Labor & Employment Law Daily ADP’s restrictive covenant not a per se restraint on trade; let the blue-penciling begin
Tuesday, April 30, 2019

ADP’s restrictive covenant not a per se restraint on trade; let the blue-penciling begin

By Lisa Milam, J.D.

ADP’s two-tiered restrictive covenants, which include a more onerous but strictly optional agreement for high-performing employees, were not per se unenforceable. However, a district court will need to strike the overbroad nonsolicitation terms.

A federal district court was unduly harsh in invalidating outright ADP’s two-tiered restrictive covenants for its sales associates—in particular, its voluntary agreements (RCA) for high-performing employees that impose more onerous restraints, but come with stock options, the Third Circuit held. New Jersey law applied here, and New Jersey courts strive, whenever possible, “to salvage restrictive covenants” by blue-penciling any provisions that exceed an employer’s legitimate interests, the appeals court observed, including a nonsolicitation term that barred former employees from soliciting prospective (and heretofore unknown) clients. Applying the state’s three-factor analysis, the court found that ADP’s agreements will pass muster once the district court, on remand, strikes any offending provisions (Rafferty v. ADP, LLC, April 26, 2019, Krause, C.).

Two-tiered covenants. ADP imposes restrictive covenants on its sales associates in two layers. The first applies to all employees and entails a “sales representative agreement” (SRA) and nondisclosure agreement (NDA). These contracts prohibit employees, for one year after termination, from soliciting any ADP clients, prospective clients, or marketing partners of businesses with which the employee was “involved or exposed.” Sales employees must enter into these covenants upon hire as a condition of employment.

Second-layer, voluntary covenants. Only high-performing employees who meet certain sales targets are eligible to sign on to the completely voluntary, second-layer Restrictive Covenant Agreement (RCA), which entitles them to participate in a stock-option award program if they consent to “undisputedly more onerous” restrictions on post-employment activities. The RCA makes it much harder for former ADP sales associates to compete with the company after termination. Its non-solicitation provision bars employees from soliciting any ADP clients to whom the company “provides,” “has provided” or “reasonably expects” to provide business within the two-year period following termination from ADP (that is, not merely those clients with whom the employee was “involved or exposed.”) Also, while the first-tier covenant bars solicitation of “marketing partners,” the RCA prohibits solicitation of all ADP “business partners,” including “referral partners.”

Injunction denied. When two of its high performers quit to work for a competitor, ADP sued to enforce the RCA against them. But a federal court in New Jersey denied the company’s motion for a preliminary injunction, concluding the restrictive covenant was an unlawful restraint on trade under New Jersey law. However, this was “an erroneous view” of the law, the Third Circuit found. Concluding that both tiers of ADP’s covenants further the company’s legitimate business needs and comport with New Jersey public policy, the appeals court vacated the order. It instructed the district court on remand to salvage the agreement by striking any provisions that are unduly restrictive and to reassess whether injunctive relief was proper.

New Jersey law. In 1970, the New Jersey Supreme Court abandoned the “complete invalidation” rule in Solari Industries, Inc. v. Malady. Ever since, courts interpreting New Jersey law have rejected the “dichotomous choice” between enforcing and invalidating a restrictive covenant. Rather, the intent is to fulfill its permissible objectives “while nevertheless ensuring that such agreements do not unreasonably hinder competition or employee mobility.” Judicial policy, then, is to salvage restrictive covenants when possible.

Three-part test. “To ensure that such agreements remain reasonable, New Jersey courts do not hesitate to blue pencil a covenant but will rarely invalidate one in full,” the appeals court explained. The state high court in Solari established a three-part test; an overbroad covenant could be saved and enforced at least in part when: (1) the agreement is “reasonably necessary to protect [an employer’s] legitimate interests; (2) it causes no undue hardship to the defendant; and (3) it does not burden the public interest. These factors “rarely favor the complete nullification of a restrictive covenant,” the court noted.

Legitimate business interest. ADP’s second-tier RCA protects the company’s legitimate interests: preserving client relationships and the goodwill they generate. The appeals court rejected the departed employees’ contention that the company’s legitimate interests were already sufficiently protected by its first-tier SRAs and NDAs. By identifying the subset of employees who meet or exceed sales goals—i.e., those who have more extensive contacts with ADP clients—the company can better ensure that former employees who pose the strongest threat to the business will be subjected to greater restrictions in competing with it.

As the court explained, “the RCA’s heightened restrictive covenants, over and above those in the SRA and NDA, are reflective of the greater damage those employees could inflict on ADP upon their departure.”

The former employees also argued the fact that the RCA was not a condition of employment, offered no greater access to protected company information, and was tied to no particular employment milestone “bespeaks an intent” by ADP to unlawfully prevent competition, and thus served no legitimate purpose. However, these factors did not render the RCA infirm.

“[W]e do not perceive a bright line rule that restrictive covenants are unenforceable restraints on trade if imposed selectively and as a second layer,” the court said. Indeed, it pointed out, restricting fewer former employees (here, the high performers) means there is even less of a restraint on trade than the first-tier covenants imposed on all ADP sales employees at the outset. Moreover, “it 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.”

No undue hardship. To determine whether and to what extent the RCA must be blue penciled, courts balance the employer’s legitimate needs against the potential hardship on the employee. The appeals court acknowledged the countervailing interests at stake—the skill and expertise acquired by the former employees, and the fact that they are significantly constrained by the RCA from utilizing these assets. “However, under these circumstances courts should tailor the restrictions through the process of blue penciling rather than holding them to be void per se where, as here, there is no allegation or evidence of bad faith.”

Because the court below had deemed the RCA unenforceable per se, it did not delve into specific terms that might prove problematic. Here, though, the appeals court ruled the RCA’s non-solicitation provision, to the extent it barred former employees from soliciting prospective clients that they did not learn about by virtue of their work at ADP, failed to strike the proper balance. The district court was directed to consider other hardship factors, the extent of the hardship, and what specific edits to the RCA were necessary to ensure the employees were not precluded from being able to earn a living in their chosen occupation.

Injury to the public. The last factor was of little consequence here, as the restrictive covenants imposed in this case had “no major public component.” (New Jersey has recognized only two “uniquely personal” professions under the “public interest” factor—psychologists and attorneys—for which a client’s freedom to choose outweighs the interest in enforcing restrictive covenants.

At any rate, the appeals court wrote, “we are confident that the approach outlined above balances the relative interests of ADP and Appellees in a way that comports with the public interest, including the clear preference under New Jersey law to modify overbroad restrictive covenants rather than nullify them outright.”

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