'Restraints of Trade: The Legal Practice' by Christopher Arup, Chris Dent, John Howe and William Van Caenegem in (2013) 36(1)
University of New South Wales Law Journal assesses
the impact of legal practice upon the enforceability of employment restraints of trade. Post-employment restraints range from those prohibiting use of confidential information acquired through employment (non-disclosure clauses), or the solicitation of previous customers (non-solicitation clauses), to wider clauses imposing an obligation on the employee not to compete with the employer for a defined period after the termination of the employment (non-compete clauses). The empirical research reported in this article demonstrates that there is much uncertainty in the operation of the law around the use of restraint of trade clauses in employment contracts. While most usefully nuanced, the evidence suggests that to a significant extent, this uncertainty weighs more heavily on the side of any dispute that is least able to bear it – the employee. In light of our findings, we have introduced a limited number of reform options (ranging from the radical to the limited, and from the substantive to the procedural) that would assist in reducing the over-enforcement, or over-observance, of restraint clauses.
The authors comment that
Employment restraints are becoming increasingly common. The common law principles have insisted that employment restraints are to be enforced very conservatively because they are likely to be contrary to public policy. Yet such conservatism is not always evident. Restraints may be seen to be over-enforced, or at least overly observed, where the courts do not apply the principles rigorously – for example, by not demanding proof of a legitimate business interest. Restraints may also be over-enforced because the legal practice discourages employees from challenging them in the courts. While the outcome of the particular case remains uncertain or indeterminate – on the basis of the vague standards to be found in the legal principles – the legal practice gives play to asymmetries and inequalities between the parties. Uncertainty is a greater burden for the party, without inside knowledge (of proceedings, courts and decisions), and without resources (financial, psychological, relational and reputational) to bargain hard and maintain litigation. That usually though not always is the employee. Our observation is that the practice has a chilling or intimidating effect, which means that employees observe restraints, even if they overreach, without challenging them in court. Even where they do challenge the restraint, they readily withdraw or they compromise when met with legal proceedings. This practice produces injustices and is also contrary to the public interest.
This article tests these common assertions against the evidence of the practice. We have gathered data about the legal practice around the state supreme courts. That data includes the legal principles, legal proceedings, cited decisions and legal commentaries. But the article goes beyond this book law to report the impressions and insights gained from a set of interviews with practitioners. These interviews provide a uniquely nuanced picture. It reveals that there are occasions of under-enforcement or genuine compromise. Overall, though, the momentum is with the employer and the practice is a daunting one for many employees to navigate. In this article, following the provision of an introductory context, we identify the uncertainty in the legal principles that contributes to the influence of the legal practice. In the third section, the legal proceedings are examined and some recent cited decisions are mentioned. The fourth section characterises the nature of the parties’ decision making about litigation and locates the burden of uncertainty. The final section nominates some reforms that are aimed at reducing the burden, particularly as experienced by employees who are subject to the restraints. We believe that they merit further consideration.
They conclude
A Legal Proceedings
Many of our findings point to hard bargaining under conditions of uncertainty, thereby confirming law and economics insights into the relevance of extra-legal economic factors to outcomes (such as the role of transactions costs, and then micro-power analyses, involving unequal access to legal expertise, financial reserves and other sources of power). The research also shows that much of the hard bargaining goes towards submission or settlement: the employer’s lawyer threatens to file with the court; the employee is advised of the factors weighing against a defence in court; and depending on nerve, cost constraints and the benefits at stake, the employee submits or some compromise is hammered out. In a few cases, proceedings are commenced and the dispute is settled or an injunction is granted. Fewer still go to trial and attract a ruling. Of those that do, some the employer wins. Decisions where the court chooses between steps, or in New South Wales an excessive restraint is read down, are still rare but are likely to increase.
The influence of the factors that weigh against proceedings cannot be broken down purely on employer versus employee lines. Nevertheless, unless the new employer is prepared to become involved, the employee is usually at a disadvantage compared to their former employer. This finding suggests that more restraints are enforced (and seen to be enforced) than would be found to have merit if they went to trial. There is a strong disincentive for employees to go into litigation. The employer can obtain a result without proceeding. Even if the employer compromises, it will leave some restraint in place. The disincentive is increased by the prospect that the employer can obtain provisional or partial enforcement. These circumstances encourage employers to overreach with heavy restraints and discourage employees from challenging their validity. The likely result is that the employees pass up opportunities to move jobs or they stand out of the industry.
