Using Restrictive Covenants to Protect Alternative Asset Managers

Sep 20 2011 | 10:44pm ET

By Robert Holtzman, Kramer Levin Naftalis & Frankel -- If it has not already happened, it will soon:  A valued employee will decide to leave your firm to become a competitor. After years of access to your strategies, processes, confidential information and clients, you may suddenly find yourself competing against that very same employee. Suddenly, you are faced with a challenge that, just moments earlier, did not even register on your radar of concerns. What’s an employer to do?

A wise employer will prepare in advance for the eventual departure of employees that may be in a position to do competitive harm when they leave.  Restrictive covenants, such as non-competition and non-solicitation covenants, can help to ameliorate the risks and damage of such competition.

The Basis for an Enforceable Restrictive Covenant

Unlike typical commercial agreements, which generally are enforced in accordance with their terms, restrictive covenants will be enforced only where there is a legitimate business justification for doing so, as they are viewed as anti-competitive arrangements that limit employees’ ability to freely market their services and earn a living in their chosen profession. Two typical bases that can support a restrictive covenant are the protection of confidential information and the protection of goodwill arising out of client relationships.

Protection of confidential information can serve as a proper basis when the employee had access to proprietary or confidential information belonging to the employer that could readily be used by the employee or a successor employer to unfairly compete against the employer after his departure. In the financial services industry, confidential trading strategies, software programs for high-speed trading and black box strategies may be sufficiently confidential to support the enforcement of restrictive covenants.

Alternatively, an employee’s contact with clients may support the enforcement of a non-competition or non-solicitation covenant restricting that employee from contacting or doing business with those clients following termination of his employment. Because the employee was able to develop these relationships only through the introduction of, or at the expense of, the employer, case law supports the proposition that an employer should be afforded a reasonable amount of time to substitute another individual in that relationship before the employee may seek to compete.

Note that the employee’s knowledge of generalized industry information does not justify the enforcement of restrictive covenants. Nor does the fact that the employee knew nothing about the industry before working for a particular employer and is in a position to obtain alternative employment and compete against the employer only because of the knowledge that was imparted to him during his employment. Conduct that seems disloyal is simply not enough, unless the employee engages in other truly wrongful conduct, such as theft of confidential information or other property.

Even where supported by a legitimate business justification, a restrictive covenant will be enforced only to the extent it is narrowly tailored to protect the interests identified as the legitimate business justification underlying the covenant. Thus, a court will assess the reasonableness of the scope of the restriction in terms of geography, duration and the activities prohibited.  The less restrictive a provision is, the more likely it is to be enforced.

While courts will occasionally enforce restrictions of up to three years in the employment context, a one-year restriction is far more common; even where a legitimate business justification exists, some courts have limited restrictions to six months because the confidential information at issue quickly becomes stale. In the financial services industry, broad geographical restrictions are commonly enforced, given that such work typically can be performed anywhere in the country or, indeed, the world.

Types of Restrictions to Consider

The broadest type of restriction is a true non-compete, a restriction by which the employee agrees not to compete with the employer following termination of his employment for some defined period of time. Even here, however, the scope of the restriction must carefully be considered. Is “competition” to be defined as working in the financial services industry? Or being associated with any hedge fund? Such a restriction runs significant risk of being found to be too broad in most circumstances. Consider instead whether the restriction can be tailored to address the particular strategies pursued by the employer, or a particular product or industry focus.

Alternatively, a customer restriction may define the scope of the covenant in lieu of a full-blown non-compete. Thus, for example, the employee may agree to forego engaging in business with certain specified clients of the firm, or with any clients of the firm with whom he communicated on behalf of the firm, or some other formulation that protects some or all of the client relationships of the employer. Such restrictions are often viewed as more reasonable than full non-competition covenants because that they allow the employee to continue working in his profession and use his expertise and merely prohibit the employee from doing so on behalf of a limited number of clients. This type of restriction is most appropriate for employees in marketing roles and portfolio managers who have become known to a firm’s clients.

Finally, employers should consider whether to restrict employees’ ability to solicit, hire or otherwise engage their co-workers and the consultants, referral sources, and vendors of their employer. Because such provisions are often viewed as less anti-competitive than the other restrictions discussed above, they are more easily enforced by courts and more commonly complied with by departing employees.

Do You Have to Pay the Employee During the Restricted Period?

Whether an employee is receiving compensation during the period of the restriction is a relevant factor that often is considered by courts. The law does not require that the employer provide such compensation—and restrictive covenants are often enforced notwithstanding that the employee is receiving no compensation during the restricted period—but one of the considerations taken into account by courts in balancing the equities is the potential impact on the employee’s ability to earn a living. Thus, continuing to pay the employee’s compensation during the restricted period helps to enhance the likelihood of enforcement of the restrictions.

Note that employers in the financial services industry typically do not pay incentive compensation during a restricted period (although they may permit continued vesting of deferred compensation if the individual is otherwise a “good leaver”). Nonetheless, because incentive compensation tends to be a large portion of total compensation, paying only base salary during the period of restriction has only a limited benefit as compared to other industries in which incentive compensation is far smaller a percentage of total compensation.

Using Restrictive Covenants to Protect Your Business

Restrictive covenants are part of an employer’s arsenal of weapons to protect against the loss of confidential information and client relationships that may ensue in the wake of the departure of valued employees. While restrictive covenants may not be appropriate for the most junior employees in an organization, particularly non-professionals, firms should consider using restrictive covenants to ensure the protection of confidential information and client relationships. When combined with nondisclosure agreements and deferred compensation arrangements, such agreements can go a long way toward avoiding—or at least reducing the damage from—unfair competition by departing employees.

Restrictive covenants must be contained in a written agreement, whether a broader employment agreement that addresses other terms and conditions of employment or a stand-alone document that addresses only these issues. If not entered into in connection with the commencement of an employment relationship, in some jurisdictions the restrictive covenants must be supported by additional consideration beyond mere continued employment. In New York, however, continued employment of an at-will employee typically is adequate consideration to support restrictive covenants.

As a final note, restrictive covenants generally must comply with the law of the state in which the employee works. There is significant variation among states in terms of their approach to restrictive covenants. Thus, for example, in New York, reasonable restrictive covenants are enforceable to the extent they are supported by a legitimate business justification, while California has a specific statutory provision that prohibits the enforcement of restrictive covenants in the employment context (although it does permit the use of restrictive covenants in connection with the sale of a business). As another example, in New York, continued employment of at-will employee is sufficient consideration to support a non-compete arrangement. In Connecticut, however, a restrictive covenant that was not entered into at the commencement of employment must be supported by separate and independent consideration. Thus, employers must be cognizant of the particular jurisdiction(s) in which they operate and ensure that their use of restrictive covenants is in compliance with local law.

Robert Holtzman is a partner in Kramer Levin Naftalis & Frankel LLP’s New York office, focusing on representing management in employment law matters.

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