Wisconsin Lawyer
Vol. 79, No. 5, May
2006
Protecting Business Interests With Covenants Not to
Compete
A buyer of a business often will want to
prevent the seller from competing with the buyer, and employers often
want to prevent employees from using resources and information gained
from the employer in competing against the employer. Read about the
characteristics of each form of covenant in both the sale of a business
context and in the employment context, and learn how Wisconsin law
affects the enforceability of such agreements.
Sidebar:
by James W. McNeilly Jr., & Darla A Krzoska
any Wisconsin attorneys encounter covenants
not to compete,
most often in one of two contexts: employment relationships and sales of
businesses. In the business sale context the noncompetition agreement is
directed at preventing the seller from competing with the buyer. In the
employment context, the agreement is directed at preventing employees
from competing with their employers using resources and information
provided by the employer or gained from the employment.
Covenants not to compete usually take one of three forms:
1) "traditional noncompetes," which prohibit the involvement with a
competing business, for a specified period of time, within a defined
geographic area;
2) "nonsolicitation" agreements, which prohibit the solicitation of a
business's customers; and
3) "confidentiality agreements," which prohibit the use of
information a business wants to keep private.
Each of these types of agreements often is referred to generically as
a "noncompete," however, this article uses the phrase "covenant not to
compete" when referring generically to all of these agreements,
regardless of the type.
This article explores the characteristics of each form of covenant
not to compete and how Wisconsin law affects the enforceability of such
agreements. This article is merely an overview; lawyers should read the
case law in depth to obtain a complete understanding of the subject.
James W. McNeilly Jr., U.W.
1981, is managing director of Lakelaw Wisconsin, with an office in La
Crosse and one to be located in Kenosha. He focuses on business law,
including real estate, creditor-debtor, and estate planning.
Darla A. Krzoska, U.W. 1998, is
with Bosshard Parke Ltd., La Crosse, where she focuses on business law,
real estate, estate planning, and probate.
The Employment Context
Employee covenants not to compete are governed by Wis. Stat. section
103.465. The statute provides:
"A covenant by an assistant, servant or agent not to compete with his
or her employer or principal during the term of the employment or
agency, or after the termination of that employment or agency,
within a specified territory and during a specified
time is lawful and enforceable only if the restrictions imposed
are reasonably necessary for the protection of the employer or
principal. Any covenant, described in this subsection, imposing an
unreasonable restraint is illegal, void and unenforceable even as to any
part of the covenant or performance that would be a reasonable
restraint." (Emphasis added.)
Soon after the enactment of section 103.465, the Wisconsin Supreme
Court, in Lakeside Oil Co. v. Slutsky,1 set forth a five-part test for the enforceability
of a covenant not to compete in the employment context.
1) Is it necessary for the employer's protection?
2) Does it provide for a reasonable time period?
3) Does it cover a reasonable territory?
4) Is it unreasonable as to the employee?
5) Is it unreasonable as to the general public?
The following cases provide guidance on the application of each of
these
factors. In Wausau Medical Center S.C. v. Asplund,2 the Wisconsin Court of Appeals stated that the
following
factors will make it more likely that a covenant will be found to be
necessary for the former employer's protection: 1) the business is based
on customer contacts; 2) the employee has access to confidential
information; 3) the employee's reputation was established through work
with the former employer; and 4) the employee obtained unique skills
through the work with the former employer.
Many cases have indicated that two years or less would be a
reasonable duration for a covenant.3
Similarly, many cases have determined that the geographic limitation
should be limited to the area of the employer's business.4
In Rollins Burdick Hunter of Wisconsin Inc. v.
Hamilton,5 the Wisconsin Supreme Court
stated: "[a]s to whether the [covenant] is unreasonable to the employee,
we do not see how such a determination could be made without considering
the extent to which the [covenant] actually inhibits the employee's
ability to pursue a livelihood in that enterprise, as well as the
particular skills, abilities, and experience of the employee sought to
be restrained."
In determining whether the covenant is unreasonable as to the general
public, the court will consider factors such as whether enforcing the
covenant would stifle competition or create a monopoly, and whether
there are customers of the employee who want to deal only with that
individual and not the former employer.6
Even if a covenant not to compete passes the five element test
outlined in Lakeside and in Wis. Stat. section 103.456, the
employee also must be given adequate consideration in exchange for
signing the covenant.7 The
provision of new employment to a potential employee would, of course,
constitute "consideration." However, when an employer requests a current
employee to sign a covenant not to compete, there is a question of
whether the mere continuation of employment constitutes consideration or
whether some additional consideration is necessary. In NBZ Inc. v.
