Avoid the Urge to Overreach in Restrictive Covenants in Employment Agreements

A recent (September 2011) New York case, Novus Partners v. Vainchenker, illustrates the difficulty of enforcing overly broad restrictive covenants in the employment context relevant to hedge funds and other private fund entities.  In this case, an employee of a hedge fund research company left to work for a competitor and was promptly accused by his former employer of violating confidentiality, non-competition and non-solicitation clauses of his employment agreement among other claims.  After suing both the ex-employee and his new employer (who was sent a notice apprising it of its new employee’s breach of contract), the plaintiff was faced with a challenge from the defendants by way of a motion to dismiss that attacked the legal sufficiency of the agreements signed by the ex-employee.

As we all know, employers like to protect themselves against this very situation with what they view as “iron-clad” contractual provisions that they offer to employees as part of their employment package and that employees (short of very few executive-level employees) tend not to negotiate.  Which is all well and good.  We certainly encourage our employer clients to arm themselves with the appropriately-drafted restrictive covenants at every stage of interaction with employees, independent contractors and service providers (normally when they enter into employment or service agreements and, upon termination, in separation or termination agreements).  However, care must be taken not to have our defensive instincts get the better of us.  New York courts, as well as courts in other states, scrutinize restrictive covenants when they are being used against former employees and may refuse to enforce them when they are seen as overly broad, unreasonable or (probably rare in the investment fund industry given the scale of typical compensation packages) unconscionable.  

Failure to follow the basic principles may make it more difficult (read expensive) to enforce these covenants or may make them completely unenforceable.  In fact, the latter is what happened in this case, where on a motion to dismiss the plaintiff (former employer) was ordered to re-plead one of its claims for the sin of seeking to enforce an overly broad non-solicitation clause related to the employer’s clients. 

So the lessons of this case for the investment fund industry employers can be summed up as follows:

  1. Geographic limitations not crucial in the context of investment management industry.   These are not terribly relevant for the alternative investments industry, which is spread widely across the major financial centers of the globe.    Most of the successful challenges to these have to do with the duration (the 1 year term here was not viewed by this court as excessive) and with the scope (apparently the nature of the hedge fund research services offered by the former employer here was sufficiently specialized not to cause offence).
  2. Scope of non-solicitation limited to clients directly known to ex-employee.  With respect to the language of the non-solicitation clause the judge held that the clause must be limited to those clients of the former employer with whom the defendant ex-employee had some contact in his prior job.  While we do not advise to limit non-solicitation clauses so that they only prohibit solicitation of those clients with whom the employee has had a business relationship in every instance, the given employee’s direct exposure to the employer’s clients and the nature of the client list should be consider.  In this case, the judge noted that the ex-employee never had much of an exposure to many of his former employer’s clients.  The judge also stated that the restriction as drafted would effectively prevent the ex-employee from soliciting any of the hedge funds for the fear of unwittingly violating this clause.  On the other hand, the court found the defendant ex-employee’s effort to induce another employee of the plaintiff employer to leave and go work at his new employer a clear violation of the non-solicitation clause. 
  3. Broad confidentiality language subject to scrutiny.  While the benefit of a well-drafted confidentiality clause is clear in this context the plaintiff employer did face a challenge from the ex-employee (and the court) related to the over-broad language of the NDA in question.  This issue comes up quite often in our practice when we try to convince our (employer) clients to be reasonable when it comes to the scope of what constitutes confidential information to be protected against disclosure and/or misuse by their employees.  The simple reason for being cautious here is that when it comes to matching facts of the case to the contractual obligation you don’t want to be arguing that just because everything you deem confidential deserves to be protected b.  For example, while the judge here allowed the claim based on the confidentiality clause to proceed, the court spoke derisively of the extent of protection afforded to client lists when a business’s customers can be easily determined.  Proprietary software, on the other hand, was easily classifiable as a trade secret and deserving of legal protection.    

The reason for the additional scrutiny given to these restrictive covenants is that in ruling on these claims a variety of equitable considerations come into play.   The key to a smooth and cost-efficient enforcement lies in customizing these clauses to the specific circumstances of each employer’s business and each employee’s position.  Using a balanced approach in drafting restrictive covenants serves to deprive former employees of the ability to challenge their validity as a tactic to delaying or avoiding enforcement.  This is one situation where employers should not be using “one size fits all” standard form agreements.  As counsel to both employers and employees in the private fund industry we regularly negotiate restrictive covenants in the employment context and review them for potential employers considering a hire subject to these restrictions.  After all, given the entrepreneurial spirit in this industry, employees of the yesteryear often become future employers and so the cycle of relying on the enforceability of restrictive covenants to protect one’s business continues.

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