Covenants Not to Compete and Trade Secrets: Protecting Your Company Against Unfair Competition

It always seems to happen when you least expect it.  Employment ends for a valuable worker who soon transforms into the corporate version of Benedict Arnold. But instead of a country, it’s a company being betrayed – and instead of military secrets, it’s financial data, customer lists, marketing strategies or other confidential information being taken or used.  Not to mention the act of suddenly going to work for a direct competitor.

So management meets and the question is asked:  “Can we stop this?”  The answer, of course, is usually the truest words spoken in trade secret and covenant not to compete law:  “It depends.”

There are two main strategies to protect a company against unfair competition and the misappropriation of trade secrets.  First is the more traditional approach of using and enforcing covenants not to compete – also known as noncompetition or noncompete agreements – which often include confidentiality and nondisclosure provisions as well.  Second is implementing a trade secret protection program, or at least taking reasonable steps to preserve the secrecy of confidential information, so you can at least argue the information is a “trade secret” when litigating a misappropriation claim in the future.

Both strategies have advantages and disadvantages, and depending on the circumstances, can be quite valuable in protecting customers and confidential corporate information.  This article provides a general overview of the most critical points for companies to be aware of in this rapidly developing area of law.

Covenants Not To Compete

Contrary to popular belief, covenants not to compete are enforceable in North Carolina and most states.  The key is whether they’re in writing, signed by the employee, supported by valuable “consideration” (such as new employment, a monetary payment or other tangible benefit), reasonable as to time and territory, and whether they satisfy any other particular requirements of the applicable state.  But it is also true that courts consistently look for ways to defeat noncompete agreements, placing the factual and legal burden squarely on the company to have drafted and executed these restrictive covenants in a proper manner.  If so, then the chance of enforcement is usually good.  If not, then count on a difficult time before a judge or jury.

Assuming that valuable consideration has been provided through the act of employment or another form of payment, the critical inquiry is whether a noncompetition agreement protects only the “legitimate business interests” of a company.  This inquiry is extremely fact-specific, and is usually a function of whether the time and territory restrictions, and any definitions of “competition,” are reasonable enough to enforce or unenforceable due to being unreasonably broad.  As a general rule, time and territory are considered in tandem, with the longer the time period the smaller the territory in order to be valid – and vice-versa.  In North Carolina, two years is usually considered the outer limit for an enforceable covenant not to compete in the employer-employee context, and the geographical territory should usually be tailored to only where the company actively conducts a significant amount of business.  In addition, North Carolina law has developed in such a way that former employees should only be restricted from actually working in those areas of their new employer that are actually competitive with the former employer, and preferably to only those areas of business in which the employee was formerly actively engaged.

Closely linked to noncompetition agreements are “nonsolicitation” restrictive covenants.  These are often part of the same written agreement, but can also be executed independently or instead of a more traditional noncompete.  Nonsolicitation agreements usually protect against a former employee soliciting to sell or selling to a company’s customer base for a limited period of time (two years again being a general maximum), with the key legal inquiry being: (1) whether the customers at issue are narrowly enough defined; (2) whether the activity being prohibited is truly competitive in nature; and (3) whether the former employee actually had material contact with the customers, or at least held a high enough position in the company (such as a vice president of sales) to where he or she regularly received confidential information regarding them, or had broad authority over other employees responsible for soliciting them.

As with noncompete agreements, the more limited the restriction the more likely a nonsolicitation agreement will be enforceable.  Unlike noncompete agreements, however, nonsolicitation restrictions usually do not require a geographical territory – rather, they’re primarily based on where the company’s customers are located.  In this sense, many courts consider nonsolicitation agreements to be a more limited, and therefore more enforceable, form of restrictive covenant, provided of course that the other requisites for an enforceable agreement are met.

Unfortunately for companies, what may be reasonable and legitimate in one set of circumstances may be quite unreasonable and illegitimate in another.  This inquiry is also governed by state law, which can be a hidden trap for multi-state corporations that use “form” noncompete agreements, as what works in one state might not work in another.

As a general rule, multi-state covenants not to compete should be avoided in favor of state-specific agreements – or at least fine-tuned for a specific state’s law if they’re used.  However, if a single format is implemented, the noncompete agreement should be drafted to satisfy the law of the most conservative state – i.e., the state where it is most difficult to enforce them.  In short, if that state’s requirements are satisfied, then odds are the requirements of less restrictive states will also be met.  But since taking this approach may sacrifice certain restrictive covenant goals that are quite valid in other states, extra care should be given to help ensure that the concern for enforcement in general does not override any critical interests which might justify state-specific formats.

