The Prisoner of (Egon) Zehnder
Non-compete clauses – are they still useful? Do they still work?
There’s no doubting that Anne M Mulcahy, former chair and chief executive of Xerox got it right: ‘Employees are a company’s greatest asset – they’re your competitive advantage. You want to attract and retain the best; provide them with encouragement, stimulus, and make them feel that they are an integral part of the company’s mission.’
Mulcahy passed up through the ranks from a field sales role through to VP for HR and on to the heights of chief executive and chair – shattering the glass ceiling over a 30-year career. In the process she became one of the world’s best-known and successful corporate leaders.
However, there comes a time in all employment relationships when people move on to new organisations and opportunities.
When these people are your top salesmen, engineers or designers – people who make a real difference to your organisation’s success, you may find yourself rooting around for their employment contract to see what protection the paperwork may provide. You may be looking for a non-compete clause in the contract and hoping that it holds water. If it does this may offer you an opportunity to delay them joining a competitor while you shore up key client relationships and take steps to neutralise the competitive threat posed by the departure.
To vary or not to vary?
So, when a court judgment comes out which makes it harder to enforce a non-compete clause, what should you do? Do you: (a) do nothing and hope that the judgment is appealed? Or (b) introduce new contracts for all staff?
The Court of Appeal’s decision in Egon Zehnder Ltd v Tillman has put the cat among the pigeons, when it comes to how the courts treat non-compete clauses. The clause in this case attempted to prevent the employee after her employment ended from ‘being engaged, interested in or concerned’ in any competing business.
What employers in the know are doing in reaction to the judgment in this case is becoming clear. The upcoming appeal to the Supreme Court should provide welcome guidance. In the meantime, businesses that do nothing are leaving themselves exposed to the risk that their employees are free to join a competitor the day after their employment ends.
The Prisoner of (Egon) Zehnder
At the High Court stage of Egon Zehnder Ltd v Tillman, the court granted an injunction to prevent Ms Tillman from working for a competitor in breach of the non-compete clause in her employment contract. Ms Tillman was at the time the global head of Zehnder’s (the world’s largest privately-held executive search firm) financial services practice group. The non-compete clause prevented her from working for a competitor for six months after the termination of her employment. The clause read:
‘You shall not without the prior written consent of the company directly or indirectly, either alone or jointly with or on behalf of any third party and whether as principal, manager, employee, contractor, consultant, agent or otherwise howsoever at any time within the period of six months from the termination date… directly or indirectly engage or be concerned or interested in any business carried on in competition with any of the businesses of the company or any group company which were carried on at the termination date or during such period.’
When Ms Tillman resigned, she told her employer (Zehnder) that she was going to work for a competitor in breach of the non-compete covenant. In response, Zehnder, applied for an injunction.
In spite of Ms Tillman arguing that the clause was unreasonably wide, the High Court disagreed – it found that the covenant was reasonable and it granted an injunction preventing her from joining the competitor until the non-compete covenant had expired.
Reversal of fortune
The decision was then appealed to the Court of Appeal. The Court of Appeal took a different approach to the one taken by the High Court. It overturned the original decision leaving Ms Tillman free to join the competitor. The focus of the case at the Court of Appeal stage was on the interpretation of the non-competition covenant and whether the words ‘interested in’ included being a shareholder.
Now to be clear, it was known that Ms Tillman did not have a shareholding in a competing business and there was no indication that she had any intention of acquiring one either. Despite this, her legal team argued that, in theory, the wide ranging scope of the covenant made it unreasonable.
While Zehnder denied that the clause covered a shareholding, it had to accept that the clause would be unreasonable if the court decided that it did cover a shareholding.
In deciding exactly what the clause meant, the Court of Appeal started with looking at the conventional meaning of the words used. It took the view that the phrase ‘interested in’ a business had to include the holding of shares in a company.
The blue pencil rule sharpened
Occasionally, the courts are able to help an employer and make minor changes to the wording of covenants so that they are effective. This includes removing the odd word or two, or a phrase but it will not include adding words to the clause or modifying the wording of other terms. This is known as the ‘blue pencil’ rule.
As the Court of Appeal found against Zehnder on the issue of construction of the contract, the company asked the court to use the blue pencil rule to strike out the phrase ‘interested in’. The court was not willing to do this for two reasons:
1) The clause would still be too wide even if the words ‘or interested’ were taken out, as the words ‘directly or indirectly engage or be concerned… in any business’ would also prevent Ms Tillman holding shares; and
2) The court said that the blue pencil rule cannot be used to sever parts of a single covenant. This suggests that the blue pencil rule can only be applied to separate covenants. Previously, it was widely thought that a court would be able to use the blue pencil rule to sever the offending wording in one covenant which was self-contained provided that the removed words did not affect the rest of the wording or distort the overall contract.
The non-compete covenant was held by the Court of Appeal to be unreasonably wide and, therefore, not enforceable. The result was that Ms Tillman was successful in her appeal and she was free to join the competitor.
So, where does this leave employers? Is your business dangerously exposed to the risk of employees leaving to join competitors because the clauses in their contracts are worthless?
As it stands, the impact of this case and the effect on restrictive covenants is unclear. One view is that following this case your contracts need to contain a non-compete clause which allows an employee to have a limited shareholding, for example 5% of the shares in a listed company. Without this carve-out, the clause may be unenforceable.
