Severed but Tethered:
The Restrictions and Implications of Post-employment Contracts
By Richard L. Hannah

Just as divorce often does not end the economic relationship of marriage, job termination does not necessarily end the economic relationship between employee and employer. To legally sever does not preclude an economic tether, which may be explicit (as in a written contract), or implicit (as in perceived constrains of employment options). This article explores that premise in the context of individual private contracting of post-employment covenants, also commonly known as non-compete agreements.1

Post—employment Controls
Post-industrial economic relations in the United States depend on knowledge-based markets. The perspective offered in this essay is that post-employment controls are emerging as an important contractual institution in the competition for knowledge workers. The increasing use of these types of contracts underscores employer belief in their potential as a practical mechanism to neutralize the competitive threat of labor mobility. Essentially, some types of information, knowledge, and human capital qualities accrued by the employee are made non-marketable. Thus, intended as a restraint of competition, post-employment covenants are somewhat incongruent with conventional theories of labor market efficiency and freedom. Nonetheless, they are legal within jurisdictionally diverse, common-law rules of reason exercised by state courts. Also, some states regulate this type of contracting with legislation designed to guide the courts.

The most commonly recognized limits placed on competition are government regulation, employer product-market monopoly power (or collusion), or power balancing institutions such as collective bargaining. The significance of this article’s exploration of post-employment covenants is to show how private contracting of non-compete agreements between the employer and employee may be an important addition to the labor market dimension of restraints to competition. Regarding post-employment covenants, economists would likely fall into two camps. One sees them as inhibiting labor market mobility, and hence, efficiency. The other follows the assumptions that information symmetry exists and free contracting has taken place, thus the market is efficient.

When post-employment contracts are believed breached, enforcement by courts is highly dependent upon the state of jurisdiction. If the decision favors the employer, remedies range from injunction to damages (economic losses). If the employee is favored, the contract may be declared void. Rules of reason in some states allow courts to strike (blue pencil) clauses contrary to law; others must void the entire contract when any part is unlawful. Another approach taken has been to guide courts by specific legislation. Examples include declaring all such contracts void, or specifically exempting professions such as physicians or broadcast personalities. These exemptions are often the result of intensive lobbying by professional associations or unions, or a declared public interest in excluding some professions, such as physicians—reflecting a societal value placed on maintaining the close and personal nature of health care.

Post-employment covenants are popularly known to apply to executives. However, court cases illustrate that a wide range of industries and occupations are subject to these restraints.2 Examples include sales, custodial services, pest exterminators, and beauty salon workers. This breadth reflects the widespread belief of employers that a former employee could economically harm their business by working for a competitor or starting a competing business.

Nevertheless, post-employment covenants for executives are very different from those for other workers in one respect, the compensation and benefits received after termination. These can be very substantial and shield the former executive from the need to participate in the labor market. If the covenant is breached, a clause usually is enforced that ends the post-employment compensation and benefits. Ample evidence of the details of such covenants can be found in the Edgar files of the Securities and Exchange Commission or through the user-friendlier onecle.com.

Prohibited Activities
The motivation of firms to require post-employment covenants is maintenance of competitive advantage, which in the legal context is referred to as a protectable economic interest. Prohibited activities of the post-employment relationship essentially bar the former employee from competing with the former employer, either as an employee with a competitor or by starting or having interest in a competing business. Common prohibitions specify the length of time enforced, the restricted geographic area of not competing, and the scope of the barred activities. The contract must be in writing, signed, and based on consideration (economic value), such as a pay increase, promotion, or specific human capital investment. In some states, continuing employment is sufficient consideration for a valid contract. Consideration is the bedrock of a legitimate exchange that compensates the ex-employee for limits on post-employment labor market freedom.

Post-employment contracts vary significantly within the restrictive categories. For example, geographic limits can range from a few miles to worldwide, and temporal limits can range from a few months to several years. Of interest in these two categories is how the firm views its competitive environment, and how courts have applied rules of reason to alleged breaches and employee contested restraints.The scope of prohibited activities requires a bit more elaboration. A model state law, the Uniform Trade Secrets Act, drafted by the National Conference of Commissioners on Uniform State Laws, governs the revelation of trade secrets. However, reference to related prohibited activities regarding trade secret protections is often made in non-competes. Otherwise, a reasonably inclusive list of other restraints is as follows:

1. Non-solicitation of ex-employer customers, clients, or patients;
2. Non-raiding of employees of the former employer;
3. Non-use of specific human capital derived from ex-employer investment;
4. Non-disclosure of confidential or proprietary information such as customer lists, production processes, marketing techniques, or pricing strategies; and
5. Non-participation, directly or indirectly, in ownership, partnership, or other economic interest in a competing firm.

