for the parties. Henley Paper, 253 N.C. 535, 117 S.E.2d at 435.  An exception to this rule exists for covenants with clearly severable territorial divisions.  If the parties themselves have made territorial divisions in the agreement, a court can enforce the reasonable restrictions and refuse to enforce the unreasonable restrictions. Schultz & Assoc. v. Ingram, 38 N.C. App. 422, 248 S.E.2d 345 (1978).

In Schultz, an employee agreed not to compete against his immediate associate or his principal for two years.  Under the facts of the case, the principal’s area of activity was much larger than the associate’s area.  The trial court found that the geographic areas of operation of the associate and the principal were sufficiently defined to enforce the covenant solely as to the associate’s area of operation.  The Court of Appeals affirmed the ruling and noted that if the parties have made divisions of a territory, a trial court can enforce the reasonable restrictions and refuse to enforce the unreasonable restrictions.

Public Policy

An anti-competitive agreement must not violate public policy. U-Haul Co. v. Jones, 269 N.C. 284, 152 S.E.2d 65 (1967).  Few cases have interpreted the public policy requirement of anti-competitive agreements. However, this factor appears to be another basis on which a court can invalidate a distasteful restrictive covenant.

In lredell Digestive Disease Clinic v. Petrozza, 92 N.C. App. 21, 373 S.E.2d 449 (1988), aff’d., 324 N.C. 327, 377 S.E.2d 750 (1989), a trial court held invalid a covenant not to compete between a physician and clinic.  Although the court could have found the scope of the agreement unreasonable, it instead ruled the agreement unenforceable as against public policy.  The Court of Appeals affirmed the ruling on the grounds that "ordering the covenantor to honor his contractual obligation would create a substantial question of potential harm to the public health." Iredell Digestive, 92 N.C. App. at 27, 373 S.E.2d at 453.  Similarly, in Nalle Clinic Co. v. Parker, 101 N.C. App. 341, 399 S.E.2d 363 (1991), disc. review denied, 328 N.C. 499, 407 S.E.2d 538 (1991), a pediatric endocrinologist signed an anti-competitive agreement with a clinic to not compete against the clinic for two years following employment "in the practice of medicine or surgery in the County of Mecklenburg, North Carolina."  The doctor presented 20 affidavits to the trial court which suggested that enforcing the covenant would have a detrimental effect on health care in the county.  The Court, as in Iredell Digestive, held the covenant unenforceable on public policy grounds.

Procedure

Battles regarding covenants not to compete are frequently won or lost long before a trial on the merits.  Complaints regarding anti-competitive agreements usually include a claim for damages as well as for a preliminary injunction.  The employee may well be enjoined from competing against his former employer if it is shown that (1) there is probable cause that the employer will establish the rights he asserts and (2) there is reasonable apprehension of irreparable loss unless the injunctive relief is granted or the injunctive relief appears reasonably necessary to protect the employer’s rights during litigation. Schultz, 38 N.C. App. at 472, 248 S.E.2d at 349.

Such an interlocutory injunction may be immediately appealable in that it affects substantial rights. See Forrest Paschal, 220 S.E.2d at 195.  However, the enjoined party bears the burden on appeal of overcoming the presumption that the injunction is correct. Schultz, 38 N.C. App. at 427, 248 S.E.2d at 349.  As a result, the hearing on the preliminary injunction hearing often either resolves the case or pushes the case towards settlement.

The actual trial on a covenant not to compete is likely to include claims in addition to breach of the contract.  Although beyond the scope of this article, most lawsuits involving the breach of an anti-competitive agreement include allegations of unfair and deceptive trade practices under N.C.G.S. § 75-1.1.  Allegations of unfair competition and tortious interference with contract may also be leveled against the employee’s new employer. See United Laboratories, Inc. v. Kuykendall, 322 N.C. 643, 370 S.E.2d 375 (1988); Peoples Security Life Ins. Co. v. Hooks, 322 N.C. 216, 367 S.E.2d 647 (1988), discussed in The Litigator, "Tortious Interference with Noncompete Covenants: What Conduct is Justified?" Vol. 11, No. 2 (Dec. 1990).  In addition, N.C.G.S. § 66-152 et seq. prohibit the disclosure and use of trade secrets.  Such trade secrets include any "compilation of information" (e.g., customer lists) and can be asserted even in the absence of an anti-competitive agreement.

Conclusion

Although once looked upon with disfavor, covenants not to compete are now commonly enforced. However, the employer must be prepared to show that all requirements of the covenant were fulfilled.  Similarly, an employee wishing to invalidate a covenant should be prepared to show that a required condition is missing.

Articles are intended to provide general information and are not legal advice or a legal opinion. Specific questions should be directed to an attorney at Black, Slaughter & Black, PA., or to another lawyer.