Traditionally, courts will analyze restrictive covenants under two tiers of scrutiny. Those covenants incidental to the sale of a business are subject to a common law rule of reason, while those tied to employment are governed by a stricter standard of scrutiny requiring the courts to examine certain other factors (which vary state-by-state).
But not all employment-related covenants merit strict scrutiny. For instance, an employment contract given to the seller of a business who stays on to assist the buyer likely will be judged under the rule of reason since it was given in connection with the underlying transaction. And even some higher level executives will have their covenants examined with a less exacting standard of review in some states given their pervasive exposure to confidential information.
Another example is one I have written about before: covenants extended in the context of a stock option grant. The law is not uniform on this, but the prevailing sentiment is that covenants which are part of a stock option award agreement will be adjudicated under the less stringent rule of reason rather than the traditional employment standard.
The Wisconsin Court of Appeals held as such in a recent case and articulated the reason behind why courts traditionally are not as likely to invalidate such covenants:
"...[U]nlike typical restrictive covenants, upon which a prospective employee's position may depend, there were no consequences attached to [the employee]'s refusal to accept the agreement. The circuit court found [the employee] was not pressured to sign the stock option agreement, nor was his employment conditioned upon his doing so. Indeed, the circuit court found [the employee]'s refusal would not have affected his employment in any way." In fact, the evidence in the Wisconsin court's case revealed the employee quadrupled his investment in company stock by accepting the agreement's benefits.
The Wisconsin court obviously reached the right result, as covenants executed in exchange for participation in an incentive program are not compulsory and are intended to align the employee's goals with the long-term best interest of the company. In fact, that case did not even deal with a traditional non-compete agreement, but rather applied only if the employee solicited firm clients or disclosed confidential information of the employer.
It is somewhat of a mistake to call the two tests used by courts as the "employment test" and the "sale of business" test. They are not limited to such confining topics. It is more appropriate to say generally that covenants that are part of an adhesive agreement are subject to strict scrutiny, while those which are the product of a bargained-for-exchange are governed by a rule of reason.
Covenants in the latter group almost certainly include those in a franchise agreement, operating or shareholder agreement, settlement agreement, or incentive plan award agreement. It might even include covenants tied to long-term employment contracts for high-level executives, though the law on this is not particularly well-developed. The former group normally will be found in most employment or independent contractor agreements.
Court: Court of Appeals of Wisconsin, District Three
Opinion Date: 7/13/10
Cite: The Selmer Co. v. Rinn, 789 N.W.2d 621 (Wisc. Ct. App. 2010)