Pilarski,8 the court of appeals
suggested (but did not definitively state) that additional consideration
might be necessary. While some states find that continued employment is
not adequate consideration for a covenant not to compete,9 other states have found that continued employment
can be adequate consideration under certain circumstances.10
It is important to note that unlike other states, in Wisconsin an
employee may be terminated for refusing to sign a covenant not to
compete. In Tatge v. Chambers & Owen Inc.,11 an employee was terminated for failing to sign a
covenant and sued the employer for wrongful discharge, alleging that the
covenant was not enforceable. The Wisconsin Supreme Court refused to
create a cause of action for wrongful discharge, stating that the time
of enforcement of the covenant, not the time of its execution, is the
proper time to consider the validity of a covenant.
Employers outside Wisconsin sometimes include a choice of law
provision that applies the laws of a state other than Wisconsin in a
covenant not to compete to be used with Wisconsin employees. In
Beilfuss v. Huffy Corp.,12 the
Wisconsin Court of Appeals held that public policy concerns about the
covenant provisions trumped the choice of law provision, and the court
required the application of Wisconsin law.
Wis. Stat. section 103.465 has also been applied in situations other
than the traditional employer-employee relationship. The statute has
been applied to a covenant involving an independent contractor and has
been used to void a provision in a profit sharing and retirement plan
and to strike down an agreement between two parties who did not have an
employer and employee relationship.
In Pollack,13 the Wisconsin
Court of Appeals, after applying the rules set forth in Wis. Stat.
section 103.465 and cases decided thereunder, upheld a covenant
involving an independent contractor.
In Holsen v. M&I Bank,14
the operative provision was part of a profit sharing and retirement plan
and stated that an employee "who intends to engage directly or
indirectly" in a competing business shall receive only 50 percent of his
or her vested benefits. The Wisconsin Supreme Court held that the
provision violated Wis. Stat. section 103.465, because it contained no
time or area limitations as the statute required.
In Heyde Co. v. Dove Healthcare LLC,15 the supreme court held that two employers cannot
agree to restrict employment of each other's employees through a no-hire
provision, without the consent of the employees. The court held that
such a provision is an unreasonable restraint of trade, a violation of
Wis. Stat. section 103.465, and a violation of public policy. However,
the court stated that "[the plaintiff could have] adequately protect[ed]
its interest through a reasonable restrictive covenant in accordance
with Wis. Stat. § 103.465."16
Traditional Noncompetes
The first covenants not to compete typically were "traditional
noncompetes," as referred to in this article. Wis. Stat. section 103.465
and the cases decided soon after its enactment in 1957 concern such
agreements. Basically, these covenants prohibit the employee from
competing in a business similar to that of the employer's, for a
specified time, and within a specified geographic area. Therefore,
traditional noncompetes are best used for businesses with local,
well-defined customer bases.
Most often, the issues in cases involving traditional covenants not
to compete revolve around whether the employer has a protectible
interest and whether the covenant is reasonable as to territory. For
example, in Lakeside Oil Co., the court found that the employer
had a protectible interest because the employee had been hired to
develop customers for the employer. The court found that the territorial
provision, which prohibited the employee from competing in Milwaukee
County, was reasonable, because 75 percent of the employer's business
was derived from that county.
In Wausau Medical Center, the employee signed a traditional
noncompete. The court found that at the inception of employment the
employer had a reasonable expectation of a protectible interest, because
the employment would provide the employee with a client and referral
base and would enhance the employee's reputation. However, the court
refused to enforce the covenant, because the employee had only worked
for 3.5 months and had not received many referrals from the employer.
Therefore the employer had not yet acquired a protectible interest when
the employment was terminated.