An alternative view is that if a contract includes a carve-out of this nature, that will not be the end of the story. This is because non-compete clauses may still be considered too wide to be enforceable, if the carve-out for an employee’s interests is too narrow. Some commentators have suggested that restrictions on the employee having an arm’s length shareholding after employment may now not be allowed by the courts.
What we do know is that employers need to be ready for employees creatively challenging whether a non-compete clause is valid.
The question for employers is what should they be doing? Should they do nothing until the Supreme Court provides further guidance? Should they take prompt action to redraft their post-termination restrictions so as not to fall foul of employees raising spurious arguments about what the clauses prevent them doing in theory? At the very least, employers should be conducting an audit to see what covenants they have in place and assessing whether this case leaves them exposed to employees being free to join the competition.
In the case of contracts for new employees or contracts given on a promotion or along with a salary increase, steps can be taken now to redraft any weak clauses and put the employer in a stronger position.
What you need to include
When redrafting or updating these clauses in contract, there are two things to consider. The first is what limits an employer is now able to place on the financial interests that a former employee may have in a competitor? The typical carve-out that is seen in contracts usually says that the employee is free to own the shares in a publicly-traded entity up to a specific level, say 5%. That may not go far enough following Tillman.
When an employer thinks about the limits on the interest an employee can have in a competitor, some things to bear in mind are:
a) Why only refer to a shareholding in a public company? Why not include shareholdings in private companies or LLPs too? Surely the employee should be free to hold a passive shareholding or to hold an interest ‘for investment purposes’ in any company or hold, for example, a tracker fund which may hold shares in a competitor?
b) Why not also think about a restriction in terms of the employee having a material financial interest in or a loan from not just a competitor but also the financial backers of a competitor?
c) What about the employee’s immediate family’s financial or beneficial interests? Should these interests be included too?
d) Why is 5% the typical shareholding? Why not 3% or 10%? Is the focus on what interest may amount to the employee having an active interest and an entitlement to vote at shareholder meetings?
e) Why stop at shareholdings? What about other financial assistance or interests such as debts or loans?
To avoid a court deciding that a non-compete clause covers a shareholding, it needs to be carefully worded. In order to work, it must be clear that the employee may not directly or indirectly be ‘interested in any capacity’ in a competitor in a range of specified ways such as being a director, partner, employee, principal, agent and consultant, and the list should not be so broad as to simply say a (mere) shareholder.
The second aspect is that post-termination covenants should be written in a way that gives the employer the best chance of persuading a court that any offending clauses can be severed using the blue pencil rule.
The limits on the availability of the blue pencil rule (following the Court of Appeal’s decision) may mean that covenants will, in future, need to be drafted so that each part of the covenant is obviously separate or stand-alone.
The result? Unfortunately, this case may mean much longer contracts with each paragraph of a covenant and the definitions needing to be separated out into distinct and discrete sections. If any of the separate covenants are held by a court to be unenforceable, the employer will be far better placed to argue that the blue pencil test should be applied to strike out the offending part of the contract leaving the rest of the clauses undisturbed.
But what about existing employees?
That’s all fine when an employer is free to write a contract for a new joiner, but a bigger concern may be the present danger of putting new or amended contracts, that are fit for purpose, in place for existing employees.
When it comes to contracts for existing employees, employers need to look at the risks they may face if a member of staff leaves to join a direct competitor. This includes how often and likely they are to use covenants as a way of preventing this from happening.
For some, non-competition covenants will merely be nice paperwork to have, but will be rarely, if ever, used in practice. If this is the case, changing them will not be a priority.
In other industries, especially where team moves are frequent and the next one is a mere phone call away, it may be too risky not to have non-compete restrictions that are enforceable.
Where employers need to introduce new contracts containing fresh covenants, they’ll need to consult with employees about the changes.
Understandably, employers will be reluctant to let employees know that some parts of their contracts don’t work and so the subject will need to be approached carefully. To avoid this, employers may decide to introduce a number of changes to contracts at the same time rather than highlight any flaws that exist in isolation. These will need to be accompanied by a valid form of consideration such as a pay rise which in itself may not be a straightforward process.
Some types of consideration given in return for an employee entering into a new contract are obvious – for example, an increase to salary, a bonus or extra holiday. For example, the offer of a flu jab and such like, while of benefit during the winter, are unlikely to be regarded as enough to amount to consideration of real value.
Often covenants are introduced at the same time as a salary increase, but a point to watch out for is that in order for the change to be ‘consideration of value’, the increase in salary or other benefits needs to be clearly linked to the employee’s agreement to the new covenants. The change cannot be something that would have been awarded to the employee in any event. For example, if a new benefit is not conditional on acceptance of the covenants, this may mean that the consideration is not effective.
When an employer does consult with employees about the introduction of new contracts, well-advised employees will be aware that they potentially hold the upper hand in these negotiations and they may ask for a significant cash payment as consideration in the circumstances.
Zehnder and out
Clearly, there is potentially a great deal for employers to think about. What’s certain is the need for action to be taken sooner rather than later by many employers in advance of the Supreme Court’s decision.
If you would like to discuss the use of restrictive covenants and the practical implications, please get in touch with Peter De Maria, partner at Doyle Clayton. He can be contacted at firstname.lastname@example.org or on +44 (0)20 3329 9090.
One Crown Court