Too Many, Too Broad, Too Long: Washington Overhauls Non-compete Agreements

July 15, 2019

Lawrence R. Cock, Jack Lovejoy, and Benjamin Byers

Gov. Jay Inslee recently signed Engrossed Substitute House Bill 1450, which substantially reforms Washington’s common law of noncompetition covenants. As a result, employers who use noncompetition covenants with Washington-based employees will need to scrutinize their agreements and make changes before the January 1, 2020, effective date.

The bill was sponsored by Sen. Marko Liias (D-Lynnwood) and Rep. Derek Stanford (D-Bothell). The legislators were troubled by the ubiquity, expanding scope of prohibited activities, and lengthening duration of noncompetition covenants. The new law effectuates seven major reforms.

• Wage thresholds. If an employee earns less than $100,000 annually, yet has signed a noncompetition covenant, the covenant is void and unenforceable. If an independent contractor earns less than $250,000 annually, yet has signed a noncompetition covenant, the covenant is void and unenforceable.

• Notice provisions. A noncompetition covenant is void and unenforceable if the employer fails to tell the employee about “the terms of the covenant” before the employee accepts the job.

• Limit on duration. Noncompetition covenants longer than 18 months are presumed unreasonable. An employer can rebut the presumption with clear and convincing evidence.

• Protection for workers who are laid off. A noncompetition covenant cannot be enforced against employees terminated “as the result of a layoff,” unless the employer continues to pay the employee’s base salary (less compensation the employee earns from a new employer).

• Restrictions on choice of law/choice of venue. A choice of law clause applying another state’s law or a choice of venue clause requiring an employee or independent contractor to litigate a noncompetition covenant in another jurisdiction is void and unenforceable if the employee or independent contractor is “Washington-based.”

• Penalty and attorney fees for overly broad covenants. If a court concludes that a covenant violates the statute, or if a court or arbitrator, applying the rule of reasonableness, revises, rewrites, or only partially enforces a noncompetition covenant, the ex-employee receives a $5,000 statutory penalty plus his or her attorney fees, expenses, and costs.

• Second jobs/workers for franchises. The ability of low-wage workers to hold a second job is better protected, and fast food and other franchise workers are protected from prohibitions on being hired by other franchisees.

To give these reforms utmost effect, the Legislature included four other provisions. First, the Legislature made the statute applicable “to all proceedings commenced on or after” January 1, 2020, “regardless of when the cause of action arose. To this extent, this chapter applies retroactively, but in all other respects it applies prospectively.” § 11.

Second, the Legislature exercised the state’s police power and instructed the courts to construe the statute “liberally for the accomplishment of its purposes.” § 12. To ensure the courts understood the Legislature’s purposes, the Legislature included findings: “The legislature finds that workforce mobility is important to economic growth and development. Further, the legislature finds that agreements limiting competition or hiring may be contracts of adhesion that may be unreasonable.” § 1.

Third, the Legislature included a broad displacement provision patterned on the Uniform Trade Secrets Act. § 10(1). Yet, the Legislature expressly allowed further “development of the common law.” § 10(2). Courts are free to re-evaluate restrictive-covenant law to the extent it is not covered by the legislation. Looked at another way, the Legislature identified practices that are no longer permitted. But it did not say that other practices are permitted; rather, the Legislature has left it to the judiciary to decide what remaining common law principles should also be reformed.

Fourth, for statutory violations, the Legislature invited the attorney general and individual employees to take the offensive. The attorney general, or “a person aggrieved by a noncompetition covenant to which the person is a party,” can initiate an action to seek the higher of actual damages or the $5,000 statutory penalty plus attorney fees, expenses, and costs.

The covenants included within the definition of “noncompetition covenant”

“Noncompetition covenant” is broadly defined. § 2(4). It includes “every written or oral covenant, agreement, or contract by which an employee or independent contractor is prohibited or restrained from engaging in a lawful profession, trade, or business of any kind.” § 2(4).

The definition has four carve-outs: nonsolicitation agreements, confidentiality agreements, a covenant entered into when a person is purchasing or selling the goodwill of a business, and a franchisee covenant when the purchase or sale has satisfied the registration requirement of the Franchise Investment Protection Act. “Nonsolicitation agreement” is narrowly defined as a provision in an employment relationship prohibiting solicitation of any employee to leave or of any customer to cease or reduce its business with the employer. § 2(5).

