To Compete or Noncompete

EXECUTIVE SUMMARY

ONE RISK EVERY CPA FIRM SHOULD CONSIDER is the possibility departing employees may attempt to take clients of the firm with them. Firms can use a noncompete agreement to prevent an employee from engaging in such actions. TO ENSURE AN ENFORCEABLE NONCOMPETE AGREEMENT, a firm should make sure its time and geographic limits are reasonable and the scope of the agreement is not overly broad. State courts do not favor noncompete agreements, so an attorney who has successfully litigated in the jurisdiction should draft the agreement. IF A CPA FIRM FIRES AN EMPLOYEE who signed a noncompete agreement, the circumstances under which the employment relationship was terminated become an important factor to the courts when they assess whether to uphold the agreement. It will balance the firm’s interests against the employee’s ability to earn a living. A firm should honor its obligations under the agreement and document its actions. A FIRM SHOULD HAVE UNIFORM NONCOMPETE agreements for all levels of employees, which avoids the possibility an employee might litigate based on an assertion that someone in top management has a less restrictive agreement. IN MANY STATES, THE COURT IS AUTHORIZED to edit to a reasonable scope a noncompete agreement that it considers to be too broad. Such blue penciling almost always is in the firm’s best interests. MANY CPA FIRMS WILL ALLOW A FORMER EMPLOYEE to take a client but include a reimbursement provision in the noncompete agreement. This provision normally requires the former employee to reimburse the firm for a percentage of the fees collected from the client for a number of years after the termination of employment.

THOMAS E. VERMEER, CPA, PhD, is an assistant professor of accounting at the University of Baltimore. His e-mail address is tvermeer@ubalt.edu . VERNON W. JOHNSON III is chairman of the general litigation and trial practice group at Jackson & Campbell PC, a Washington, D.C., law firm. He handles commercial litigation and noncompete agreements. His e-mail address is vjohnson@jackscamp.com .

anaging business risk is a concept familiar to CPAs, who routinely encourage clients to protect themselves against many operational vulnerabilities. One risk every firm should manage is the possibility an employee who moves to a new job or starts a practice may try to use proprietary information or take clients of the firm away. A noncompete agreement can protect a CPA firm from potential losses caused by departing staff with access to business secrets. It even can clarify the situation for clients who wonder whether they can move with the employee to his or her new position (usually not for at least six months to two years, depending on the agreement and the interests involved). This article explains what issues may limit the effectiveness of noncompete agreements, says how state courts have ruled and gives tips on how to obtain an enforceable contract.

CONSULT AN ATTORNEY
Noncompete laws vary widely by state and our legal system places a high value on an individual’s right to earn a living. Because the judicial climate is somewhat weighted against a firm or company, it’s especially important to have a competent attorney draft a noncompete agreement informed by relevant regional laws. Whether a CPA wishes to protect his or her own firm, is employed in industry or is advising a client company, the following tips apply:

Review existing employee agreements and noncompete contracts, if any, to see whether the organization is adequately protected against employees’ taking clients away.

Is It Fair? Court rulings on noncompete agreements have resulted in time-frame guidelines. Subject Reasonable Iffy Unreasonable Trade secrets Up to 5 years 5–10 years 10 years Sale of a business Up to 3 years 3–7 years More than 7 years Other (client lists) Up to 6 months 6 months–2 years More than 2 years Source: MyLawyer.com , www.hrlawinfo.com/lawguide/Termination/agreements_not_to_compete.asp .

To create noncompete agreements, obtain the services of a lawyer who has drafted and litigated them in the jurisdiction and who knows how courts approach the issues involved.

Lay out the facts in a consultation. Every noncompete should be tailored to protect the firm’s specific interests, so help the lawyer gain a good feel for your business—describe who your clients are, what types of services you provide for them and how your employees provide services to those clients. The attorney needs to understand fully what the interests are to know how best to protect them.

Have the lawyer prepare the agreement and draw it as narrowly as possible. Make sure you understand the provisions of the contract and that all of your concerns are covered. Don’t be afraid to ask questions.

WILL IT BE ENFORCEABLE?
Under a noncompete contract, employees agree not to use specific resources or participate in a certain market for a set period of time following their termination or resignation. Enforceability varies by state, and courts generally uphold only those provisions considered reasonably necessary to safeguard a firm or company’s “protectable” interests (see “ What the Agreements Cover ”). “Be specific in terms of equipment, technology, strategy, sales prospects and other pertinent proprietary information,” says the CCH Business Owner’s Toolkit (see “ Recommended Reading ”). Courts closely scrutinize the noncompete document if you have to enforce it, and they are more likely to uphold agreements that limit

The length of the noncompete period. In general courts have found a time limit of two years or less after employment ends to be reasonable ( Schulhalter v. Salerno, 279 NJ Super. 504, 653 A2d 596 (App. Div. 1995)).

The scope of the agreement. (Courts have found that to be enforceable a noncompete agreement’s scope should not be overly broad. For a CPA firm, scope normally is stated in terms of the firm’s client list or all the clients an employee had contact with during a certain period of time.)

