Garden Leave and Non-Compete Reform
In 2018, Massachusetts became the first state to provide for garden leave payments – payments to employees forced to sit out employment during a non-competition agreement. It was a reform gone wrong. The original goal was to level the playing field between the East Coast and California, where employment noncompete has been banned for decades. What could this turn of events mean for non-compete agreements elsewhere?
The Massachusetts Noncompetition Agreement Act (“Act”) codifies some aspects of Massachusetts case law and overrides others. Its most significant feature is a mandate that all noncompetition agreements contain (1) a garden leave clause, containing a pro-rata payment during the restricted period (twelve months) of at least fifty percent of the employee’s highest annualized base salary, or (2) such other mutually agreed upon consideration specified in the agreement.
Noncompetition agreements must be in writing, signed by both parties, and subject to new notice requirements. It codifies safe harbors for an agreement’s geographic scope and the scope of prohibited competitive activities. The Act prohibits enforcement of non-competes against large classes of low-wage employees,
A persistent narrative in the protracted battle for legislative change to Massachusetts’s treatment of non-compete agreements is the claim that the rise of California’s high-tech industry and the decline of Massachusetts's high-tech industry over the same time were tied to the fact that Massachusetts enforces non-compete agreements and California does not. Both high-tech industrial districts started nearly even in total technology employment. Both were the direct outgrowth of government-funded, university-based research and development; In Massachusetts, the focal point was MIT and Harvard. In California, it was Stanford and U.C. Berkeley. By the turn of the twenty-first century, however, California had re-invented itself through spin-offs and start-ups, fueled by technological innovations mostly spawned from the district itself and not its academic institutions. Significant multiples outstripped Massachusetts in production, export, and employment, and that trend continues.
This history is a natural experiment in economic geography; a field pioneered in the 1960s. It identifies agglomeration industries that achieve economies of scale in production through inter-relationship among multiple firms in an industry focused on a specific geographic location. An agglomeration economy is a localized economy in which a large number of companies, services, and industries exist nearby and benefit from the cost reductions and efficiency gains that result from the proximity.
Examples include the U.S. auto industry in Detroit and the tech industries in Silicon Valley and Route 128. Only Silicon Valley achieved second and third-stage economies of scale by evolving newer technologies based on micro-computers, intelligent devices, and Internet applications. The Route 128 industrial district largely failed to evolve.
The argument is that achieving a second-stage agglomeration economy where knowledge spills over from firms in the district rather than from the universities requires free movement of scientifically trained workers from firm to firm. Free movement was the norm in Silicon Valley, but not along Route 128. California’s statutory prohibition against enforcement of post-employment covenants not to compete was identified as the critical factor in creating Silicon Valley’s high-mobility employee culture.
Some question this conclusion. The argument is that the East and West Coasts focused on different types of technology; minicomputers versus personal computers. Even that argument realizes that job-hopping results in second-stage agglomeration economies.
Research in the last twenty years tentatively confirms the hypothesis that non-competes reduce labor mobility to some extent. Whether this is sufficient to account for the dramatic difference is unknown.
A U.S. Treasury report found that research suggests that non-competes cover eighteen percent of all workers, and even nineteen percent of workers in California are bound by non-competes, despite the general lack of enforceability in that state. The report concluded that while non-competes provide benefits, like protecting an employer’s trade secrets, they impose costs on employees regarding reduced mobility, freedom, and bargaining power. Treasury argued that reduced job churn results in lower labor productivity. The report recommended greater transparency in non-competes through notice and a requirement that firms provide consideration to workers bound by non-compete contracts in exchange for both signing and abiding by non-competes.
Massachusetts courts have long upheld contracts in restraint competition, although with reluctance. By 1940, it was settled that a covenant restraining competition, inserted in a contract for personal service, is not invalid if the interest to be protected is consonant with public policy and if the restraint is reasonably limited in time and space. The courts have always engaged in a balancing act. Contracts restraining freedom of employment were enforceable only when the restraints were reasonable and not wider necessary for the protection to which the employer is entitled and not injurious to the public interest.
In general, non-competition agreements arising out of the sale of a business have been subject to less scrutiny than those arising out of an employer-employee relationship because there is more likely to be equal bargaining power between the parties. The sale proceeds generally enable the seller to support himself temporarily without the immediate practical need to enter into competition with his former business.
Post-employment restraints are scrutinized more carefully to ensure they go no further than necessary to protect an employer’s legitimate business interests, such as trade secrets, other confidential information, or the goodwill of the employer acquired through dealings with his customers.
Public policy favors every person carrying on his trade or occupation freely. Scrutiny is warranted because an ordinary employee typically has only his labor to sell and often is not in a position to bargain with his employer. Parties often enter into these agreements with very different bargaining power and enforcing a noncompetition agreement might deprive an employee of his ability to earn a living.
