Careful Drafting Key to Enforceable Noncompetition and Nonsolicitation Covenants

Insurance is a business based on relationships. Because the profits for an insurance brokerage are driven by the producers’ relationships, brokerages often seek to keep their producers from taking those relationships to competitor brokerages through noncompetition or nonsolicitation covenants.

A noncompetition covenant prevents a former employee from competing with a former employer for a certain period of time after the end of the employment. A nonsolicitation covenant prevents a former employee from soliciting the clients and/or other employees of a former employer.

Since the solicitation of clients is essential to the insurance business, a nonsolicitation covenant can have the same effect as a noncompetition covenant. The use of these restrictive covenants is common in the insurance industry, but it can be tricky to make sure they are enforceable.

In some states, such as New York, Delaware and Texas, a properly drafted restrictive covenant between an employee and employer can be enforced. Although the specific requirements vary by state, certain rules typically apply.

First, the geographic scope of the restrictive covenant must be reasonable. A court’s interpretation of what is reasonable will likely be influenced by the actual geographic scope of the employer’s business. A reasonable geographic scope could be one or two counties or it could be statewide, depending on the context.

Second, the restrictive covenant must be of a reasonable duration. Many courts will find that a covenant effective for one year following the employee’s termination is reasonable, and some courts may even enforce a two- or three-year covenant.

Third, the restrictive covenant must be necessary to protect the employer’s legitimate business interests. Legitimate business interests commonly include protection of the employer’s trade secrets or the employer’s goodwill.

Finally, in determining whether to enforce a restrictive covenant, a court may take into account the public interest or may weigh the hardship to the employee against the hardship to the employer.

In states where restrictive covenants can be enforced, many courts are also willing to “blue-pencil” or rewrite portions of the covenant that are overly broad. For example, if an employer seeks to enforce a noncompetition covenant against its former employee and the court determines that the duration of the covenant is too broad, the court may enforce the covenant for a more limited time frame. Similarly, a court may narrow an overly broad geographic scope.

In California, however, restrictive covenants are generally void and unenforceable, no matter how reasonable or narrowly drafted they may be. While there are certain statutory exceptions that permit restrictive covenants in connection with the sale or dissolution of a business, a company that buys a business and seeks to impose a noncompetition covenant upon the seller must carefully comply with the statute and case law in order to make sure the resulting covenant is enforceable. Since California does not look favorably on restrictive covenants, a seemingly simple change in wording can cause an otherwise compliant covenant to become unenforceable.

For instance, California Business and Professions Code section 16601 allows any person to sell his business and agree with the buyer to refrain from carrying on a similar business within a certain area, so long as the buyer carries on that business. In the insurance industry, a large insurance agency may buy out an individual producer with his own agency, include a restrictive covenant in the purchase agreement, and employ the individual following the purchase. Because a producer who becomes the buyer’s employee will grow his business and client list during that employment, the buyer may try to protect itself from this broader scope of competition by defining the restrictive covenant in terms of the buyer’s business, as opposed defining it in terms of the seller’s business or clients at the time of the sale. Such covenants not only prevent competition with the buyer’s business at the time of the sale, they continually grow with the buyer’s business to encompass the scope of the business at the time the seller’s employment is terminated.

Starting in 2006 with non-insurance cases, California courts began examining the language in restrictive covenants that purports to prohibit competition with the buyer’s business or the solicitation of the buyer’s employees or customers. In doing so, these courts have found that a restrictive covenant tied to the buyer’s business does not comply with Business and Professions Code section 16601, and that a covenant must be limited to the seller’s business in order to be enforceable.

Strategix Ltd. v. Infocrossing West, Inc. is a landmark decision on this issue. Strategix had agreed to sell its assets and goodwill to Infocrossing’s predecessor, and the sale agreements contained nonsolicitation covenants. The covenants prohibited Strategix and its parent company from soliciting the buyer’s employees and customers for one year after the termination of the parties’ consulting relationship. When the deal fell through, Infocrossing sought an injunction forbidding Strategix, its parent company, and an individual from soliciting Infocrossing’s customers and employees. The court ruled that the restrictive covenants were unenforceable because they prohibited the solicitation of the buyer’s employees and customers.

A properly drafted covenant would have prohibited the solicitation of the employees and customers of the sold business, in this case Strategix’s employees and customers. The court explained that the purpose of California’s narrow exception allowing restrictive covenants is to protect the value of the acquired business — not to protect the buyer from any competition it may face at the expense of the seller’s right to fairly compete. Importantly, the court declined to blue-pencil the overbroad covenants to make them enforceable. After Strategix, other courts have followed suit and refused to enforce overly broad restrictive covenants that were improperly tied to the buyer’s business.

This is just one of several potential hurdles in the enforceability of a restrictive covenant in connection with the sale of a business in California, and some other issues have yet to be thoroughly examined by the courts.

Whether an insurance brokerage is in California or another, more employer-friendly state, cases such as Strategix reinforce the need for careful drafting and serious consideration of restrictive covenants.

Topics California