Court Explains Limits of Restrictive Covenants in Lift Out of Executive Team

Court Explains Limits of Restrictive Covenants in Lift Out of Executive Team

January 2, 2018

By Richard Reice and Julian Brod

The defection of a team of high-level executives to a competing business is a crisis for almost any company. Savvy businesses can try to mitigate the effects of such departures by entering into restrictive covenants, including non-competition and non-solicitation agreements, with their high-level employees. However, as a recent New York restrictive covenant case illustrates, courts remain skeptical of agreements that excessively restrict the freedom of employees to move between jobs.

The case, In re Document Technologies Litigation – F. Supp. 3d – (S.D.N.Y. 2017) (Rakoff, J.), involved a lift out of a team of four high-level sales executives at Document Technologies, Inc. (“DTI”), a provider of litigation services. Each executive’s employment agreement contained numerous restrictive covenants. These included a one-year non-competition agreement, a one-year prohibition on soliciting the company’s clients, a one-year prohibition on soliciting the company’s employees, a broad non-disclosure provision, and a covenant to return the company’s confidential information upon termination of employment.

In early 2017 the four executives – calling themselves the “Four Horsemen” – signed on with one of DTI’s competitors, LDiscovery, and then submitted simultaneous resignations to DTI. The executives agreed to honor their non-competition agreements with DTI by taking a “sabbatical year” in which they would be paid by LDiscovery but would perform no work.

DTI was not placated by the Four Horsemen’s promise of a “sabbatical year” and filed suit in federal court seeking a preliminary injunction. It argued that the executives had breached the non-competition agreement by making a “game plan” for their post-sabbatical activities and by circulating a spreadsheet in which they planned to input client information. It also argued, provocatively, that the executives had breached the employee non-solicitation agreement by coordinating their “en masse” resignation – that is, by soliciting each other to work at LDiscovery.

The court made short work of DTI’s contention that the executives had breached their non-competition agreement. Generally, a former employee may “prepare to compete” during the term of a non-competition provision. The former DTI executives had engaged in modest planning-type activities, and so, the court held, they had not crossed the line into actual competition.

The court next turned to DTI’s contention that the executives had breached the employee non-solicitation agreement by “jointly” deciding to move to LDiscovery. New York applies a three-part reasonableness test to covenants prohibiting the recruitment of employees. Under this test, a covenant is reasonable only if it: “(1) is no greater than is required for the protection of the legitimate interest of the employer; (2) does not impose undue hardship on the employee; and (3) is not injurious to the public.”

On the first prong, the court observed that harm arising from a coordinated en masse resignation “is not a legally cognizable interest for the purposes of a restrictive covenant.” The court thus found that the covenant was broader than required to protect the legitimate interests of the employer. Turning to the second and third prongs, the court found that DTI’s broad interpretation of the covenant as prohibiting “any speech that ‘encourages’ or ‘induces’ an employee to terminate his or her employment” was “nothing short of a contractual gag rule on employee complaints.” The court therefore found that the covenants imposed an “undue hardship” on the departing employees, and because they prohibited “free flow of information concerning alternative employment,” they were also injurious to the public. The court held that the restrictive covenant was unenforceable “insofar as it purports to prohibit at-will employees, who have yet to accept an offer of new employment, from ‘inducing’ or even ‘encouraging’ their coworkers to leave their present employer.” The motion for a preliminary injunction was denied.

The lesson of In re Document Technologies Litigation is that, when it comes to restrictive covenants, less is frequently more. The covenant provides an entryway to the courtroom, but it is not self-effectuating, and judges will closely scrutinize requests for injunctive relief. That said, restrictive covenants remain enforceable in New York in appropriate circumstances. A carefully crafted restrictive covenant addressed to the circumstances of the employment relationship remains a legitimate means by which an employer may protect itself against at least some of the effects of high-level defections.

Richard Reice is a partner at HNRK. Julian Brod is an associate. 

 

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