Tread Carefully When Using Noncompete Agreements

This article originally appeared in the March 2022 issue of the Journal of Accountancy. 

Consider this scenario: Your consulting practice concentrates on serving a niche client industry. To protect your practice, your firm has included a noncompete clause in its employment contracts for employees you hire. The clause was drafted several years ago with the advice of legal counsel and precludes employees from being in direct competition with your firm in any capacity in all states in which you currently do business and for a period of three years. One day a valuable senior manager in your advisory practice section announces she's leaving the firm. It's a big loss, but it also is compounded by the fact that she's going to a consulting firm across town that directly competes in your niche industry and actively tries to solicit your clients. You're likewise concerned that she will reveal confidential information regarding your firm's marketing and business planning strategies. You move to enforce the noncompete language you had with the former employee. You think it's an ironclad agreement and that it will prevent the employee from competing with you.

However, instead of adhering to the terms she agreed to, the former employee sues your firm for retaliation and moves to enjoin your firm from enforcing the noncompete agreement. The court grants the injunction finding the noncompete agreement unreasonable and against public policy and allows her retaliation suit to proceed.
Firms desiring noncompete protections should carefully consider how such clauses are handled in their state and thoughtfully craft and regularly review their agreements to help ensure they stand up to challenges. Firms also should consider alternatives, such as nonsolicitation or confidentiality agreements.

In a day and age where information such as client lists is easily transferable via electronic means, and increasingly people with access to proprietary data are temporary workers hired for a limited purpose or project, it is difficult to implement safeguards to prevent the dissemination of such information to direct competitors. For many years, a method used to restrict access was to require employees to sign noncompete agreements prohibiting them from directly competing after they leave a firm. However, with an expanding mobile workforce operating in a global economy, the use of these restrictive covenants to prevent this from occurring is being reexamined by the courts and state legislatures.
 

Know your state's laws when drafting noncompete agreements

A noncompete agreement is a contract between an employer and employee wherein the employee typically agrees not to work for their employer's competitors within a certain geographical region and for a designated amount of time after they leave the firm.

In recent years, the legal landscape for noncompete agreements has shifted. Increasingly courts and state legislatures are pushing back against what they perceive to be an overuse of restrictive covenants in agreements with employees who do not pose a competitive risk. Each state has its own laws and rules about whether, when, and to what extent a noncompete agreement is enforceable.

Many states still recognize and enforce various forms of noncompete agreements. According to New York law, for example, a noncompete clause is generally considered reasonable when (1) it is necessary to protect the employer's legitimate interests, (2) does not impose an undue hardship on the employee, (3) does not harm the public, and (4) is reasonable in time period and geographic scope. Some states, however, such as California, Montana, North Dakota, and Oklahoma, as well as the District of Columbia, ban or severely restrict the use of noncompete agreements. Recently, the Biden administration issued an executive order asking the Federal Trade Commission to ban or limit such agreements. While the order is expected to be challenged by employers, it represents the latest push to promote competition and remove obstacles that are perceived as hindering economic growth.
 

Understand the role of noncompete agreements with independent contractors

CPA firms performing consulting and other nontraditional services often outsource certain tasks on an as-needed basis to contracted workers. While this offers many benefits to a firm, it also presents a challenge: How can you effectively protect against competition by independent contractors?

Generally speaking, if a person or entity is an independent contractor, a noncompete agreement will not be enforceable, as the noncompete agreement suggests a level of control exercised by an employer over an employee. But some states (for example, Florida) allow noncompete agreements with an independent contractor just like an employee under certain circumstances. Accordingly, it is important to check applicable state law before entering into such an agreement with a temporary worker.

While you can certainly use a noncompete agreement while engaging independent contractors if you are located in a state that allows it, practical challenges may still limit the agreement's effectiveness. For example, given the short duration and nonexclusivity of relationships with independent workers, noncompete agreements may be impractical or unenforceable. Moreover, since many temporary workers work remotely using their own mobile device or computer, CPA firms have less practical ability to protect the confidential information entrusted to them.
 

Consider ways to mitigate risk

Initially, CPA firms should engage counsel to carefully review their existing noncompete agreements to assess whether they comply with current law. Ensure that any such agreements are reasonable in duration. The amount of time considered to be "reasonable" depends on the state. The agreement should not restrict competition for too long (generally over two years) or restrict competition in an unreasonably large geographical area (this varies by state and the facts of each case, but courts generally look to whether the restriction is meant to protect the employer's business and customers but not restrict all competition or severely limit an employee's ability to make a living). There should also be some consideration provided to the employee for signing the agreement. In other words, provide the employee with something of value other than at-will employment for signing the noncompete agreement, such as agreeing to provide additional compensation for the rights they are giving up should they leave.

You should likewise update your noncompete agreements at least annually, or when the circumstances of your business and/or the laws governing the agreement change. Courts are more likely to conclude a noncompete agreement is irrelevant to a business's legitimate needs if it has not been reviewed and updated periodically.

Consider drafting and implementing alternative agreements, such as nonsolicitation and/or confidentiality agreements, which similarly have the effect of guarding against unfair competition. A nonsolicitation agreement, for example, is less restrictive and narrowly focused at preventing an employee from soliciting his or her former employer's clients. Unlike a noncompete agreement, a nonsolicitation agreement allows an employee to immediately begin work in the same industry and within the same geographic area. Courts generally view nonsolicitation agreements more favorably than noncompete agreements, as they do not impose limitations on an employee's right to work.

Consider how you structure client relationships. Maintaining and fostering client relationships should be done by a firm owner rather than a temporary worker or lower-level staff employee who might be reasonably expected to take a position with a direct competitor. Moreover, courts often look more favorably on noncompete agreements signed by partners or owners, as these employees often receive lucrative payouts when they leave a firm and potentially pose a much greater threat to one's business if they go to a competitor.
 

Final Thoughts

Many state courts and legislatures, as well as the federal government, have cast an increasingly critical eye toward noncompete agreements. Many feel that such agreements are against public policy, as they unfairly restrict trade. In states where noncompete agreements are enforceable, firms that choose to use them should ensure that any such agreements are reasonable in scope, narrowly drafted to protect a legitimate business need, and not detrimental to the public interest, and that the employee received something of value in exchange for signing. In states where noncompete agreements are not enforceable, firms may consider alternative restrictive provisions, such as nonsolicitation clauses, to accomplish the same goals. At the very least, CPA firms using noncompete agreements should consult with counsel to review their existing agreements in light of current law and assess whether those agreements should be updated or whether alternative covenants should be used.


Stanley D. Sterna, J.D., is Vice President and Accountants Risk Control Lead at Aon Affinity.