United States: Third Circuit Reverses On Restrictive Covenant Agreement's Enforceability In New Jersey

On April 26, 2019, the Third Circuit Court of Appeals vacated and remanded two district court decisions in which the courts had held that a restrictive covenant agreement—offered only to the company’s highest-performing sales employees in exchange for eligibility to participate in a stock-option award program—was unenforceable per se under New Jersey law. ADP, LLC v. Rafferty, 18-1796, 2019 WL 1868701 (3d Cir. Apr. 26, 2019).

ADP utilized two separate layers of agreements containing postemployment restrictive covenants: (1) sales representation agreements (SRAs) and nondisclosure agreements (NDAs) signed by all employees at the time of hire and as a condition of employment; and (2) restrictive covenant agreements (RCAs) with certain high-performing employees as a condition of those employees’ eligibility to participate in the company’s stock-option award program. The RCAs contained more restrictive provisions than the SRAs and NDAs.

ADP filed separate lawsuits and sought preliminary injunctions against Nicole Rafferty and Kristi Mork after they voluntarily terminated their employment with ADP and began working with a competitor. Rafferty and Mork had each signed both layers of agreements containing postemployment restrictive covenants. In each case, the district court found that the less restrictive agreements—the SRAs and NDAs—were enforceable and issued preliminary injunctive relief based on the restrictions in those agreements. The district court, however, found the RCAs unenforceable in each case, reasoning that the “purpose behind the RCA is not to protect [ADP]’s legitimate interests, but rather to decrease competition.” ADP, 2019 WL 1868701, at *2. The district court also found that the RCAs placed an undue hardship on employees because the RCAs “appl[ied] broadly to all of ADP’s current or prospective clients regardless of whether [the employees] had contact with those clients.” Id. ADP appealed the district courts’ denials of its preliminary injunction motions seeking to enforce the RCAs, and the appeals were consolidated.

The Third Circuit performed an in-depth analysis of the evolution of New Jersey law, which originally favored “invalidating overbroad restrictive covenants outright,” but subsequently adopted the more flexible approach of narrowing the scope of such covenants to make them valid through a process called partial enforcement or “blue penciling.” Id. at *4. The Third Circuit, citing the New Jersey Supreme Court case of Solari Industries, Inc. v. Malady, recognized that New Jersey’s public policy requires courts to “partially enforce an overbroad covenant as long as it is [1] reasonably necessary to protect [an employer’s] legitimate interests, [2] will cause no undue hardship on the defendant, and [3] will not impair the public interest.” Solari, 264 A.2d 53, 56, 61 (N.J. 1970). The Third Circuit noted that this test rarely justifies total invalidation of restrictive covenants and that partial enforcement is favored where, as the court found in this particular case, there were no allegations or evidence of bad faith.

Applying the Solari factors, the Third Circuit found that the RCAs were reasonably necessary to protect ADP’s legitimate business interests in preserving its client relationships and the goodwill they generate—interests that would be threatened by high-performing employees like Rafferty and Mork participating in the competitive activities prohibited by the RCAs. The Third Circuit further found that ADP’s selective imposition of the RCAs did not negate its legitimate business interests. The court weighed ADP’s legitimate business interests against the undue hardship that ADP’s former employees would suffer if the RCAs were enforced against them. Specifically, the court explained that the RCAs’ prohibition against working with any of ADP’s prospective customers within the two-year period following termination of their employment and its prohibition against soliciting prospective customers that employees did not interact with while employed by ADP likely rendered the RCAs overbroad. The Third Circuit determined that the last factor—injury to the public—would be neutral because the public’s interest in allowing employees to use the skills they gleaned while working at an employer is balanced with the employer’s interest in protecting its goodwill and client relationships.

Upon weighing these factors, the Third Circuit determined the RCAs were not per se unenforceable and that the factors favored partial enforcement. The Third Circuit ultimately remanded the cases to the district courts to “blue pencil” the RCAs in order to balance ADP’s legitimate business interests against the potential undue hardship to Rafferty and Mork.

The Third Circuit’s opinion in ADP, LLC v. Rafferty reinforces the importance of having agreements containing postemployment restrictive covenants reviewed by counsel to increase the likelihood the covenants are enforced.

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