In Pollack, the plaintiff (Pollack), an osteopathic
physician, signed a traditional noncompete with a clinic. The agreement
prohibited him from engaging in the type of business (pain relief)
conducted by that clinic within a 20-mile radius of Racine. The court
found that the clinic had "expended considerable time, effort and
advertising to generate new patients, most of whom were referred to
Pollack," and that the clinic contributed to Pollack's expertise in pain
management.17 The court further found it
reasonable to believe that: many of the clinic's patients would have
followed Pollack to a new location; Pollack had full access to the
clinic's extensive patient lists; and "the protection of a business's
stock of customers is a legitimate interest for the employer."18 Based on those facts, the court found that the
clinic had a protectible interest. Also, while the "bulk" of the
clinic's patients lived within five to seven miles of the clinic, the
court found that the advertising "generated numerous patients from
within a twenty-mile radius of Racine," making the territorial limit
reasonable.19
Confidentiality Agreements
Confidentiality agreements prohibit the employee from disclosing or
using certain information provided by the employer. Wis. Stat. section
103.465 applies to confidentiality agreements.20 In addition to meeting the requirements of the
five-part Slutsky test, the drafter of a confidentiality
agreement also must define what information is to be kept
"confidential."
For purposes of this discussion, information that employers attempt
to keep confidential may be divided into two categories: 1) information
that qualifies as a trade secret under Wis. Stat. section 134.90,
Wisconsin's Uniform Trade Secrets Act, and 2) information that does not
so qualify.
The Uniform Trade Secrets Act, in contrast to Wis. Stat. section
103.465, protects trade secrets without any time or geographic limits,
presumably because trade secrets may be used anywhere in the world to
compete with a former employer, and oftentimes will not lose their
character as trade secrets, even over an extended period.
However, it is important to note that information that does not
qualify as a trade secret sometimes also may be used anywhere in the
world by a former employee to compete with a former employer, even after
the standard two-year limit of a covenant not to compete has
expired.
Some forms of confidentiality agreements attempt to use the same
language to protect both the trade secret information and the
information that does not qualify as a trade secret. Such an agreement,
if it complies with the requirements of Wis. Stat. section 103.465 by
including time and geographic limits, fails to fully protect the
employer from unfair use of the trade secret information. If the
agreement omits time and geographic limits so as to fully protect the
trade secret information, the agreement potentially is unenforceable
under Wis. Stat. section 103.465.
Other confidentiality agreements treat the trade secret information
separately from the nontrade secret information. The prohibition on the
use of trade secrets in these agreements contains no time or geographic
limitations. The prohibition on the use of the nontrade secret
information contains time and geographic limitations. Although this form
of agreement protects against the misuse of the trade secret
information, it fails to protect the employer against the detrimental
misuse of the nontrade secret information anywhere in the world or after
the time limit expires even when such use would harm the employer.
It is important to note that in IDX Systems Corp. v Epic Systems
Corp.,21 the Seventh Circuit Court of
Appeals stated that Wisconsin law does not require time or geographic
limits for confidentiality agreements that involve intellectual
property, even though intellectual property does not rise to the level
of a trade secret. Although IDX Systems did not involve an
employer/employee relationship, the court implied that requiring such
limits on the prohibition of the use of such property in an
employer/employee relationship also would not make sense, stating: "it
is impossible to understand how a non-disclosure agreement could place
`geographical' limits on the dissemination of intellectual property
comparable to those restricting the locale where a salesman may try to
drum up customers for a new employer," and "knowledge does not respect
borders."22
Nonsolicitation Agreements
Nonsolicitation agreements typically prohibit the employee from
contacting or servicing the former employer's customers for a set period
of time after the termination of employment.
Chuck Wagon Catering Inc. v. Raduege23 is one of the early cases involving the
nonsolicitation of customers. In Chuck Wagon, the
nonsolicitation clause prohibited a lessee from soliciting customers
along the lessee's route for one year after termination of the lease.
The Wisconsin Supreme Court, after applying the Wis. Stat. section
103.465 requirements to the nonsolicitation covenant, upheld the
covenant even though it contained no geographical limitation per se. The
court stated "[in] Wisconsin a covenant is considered reasonable as to
territory if, like this covenant, it is limited to the route or
customers defendant actually services."24
Similarly, in Farm Credit Services of North Central Wisconsin ACA
v. Wysocki,25 the Wisconsin Supreme
Court found that even without such a geographic restriction, a covenant
that prohibited an employee from performing accounting and tax services
for customers the employee serviced in the one year before termination
of employment was not invalid on its face, because the covenant was
narrowly tailored to a customer list.
