COVID-19 and Restrictive Covenant Agreements

COVID-19 and Restrictive Covenant Agreements

7.10.2020

By Maryann C. Stallone, Richard W. Trotter and Marisa Sandler

With the global economy reeling from the COVID-19 pandemic, employers across the United States have terminated employees or reduced hours and compensation. Employees who have been terminated or have had their compensation reduced may look for opportunities with competitors, and competitors may attempt to capitalize by hiring away top talent. This gives rise to a crucial question that employers may want to consider as they make difficult workforce decisions during this period: how might layoffs and reductions in employee compensation affect the enforceability of their employees’ restrictive covenant agreements?

This article discusses the risks employers may encounter in enforcing their employees’ covenants not to compete, not to solicit or service clients, or not to solicit or hire employees (“restrictive covenants”) if they lay off employees or reduce their compensation. Employers may be able to mitigate the risk of compromising the enforceability of their restrictive covenant agreements by familiarizing themselves with certain employment options before making important business decisions.

Key considerations that we will address include: (1) whether employers may want to enter into separation agreements with terminated employees; (2) whether employers who do not want to lose their key personnel to competitors may want to implement a reduction in compensation across their workforce in lieu of terminating employees to reduce costs; and (3) whether such reductions in compensation would constitute a “constructive discharge” and thereby potentially render employees’ restrictive covenant obligations unenforceable.

Will Terminating Employees Without Cause Render Restrictive Covenant Agreements Unenforceable?

Relying on the New York Court of Appeals’ decision in Post v. Merrill Lynch, Pierce, Fenner & Smith, Inc. ^[i], employees terminated without cause frequently argue that their restrictive covenant agreements are unenforceable. In Post, the Court of Appeals held that “where an employee is involuntarily discharged by his employer without cause and thereafter enters into competition with his former employer, and where the employer, based on such competition, would forfeit the pension benefits earned by his former employee, such a forfeiture is unreasonable as a matter of law and cannot stand.”^[ii] “Where the employer terminates the employment relationship without cause . . . his action necessarily destroys the mutuality of obligation on which the covenant rests as well as the employer’s ability to impose a forfeiture.”^[iii]

New York federal and state courts have since reached inconsistent conclusions on whether an employer’s termination of an employee without clause renders restrictive covenants unenforceable.^[iv] While some courts have limited Post to cases involving an employer’s denial of post-employment benefits that an employee is contractually entitled to receive, others have concluded that simply terminating an employee without cause renders restrictive covenants unenforceable. ^[v]

Consequently, there is a risk that courts may conclude that the post-employment restrictive covenant obligations of employees who were terminated without cause due to the pandemic are unenforceable. The economic hardship inflicted by the COVID-19 pandemic may further increase this risk. With millions of Americans currently unemployed, courts may be less inclined to enforce restrictive covenants that keep employees out of work.

What, then, are employers to do if they need to lay off employees or reduce compensation to cut payroll costs, but are concerned about rendering their restrictive covenant agreements unenforceable?

Separation Agreements Present Opportunities for Employers to Have Employees Reaffirm Their Restrictive Covenant Obligations

Separation agreements are a useful tool for employers seeking to set forth the terms and conditions of employees’ separation of employment and obtain a release of legal claims in exchange for a benefit (such as severance pay). Separation agreements also allow employees to reaffirm their restrictive covenant obligations. Such agreements should be in writing and expressly confirm the survival of existing restrictive covenant obligations.

If entering into separation agreements is unrealistic (e.g., because terminations are occurring on a wide-scale basis or employers cannot afford to offer employees any separation benefit), employers may also consider an across-the-board reduction in compensation for all employees or similarly situated employees.

Reductions in Compensation May Preserve Restrictive Covenant Obligations Provided They Do Not Result in “Constructive Discharge”

In lieu of terminating employees, employers may choose to retain their workforce by implementing across-the-board pay cuts to reduce payroll expenses during the pandemic. But will this help preserve the enforceability of the employees’ restrictive covenants?