The geographical area in which the employee is prohibited from competing. (A scope restriction based on a specific region may not be useful to a CPA firm if the employee services clients across a wide area, however.)

Recommended Reading CCH Business Owner’s Toolkit has extensive information on noncompetes, www.toolkit.cch.com . Covenants Not to Compete: A State-by-State Survey, American Bar Association, Section of Labor and Employment Law, 2001. How to Create a Noncompete Agreement by Shannon Miehe, Nolo, 2002. Noncompete Agreements—An Overview by William M. Corrigan Jr., www.mobar.org/journal/1998/mayjun/corrigan.htm .

FOLLOW THE STATE LAW
Many states recognize that relationships between a firm and its clients constitute an important “protectable” asset, yet courts typically don’t favor agreements that restrain trade (see “ Case Study ”). Most states try to balance the legitimate interests of the employer against potential hardship to an employee and the public. ( Note: California and North Dakota don’t enforce any noncompete agreements except in the sale of a business or to restrain raiding in anticipation of a partnership dissolution.) Here’s how the states respond to some of the issues affecting noncompete agreements’ enforceability.

What qualifies as sufficient consideration to the employee in exchange for signing a noncompete agreement? Many noncompete agreements use the legal term “sufficient consideration” to express the benefit (compensation) the employer provides the employee in exchange for a promise not to compete. As in most contracts, sufficient consideration is a necessary condition of a valid agreement.

If the agreement is part of the hiring process, the job itself is the consideration. All state courts recognizing noncompete contracts agree that executing one when the employee starts is sufficient consideration, as is a big change in the job such as the promise of a raise or a promotion. If the firm introduces the agreement after hiring (because its policy or the employee’s responsibilities change), a raise or a promotion probably qualifies as sufficient consideration. But some state courts (Utah and Virginia, for example) may consider continued employment sufficient if the employer can show it would have fired the employee for not signing the agreement.

Of those courts that said continuing employment was sufficient consideration, most said the agreement was enforceable only if the employment continued for a substantial period of time. However, Maryland and New Jersey enforce a noncompete agreement even if it isn’t a condition for future employment. Courts in Connecticut, Minnesota, North Carolina, Oregon, Pennsylvania, Texas and West Virginia say continued employment alone is not sufficient, and they enforce noncompete agreements linked to salary increases, promotions or other types of consideration.

Is a noncompete agreement valid if you let an employee go? If a firm fires an employee, it makes it difficult to enforce a noncompete agreement in many states. A CPA firm or a company considering firing an employee and wishing to uphold a noncompete contract should be cautious. Some actions may render a noncompete agreement unenforceable, such as the firm being guilty of misconduct or perceived misconduct. If a firm wrongfully withholds compensation from a departing employee it may invalidate an otherwise sound agreement, for example.

The circumstances under which a firm terminates an employment relationship are important to courts, which weigh the firm’s interests against the employee’s ability to earn a living. Many states enforce a noncompete agreement even when the firm has fired the employee if there has been no employer misconduct. Arkansas, the District of Columbia, Georgia, Kentucky, Maryland and New Mexico may not enforce one if an employee was let go without fault. Courts in Pennsylvania, Vermont and Washington consider the circumstances under which an employee leaves an important factor. Courts in Alaska, Hawaii, Michigan, Montana, Nebraska, Nevada, New Hampshire, Oklahoma, Oregon, Rhode Island, Tennessee, Texas and West Virginia have not decided this issue. To be on the safe side, a firm should keep a detailed record of its actions with respect to the fired employee.

RESOURCE S For more information on noncompete agreements, see “Tax Case: Taxing the Sale of a Business,” JofA , Jul.03, page 79, www.aicpa.org/pubs/jofa/jul2003/taxcases.htm . “Noncompete Agreement,” The Practicing CPA, Jan.00, www.cpa2biz.com . “Goodwill Requires Enforceable Covenant Not to Compete,” The CPA Expert, special ed.99, www.cpa2biz.com . e-MAP: Management of an Accounting Practice Handbook, chapters 310 and 408, www.cpa2biz.com . (MAP-XXJA, for a one-year electronic subscription.)

Who has to prove the reasonableness or unreasonableness of a noncompete agreement? In most states the employer has to show its noncompete agreement is reasonable. However, Arkansas, Colorado, the District of Columbia, Minnesota and Utah place the burden of proof on the employee who challenges the validity of a contract. Maryland and Texas place the burden of proof on both employer and employee: The firm must prove a violation of the contract likely will cause irreparable injury to the firm. The employee must show the employment contract is unreasonable. Consult an attorney about guidelines in your state.

If a noncompete agreement is too broad, can the courts amend it to make it enforceable? State law varies on this, too. In many states if the courts find a noncompete agreement has overreached, the judge is authorized to “blue pencil” (edit) the agreement; in some states he or she even may increase its scope. Other courts enforce some provisions but eliminate those they consider unreasonable. However, in Arizona, Georgia, Nebraska, Vermont, Virginia and Wisconsin a noncompete agreement either is reasonable and wholly enforceable or it is unreasonable and, therefore, wholly unenforceable.