Due to § 2(5), drafters will likely want to avoid including prospective customers from nonsolicitation provisions in future contracts. Due to the broad definition of “noncompetition covenant” and the narrowness of the carve-outs, drafters may also want to avoid nonacceptance-of-business clauses.

When and how the wage threshold is calculated

The Legislature wanted to eliminate the use of noncompetition covenants for many or most workers. As noted above, it carried out this intent by establishing two wage thresholds.

If an employee earns less than $100,000 annually, yet signs a noncompetition covenant, the covenant is unenforceable. § 3(1)(b). If an independent contractor earns less than $250,000 annually, yet signs a noncompetition covenant, the covenant is unenforceable. § 4(1). The higher threshold for independent contractors encourages employers to not misclassify employees as contractors. The $100,000 and $250,000 thresholds are adjusted every September 30th for inflation, and the adjusted amount applies the following January 1st. § 5.

A worker’s “earnings” are calculated on the earlier of “the date of separation” or “the date enforcement of the noncompetition covenant is sought.” § 2(1). But the calculation looks back to the employee’s or independent contractor’s previous calendar year and uses the Form W-2 (Box 1) or Form 1099. § 2(1). For example, if an employee quits on November 21, 2020, her “earnings,” for the purpose of the statute, are the employee’s 2019 earnings. If the previous year is a partial calendar year, the earnings are annualized.

Box 1 of a worker’s earnings includes total wages, bonuses, prizes, and awards, along with various other items. Still, Box 1 “earnings” will be lower than an employee’s Medicare earnings (Box 3) if, for example, s/he participates in a traditional (e.g., before tax) retirement deferral program. If the employee worked a partial year in the prior calendar year, the amount is annualized and then compared to the threshold.

Example: An employee commences work on January 1, 2020, and signs a noncompetition covenant. S/he is paid a salary of $9,000 per month and receives no other compensation included in Box 1 of the Form W-2. The employer has a 401(k) plan and the employee chooses to defer $1,000 per month into a traditional 401(k) plan. The employee resigns on January 2, 2021. The employee’s Form W-2, Box 1, for 2020 will reflect earnings of $96,000 ($108,000 minus $12,000). Assume that the Department of Labor & Industries, in fall 2020, determined that the threshold for inflation required a 2% increase. The noncompetition covenant is void and unenforceable because the threshold as of January 1, 2021, is $102,000 and the employee’s “earnings” were $96,000. In a legal proceeding concerning the covenant, the employer will be assessed a $5,000 statutory penalty (or actual damages, if greater) and required to pay the ex-employee’s attorney fees. (The result would be different if the employee was making Roth 401(k) contributions. In that case, the Box 1 earnings would be $106,000.)

A worker could sign an agreement while earning less than the threshold, but the covenant could nevertheless become enforceable if the worker, in the year preceding the separation date or enforcement, exceeded the threshold. § 3(1). An employer must, however, specifically disclose this potential future enforceability no later than the time the employee accepts the offer of employment. § 3(1).

There is an additional issue presented by businesses structured into multiple legal entities. The employee must receive the “earnings from the party seeking enforcement.” § 3(1)(b). The “party seeking enforcement” is the “named plaintiff or claimant in a proceeding to enforce a noncompetition covenant or the defendant in an action for declaratory judgment.” § 2(6).

Example: The employer is a wholly owned subsidiary. The parent corporation decides to offer the subsidiary’s employees a stock bonus in exchange for a noncompetition covenant. But the value of the stock bonus is less than $100,000 in the year preceding the employee’s resignation. If the parent corporation tries to enforce the noncompetition covenant, the covenant will be unenforceable because “the party seeking enforcement” (the parent corporation) paid the employee less than $100,000 in the preceding calendar year.

Looked at another way, a noncompetition covenant supported by consideration may nevertheless be void and unenforceable.

Notice requirements and midstream covenants

An employer must notify a prospective employee in writing about “the terms of the covenant” … “no later than the time of the acceptance of the offer of employment.” § 3(1)(a)(i). A separate notice requirement applies when the worker makes less than the threshold at the time of signing, but the employer nevertheless has him/her sign a noncompetition covenant because the worker might ultimately exceed the threshold.

