After Termination 'Without Cause': Restrictive Covenants

The misperception is not without support. New York law governing enforcement of restrictive covenants in employment agreements against former employees who have been fired or otherwise discharged "without cause" is often misapplied.

Some case law and commentaries allude to such a bright-line rule. They are mistaken, however. A recent case demonstrates the error of this common misperception. In Morris v. Schroder Capital Management International, 2006 Slip Op. 08638, 2006 WL 3359077 (N.Y. Nov. 21, 2006), the Court of Appeals underscored the notion that a restrictive covenant applicable to a former employee who has been terminated involuntarily and without cause can be subject to the traditional test of whether it is "reasonable," and thus may be enforceable despite the involuntary termination. In short, there is no bright-line rule invalidating restrictive employment covenants in all cases of "without cause" terminations.

The general rule is that restrictive covenants may be enforced against former employees terminated "without cause" provided that the employer has not materially breached the contract containing the restrictive covenant and provided that the covenant passes the "reasonable" tests traditionally applied in cases where employees voluntarily quit and engage in forbidden competitive activities: Post-employment restrictive covenants are enforceable where the covenants are reasonable as to time, scope and geographical limitation necessary to protect the l egitimate interests of the employer; where they are not harmful to the public, and where they do not impose undue hardship on the employee. BDO Seidman v. Hirschberg, 93 NY2d 382, 388-89, 690 N.Y.S.2d 854 (1999); Reed Roberts Assocs., Inc. v. Strauman, 40 NY2d 303, 307, 386 N.Y.S.2d 677 (1976). Moreover, where the restrictive covenant is ancillary to a contract for the sale of a business, it is enforceable merely if reasonable in geographic scope and duration.

The Misperception

It is not correct that New York courts have adopted a universal, bright-line, pro-employee view, refusing to enforce noncompetition clauses in cases of involuntary termination "without cause." Some courts, however, have refused to enforce restrictive covenants, apparently on the mistaken assumption that such a bright-line rule exists. See, e.g., SIFCO Industries, Inc. v. Advanced Plating Technologies, Inc.,867 FSupp 155, 158 (S.D.N.Y. 1994) ("New York courts will not enforce a noncompetition provision in an employment agreement where the former employee was involuntarily terminated."); In re UFG International, Inc.,225 B.R. 51, 55 (SDNY 1998) ("the employee's otherwise enforceable restrictive covenant is unenforceable if the employee has been terminated involuntarily, unless the termination is for cause").1 Other courts, before enforcing restrictive covenants against involuntarily terminated employees, have required a finding that the termination was for cause. Borne Chemical Co. v. Dictrow, 85 AD2d 646, 445 N.Y.S.2d 406 (2d Dept. 1981) (issue of whether employee had been discharged for incompetence was critical in determining its enforceability); MTV Networks v. Fox Kids Worldwide, Inc.,No. 605580/97, 1998 WL 57480 (N.Y. Sup. Feb. 4, 1998) (defendant was properly terminated for cause, and employer was therefore entitled to injunctive relief under noncompete provision of employment contract); Gismondi, Paglia, Sherling, M.D., P.C. v. Franco, 104 FSupp2d 223, 233 (SDNY 2000) (since defendant was terminated for cause, plaintiff employer could seek to enforce noncompete clause), order vacated in part, 206 FSupp2d 597 (SDNY 2002).

The 'Post' Case

These cases cited above are based on a misapplication of Post v. Merrill Lynch, 48 NY2d 84, 421 N.Y.S.2d 847 (1979), which does not stand for the proposition that all restrictive covenants are unenforceable if the employee was terminated without cause. The cases mistakenly applying a bright-line rule often rely on only selected excerpts of the following paragraph in Post:

Acknowledging the tension between the freedom of individuals to contract, and the reluctance to see one barter away his freedom, the State enforces limited restraints on an employee's employment mobility where a mutuality of obligation is freely bargained for by the parties. An essential aspect of that relationship, however, is the employer's continued willingness to employ the party covenanting not to compete. Where the employer terminates the employment relationship without cause, however, this action necessarily destroys the mutuality of obligation on which the covenant rests as well as the employer's ability to impose a forfeiture. An employer should not be permitted to use offensively an anticompetition clause coupled with a forfeiture provision to economically cripple a former employee and simultaneously deny other potential employers his services. Post, 421 NYS2d at 849.

