Lessons on Navigating the Minefield of Restrictive Covenants

October 19, 2017

Over the last several years, Wisconsin appellate courts have decided a number of cases that have changed the law regarding the use of restrictive covenants in employment agreements. The decisions have given both employers and employees additional guidance on the enforceability of employment restrictions. Manitowoc Company, Inc. v. Lanning is currently pending before the Wisconsin Supreme Court, which is considering the enforceability of a restrictive covenant that prohibited a departing employee from soliciting other employees of the company. The court heard oral arguments in the case in early September. Additionally, on September 7, 2017, the Wisconsin Court of Appeals issued a decision in which it ruled that three restrictive covenants were unenforceable.

If you use restrictive covenants (including covenants not to compete, provisions protecting confidential information, or provisions prohibiting solicitation of employees or customers), it is important to stay up to date on this area of the law and to modify your employment agreements as needed to minimize the possibility that a restrictive covenant will be deemed unenforceable.

Restrictive Covenants in Wisconsin

Like many states, Wisconsin has a specific law governing the use of restrictive covenants by employers. In Wisconsin, the law is Section 103.465. In general, a restriction must be reasonable, and it is the employer’s burden to demonstrate reasonableness. Wisconsin courts typically look at five factors in evaluating the reasonableness of a restrictive covenant. A reasonable restrictive covenant:

  1. Is necessary for the protection of the employer;
  2. Provides a reasonable time limit;
  3. Provides a reasonable territorial limit;
  4. Is not harsh or oppressive to the employee; and
  5. Is not contrary to public policy.

Restrictive covenants are generally disfavored and regarded with suspicion by courts because the law encourages the mobility of employees. Generally, if a restrictive covenant is unreasonable, a court will not rewrite it to make it reasonable. Rather, the court will rule that the restriction is unenforceable. For example, if a restriction’s duration is three years and a court determines that a two-year period is reasonable but a three-year period is not, the court will not rewrite the restriction to make it only two years and then enforce it.

Additionally, until relatively recently, if any part of a set of restrictive covenants was found to be unenforceable, all restrictive covenants in the agreement were unenforceable. Wisconsin courts will now look at whether restrictive covenants are divisible.

Recent Case

John Karsten was a longtime employee of Terra Engineering and had served as its president and as a member of its board of directors. In 1991, he signed an agreement that included restrictive covenants limiting his ability to engage in competitive activity against Terra during his employment with the company and following his separation from employment. Twenty-two years later, he left Terra and began working for Midwest Drilled Foundations & Engineering, LLC, Terra’s competitor. Terra claimed that Karsten directed business to Midwest in violation of his restrictive covenants.

Karsten filed a lawsuit asking the court to declare that the restrictive covenants were unenforceable. Terra countersued Karsten for violating his noncompete, and added a tortious (wrongful) interference claim against Midwest. The trial court ruled that the restrictive covenants were unenforceable, and Terra appealed.

The first question the Wisconsin Court of Appeals addressed was whether Section 103.465 applied to Karsten’s restrictive covenants. The court had to make that determination because it decided Selmer Company v. Rinn in 2010. In that case, the court ruled that Wisconsin’s restrictive covenant law applies when either (1) the covenant is a condition of employment or (2) the employer possesses an unfair bargaining advantage over the employee.

In Karsten’s case, the court rephrased the test in the converse: Section 103.465 does not apply when a restrictive covenant is not a condition of employment and the employer does not possess an unfair bargaining advantage over the employee. The court concluded that Karsten’s restrictive covenants were a condition of employment even though they were contained in a stock option agreement.

After finding that the restrictive covenants were governed by the reasonableness analysis in Section 103.465, the court addressed whether the challenged restrictions passed the reasonableness test. The court could have found that the restrictions were indivisible (therefore, if one failed, all three were unenforceable). Instead, it assumed the restrictions were divisible and examined the reasonableness of each of the restrictions.