If the noncompetition agreement has confidentiality and nondisclosure provisions, this can also be a helpful avenue for protecting trade secrets.  That way, even if the noncompete portion of the agreement is for some reason unenforceable, the confidentiality section might remain in effect and provide another type of breach of contract action for protecting the company.

But what happens when there is no covenant not to compete?  Or when the noncompete agreement and its confidentiality provisions are unenforceable or not comprehensive enough to adequately protect the company?  Enter the world of trade secret protection – a rapidly growing area of intellectual property law that’s usually quite separate from the traditional intellectual property fields of patent, trademark and copyright law.

Trade Secret Protection

Trade secret law frequently overlaps with enforcing covenants not to compete, but is so distinct that it can and often does stand alone.  In fact, if trade secrets truly are at issue, it can be the preferred avenue for litigation, especially in light of a poorly drafted or improperly executed noncompete agreement that probably is not enforceable.

Unlike covenants not to compete, which are usually governed by a state’s common law, trade secret law is often governed by statute.  In fact, all but two states have now adopted some version of the Uniform Trade Secrets Act, including North Carolina.  Unlike covenants not to compete, a written agreement is helpful but not required to protect trade secrets.  Therefore, trade secret law has much more flexibility than litigation involving covenants not to compete — assuming, of course, that you can prove trade secrets actually exist and have been misappropriated.

On this point, think of the Venn diagrams you probably learned in ninth grade geometry.  Then place a small circle consisting of trade secrets within a larger circle of information your company considers confidential and proprietary.  This illustrates the first key principle in trade secret law:  All trade secrets are confidential, but not all confidential information is a trade secret.  Which directly leads to the second key principle:  No matter how confidential the trade secret, if not properly cared for and protected it may lose its “trade secret” status.

Although case law varies as to what constitutes a “trade secret”, courts have generally held that it can include such diverse information as pricing, cost and other financial data, marketing strategies, product design information, research & development, feasibility forecasts, compilations of commonly known information into a unique formula, and in certain circumstances, even customer lists.  In short, trade secrets can consist of virtually any information, process, method or system if it has “independent actual or potential commercial value” and reasonable steps have been taken to preserve the very secrecy from which its value derives.

Once a trade secret is proven, then for legal action it must also be “misappropriated.”  Again, what constitutes misappropriation varies according to state law.  Typically, misappropriation is defined as the acquisition, disclosure or use of someone else’s trade secret through improper means or at least without express or implied authority or consent – unless the trade secret was arrived at by independent development, reverse engineering, or was obtained from another person with a right to disclose it.  To establish a valid claim of misappropriation, a party usually must show that the defendant knew about the trade secret and had a specific opportunity to acquire it for disclosure or use, or did in fact acquire, disclose, or use it through improper means or without the trade secret owner or possessor’s authority or consent. 

Because confidential information is not always a trade secret, the stories are legion of companies that fail the initial requirement of demonstrating a trade secret exists, regardless of whether the information has been “misappropriated.”  In addition, this realization often comes too late – after the company sues for misappropriation only to have its opponent show how reasonable steps were never taken to maintain the information’s secrecy.  In other words, if a company is going to allege trade secrets, it must be proactive from the start.  Long before a lawsuit is filed to protect them.

One of the best methods for designating confidential information as trade secrets is to implement a corporate program to achieve this objective – and since “reasonable steps to preserve secrecy” are critical to proving that trade secrets, those measures should be taken sooner rather than later.  The steps in a trade secret protection program may vary by company and the type of information being protected, but in general the process involves at least the following:  (1) identify and classify all information you consider “confidential”;  (2) improve internal and external physical security [from passwords and confidential markings to limiting facility access];  (3) address employee relationships by implementing internal confidentiality policies, noncompete agreements and/or other security measures; and  (4) protect against third-party disclosures by taking appropriate confidentiality measures with vendors, suppliers, co-manufacturers and visitors.

Conclusion

Although much more can and should be considered about covenants not to compete and implementing a trade secret protection program, this article provides a general overview of the key concepts in drafting restrictive covenants and protecting against unfair competition.  Always remember, though, that each company’s situation is different and should be analyzed separately with agreements and programs tailored to its specific needs.  Although the burden is squarely on employers when enforcing noncompete agreements and pursuing trade secret claims, the good news is that unfair competition can be avoided, and that customers, marketing strategies, financial data and other confidential information can be protected.  The key is doing it in the right manner at the right time – and unlike Benedict Arnold, for all the right reasons.

This article was written by Ken Carlson of Constangy, Brooks, Smith & Prophete, LLP