We wrote an earlier post about the Third Circuit’s opinion in ADP, LLC v. Rafferty, et al., confirming courts’ blue penciling authority (see here); but the Third Circuit’s analysis of ADP’s two-tiered restrictive covenant structure is also worth discussing, as it may have employers doing some head scratching.
Why the focus on ADP’s two-tiered contracting approach?
ADP’s first-tier agreements for new hires included confidentiality obligations and a one-year customer non-solicit tailored to the employee’s assigned role and contacts, but no non-compete. ADP’s second-tier agreements (used in connection with stock incentives offered to high-performing employees) added a one-year territory-based non-compete and broadened the scope of the one-year non-solicit to include all customers and business partners for which ADP has provided services and all prospects for which ADP reasonably expects to provide services during the two-year period following the employee’s termination—regardless of the employee’s responsibility for them or access to confidential information about them during employment.
Because ADP did not require all employees in the role to sign the second-tier agreements and did not terminate those who refused, some practitioners and the lower courts questioned whether those agreements truly align with ADP’s legitimate business interests. In other words, if ADP needs such broad protection, shouldn’t all new hires and employees at that level be required to sign that form of agreement? That is, after all, a common practice.
Contrary to some expectations, the Third Circuit split from that common practice, holding that ADP’s approach “manifests a reasonable business judgment as to how to best balance its employees’ and the public’s need for free competition with its own need to protect its legitimate business interests.” Explaining its rationale, the Third Circuit observed that “ADP is not in a position to know at the time of hire from which of its employees it will most need that protection,” and “[t]hus, ADP restrains trade less by declining to uniformly, and perhaps prophylactically, impose the [second agreement] until it knows, through the proxy of met sales targets, which of its employees will go on to develop either a greater number of or deeper relationships with ADP’s clients (or both).”
What to make of the Third Circuit’s apparent support for a two-tiered contracting practice?
Although not highlighted in the Third Circuit’s analysis, it is important to note that, because continued employment may constitute sufficient consideration under New Jersey law, no financial consideration is required to support post-hire restrictive covenant agreements. Of course, a pot sweetener, such as ADP’s stock option award, may very well be needed to entice existing employees to sign a more restrictive second-tier agreement.
As you might imagine, it is difficult to predict which active employees will be willing to sign a post-hire agreement. Employers may also be unwilling or unable to provide the financial (or other) consideration necessary to entice active employees to sign more restrictive agreements in the midst of their employment tenures, and could even end up caught in ever-escalating compensation negotiations with employees with ultimately little success in securing signatures. As a result, employers who follow ADP’s lead or who take comfort in the Third Circuit’s characterization of ADP’s approach as a “reasonable business judgment” risk giving up their best shot to secure an employee’s commitment to restrictive covenants—which is at the time of hire. That is why many employers include in their new-hire packages the broadest restrictive covenants they can justify, relying (if necessary) on the courts’ ability to blue pencil the covenants down the road.
But the Third Circuit’s rationale in ADP has the potential to upend how and when employers implement or amend restrictive covenant agreements and how courts analyze their enforceability going forward. Time will tell whether and how the Third Circuit’s analysis will be applied, so stay tuned. In the interim, please contact a member of our team if you have any questions about the impact of this ruling on your contracting, recruitment, and hiring practices and what may be the best strategy for your business.