However, limiting the covenant to a customer list is not always
enough. In Mutual Service Casualty Insurance Co. v.
Brass,26 the Wisconsin Court of
Appeals held that a covenant prohibiting an employee from contacting any
of the employer's customers, whether known or unknown, anywhere in the
world, was unreasonable. Additionally, in Equity Enterprises Inc. v.
Milosch,27 the court of appeals
refused to enforce a nonsolicitation clause that prohibited the employee
from doing business with any customer of the employer with whom the
employee had done business at any time during his
employment.
The courts in the cases following Chuck Wagon examine the
reasonableness of a particular nonsolicitation agreement by defining the
customers the former employee is being prohibited from contacting in
terms of a geographical or territorial limitation. As more
fully explained in the article "Wisconsin Courts Struggle with Geography
in Nonsolicitation Agreements,"28
"discussions of territorial scope are generally irrelevant in assessing
the reasonableness of a nonsolicitation agreement. All nonsolicitation
agreements contain an implicit limit to their geographic scope." As the
article authors make clear, with nonsolicitation agreements, viewing
customers in terms of a geographic limit is at best, unnecessary, and at
worst, unworkable. The language in the cases after Chuck Wagon
has misled some practitioners into believing that to be enforceable, a
nonsolicitation agreement must contain a geographical limitation that is
separate from the list of customers the employee is prohibited from
soliciting.
No matter how the limitation is defined, in terms of territory or
otherwise, it is imperative to narrowly define exactly which customers
the employee is prohibited from soliciting after employment is
terminated.
Enforcing Employee Covenants Not to Compete
In addition to the stringent requirements set forth in Wis. Stat.
section 103.465 and the cases decided thereunder, the supreme court in
Farm Credit Services29 stated:
"Consistent with encouraging the free movement of employees, we have
applied the following canons of construction to covenants not to
compete: (1) such covenants are prima facie suspect; (2) they must
withstand close scrutiny to pass legal muster as being reasonable; (3)
they will not be construed to extend beyond their proper import or
further than the language of the contract absolutely requires; and (4)
they are to be construed in favor of the employee." The employer bears
the burden of proof as to the covenant's enforceability.30
Businesses that hire employees who have signed a previous employer's
covenant not to compete can be sued for intentional interference with
contract. The following are essential elements of intentional
interference with contract in this context: 1) The covenant not to
compete was a valid contract between the employee and the former
employer. 2) The new employer interfered with the covenant not to
compete. 3) The interference was intentional. 4) The interference caused
damage to the former employer. 5) The interference was not
justified.31
Sometimes an employee will sign a covenant not to compete without
reading it, relying instead on the employer's or manager's
misrepresentations as to its true nature. In Bank of Sun Prairie v.
Esser,32 the Wisconsin Supreme Court
held that a party who signs a contract without first reading it is not
barred from claiming fraud in the inducement. The elements of a
fraud-in-the-inducement as a defense to an action to enforce a covenant
not to compete are: 1) the person presenting the document for signature
misrepresented the document's substance and significance; 2) the
employee relied on the misrepresentation; and 3) the reliance was
reasonable.33
Another defense to an action to enforce a covenant not to compete is
that the employer's actions constituted a breach of the contract. For
example, an employer might give an employee a raise concurrent with
requiring the employee to sign a covenant and then later reduce the
employee's compensation. If the employer's breach of the employment
contract is material, the employee may successfully defend against an
action to enforce the covenant not to compete.34
If the court finds a covenant to be valid, the court may award actual
damages. Many covenants provide for liquidated damages, which, if not
penal in nature, may be awarded.35 If by
breaching the covenant the employee violates the Uniform Trade Secrets
Act, the court also may award damages for actual losses and unjust
enrichment.36
The court also may enjoin the employee from violating the covenant.
Injunctions are considered a reasonable and necessary means to enforce
the covenant.37 In recognition of the fact
that the employee may have the ability to damage the employer's business
during the pendency of a case, the employer often moves for a temporary
injunction. The court will grant the injunction if the employer can show
that it has a reasonable probability of success on the merits, has no
adequate remedy at law, and will suffer irreparable harm if an
injunction is not issued.38 The temporary
injunction hearing often becomes the real "day of reckoning." If the
employer prevails at this hearing, even if the covenant is later held to
be unenforceable, the employee is enjoined from competing until the
trial, which often is not held until several months later. As a result,
the employee usually cannot work for the new employer and may have
financial difficulty proceeding with the case. The fear of this result
often convinces employees not to compete with former employers.
