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  • October 19, 2015

    Seventh Circuit Finds Employee Restrictive Covenants in a Highly Competitive Industry Unenforceable

    A recent Seventh Circuit decision may give some Wisconsin employees with restrictive covenants a stronger basis upon which to challenge the restrictions on their ability to compete with their employer and take co-workers with them.

    Katherine L. Charlton

    A recent Seventh Circuit decision may give some Wisconsin employees with restrictive covenants a stronger basis upon which to challenge the restrictions on their ability to compete with their employer and take co-workers with t hem. The Seventh Circuit in July, 2015 in Instant Technology, LLC v. DeFazio, 793 F.3d 748 (7th Cir. 2015), rejected an employer’s effort to enforce restrictive covenants even though the former employers admitted that they violated the terms of their restrictive covenants by setting up a competing business and directly soliciting their former employer’s current clients. Under Illinois law, a restrictive covenant in an employment agreement is valid only if it serves a “legitimate business interest”. The Seventh Circuit affirmed the Illinois District Court judge’s decision that the restrictive covenants were overly broad and unenforceable because the employer could not establish that it had a “legitimate business interest” given the competitiveness and volatility of the staffing industry.

    DeFazio was Instant’s Vice President for Sales and Operations. She and her co-workers signed noncompetition, nonsolicitation and nondisclosure agreements. Instant is a professional staffing company whose sales people identified candidates looking for work in high tech fields, and companies looking to hire those candidates. The court noted that the professional staffing market is known for its robust competition and lack of client loyalty as reflected by the fact that companies seeking candidates and the candidates themselves frequently work simultaneously with multiple staffing entities and online services. Instant did not have an exclusive relationship with any of its clients, and could expect to earn a commission in only 10% of the situations in which it tried to place a prospective employee. Instant’s own workforce was subject to high turnover rates.

    DeFazio and the other defendants did not dispute that they breached the covenants not to solicit employees or to recruit Instant’s clients. The court found those provisions to be unreasonable and unenforceable under Illinois law, because Instant did not establish a protectable client relationship to support the restrictions.

    Post-employment restraints on employees are frequently supported on the ground that the employer has a legitimate business interest in preventing the former employee from appropriating the employer’s customer relationships developed over time and to which it devoted resources, and raiding staff in whom the employer made an investment to train. Because they are viewed as a restraint on trade and worker mobility, restrictive covenants must withstand close scrutiny, as set out in Wisconsin in Section 103.465, Wis. Stats. Restrictive covenants are lawful and enforceable only if the restrictions imposed are reasonably necessary for the protection of the employer. Wisconsin courts have interpreted that phrase to mean that an employer must be able to establish the following five elements in order to be enforceable.

    1. The employer must have a protectable interest in limiting competition;
    2. A non-competition agreement must contain a reasonable time limit;
    3. A non-competition agreement must contain a reasonable geographic limitation;
    4. The restrictions on the employee must be reasonable; and
    5. The restrictions must be reasonable to the general public.

    If a restrictive employment agreement fails to satisfy all five elements, or lacks “consideration” for the employee, a court may decline to enforce it.

    The District Court found, and the Seventh Circuit affirmed that Instant’s restrictive covenants did not serve a “legitimate business interest” because the tech staffing firm did not build relationships with its clients that would justify restricting its employees from setting up their own shops. Wisconsin employees in highly competitive industries where employers do not have an exclusive relationship with their clients, or the volume of customers is high, may have strong arguments that otherwise well-drafted restrictive covenants are unenforceable because the employer cannot demonstrate the first prong of the Section 103.465 test.

    Katherine L. Charlton
    Hawks Quindel, S.C.

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