Generally, a reduction in compensation will not render restrictive covenant agreements unenforceable. However, employees who suffer a drastic cut in compensation may argue that they were “constructively discharged” and that their restrictive covenant obligations are unenforceable as a result. Under the constructive discharge doctrine, a court may conclude that, even where an employee resigned, the employee was constructively (i.e., effectively) terminated by the reduction in compensation or a hostile work environment created by the employer.

While courts consider a variety of factors in assessing whether an employee has met its burden of establishing a constructive discharge, a significant reduction in compensation is an important consideration in making such a determination. “Where the claim of constructive discharge is founded upon loss of pay, courts look to the compensation paid to comparable employees, the percentage of the reduction, and the reasonable expectations of the parties.”^[vi] Similarly, in Morris v. N.Y. City Department of Sanitation, the District Court for the Southern District of New York found that the plaintiff had made a prima facie showing of constructive discharge by establishing that his salary would be reduced by $25,000 and his pension benefits would be curtailed.^[vii]

Even where there is a substantial reduction in employee compensation, to establish constructive discharge is no light burden; the employee must show that the employer intentionally created an “intolerable workplace condition” by creating an atmosphere that was “so intolerable as to compel a reasonable person to leave” the job.^[viii] In both Kirsch and Morris, the reductions in compensation were substantial and the motivation behind those salary reductions was to make the employees’ working conditions so unbearable as to prompt the employees to quit. While Kirsch, Morris and Granser arose from claims of discrimination and wrongful termination, the arguments presented in Integra Optics, Inc. v. Messina – which was a restrictive covenant case – show that the constructive discharge doctrine is likely to be raised as a defense to enforcement of a former employees’ restrictive covenant obligations.^[ix] Employers reducing compensation as a result of the COVID-19 pandemic can argue that the reductions were reasonable in light of the economic turmoil caused by the pandemic and that such reductions did not amount to a constructive discharge. The employers’ argument will be even stronger if the reductions are fixed and imposed on all similarly situated employees.

By keeping employees on payroll, employees remain bound by their common law duty of loyalty to “exercise the utmost good faith and loyalty in the performance of his duties.”^[x] As a result, employees cannot act directly against their employers’ interests, such as by “improperly competing with their current employer.”^[xi] While we did not find a case involving compensation reductions implemented as a direct result of a global financial crisis or natural disaster of the sort businesses are currently facing in light of the COVID-19 pandemic, reductions in compensation compelled by a crisis, and implemented on a company-wide basis, likely will not (and we believe should not) be deemed a “constructive discharge” – particularly where the purpose of the reductions is to retain as many employees as possible, and the reductions are company-wide.

Across-the-board reductions in compensation for employees may therefore be preferable to terminating employees without cause and potentially compromising the enforceability of employees’ restrictive covenant obligations.

The Preservation of Restrictive Covenants May Be an Important Consideration in Employers’ Cost-Cutting Decisions

The preservation of restrictive covenants may not be employers’ top priority during these difficult times, but it could be a significant factor in how employers manage their workforce. By considering their options, employers may be able to balance cutting costs, keeping key employees, and preserving employees’ restrictive covenant agreements.

Employers are reminded to consult with their employment counsel prior to terminating employees or implementing any compensation reduction in their workforce, as certain other employment laws may be implicated, such as the federal Worker Adjustment and Retraining Notification Act, the federal Fair Labor Standards Act, the New York State Worker Adjustment and Retraining Notification Act, New York State’s Minimum Wage Act and New York State’s Wage Theft Prevention Act. Moreover, in light of the fact that non-compete agreements are generally given increased scrutiny by courts, employers may want to consider revising their agreements to include more narrowly tailored non-solicit and non-service agreements – rather than broad non-compete agreements – in order to increase their chances of enforcing such agreements.

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^[i] 48 N.Y.2d 84 (1979).

^[ii]  Id. at 84–85.

^[iii]  Id. at 89.