Under that circumstance, the employer must “specifically disclose that the agreement may be enforceable against the employee in the future.” § 3(1)(a)(i). Employers will be unlikely to avail themselves of this opportunity, however, because they risk paying the statutory penalty and the ex-employee’s attorney fees if s/he quits or is terminated at a time when his/her previous calendar year’s earnings are less than the threshold.

The Legislature enshrined the common law principle enunciated in Schneller v. Hayes1 and Labriola v. Pollard Group.2 A restrictive covenant entered into after the commencement of employment must be supported by “independent consideration for the covenant,” and merely continuing an employee’s employment is not consideration. § 3(1)(a)(ii).

Limits on duration

Regardless of an individual’s earnings, noncompetition covenants longer than 18 months are presumed unreasonable. § 3(2). An employer can overcome the presumption, but only if the employer proves by “clear and convincing evidence that a duration longer than 18 months is necessary to protect the party’s business or goodwill.” § 3(2).

Some restrictive covenants provide that the running of the restricted period is “tolled” at all times when the ex-employee is in breach. Unless capped at 18 months or the employer meets the heightened evidentiary standard, these tolling provisions will be “unreasonable and unenforceable” and subject to the statutory penalty and attorney fee provisions in section 9.

The Legislature also enacted a very short durational limit specifically for performers: “The duration of a noncompetition covenant between a performer and a performance space, or a third party scheduling the performer for a performance space, must not exceed three calendar days.” § 4(2).

Layoff

“A noncompetition covenant is void and unenforceable against an employee: … If the employee is terminated as the result of a layoff, 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.” § 3(1)(c).

“Layoff” is not defined in the statute. A dictionary definition is (1) a period of inactivity or idleness, or (2) the act of laying off an employee or a workforce.3

Specifying a different jurisdiction or choice of law is void if the worker is “Washington-based”

The effectiveness of legislative reforms could be diminished if employers could avoid the application of Washington law. Hence, for “Washington-based” workers, the Legislature prohibited an employer from using a choice of law clause that “deprives the employee or independent contractor of the protections or benefits of this chapter.” § 6(2). It also prohibited employers from requiring an “employee or independent contractor to adjudicate a noncompetition covenant outside of this state.”

The application of “Washington-
based” language is taken from Bostain v. Food Express, Inc.,4 which applied Washington’s Minimum Wage Act to an interstate truck driver. Using a choice of law or choice of venue clause made “void and unenforceable” by section 6 exposes an ex-employer to a statutory penalty and attorney fees described in section 9.

Penalty and attorney fees for overly broad covenants

The Legislature’s concern about overly broad covenants is most apparent in section 9. Section 9(1) allows either the attorney general or a party to a covenant to bring a cause of action under the statute.

If a noncompetition covenant violates the statute, section 9(2) requires courts and arbitrators to impose a statutory penalty of $5,000 (or actual damages, if greater) and require the ex-employer to pay the ex-employee’s attorney fees, expenses, and costs.

Employers have long been able to draft deliberately overbroad covenants, knowing that courts would rewrite and then enforce them under the holding in Wood v. May.5 Section 9 is designed to motivate employers to stop this practice. Section 9(3) imposes a $5,000 statutory penalty and requires the ex-employer to pay the ex-employee’s attorney fees, expenses, and costs when the court or arbitrator “reforms, rewrites, modifies, or only partially enforces any noncompetition covenant.”

In other words, a court may still apply the rule of reasonableness and revise a covenant, but the cost to the ex-
employer is substantial. Section 9 is designed to motivate employers to stop drafting deliberately overbroad covenants. In Emerick v. Cardiac Study Center, Inc., P.S.,6 the court reduced both the geographic scope and duration of a noncompetition covenant, but nevertheless awarded the ex-employer attorney fees. Section 9(3) legislatively overrules that holding.

There is one exception in § 9, applicable to covenants signed prior to January 1, 2020. A signatory may not bring a cause of action for the statutory penalty and attorney fees “if the noncompetition covenant is not being enforced.” § 9(4).

Section 9(4) can be read in different ways. It might mean that an employee who signed an agreement prior to January 1, 2020, and who initiates a declaratory judgment action cannot recover the statutory penalty or recover the statutory attorney fees. If so, the legislative intent was to prevent ex-employees from initiating actions and recovering the statutory penalty even though the ex-employer was not pursuing its own claims. This interpretation will result in employers drafting new agreements, paying independent consideration, and having employees sign prior to January 1, 2020.