How Pervasive?
Estimating the extent of post-employment agreements by observing court cases is much like judging the size of icebergs by looking above the water’s surface. All that can be observed is the cases before courts, while what remains hidden is much larger number of contracts in place and, if breached, settled out of court or simply never contested. In fact, Rachel Arnow-Richman maintains that the uncontested category is likely to be substantial due to the fear that employers are likely to generate among former employees by threatening legal action in the case of perceived covenant violations.3

Quantitative evidence describing the pervasiveness of post-employment covenants and related descriptive variables of interest, such as court outcomes, is scarce.4 Citations point to only the results of a limited survey, published in 1990, that identifies categories of occupations frequently cited in appellate court cases.5 In that study, Peter Whitmore analyzed 105 appellate court cases in an attempt to determine whether outcomes of court decisions regarding post-employment breaches were predictable. He concluded no predictability, but according to his occupational groupings of cases reviewed, the largest groups were sales (51 percent), middle management (14 percent), physicians (9 percent), and skilled labor (9 percent).

The two primary documents that catalog and update court cases concerning non-compete employment agreements are by Mark Filipp (2007) and Brian Malsberger (2005).6 These were produced for legal reference, generally following the logic of case law, and reconfiguring the data for empirical inquiry presents a considerable challenge. Nonetheless, a descriptive comparison between Malsberger’s data and Whitmore’s earlier study indicates an expansion of occupations subject to post-employment covenants.

For example, consider Table 1, illustrating the top four percentages by Whitmore (total of 105 observations) and Malsberger (total of 3,103 observations). The more recent Malsberger data reveal distinct categories such as attorneys, accountants, engineers, consultants, exterminators, and broadcasters, as well as a myriad of other occupations. The combined Whitmore and Malsberger data represent the essence of existing quantification relevant to the topic.

Research Questions
Published scholarship has generally been concerned with the implications of the spreading use of post-employment covenants and whether they are unnecessarily restrictive or overly broad in construction.7 This literature leaves us with several questions. For example, do employers require post-employment covenants even when there is a high probability that courts would not enforce them? The assumption is that employees who sign such contracts live under the threat of legal action and hence modify their labor market behavior to comply. Examples of compliance include not seeking employment opportunities in a given geographic area, or relocation out of the designated non-compete area. Hence, the derived question is whether there is a link between employment opportunities and post-employment covenants.

Other questions include the following. Do employees sign contracts with intentions of breaching or contesting the covenants in court in the future? Do employers actually preserve competitive advantage (or a degree of monopoly power) in product markets by requiring post-employment covenants? Do covenants effectively prevent human capital acquired during employment to be applied later during employment with a competing firm?8

To expand the descriptive boundary, the Filipp (2007) data were reformatted into approximately 1,100 records that contain the observations about the conditional language in post-employment covenants (e.g., geographic, temporal, and scope) and the court decisions as outcomes. The data cover all 50 states, the District of Columbia, and Puerto Rico. These data facilitate the derivation of descriptive statistics and suggest additional research questions and more fertile areas of inquiry. Researchers who have attempted to transform the text and logic of legal cases into quantifiable variables likely will not disagree with my assessment of the effort as akin to ungrinding sausage. The data are too simplified for conclusions, but they are offered to stimulate thought about the possibilities.

Question 1: Has use of post-employment covenants changed over time?
This is an important question because it touches on the idea of labor market freedom as contrasted to contractual instruments of control. A significant methodological challenge is to develop data sources that balance employee and employer views of whether post-employment covenants can be a workable compromise in our evolving information and knowledge-driven economy.

Table 2 presents the Filipp cases classified by decade with 1889 as the year of the earliest contract settled by a court. (Note that the full historical record is centuries long, with a traceable migration from English common law to U.S. common law.) The numbers of observations within the period discussed herein obviously reflect a wide array of influences, especially the maturing of common law and passage of state legislation in different eras. Yet, in the context of the nation as a whole, the totality of observations doesn’t indicate an explosive trend. However, the iceberg analogy applies. These data do not reflect out-of-court settlements, arbitrations, or uncontested breaches. Furthermore, the cases that make their way into the courts likely greatly underestimate number of contracts in place and their impacts on unobserved labor market behaviors that comply with or violate these contracts. Hence, a fertile area of research is one that that leans toward primary data collection and that better articulates the extent to which such covenants are used.