^[iv]  See Greystone Funding Corp. v. Kutner, 137 A.D.3d 427 (1st Dep’t 2016) (recognizing that the Second and Fourth Departments have rendered divergent conclusions).

^[v] Compare Hyde v. KLS Prof’l Advisors Grp., LLC, 500 F. App’x 24, 26 (2d Cir. 2012) (cautioning against extending Post beyond its holding); Kelley-Hilton v. Sterling Infosystems Inc., No. 19-cv-9963 (DLC), 2019 WL 6617909, at *6–7 (S.D.N.Y. Dec. 5, 2019) (rejecting argument that employee’s termination without cause alone renders restrictive covenants unenforceable; limiting Post to cases involving a forfeiture of post-employment benefits); Wise v. Transco, Inc., 73 A.D.2d 1039, 1039 (4th Dep’t 1980) (same); Globaldata Mgmt. Corp. v. Pfizer Inc., 10 Misc. 3d 1062(A), at *8, n. 9 (Sup. Ct., N.Y. Co. 2005) (same); Paul Andrew King v. Marsh & Mclennan Agency, LLC, No. 653707/2019, 2020 WL 1498537, at *3–5 (Sup. Ct., N.Y. Co. Mar. 27, 2020) (a termination without cause does not necessarily render a restrictive covenant unenforceable); with SIFCO Indus., Inc. v. Adv. Plating Techs., Inc., 867 F. Supp. 155, 158 (S.D.N.Y. 1994) (“New York courts will not enforce a non-competition provision in an employment agreement where the former employee was involuntarily terminated.”); Buchanan Capital Markets, LLC v. DeLucca, 144 A.D.3d 508, 508 (1st Dep’t 2016) (covenants not to compete “are not enforceable if the employer (plaintiff) does not demonstrate ‘continued willingness to employ the party covenanting not to compete’ . . .  , i.e., defendants”); Grassi & Co., CPAs, P.C. v. Janover Rubinroit, LLC, 82 A.D.3d 700, 702 (2d Dep’t 2011); Marsh USA, Inc. v. Alliant Ins. Servs., Inc., 49 Misc. 3d 1210(A), at *3 (Sup. Ct., N.Y. Co. 2015).

^[vi] Integra Optics, Inc. v. Messina, 52 Misc. 3d 1210(A) (Sup. Ct., Albany Co. 2016) (citing Scott v. Harris Interactive, Inc., 512 F. App’x 25, 28 (2d Cir. 2013)).   For example, in Kirsch v. Fleet Street Ltd., the Second Circuit upheld a jury finding of constructive discharge where the employer reduced the employee’s salary from $60,000 to $26,000, 148 F.3d 149, 161–62 (2d Cir. 1998).

^[vii] No. 99cv4376(WK), 2003 WL 1739009, at *5 (S.D.N.Y. April 2, 2003); see also Granser v. Box Tree South Ltd., 164 Misc. 2d 191, 196 (Sup. Ct., N.Y. Co. 1994) (New York trial court held that plaintiff’s allegations of a retaliatory demotion and a corresponding reduction in salary were [at the pleading stage] sufficient to state a claim of constructive discharge).

^[viii] Morris v. Schroder Capital Mgmt. Int’l, 7 N.Y.3d 616, 622 (2006) (quoting Lumpkin v. H.E.L.P. USA, No. 02-cv-5475, 2005 WL 839669, at *5 (E.D.N.Y. Jan. 7, 2005)); see also Petrosino v. Bell Atlantic, 385 F.3d 210, 229 (2d Cir. 2004); Integra Optics, Inc., 52 Misc. 3d 1210(A), at *5.

^[ix] See Integra Optics, Inc., 52 Misc. 3d 1210(A), at *5.

^[x] Duane Jones Co. v. Burke, 306 N.Y. 172, 188 (1954).

^[xi] Veritas Capital Mgmt., L.L.C. v. Campbell, 82 A.D.3d 529, 530 (1st Dep’t 2011).