The first restriction prohibited Karsten from working for a competitor in states or comparable foreign political subdivisions in which Terra sold or actively attempted to sell its products or services. The restriction had a two-year duration, which the court said was not unreasonable per se. Although there may be a question of whether the circumstances dictate that two years is too long, restrictions with a duration of two years or shorter generally are upheld. Longer durations generally are found unenforceable. In Karsten’s case, the court observed that the restriction lacked any meaningful territorial limitation. Also, Terra did not show how many states or countries it marketed its business in during the 12 months prior to Karsten’s separation.

Terra made two arguments for why the restriction should be deemed reasonable. First, it argued that it applied only to products and services over which Karsten had managerial control while working for the company. The court noted that “management responsibility” language may be an appropriate limitation in the right case. However, in this case, Karsten was prohibited from performing similar work for anyone in any state or territory in which Terra had customers or had attempted to obtain even one customer during the specified period. That prohibition allowed Terra to include all potential customers in any territory where it marketed its business, even if it had no interest in soliciting the customers.

Second, Terra argued that Karsten held a high-level position. The court agreed that was a valid consideration, but remained concerned that the restriction was not narrowly tailored to Terra’s actual customers. To use the high-level-employee factor to establish the reasonableness of a restrictive covenant, an employer must show why the issue makes a difference when comparing the individual to other employees—for example, midlevel managers or sales personnel. Thus, the court found that the restriction was overly broad and unreasonable.

The second restriction prohibited Karsten from working in any capacity that utilized his special skills in selling any products or services that were similar to Terra’s to any company to which Terra sold or attempted to sell its products during the previous 12- month period. It, too, was found to be overly broad and unreasonable. There were two primary problems with the restriction: (1) There was no territorial limit, and (2) Karsten was effectively barred from soliciting customers Terra was unsuccessful in soliciting.

The final restriction the court examined is routinely used by many employers—a restriction on disclosing or using confidential company information. Karsten was prohibited from performing similar work that would reasonably be expected to use confidential information he acquired during his employment with Terra. The term “confidential information” was broadly defined, as it nearly always is in this type of restrictive covenant. The court did not quibble with how “confidential information” was defined, but it nevertheless found the restriction unenforceable for two reasons. First, if Karsten engaged in similar work, he would be required to prove “beyond a reasonable doubt” that the confidential information had become public, if that was his argument. The court was troubled by the use of the high standard of proof, which typically applies only in the criminal context. Second, the restriction did not require the actual use of confidential information. Rather, it was enough that the similar work “would reasonably be expected” to use confidential information.

Also, the court questioned whether the Selmer Company decision remains good law in Wisconsin. After the Karsten ruling, it may be difficult for an employer to rely on the Selmer Company exception to persuade a court to uphold an otherwise questionable restrictive covenant. Karsten v. Terra Engineering & Construction Corporation, No. 2016AP2025 (Wis. Ct. App., Sept. 7, 2017).

Bottom Line

Preparing a restrictive covenant that is enforceable is always difficult, particularly given Wisconsin’s policy favoring employee mobility and the suspicion with which courts look at such restrictions. This area of law has become more complicated because of decisions coming from Wisconsin’s appellate courts. Some areas of the law are fairly intuitive. We all know that employers cannot fire or refuse to hire an individual because of his gender, race, or religion and that nonexempt employees typically must be paid overtime for all hours worked in excess of 40 in a workweek. Restrictive covenants, including covenants not to compete, confidential information restrictions, and nonsolicitation agreements (for customers or employees), are far more nuanced. If you use restrictive covenants for some or all of your employees, be certain that your legal counsel has had an opportunity to review the agreements to ensure they comply with existing law.

This article, slightly modified to note recent updates, was featured in the October 2017 issue of the Wisconsin Employment Law Letter, which is co-edited by Axley Brynelson Attorneys Saul Glazer and Michael Modl and published by BLR®—Business & Legal Resources. Reproduced here with the permission of BLR®—Business & Legal Resources.