Postdoes not hold that all noncompetition clauses are unreasonable as a matter of law if an employee is terminatedwithout cause. Postinvolved employees terminated without cause by Merrill Lynch, who subsequently competed with Merrill Lynch and then were informed by Merrill Lynch that they had forfeited their rights in the firm's pension plans because of that competition, pursuant to a noncompete provision in the pension plan. Posttherefore arose in circumstances near to the "employee choice" doctrine, which requires that where an employee chooses to resign and then goes to work for a competitor, the employee will be barred from challenging the reasonableness of a non-competition clause, where forfeiture of some benefit is the penalty for the violation.

'Employee Choice' Doctrine

This "employee choice" doctrine is based on the assumption that one who elects to leave a firm makes a knowing choice between forfeiting a certain benefit or retaining the benefit by staying with the employer. See Kristt v. Whelan, 4 AD2d 195, 164 N.Y.S.2d 239 (1st Dept. 1957), aff'd 5 N.Y.2d 807, 181 N.Y.S.2d 205 (1958).

In Post, the New York Court of Appeals held that an employee discharged without cause has the right to challenge the reasonableness of a noncompetition forfeiture clause, not that such an employee is automatically excused from adhering to the clause. York v. Actmedia Inc., No. 88 Civ. 8763 (TPG), 1990 WL 41760, *1 (S.D.N.Y. 1990); Sarnoff v. American Home Products Corp., 798 F.2d 1075, 1084 (7th Cir. 1986) ("The holding of Postis that a no-competition condition is unenforceable if it is unreasonable and if the employee was fired without cause.").

The Postcourt held forfeiture of pension benefits to be unreasonable as a matter of law, emphasizing the strong national policy against pension forfeiture in the Employee Retirement Income Security Act of 1974 (ERISA), as well as New York's policies favoring freedom to work wherever one pleases and against forfeiture in general. The court's aims in Postthus were to prevent forfeiture of ERISA pension benefits and to prevent an employer that has fired an employee without cause from having its cake and eating it too: "An employer should not be permitted to use offensively an anticompetition clause coupled with a forfeiture provision to economically cripple a former employee and simultaneously deny other potential employers his services." Post, 421 NYS2d at 849.

Accordingly, even in forfeiture cases, courts do apply and should apply an analysis of reasonableness to restrictive covenants where employees are involuntarily terminated without cause. In the employee choice/forfeiture context,

[A]lthough a restrictive covenant will be enforceable without regard to reasonableness if an employee left his employer voluntarily, a court must determine whether forfeiture is "reasonable" if the employee was terminated involuntarily and without cause. Morris v. Schroder Capital Management International, 2006 Slip Op. 08638, 2006 WL 3359077 (N.Y. Nov. 21, 2006).

While plaintiff was involuntarily discharged, this restrictive covenant does not involve a forfeiture of rights under an "employee benefit plan" that would be covered by ERISA. We do not think, therefore, that under Post v. Merrill Lynch, supra, the forfeiture was unreasonable as a matter of law solely because the discharge was involuntary. Wise v. Transco, Inc.,73 AD2d 1039, 425 N.Y.S.2d 434-435-36 (4th Dep't 1980).

Postdoes not hold that all noncompetition forfeiture clauses are unreasonable as a matter of law if an employee is terminated without cause. Rather it stands for the narrow proposition that such an employee has a right to challenge the reasonableness of a clause, and that a forfeiture clause which deprives an employee of his pension benefits will be held unreasonable as a matter of law. York, 1990 WL 41760 at 2 (enforcing provision requiring forfeiture of stock options against former employee terminated without cause who went on to compete with defendant).