Question 2: Have the courts reasonably balanced the employer-employee power relationship?
That an individual employee is at a disadvantage in designing the contractual relationship with an employer is conventional wisdom. Common law takes this into account by considering the hardship worked on ex-employees and the right to pursue one’s profession. Also, employers must show a reasonable and well-defined, protectable economic interest to justify labor market restraints.

Reflecting both the power relationship and the legitimate economic interests of employers, Table 3 presents the decisions made by the courts throughout the historical period. Federal and state labor legislation should clearly be included in a quantitative model to test for causal shifts. Even within the limited boundary of cases, a separation of plaintiff or defendant as classified by employer or employee could further clarify motivation for enforcement or invalidation of the contracts. Nonetheless, as a gross historical perspective, the numeric results indicate that state courts have been reasonably balanced in decisions.

Question 3: Can human capital or information obsolescence be inferred?
This is an intriguing aspect of post-employment covenants because the period of competitive threat may serve as a proxy for information or human capital obsolescence. On one hand, it is arguable that to some extent employers reveal their view of how long an ex-employee may be a competitive threat through the time period specified in the post-employment covenant. On the other hand, in developing and applying reasonable and consistent standards to decisions about the time period, courts have influenced the limits of contracts being drafted. My rough estimate is that the life cycle of economic threat posed is about 2.5 years. This is based on 532 cases in which the time period was specifically given. However, the standard deviation was 1.90, reflecting a range of 3 months to 10 years.

Other interesting questions for further research are whether the time period exhibits significant trends historically or by occupational classification. Note that earlier contracts were often silent on the time period, or clearly stated “forever” or “no limit.” Courts have generally ruled against open-ended language.

Question 4: Can information be separated from knowledge?
The significance of this question is that courts have generally parsed the issues at hand in breach of contract cases into discrete categories. From a labor market perspective, people are viewed as couriers of information and/or couriers of knowledge (in a traditional human capital sense). Table 4 lists the categories form the Filipp source with my derived number of observations linked to the issues being decided. These are very tenuous because contracts often have multiple issues involved in a breach or contested validity. However, I draw the reader’s attention to the two very broad categories of information related and human capital related criteria (the last two). Identification and review of the specific contracts reflected in the latter division could be very insightful as to the qualitative dimensions of human capital “neutralization” in the post-employment context. Finally, the last entry’s language “advertising employee connection to business” is a niche, but involves a very interesting application regarding media personalities. In essence, product and human resource development become synonymous from the firm’s perspective of investing in creating a persona.

Question 5: Do firms accurately define their labor and product markets with post-employment restraints?
Information and knowledge-driven markets are also labor markets in the sense that these intangible qualities move with workers. Firms compete for these resources by offering higher compensation, but firms are also concerned by the exit of workers, and seek to restrict this talent from migrating to product-market competitors. The definition of geographic boundaries in post-employment covenants affords insights into the firm’s perceived labor-product market linkage.

Table 5 illustrates how such boundaries are commonly articulated. As with duration of time or activity restraints, courts rule on the reasonableness of the geographic dimension by considering factors such as whether the firm’s view of its market is overly broad, the denial of employment opportunities to the former employee, and public policy aversion to restraint of free trade. These are significant economic issues, and interestingly, states have approached them from very different, sometimes opposing, perspectives. For example, some states are permissive in post-employment contracting, and a few (such as California) declare them illegal.

Table 5 is derived from 153 cases that had specific geographic restrictions as measured by the distance of miles. This means that the former employees cannot compete within the defined boundaries. However, the boundary is not always clear. Examples include miles from a unique business location, or miles from any business or branch location of the employer. The range of miles was 1 to 600. In some covenants, additional, qualitative dimensions are included and indicate the nature of the occupation; “former territory,” for instance, generally includes sales (e.g., insurance) or specialized services (e.g., pest extermination).