The Sale of Business Context
Buyers of businesses almost invariably desire to prevent the seller
from competing with the business the buyer is purchasing. As a result,
most sale-of-business agreements provide for the seller to execute a
traditional noncompete covenant, although the buyer could require the
seller to execute one of the other types of covenants not to compete.
Many sales involve businesses that have local clientele (for example,
accounting offices and taverns). The traditional noncompete is well
suited to protecting the buyer's interests with these types of
businesses, because it prohibits the seller from competing within the
area customarily served by the business being sold for a period of time
long enough for the buyer to establish a relationship with the seller's
former customers.
Although traditional noncompete covenants used in the business
context very often are worded in a manner similar to those involved in
employment relationships, Wis. Stat. section 103.465 is not applicable
to the sale of a business. In Reiman Associates Inc. v. R/A
Advertising Inc., the Wisconsin Court of Appeals set forth the
criteria by which a covenant not to compete would be judged:
"If a covenant not to compete is unreasonable, it is unenforceable.
Whether such a covenant is reasonable is a matter of law to be
determined from the writing, and is determined `with reference to the
particular case.' In determining reasonableness, the court must examine
whether the covenant is (1) reasonably necessary for the protection of
the beneficiary; (2) reasonable as between the parties, and particularly
as to the party restrained, considering time, space, purpose, and scope;
and (3) not specially injurious to the public.
"Covenants not to compete incidental to the sale of a business are
not subject to exacting scrutiny.... Additionally, covenants
incidental to the sale of a business benefit from full application of
the rule of partial enforcement: even an unreasonable restraint will be
enforced to the extent necessary and reasonable under the
circumstances."39
Determining whether a covenant not to compete pertains to an
employer-employee relationship or to a business sale context is crucial
to determining the covenant's validity. In Corporate Express Office
Products Inc. v. Brown,40 the U.S.
District Court for the Western District of Wisconsin applied different
standards to a covenant not to compete between the parties to the sale
of a business than it applied to a covenant not to compete, between the
same parties, that was contained in an employment agreement, even though
the language of both covenants was essentially the same. The court held
that the covenant not to compete incident to employment was
unenforceable but then partially enforced the agreement incident to the
sale.
Conclusion
Wis. Stat. section 103.465 and the case law decided under it impose
severe restrictions on the terms of covenants not to compete used in
employment contexts. The statute and cases set forth stringent
requirements that the covenant must meet to be enforceable. If the
covenant is unreasonable even in part, the statute and the case law
require the court to void the entire covenant; the court is powerless to
enforce those parts of the covenant that are reasonable or to amend the
covenant so that it is reasonable.
The case law on traditional noncompetes has developed in a way that
makes it relatively easy to draft such covenants. A traditional
noncompete, however, does not fully protect an employer whose customers
do not come from a well-defined local area, much like the customers of
many Internet-based businesses. Unfortunately, the statute appears to
have been drafted with traditional noncompetes in mind, and thus the
statute does not fit confidentiality agreements or nonsolicitation
agreements nearly as well. As a result, the cases deciding the validity
of confidentiality and nonsolicitation agreements often are confusing.
Finally, even though confidentiality and nonsolicitation agreements
appear to be less of a burden on the employee compared to a traditional
noncompete (because they do not prohibit the employee from opening a
business in the same area as the employer, and thus do not require the
employee to move), Wisconsin courts have been just as strict in their
analysis of confidentiality and nonsolicitation agreements as in their
analysis of traditional noncompetes. It is significantly more difficult
to draft enforceable confidentiality and nonsolicitation agreements due
to the combination of a governing statute that is not directed at these
agreements, confusing case law interpreting those agreements, and
stringent court review.
In contrast, the restrictions on covenants involved in the sale of a
business are significantly less stringent, and the courts will almost
always enforce such covenants as drafted. Even if the covenant is
unreasonable as drafted, the court has the power to enforce the covenant
"to the extent necessary and reasonable under the circumstances."41
Endnotes
Wisconsin Lawyer