If it could not be demonstrated that the employer has a legitimate business interest at risk, Massachusetts courts have concluded that the employer’s purpose can only be to enforce the covenant to protect itself from ordinary competition, which it cannot do. Protection from ordinary competition is not a legitimate business interest, and a noncompetition agreement designed solely for that purpose will not be upheld. An employer cannot use a covenant not to compete to prevent its former employee from using the skill and intelligence acquired or increased and improved through experience or instruction received during employment.
Massachusetts courts have taken particular care to scrutinize the duration and the geographic scope of the restraint on competitive employment. Older cases allowed longer periods of restriction, from three to five years. More recent cases have favored restricted periods of one to two years. However, if the case involved the sale of a business, a longer period has still been upheld.
On geographic scope, the courts rejected a rule which would arbitrarily limit the restriction to the geographic area of the place of employment. Instead, they have ensured that the geographic scope restricted by the noncompetition agreement is no greater than is necessary to protect the employer’s legitimate business interest. The test is reasonableness. If the restriction is too broad as to time or territory, it may be enforced to the extent necessary to protect the plaintiff. Nonetheless, the courts have held that restrictive covenants are enforceable even when they apply to large geographic areas.
Comparing Massachusetts case law to the Act, a few points need to be noted. First, covenants not to compete have also been held enforceable in Massachusetts against independent contractors. Second, continued employment has been considered sufficient to support a noncompetition agreement. Third, termination of employment by the employer's initiative does not invalidate a noncompetition provision.
While the Massachusetts courts have not adopted the Blue Pencil doctrine (which permits a court to modify or revise a covenant to make it enforceable), they have adopted the concept.
A way of balancing competing employer and employee interests has evolved in the United Kingdom through garden leave agreements. Traditionally, these agreements are triggered when an employee gives notice of employment termination. Statutory notice periods in the United Kingdom vary based on length of employment. A garden leave provision lengthens the notice provision contractually. The employee will serve her notice period and continue receiving her salary and benefits but will not undertake regular work duties. The employee will remain at home to separate the employee from sensitive client or confidential information. Because the employee remains employed and receives compensation, the employee still owes a duty of loyalty to her employer and may not actively work for a competitor. In the United Kingdom, restricting competition or using confidential information other than trade secrets during the post-employment period may be made only through express agreement.
English Law surrounding employee loyalty rests entirely on common law. Garden leave provisions responded to the uncertain landscape of what may or may not be an enforceable restriction. These provisions balance the employer’s interest in reducing competition and protecting confidential client or business information with the employee’s interest in earning a wage.
Garden Leave in Massachusetts
The financial industry probably introduced Garden leave in the United States, having borrowed the concept from London. The key difference between American and English garden leave provisions is that American garden leave occurs post-employment termination.
Before the Act, Massachusetts courts we reluctant to enforce garden leave provisions/ The Legislature stepped in. The final version of the Act adopted a statutory version of garden leave, providing Massachusetts employers with a safe harbor for noncompetition agreements if they follow the specified rules.
For new agreements, the Act provides that, to be valid and enforceable, noncompetition agreements shall be supported by a garden leave clause or other mutually agreed upon consideration between the employer and the employee, provided such consideration is specified in the noncompetition agreement.
Garden leave requires (1) payment consistent with the requirements for the payment of wages under section 148 of chapter 149 of the general laws, (2) payment on a pro-rata basis during the entirety of the restricted period (the period during which the employee is restricted from engaging in activities competitive with their employer, and (3) payment of at least fifty percent of the employee’s highest annualized base salary paid by the employer within the two years preceding the employee’s termination of employment.
Bonuses are not considered when calculating the specified garden leave payments. It is unclear how fringe or retirement plan benefits should be treated under the Act.
An employer is not permitted to unilaterally discontinue or otherwise fail or refuse to make such garden leave payments, except in the event of a breach by the employee. What constitutes a breach by the employee is not specified.
In a move that both codified and changed Massachusetts common law, the Act limited the restricted period permitted in a new noncompetition agreement to a maximum of twelve months from the date of cessation of employment. The restricted period can be extended beyond twelve months to a period of no more than twenty-four months under two circumstances: (1) where the employee has breached their fiduciary duty to the employer, or (2) where the employee has unlawfully taken, physically or electronically, property belonging to the employer. The Act goes on to clarify that if the restricted period has been increased beyond 12 months for these reasons, the employer is not required to provide payments to the employee during the extended period.
The Act does not say what fiduciary duty a former employee would have that they could breach to the employer. Under U.K. law, the basis for holding an employee to a continuing duty of loyalty to his employer is the fiction that the garden leave payments are like continued employment for the employer, during which the employee is required to do the job of doing nothing. Massachusetts law says an employee’s loyalty to his former employer ceases upon termination of employment unless it can be demonstrated that the employee left with confidential information, in which case a continuing duty of loyalty may be implied.
New noncompetition agreements must be in writing and signed by both the employer and the employee. The agreement must expressly state that the employee has the right to consult with counsel before signing. In a departure from Massachusetts case law, if an agreement is entered into after the commencement of employment but not in connection with an employee’s separation from employment, it must be supported by fair and reasonable consideration independent from the continuation of employment.