Toward More Robust Research
My purpose herein has been to describe how post-employment covenants fit into the broader context of evolving post-employment relationships. The applications, or shortcomings, of human capital theory in this area are intriguing. Inquiry is confounded when we consider the interplay with intellectual capital, intellectual property, and control vs. ownership of resources. Even restraints of social capital (e.g., non-solicitation of former co-workers) have bearing. If we believe the pundits’ pronouncements that the 21st century will yield even more intensive competition for human capital in knowledge markets, then the importance of the post-employment relationship may gain more traction as a private contracting mechanism shielding firms from specifically defined competitive threats arising from labor market mobility.

There is a need for more empiricism about post-employment relationships. The most fruitful effort would be primary data collection, perhaps with the cooperation of employee associations or unions for which existing post-employment covenants have arisen as an issue during organizing drives. However, firms are unlikely to reveal the extent of use and nature of their contracts in a survey.

I close with a personal anecdote of importance from a teaching perspective. I have discovered post-employment covenants are a hot topic among my graduating seniors who are being recruited, and among my MBA students who often bring personal examples to the classroom for discussion. These students are quite stimulated by this practical topic and the way it intersects with employment terms and conditions, labor market theory, and personal experience.9

Notes

1. To preserve brevity, legally required post-employment economic relationships, such as COBRA and ERISA, are not discussed in this article. These are not within the individual private contracting category. In the collective-bargaining context, meanwhile, the post-employment economic relationships are typically of a different and now declining quality (e.g., retiree health care). There is scant evidence of individual non-compete contracts in the collective-bargaining setting. Finally, legal settlements within the boundary of legislated flexibility (e.g., Workers Compensation) or a result of individual ex-employee actions (e.g., wrongful discharge) are also omitted from this discussion.
2. The full text of such decisions is available via keyword searches on the LexisNexis Academic database.
   
3. See Arnow-Richman, Rachel. Fall 2003, “Noncompetes, Human Capital, and Contract Formation: What Employment Law Can Learn from Family Law,” 10 TEX. Wesleyan L. Review 155.
   
4. See Bishara, Norman D. 2006, “Covenants Not to Compete in a Knowledge Economy: Balancing Innovation from Employee Mobility Against Protection for Human Capital Investment,” Berkeley Journal of Employment and Labor Law 287.
   
5. See Whitmore, Peter J. 1990, “A Statistical Analysis of Noncompetition Clauses in Employment Contracts,” 15 Journal of Corporation Law 483, 485.
   
6. See Filipp, Mark, Covenants Not to Compete (Frederick, MD: Aspen Publishers, 2007); and Malsberger, Brian M. (ed.) 2005; and Covenants Not to Compete: A State-by-State Survey, 5th edition (Washington, DC: BNA Books, 2005)
   
7. Recent examples include: Garrison, Michael J. and John T. Wendt. Spring, 2008, “The Evolving Law of Employee Noncompete Agreements,” American Business Law Journal (45 Am. Bus. L.J. 107); Dawson, Peter C. September, 2007, “The Economics of Valuing Covenants Not to Compete Under the Fair Market Value Standard,” Journal of Legal Economics (14 J. Legal Econ. 25); and Glick, Mark A., et al. 2002, “The Law and Economics of Post-Employment Covenants,” George Mason Law Review 357.
   
8. The human capital issue centers not only on the practicalities of separating general and specific training, but on how knowledge embedded in workers can be separated from their awareness of competitive information, such as customer lists. These theoretical and practical tensions are described in the following: Arnow-Richman (see note 3 above); Posner, Eric A., George G. Triantis, and Alexander J. Triantis, “Investing in Human Capital: The Efficiency of Covenants Not to Compete,” Extracted from SSRN Working Paper Series (ssrn.com), January 2004; and Rubin, Paul H. and Peter Shedd, “Human Capital and Covenants Not to Compete.” The Journal of Legal Studies (1981) 10: 93-110.
9. The author wishes to thank two anonymous referees whose many helpful suggestions were incorporated into this essay.

Richard L. Hannah is professor of economics at Middle Tennessee State University, and Director for MTSU's Center for Economic Education. With a PhD in Economics from the University of Utah, he has extensive teaching, research, and practical experience. He teaches Employment Relations, Employee Benefits, Managerial Economics, and other economics courses. His research has primarily concerned labor markets, pension systems, compensation systems, e-commerce, and e-education. His practical experiences range from Fuel Economist to Rate Analyst and HR Director, with organizations like the Tennessee Valley Authority. He has also served as the Local Union President for the TVA Engineering Assn.

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