All the same, the factors can militate against the enforcement of restraints. As well as the legal costs, which would weigh heavily on smaller employers, there were the difficulties obtaining evidence; the lack of monitoring in some cases, so that whether the ex-employer finds out about the actions of the ex-employee is fortuitous; the desire to maintain good relations; the negative signal to others from a court loss; and the demoralising effect on other employees. Even a win can be a loss in certain situations. On this basis, it was our impression that employees tend to underestimate the factors that militate against the employer taking the matter to court and not settling, and therefore are more ready to compromise than is actually strategically required. However, some do use this situation to ignore the restraint.
Finally, enforcement draws the parties into legal proceedings in and around a supreme court. The insights of the repeat players, the lawyers themselves, are of great value here. The knowledge available to insiders helps parties predict – and even shape – the response of the courts. They can pitch the right arguments to the court and they can even characterise the decisions in their feed-back to employers and employees. The ongoing relationships also give these lawyers insights into the nature of settlements that are considered acceptable. There were signs that the practitioners also act as peacemakers, giving advice not to proceed or to settle for a lesser restraint when they perceive that the employer’s claim was unreasonable.
Indeed, as we have seen, they sell ‘new transactional products’ to the employers. These are useful services given that the costs of dispute can run high. As well, the lawyers have their own reputation and integrity to protect. Nevertheless, inside knowledge interacts with hard bargaining. The specialists with the inside knowledge are in principle available to anyone, certainly they will work both for employers and employees. However, the party must command resources to enjoy the best of this access and to withstand the pressure from the other side in circumstances where it also has access to resources.
B Law Reforms
It is this imbalance of resources, particularly when coupled with the overall sense of uncertainty in terms of the enforcement of restraints, which indicates to us the need for changes to be made. From this research of the legal principles, legal proceedings, cited decisions, commentaries, and particularly the insights and impressions gained from the legal practitioners, we identify the following possible reforms. They are presented, in three broad categories, for further consideration; with space limitations they cannot be argued at length here.
1 Outlaw restraints
This is the most radical of possible reforms and, therefore, the least likely to be adopted. We note, nonetheless, that several states in the United States have legislated to make restraints unlawful. While that initiative should resonate with competition and labour policy, governments in Australia are unlikely to take command. Yet, in recent years, the state governments have put substantial resources behind the strategy of creating a clever cluster economy around their capital cities. The economic research suggests that a state government might well gain an advantage for its local economy if it outlawed restraints. There is more local knowledge transfer and knowledge workers may be attracted from other locations where restraints are burdensome. Policy would benefit greatly from a rigorous discussion of this option.
It is to be remembered that employers have other remedies against employees should restraints no longer be available. The argument has been made that the employers should make more of the protections for intellectual property or the protections in equity against breach of obligations of confidence or fiduciary duties and duties of good faith and fidelity. The employers also have strategies beyond the law, such as the use of attractive staff retention packages, to protect their interests. On this basis, reliance on the non-compete is regarded as a lazy fallback option.
2 Limit restraints
If it is realistic to think that the state governments would see it as a big step to override the common law and take an established power away from individual employers, other reforms can be considered. Legislation, possibly in the form of a national uniform law, could be deployed to place limits on the common law. These reforms include placing upper limits on the length of the period of the restraints. Another would be to require employers to pay employees during the period of the restraint. These reforms are aimed at a better balance between the employers and employees, even if the employer is found to have a legitimate interest to protect. Employees would be less indisposed by the restraints and freer to circulate.
In the absence of legislative reforms, courts could adhere more vigilantly to the principle that restraints are presumed against public policy. Arguments that give greater legitimacy to business interests, or suggest that wider and longer restraints are reasonable, should be viewed with a very wary eye. Greater specificity in the rules would come at the expense of the flexibility afforded the courts to fit the restraint to the circumstances of the case. Yet the evidence suggests that some courts are allowing the employers too much leeway. The courts could send a much clearer message to employers that they cannot have provisional or partial enforcement. The onus should firmly be on the employer to get the restraint right or face the prospect that any enforcement will be denied.
