Restrictive Covenants
Noncompetition, nonsolicitation and nondisclosure agreements are examples of restrictive covenants. Restrictive covenants can be part of the sale of a business or part of an employment or contractor relationship.
Used in the sale of business, a restrictive covenant may limit a seller’s right to open or operate a new competing business in the same market. This restriction protects the buyer’s expectation in the continued performance of the business purchased.
In the employment context, restrictive covenants may bar an employee from working for a competitor, soliciting customers, soliciting coworkers, or disclosing confidential information during employment or after termination. Such restrictions allow the employer to share relationships and confidential information while safeguarding against the risk that the employee will abscond with them.
Restrictive covenants may be referred to as non-compete, non- solicit, non-dealing, non-poaching, anti-piracy, non-recruitment, non- hire, anti-raiding, or confidentiality provisions. Whatever the name, the validity of these covenants is analyzed in the same way.
Validity of Restrictive Covenants
As a public policy matter, the State of Utah supports competition and free access to employment.3 Restrictive covenants are generally disfavored under Utah law.4 This means that a restrictive covenant must be written and signed—they will almost never be implied.5 The restriction must be “necessary for the protection of the business” and impose no greater restraint than “reasonably necessary to secure such protection” to be enforceable.6
In 1951, the Utah Supreme Court imposed a four-part test to analyze the validity of a restrictive covenant. Under the Rose Park test, a restrictive covenant is valid only if it is:
supported by consideration,
negotiated in good faith,
necessary to protect confidential information or goodwill, and
reasonably limited in time and geographic area.7
Although this test arose in the analysis of a covenant negotiated in the sale of a business, 8 it is also applied to restrictive covenants arising in the employment context.9
First Requirement: Consideration
Consideration is something of value given in exchange for a promise or performance. It is necessary to give some form of consideration to validate a restrictive covenant. However, it is not necessary to provide separate consideration. For example, in the context of the sale of a business, consideration for a restrictive covenant can be part of the payment given for the business. In the context of an employment relationship, consideration may be an offer of employment or continued employment.10
It is not enough to promise to provide something of value. Consideration must actually be delivered. For example, if a separate payment is offered for the restrictive covenant, and then the payment is not provided, the covenant is invalid. Similarly, if consideration is tied into the payment for a company or an offer of employment, and the payment or employment is not provided, the covenant is invalid.11
In some states, an employer must provide separate consideration to an existing employee in order to validate a restrictive covenant. However, this is not the case in Utah. Even if a Utah employer does not present a restrictive covenant to an at-will employee until well after the employee has started working, the promise of continued employment is sufficient consideration to validate the covenant.
Second Requirement: Good Faith Negotiation
Since the adoption of the Rose Park test, Utah courts have repeatedly restated that restrictive covenants are enforceable only if negotiated in good faith. However, the appellate courts have not identified many examples of bad faith. Examples of bad faith may include the following:
Promising payment in exchange for signing the covenant, and then refusing to pay.12
Offering employment with the intent of employing an employee only long enough to bind the employee to a covenant not to compete.13
Third Requirement: Legitimate Business Interest
In Utah, restrictive covenants are only valid if used to protect a legitimate business interest. Utah courts recognize three such interests:
confidential information, (2) goodwill, and (3) an investment in education or training of an employee.14
Most confidential information is subject to the Utah Uniform Trade Secrets Act, Utah Code § 13-24-1, et seq., and discussed more fully in the Trade Secret section of this text.