The Act also has new notice requirements. If the agreement is entered into in connection with the commencement of employment, it must be provided to the employee by the earlier of a formal offer of employment or ten business days before the commencement of the employment. If an agreement is entered into after the commencement of employment but not in connection with an employee’s separation from employment, a notice of the agreement must be provided at least ten business days before the agreement is to be effective.” An agreement must be no broader than necessary to protect one or more of the following legitimate business interests of the employer: (A) the employer’s trade secrets; (B) the employer’s confidential information that otherwise would not qualify as a trade secret; or (C) the employer’s goodwill.
As a limited “safe harbor,” a non-competition agreement will be presumed necessary where the legitimate business interest cannot be adequately protected through an alternative to a restrictive covenant, including but not limited to a non-solicitation agreement or a non-disclosure or confidentiality agreement. This allows restricted former employees to argue both that a covenant not to compete is broader than is necessary to protect one of the specified, legitimate business interests and that the business interest could have alternatively been protected through a non-solicitation, non-disclosure, or confidentiality agreement, instead of the covenant not to compete.
The Legislature partially defined what would be considered reasonable regarding the geographic scope and proscribed activities. For new agreements, a geographic reach must be reasonable concerning protected interests. Still, a geographic reach will be presumed reasonable if it is limited to only the geographic areas in which the employee, during any time in the past two years of employment, provided services or had a material presence of influence.
The Act also addresses the scope of proscribed activities. They must be reasonable concerning the interests protected, but a restriction on activities that (1) protects a legitimate business interest and (2) is limited to only the specific types of services provided by the employee at any time during the last two years of employment is presumptively reasonable. The Act codifies the blue pencil doctrine, saying a court may reform or otherwise revise a noncompetition agreement to render it valid and enforceable to the extent necessary to protect the applicable, legitimate business interest.
As significant as the codification of garden leave in noncompetition agreements have been, so is the legislative pronouncement on who cannot be covered under any circumstance by any non-competition agreement. The Act says it applies to all employees and independent contractors working in Massachusetts, regardless of whether the agreement has a choice of law provision specifying that the law of some other jurisdiction applies. Henceforth, noncompetition agreements cannot be enforced against (1) employees who are classified as non-exempt under the Fair Labor Standards Act; (2) undergraduate or graduate students who partake in an internship or short-term employment while enrolled in an educational institution; (3) employees who have been terminated without cause or laid off; and (4) employees who are eighteen years of age or younger.
There may be future litigation as to whether or not an employee was terminated without cause since the Act does not define it. Still, the Act is a statement of public policy that an employee whom an employer is willing to terminate voluntarily is not now prohibited from securing employment immediately with some other employer.
Developments Beyond Massachusetts
Legislative sessions in other states following the Act have been active in the area of non-competes. Nine other states have passed legislation banning the application of non-competes to workers in the state based on income: Illinois, Maine, Maryland, Nevada, New Hampshire, Oregon, Rhode Island, Virginia, and Washington. These legislative efforts have focused on either defining broad categories of low-wage workers to whom a complete ban applies or establishing an income threshold below which a total ban applies. Washington, D.C. passed a near-total ban on the use of non-competes, putting it in the company of California.
Bans on non-competes now apply in Illinois for employees earning less than $13 per hour and have been amended to include those whose earnings are less than $75,000 per year; Maine for those earning below 300% of the federal poverty level; Maryland for employees earning $15 per hour or less; Nevada for all hourly workers; New Hampshire for those earning at or below 200% of the federal minimum wage or 200% of the state topped minimum wage; Oregon for employees whose salary plus commissions do not exceed the U.S. Census Bureau’s medium income level for a family of four; Rhode Island for those earning less than 250% of the federal poverty level; Virginia for those whose fifty-two-week earnings average is less than the weekly average for the Commonwealth; and Washington for those earning $100,000 or less.
Three states have ventured into the garden leave arena. Under the new law passed in Washington, if an employee is terminated as the result of a layoff, the non-competition agreement will be void unless enforcement of the noncompetition covenant includes compensation equivalent to the employee’s base salary at the time of termination for the period of enforcement minus compensation earned through subsequent employment during the period of enforcement. In Illinois, a covenant not to compete specifically does not include clauses or an agreement between an employer and an employee requiring advance notice of termination of employment, during which notice period the employee remains employed by the employer and receives compensation.
President Biden issued an Executive Order on Promoting Competition in the American Economy at the federal level, which encouraged the Federal Trade Commission (FTC) to exercise its rulemaking authority to curtail the use of unfair non-compete clauses that may unfairly limit worker mobility. The FTC and the Department of Justice held a public workshop. It is unclear whether the FTC will take substantive action to limit the use of such agreements based upon Biden’s Executive Order and any consensus that may have been reached as a result of the workshop.