A more specific reform, and one both favoured by the US critics and consonant with the traditional common law position, is a policy of no modification to restraints – or, at least, only modification to make good the restraint if the parties can show they had genuine doubts about the appropriate restraint to apply to a particular position. This approach denies ambit claims and refuses to enforce the lower steps in a cascading or laddered restraint or to read down a wide restraint until it is enforceable. In first drafting the contract, the employer must have used specific terms and have nominated precisely the restraint it wishes to enforce. Otherwise the court will strike down the restraint. Pivateau argues that employers should nominate precisely the position from which the employee would be barred, the interest that is worthy of protection, and the extent of the restraint that is considered reasonable.
Such a policy would militate against broad non-competes in contrast to particularised non-disclosure and non-solicitation obligations. The restraint would stand or fall on one nominated period of time and one territory of operation. Cascading clauses are still in the minority. But they will become increasingly popular if the courts do not reject them. It is not so much that they necessarily produce an unfair outcome in the individual case, as that they make it riskier for employees to challenge restraints.
3 Procedural reforms
The third category of reforms relates to how restraint clauses, assuming that they are not outlawed, are adjudicated. Again, starting with the most radical option, it would be possible to shift the jurisdiction from the supreme courts and their commercial and equity lists to a more informal, possibly more employment-minded forum, such as the magistrates’ courts or industrial tribunals. Other jurisdictions, such as the federal industrial tribunal Fair Work Australia, have experience with the award of specific relief. This reform raises the key question as to whether the restraint disputes should be regarded essentially as employment disputes between employers and employees or as commercial disputes between employing firms (in other words, as failures to deal constructively and fairly with employees or as contests between rivals for valuable capital assets). It would be necessary to keep cases of employment restraints separate from cases of other restraint situations such as the sale of businesses. While the principles could be distinguished, the practical problem is the sometimes variable status of the professional – employee, director, partner, independent contractor.
An employment tribunal should reduce the expense faced by the parties; a contentious part of this reform would be the exclusion of lawyers from proceedings, except by leave of the forum. However, even if adjudication remains with the courts, there are a number of ways in which costs to the employee may be reduced (as employees tend to have access to less resources, and bear the greater burden of uncertainty, the emphasis is on reducing the costs of the employees). One such reform is to make it a jurisdiction in which the parties bear their own costs. But that reform would not necessarily even the equation.
While cost penalties continue to apply, as they do now, the courts should be reluctant to award costs against employees when they are granting employers interlocutory relief, approving a settlement or making good a restraint. Or they should at least limit the costs; senior and junior counsel and instructing solicitor makes an expensive team. The courts should assure the employer who is hiring the employee that it may fund the employee’s defence without fear of tortious liability. Further, the courts should be prepared to award full indemnity costs against an employer who litigates an invalid or excessive restraint. If employees are to have access to the courts, they should be confident they will not be left out of pocket. That penalty would also increase the pressure on the employer to be conservative about restraints.
One final set of reform options focus on interlocutory procedures, on the basis that it is often the practical determinant of the matter. First, it would be preferable for the courts to require the employer to make out a stronger case before an interlocutory injunction is granted. Some of the courts are already doing so, ‘putting the advocates through their paces’. Furthermore, the balance of convenience should be inclined towards the employee. The courts should insist that the employers demonstrate they will suffer real harm if the restraint is not observed. They should not protect the employer’s interest if the hardship to the employee is greater. The courts should be realistic about the impacts on the employees.
A cleaner reform, though a much bigger step to take, would be to withhold interlocutory injunctive relief altogether from employers and require them to go to trial (on an expedited basis) to plead the merits of the restraint. Moreover, at the trial, the employers would be put to their proof of actual damage. This would increase the risks for the employer. It may be argued that employers would be denied an effective remedy for breach of the restraint in those cases where the interest was legitimate. The breach will have occurred by this time. Further, even in those cases in which damages were an adequate remedy, most employees would not be in a position to pay them, though this might change if the employee has established her own firm to compete with the employer. To remove interlocutory injunctive relief altogether, therefore, might shift the balance too far in the employees’ direction. But the prospect of a trial would also increase some pressures on the employee. So perhaps the right path is to improve the interlocutory procedure.