Goodwill is defined as “a business’s reputation, patronage, and other intangible assets that are considered when appraising the business.”15 A company’s customer base is the goodwill component most likely to be subject to a restrictive covenant.16 A covenant may be necessary where an employee will “likely draw away customers from his former employer if he were permitted to compete nearby.”17
If a covenant is used to protect goodwill, then an employer seeking injunctive relief must show that the employee is “special, unique or extraordinary.”18 In one example, the Utah Supreme Court found that an employee was “special and unique in comparison to other employees” where she provided managerial and marketing services beyond the roles of other “employees with sales related positions.”19 In contrast, a salesman did not meet this heightened standard where there was nothing to indicate that he “had any greater effect on plaintiff’s goodwill, or other legally protectable interest, than the competition of any other salesman employed by a competitor of plaintiff.”20 Because his covenant served no purpose other than to restrict him from competing with a former employer, the covenant was void.21
The “special, unique or extraordinary” standard prevents employers from excluding employees with a “common calling,” such as salesman, from working in their field. To address this concern, Utah courts hold that “general knowledge and expertise” as well as the “efficiency and skills
which an employee develops through his work belong to [the employee] and not to his former employer.”22
A restrictive covenant that does not protect a legitimate interest, but that exists to restrict competition is not enforceable. 23 Restrictive employment covenants must be “carefully drawn to protect only the legitimate interests of the employer.”24 Employers should avoid overreaching, as it can be construed as restricting competition rather than protecting legitimate interests. If confidential information is adequately protected by a non-solicitation agreement, then an additional non-compete may be overreaching.25 For example, if an employer could protect goodwill by barring an employee from contacting the employer’s fifteen customers for two years, then an additional covenant barring the employee from working in the industry for two years may be unenforceable.26
Fourth Requirement: Reasonableness
Finally, to be enforceable the restrictions that a covenant imposes must be reasonable. “The reasonableness of a covenant depends upon several factors, including its geographical extent; the duration of the limitation; the nature of the employee’s duties; and the nature of the interest which the employer seeks to protect such as trade secrets, the goodwill of his business, or an extraordinary investment in the training or education of the employee.”27 The most frequently cited limits on reasonableness in Utah case law are time and geographic scope.
Courts analyze these factors on a case-by-case basis, taking into account the particular facts and circumstances of each situation.28 These factors should be considered together. For example, a more limited geographic scope might suggest a longer time period is permissible.
Utah courts have approved a broad range of time restrictions in restrictive covenants. Reasonable time limits may be more generous in the context of a sale of a business. For example, the Utah Supreme Court has approved a twenty-five year non-compete arising from the sale of a business.29 Periods of seven and five years have also been upheld.30 However, in the employment context, restrictions are typically limited to one or two years.31
A geographic restriction is reasonable if it is limited to the area where a business “has been and is seeking its market.”32 If a company’s market is nationwide, some limitation other than a geographic restriction may be more appropriate. For example, in one case where a company had just 2,500 potential clients in the United States, an activity-based restriction was deemed more appropriate than a geographic restriction.33 There is no hard line test for validating the geographic restriction in a restrictive covenant; however, courts are more likely to void an agreement on the basis that it lacks a geographic restriction where the customer base at issue is local.34 Activity-based restrictions rather than geographic restrictions may be more appropriate for companies engaged in internet- based commerce.
Litigation Arising from an Employment Relationship
Lawsuits involving restrictive employment covenants typically arise in one of two circumstances: (1) an employee seeks to invalidate a covenant, or (2) an employer seeks to enforce a covenant.
Employees may ask the court to declare that a covenant to which they have agreed is invalid.35 Utah courts are authorized to issue a declaration of invalidity even before any wrongdoing may have been committed.36 This procedure allows an employee to determine whether the covenant is enforceable before accepting a position with a competitor or taking some other action that may violate the express language of the covenant.
If an employee has violated a covenant, an employer may file an action against the employee to enforce the agreement. In some circumstances, the employer may also sue a new employer in a tort or conspiracy action related to the employee’s conduct.
Prior to litigating a restrictive employment covenant, there are number of concerns that the employee or employer should consider. These include but are not limited to the following:
The party seeking to enforce the covenant generally has the burden of proving that the covenant is valid and enforceable.37
Because restrictive employment covenants are disfavored, they may be strictly construed against the employer.38
The covenant may be governed by the law of a state other than Utah, and may require that any lawsuit be brought in another state. This may be the case if the covenant contains a choice of law provision selecting the law of another state or if one of the parties or business entities resides in another state with an interest in the outcome.39
In some states, courts are authorized by statute to edit the covenant to make its restrictions reasonable and enforceable.40 The question of whether to authorize this power (called “blue penciling”) has not yet been decided in Utah. However, courts in other states have explained why blue penciling should not be employed.41 Notably, if a covenant may be edited rather than voided, employers have no incentive to impose reasonable restrictions in the first instance.