Most jurisdictions use some degree of the blue pencil approach, but some will edit only if the noncompete agreement is organized into discrete sections. Include a severability clause, which says if one part of the agreement is held invalid, the remainder of it still should be enforced. It is usually in the CPA firm’s best interests for the courts to edit the agreement, so include a provision authorizing a court to modify an agreement to aid its enforcement.

Can a CPA firm obtain a preliminary injunction to enforce a noncompete agreement? A CPA firm may win a court case only after a former employee causes harm to the firm, so all state courts that recognize noncompete agreements give employers the right to obtain a preliminary injunction enforcing the agreement under certain circumstances. A CPA firm, in consultation with its attorney, must show three things to get such an order:

There is a legal basis for asking the court to enforce the agreement by a specific injunction directing the former employee not to violate the agreement.

The injunction is necessary to prevent irreparable harm.

Such harm is imminent as well as irreparable.

Should a firm draft different noncompete agreements for various levels of employees? No; there is no reason to have substantially different noncompete agreements for different levels of employees. In fact, a uniform agreement avoids the possibility an employee might litigate based on an assertion that a noncompete agreement applicable to top management is less restrictive, for example. A firm should make everyone sign the same agreement and make sure all employees comply with the agreements they sign.

As a practical matter, some higher-level employees do have the bargaining power to negotiate a modified version of a firm’s normal contract. In the rare cases when an employee has such leverage, have the firm’s attorney keep changes to a minimum. Carefully and fully document the reasons why the case has been treated differently. How does a firm proceed if a former employee violates a noncompete agreement? It isn’t unusual for a client to tell a CPA firm when a former employee solicits its business. If this occurs, the firm has to decide whether to subpoena the client to testify on the firm’s behalf. If he or she won’t testify against the former employee in court, the firm is in a difficult position. It can choose to force the client to do so (and likely upset him or her) or it can allow the client not to testify and possibly be unable to provide admissible evidence of a violation. On the advice of their attorneys some firms find it simpler to arbitrate their dispute or otherwise attempt to settle it outside the courts. COMMON DAMAGES PROVISIONS The types of damages provisions a noncompete agreement includes can vary greatly. Most courts ultimately will award an amount sufficient to return the firm to the position it would have occupied had the breach not occurred, and most will award liquidated damages if they are reasonable and not intended as a penalty.

PRACTICAL TIPS TO REMEMBER Firms should review their employee agreements and any existing noncompete contracts to see whether they have adequately protected themselves against employees’ taking clients with them when they leave. Firms that do not have a noncompete agreement should consult with an attorney to draft one appropriate to the business and relevant state laws. A firm should make everyone sign the same noncompete agreement and make sure all employees comply with the agreements they sign. A firm should not wrongfully withhold compensation from a departing employee, which may invalidate an otherwise sound noncompete agreement. An agreement should include a provision to authorize a court to modify it to aid its enforcement. Firms should consider including a provision to allow a former employee to take a client in exchange for a percentage of the fees he or she collects from that client for a period after employment ends.

Enforcement is burdensome, however. Firms that foresee upholding noncompete agreements as a potentially expensive nuisance may include a provision in their noncompete agreement to allow the former employee to take a client in exchange for reimbursement. This normally requires the former employee to pay the firm a percentage of the fees it collects from the client for a period of several years after employment ends. Many courts favor these arrangements. In Packer, Thomas & Co. v. Eyster, 126 Ohio App3d. 109, 709 NE2d 922 (1998), the judge noted that a reimbursement provision is not injurious to the public as the only parties affected are the former employee and the CPA firm. This lets clients transfer their accounts to any accounting firm they choose.

WHAT SHOULD YOUR FIRM DO?
Every firm should consider and mitigate the possibility that an employee who moves to a new job or becomes an independent practitioner may attempt to use proprietary information or take clients of the firm away. Practices that have formal employee agreements should—with the aid of an attorney—review them and any existing noncompete contracts to see whether the firm has adequately protected itself. Firms that don’t have a noncompete agreement should consult with an attorney to draft one. A noncompete agreement clarifies the proprietary nature of some types of business information and helps to safeguard the most valuable asset a CPA firm has—its clients.

In that case a CPA, employed by the seller, had signed agreements that imposed postemployment restrictions on competition and on the use of confidential and proprietary information. Upon selling the business, the seller and its principals agreed not to compete with the purchaser in the metropolitan area in which the seller was located.

When the CPA left the newly formed firm and started his own practice, that firm sued to enforce the noncompete agreement and other restrictions. The court found the noncompete agreement was between the CPA and the seller and was unenforceable. Because the seller had essentially “withdrawn from the market” and agreed not to compete there, it had no legitimate business interests in preventing the CPA from working in the metropolitan area in which the seller had been located, even though he was in competition with the purchaser. However, the court did allow the purchaser to pursue a claim for tortious interference with its contract to purchase the firm.