On the other hand, section 9(4) could mean that an ex-employer can initiate an action but limit the enforceable portions of a covenant signed prior to January 1, 2020. For example, an ex-employer could sue for breach of a nonsolicitation covenant, while not suing to enforce a noncompetition covenant in the same agreement. This interpretation would allow employers to sue for limited recovery while avoiding the penalty and attorney fees for overly broad covenants.

Still, courts are instructed to construe the chapter “liberally for the accomplishment of its purposes.” § 12. The question then becomes whether one interpretation will better foster “workplace mobility” or better protect employees against contracts of adhesion. § 1.

Protection for workers needing to hold a second job

The Legislature was aware of the need for many lower wage workers to hold a second job (and even a third) and concerned about employers that restrict supplementary employment. The new law provides a measure of protection for workers earning less than twice the applicable state minimum wage.

In section 8(1), employers are prohibited from restricting, restraining or prohibiting such workers from “having an additional job, supplementing their income by working for another employer, working as an independent contractor, or being self-employed.”

Section 8(2) limits this protection to some degree if the employee’s position raises “issues of safety” or the second job interferes “with the reasonable and normal scheduling expectations of the employer.” Section 8(2)(b) limits the protection to a degree by stating that section 8 does not alter the common law duty of loyalty or laws preventing conflicts of interest.

Protection of workers for franchisors and franchisees

The Legislature included two specific provisions to address abuses in the franchise area. The new law prohibits a franchisor from restricting, restraining or prohibiting a franchisee from soliciting or hiring employees from other franchisees. § 7(1). It also prohibits a franchisor from restricting, restraining or prohibiting a franchisee from soliciting or hiring the franchisor’s employees. § 7(2). The attorney general had already commenced an effort to address abuses in the franchise area.

Section 9(1) specifically authorizes the attorney general to bring actions to enforce the statute. Because a no-hire provision falls within the definition of a “noncompetition covenant,” a franchisee may be able to bring an action against a franchisor for violation of section 7. It seems likely that a franchisee is a “person aggrieved by a noncompetition covenant to which the person is a party.” § 9(1).

Effective date and application to “all proceedings” initiated after 1/1/2020

Section 11 provides: “This chapter applies to all proceedings commenced on or after the effective date of this section, regardless of when the cause of action arose. To this extent, this chapter applies retroactively, but in all other respects it applies prospectively.”

While limiting the application of the new statutory framework to actions commenced after the effective date, the new limitations on non-compete agreements are effective to all challenged agreements going forward — regardless of when such an agreement was entered into. That is why the Legislature stated that it was exercising the police power. § 12.7

Those involved in lawsuits filed prior to January 1, 2020, need not worry about the statute: It does not apply. But employers need to analyze their existing agreements and then decide whether, prior to January 1, 2020, they should draft new agreements to replace existing ones.

The Legislature recognized that restrictive covenants may be contracts of adhesion and that worker mobility is beneficial. Employers with Washington-based employees have until January 1, 2020, to comply with the law by using noncompetition covenants only with highly compensated employees, and drafting shorter, narrower covenants for them.

Lawrence Cock, Jack Lovejoy and Benjamin Byers practice law at Corr Cronin, LLP. Lawrence Cock assisted the Washington Employment Lawyers Association with the drafting of Engrossed Substitute House Bill 1450 and testified in favor of the bill. The authors may be contacted as follows: LRC@corrcronin.com (206-812-0836); jlovejoy@corrcronin.com (206-812-0894) and bbyers@corrcronin.com (206-501-3512). © 2019

1 176 Wash. 115 (1934).

2 152 Wn.2d 828 (2004).

3 https://www.merriam-webster.com/dictionary/layoff

4 159 Wn.2d 700 (2007).

5 73 Wn.2d 307 (1968).

6 189 Wn. App. 711, 737-38 (2015).

7 See Optimer Int’l, Inc. v. RP Bellevue, LLC, 151 Wn. App. 954, 969, 214 P.3d 954, 961 (2009), aff’d, 170 Wn.2d 768, 246 P.3d 785 (2011) (retroactive legislation affecting existing contract upheld due to “rational connection between the purpose of the statute and the method the statute uses to accomplish that purpose”).

 

Originally published in the July issue of the King County Bar Association Bar Bulletin.  Reprinted with permission of the King County Bar Association.

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