Employers face a significant risk if a form covenant is invalidated. Under principles of res judicata, if one employee is successful in defeating a covenant, it could effectively invalidate form covenants used with other employees.43 The employer would thus be required to have all employees sign a new, less restrictive covenant, and former employees would not be bound by the overly restrictive covenant. On the other hand, if an employer succeeded in enforcing a covenant against one employee, that decision would not be binding on other employees, who may assert different arguments or defenses.
In extraordinary cases, where a party uses the litigation processes wrongfully to stymie competition, damages may be available. For example, if an employer brings a bad faith claim to prevent an employee from working for a competitor, and the employee ultimately wins the lawsuit, the employee may bring a subsequent action against the employer for abuse of process or wrongful use of civil proceedings.44 Such cases are not common, but do occur.
Litigation Arising from the Sale of a Business
Lawsuits challenging a restrictive covenant negotiated in the sale of a business are similar to litigating employment covenants. As discussed above, the Rose Park test for validity applies to both employment covenants and sale of business covenants. However, reasonable time restrictions may be substantially longer when the covenant arises in the sale of a business context.
Litigation Remedies
A remedy is the award granted by the court in litigation. In cases involving restrictive covenants, there are a number of remedy options, including: declaratory judgment, injunctive relief, and monetary damages.
A declaratory judgment, discussed above, consists of a declaration from the court that the covenant is, or is not, valid. A declaratory judgment has the advantage of seeking a court ruling before assuming the risk of breach and accompanying damages.
Injunctive relief is the power of the court to ban conduct that would violate the covenant. A temporary restraining order is an emergency order, often granted at the outset of a case on little or no advance notice, barring conduct for a period of up to 14 days.46 Preliminary injunctive relief is issued at the outset of the action to prevent certain conduct while the case is pending.47 Permanent injunctive relief is granted at the conclusion of a case, ordering a party to take certain action, or refrain from taking a particular action, for a time certain.
Monetary relief takes the form of a judgment for the payment of money. Monetary relief may consist of actual damages, liquidated damages and litigation expenses.
Actual damages are measured by the claimant’s lost profits, which are the profits that the claimant would have earned but for the breach of the covenant.48
Liquidated damage is an amount specified in the covenant or contract (e.g. the covenant may specify that if the employee breaches the non-solicitation provision, the employer will be entitled to liquidated damages of $5,000 per breach). To be enforced, a liquidated damages amount must represent a fair and reasonable estimate of the amount necessary to compensate the injured party.49 Liquidated damages that are grossly disproportionate to an estimated injury or that are designed to penalize the breaching party will not be enforced. A claimant cannot recover liquidated damages and actual damages, but may be able to plead both in the alternative and elect a remedy as the litigation progresses.
Attorneys’ fees and costs of suit can be significant in restrictive covenant litigation. The prevailing party may be entitled to reimbursement of attorneys’ fees if provided in the contract. Costs of suit, which are typically a small percentage of litigation expenses, are generally awarded to the prevailing party as a matter of course.50
Attorney Exception
In Utah, attorneys are generally exempt from restrictive covenants. The professional rules governing lawyers bar any employment agreement or settlement agreement that restricts lawyers from practicing law.51 Utah has not yet recognized a statutory or regulatory exemption for any other profession or industry, although strong policy reasons for exemptions may exist, such as in the case of medical professionals.
Drafting Considerations for Employers
While it is a common practice to use a uniform restrictive covenant for all employees, the better business practice is to customize restrictive covenants for each employee—especially for each key employee. To the extent a restrictive covenant is designed to protect confidential information, the protected information should be identified with as much particularity as possible, identifying how the employee subject to the covenant will have access to that information. For covenants designed to protect goodwill, restrictions to customer relationships should be limited to those that the employee will develop and maintain in the course of his or her employment. Applying these limitations will provide the best opportunity for the employee to understand and abide by the restrictions, and it will increase the likelihood that a Utah court will uphold the validity of the covenant.