Dave Neal – VC

Current Problems with Non-Competes In The US

In my previous post, we discussed how we got to the present situation where 47 of 50 U.S. states allow some form of non-compete agreements. Let’s now take a look and how the underpinnings of these laws are being challenged.

Non-compete agreements have never been popular with anyone except employers. Most employees don’t read the agreements but if they did they would likely be offended by the notion that they can’t make professional moves freely if such moves take them to a competitor of their current employer. Enforcement and use of non-competes has gotten more harsh in recent years. A recent New York Times article by Steve Lohr focused attention on a couple such situations.

The article highlights the travails of Brian Conolly, an engineer who lost his job at a diagnostic device company in a layoff during the 2008 financial crisis. This fellow met with a potential new employer after the layoff. He soon received a call from his prior company informing him that his non-compete prohibited him from joining any firm in the diagnostic device space. In this case the product and the underlying technology were different from his previous employer. Despite these facts Conolly was forced to take work outside his field until the expiration of the one year non-compete.

Does this seem reasonable to you? It doesn’t to me. The company laid off Mr. Conolly. in that situation there’s a question of basic fairness in the decision of whether to enforce the non-compete. Most employees sign non-disclosure agreements in addition to the non-compete. These NDA’s also prohibit the disclosure or use of confidential information on behalf of the new employer without limiting the ability to obtain appropriate employment. Conduct damaging to the prior employer could be addressed via the NDA, especially in the situation where the employee left the prior employer without fault at the company’s behest.

It’s not difficult to understand why companies with sophisticated technology want to protect it using tools like non-competes. How about sandwich shops? Believe it or not, Jimmy John’s has received a ton of negative publicity due to the fact that they required low-wage employees in their shops to sign non-competes that prohibited them from working in any sandwich shop within 2 miles of a Jimmy John’s anywhere in the U.S. What kind of information does a sandwich shop need to protect? How can that be reasonable in view of the fact that a  line worker at Jimmy John’s is prohibited from making money at nearby sandwich shops? The answer: It’s not. Jimmy John’s recently dropped this requirement for its employees after at least one state sued them to limit this practice.

It’s easy to understand why companies that spend a lot of money to create intellectual property wish to protect it. It’s another thing altogether when people who are laid off are prevented from employment in companies with non-competitive products or when fast food workers are prohibiting from changing jobs or adding a second job. Both of those cases take the concept of non-competes too far and explain why opposition to non-competes is coalescing.

Shaky Ground Under Non-Compete Agreements – Changes Afoot?

Non-compete agreements have been a fixture in the employment relationship at tech companies for a long time. Most involved have accepted these agreements as a normal part of doing business in the tech industry. Recently, legislatures and others have started to scrutinize the economic effects of non-compete agreements. Many of the people who have looked at the question have advocated elimination or restrictions on non-competes. They argue that non-competes often run afoul of basic fairness and that they are inhibitors on the economic progress of a state.

How did these agreements come into being in the first place? When a company hires someone the new employee is brought into the company and is brought into a circle that has access to special knowledge and know-how. The company has invested time and capital into the creation of that knowledge and know-how. Therefore, it’s reasonable that the company can forbid you from using that know how against the interests of the company.  Courts have protected this interest long before the advent of the technology industry.

At the same time, the courts have never given companies unlimited power with regard to non-competes. It’s always been necessary to make sure that these agreements are limited as to time, geographic scope and industry classification. But even these types of “reasonableness” tests have been questioned of late. Since non-compete agreements limit the ability of a person to pursue a trade or profession they can actually limit the amount of competition in specific labor market sectors.  Studies suggest that non-competes suppress wages by at least a few percentage points. There are enough questions to ask whether non-compete agreements should be used as heavily as they are today.

California is perhaps the most innovative state in the U.S. Non-compete agreements are essentially impossible to enforce in California. In the tech industry this fact has created one of the world’s most fluid and dynamic labor markets. Companies in Silicon Valley compete very hard to lure and maintain the best talent. The inability to impede the movement of workers between firms forces firms to keep their employees happy. This ability to move between companies also facilitates the dissemination of many types of specialized “know how”, making all the companies in a sector stronger as that knowledge is spread and put to use. Some theorize that this is one of the factors behind the creation and growth of the Silicon Valley.

According to the Wall Street Journal, as of May 2016 47 out of the 50 states allow non-compete agreements “most or all of the time”. How did California avoid this policy and end up with the world’s most impressive innovation engine with its borders? Part of it is sheer good fortune. In 1847 the State of New York engaged an attorney to codify the laws of the courts in that state. This codification was never adopted in New York but a a newly-admitted state California wanted to enforce standard laws across its territory. It adopted the New York codification. Part of it was the predecessor to California Business and Professions Code Section 16600 which provides:

16600.  Except as provided in this chapter, every contract by which
anyone is restrained from engaging in a lawful profession, trade, or
business of any kind is to that extent void.

Obviously, a non-compete restrains a person from engaging in a lawful occupation. For more than a century and a half this has been unlawful in California.