Thus, the holding in Postis rightly limited; it provides a complement to the "employee choice" doctrine in cases where restrictive covenants are tied to forfeiture provisions. See Lucente v. IBM Corp.,262 FSupp2d 109, 114 (SDNY May 2, 2003) (restrictive covenant based on forfeiture "is enforceable without regard to reasonableness if an employee left his employer voluntarily, but a court must determine whether such a covenant is 'reasonable' if the employee left involuntarily and without cause"); Cray v. Nationwide Mutual Insurance Co.,136 FSupp2d 171, 178-79 (W.D.N.Y. 2001) (declining to determine on summary judgment whether termination was for cause, but discussing possible application of Post or Kristtto forfeiture/non-compete provision). Postdoes not establish a rule invalidating restrictive covenants in all circumstances relating to "without cause" terminations.

Conclusion

Where a noncompete is not tied to a forfeiture provision, neither Postnor the employee choice doctrine governs. Instead, in nonforfeiture cases of involuntary termination without cause, the first question should be whether the employer materially breached the contract containing the noncompete provision. If such a breach occurred, the noncompete provision is unlikely to be enforced. Cornell v. T.V. Dev. Corp.,17 NY2d 69, 75, 268 N.Y.S.2d 29, 34 (1966) (otherwise valid covenant against competition is unenforceable "when the party benefited was responsible for the breach of the contract containing the covenant"); Michael I. Weintraub, M.D., P.C. v. Schwartz,131 AD2d 663, 665-66, 516 N.Y.S.2d 946, 948-49 (2d Dep't 1987) (even reasonable portion of restrictive covenant unenforceable, because employer breached contract by failing to provide timely written notice of termination).

If the employer has not breached the contract containing the restrictive covenant, the employer may then insist on performance of the covenant, to the extent necessary to protect the employer's legitimate business interests (i.e., clients, trade secrets, investments in unique employees), provided that it is not unduly burdensome to the employee and not injurious to the public interest. See BDO Seidman v. Hirschberg,93 NY2d 388-89, 690 N.Y.S.2d 854, 857 (1999).

Also, where the restrictive covenant has been agreed to in conjunction with the sale of the employee's business, thecovenant, whether contained in a sale agreement or an employment agreement, will be enforced if reasonable (even without a showing that employee's skills are unique or that employee has knowledge of trade secrets). Mohawk Maintenance Co. v. Kessler, 52 NY2d 276, 283-84, 437 N.Y.S.2d 646 (1981) (express covenant not to compete, which relates to seller's duty to refrain from competing with purchaser, will be enforced if reasonable in geographic scope and duration); Borne Chemical Co. v. Dictrow, 85 AD2d 646, 445 N.Y.S.2d 406, 412 (2d Dept. 1981); Lund v. Agmata Washington Enterprises, Inc.,190 AD2d 577, 593 N.Y.S.2d 517 (1st Dept. 1993) (covenant contained in rider to security agreement); MedX, Inc. v. Ranger,780 FSupp 398 (E.D. La. 1991) (sales agreement and separate employment agreement containing covenant were clearly part of single transaction, and rule disfavoring restrictive covenants in employment agreement would not apply).

Peter L. Altieri is a member of Epstein Becker & Green PC, where he focuses on advising companies on the movement of employees and information between firms. David Clark, an associate at the firm, assisted in the preparation of this article. The views expressed herein are those of the authors and should not be attributed to theirfirm or clients.

Endnotes:

1. Some secondary authorities have also mistakenly cited such a bright-line rule. See 104 N.Y. Jur. 2d Trade Regulation § 70 "Effect of Employee's Involuntary Discharge Without Cause" ("In cases of involuntary discharge, if the employment was pursuant to a contract and was terminated by the employer without cause, the employer will not be permitted to invoke an anticompetition covenant in the contract."); Kenneth J. Vanko, "'You're Fired! And Don't Forget Your Non-Compete . . . ': The Enforceability of Restrictive Covenants in Involuntary Discharge Cases", 1 DePaul Bus. & Com. L.J. 1, *10 (Fall 2002).