On August 20, 2024, a Texas District Court gave employers and employees the long-awaited answer to questions surrounding the enforceability of the Federal Trade Commission’s (FTC) Non-Compete Clause Rule banning non-competition clauses (the “Rule”).[1]

In Ryan LLC v. Federal Trade Commission, the Court set aside the Rule with a nationwide effect.[2]

Consistent with the reasoning stated in its preliminary injunction enjoining enforcement of the Rule,[3] the Court reasoned that “the FTC lacks statutory authority to promulgate the Non-Compete Rule, and that the Rule is arbitrary and capricious.”[4]

The Court’s decision to grant Plaintiffs’ Motion for Summary Judgement and deny the FTC’s Motion for Summary Judgment is appealable. Whether the FTC will continue to push for the non-compete ban through an appeal is undetermined.

For now, non-compete clauses will remain in effect and employers no longer need to comply with the Rule’s September 4, 2024 effective date.

If you need assistance in assessing your business’s non-compete agreements, please contact Andrew Hazen (ahazen@fh2.com; 770-771-6818) or Anne Marie Simoneaux (asimoneaux@fh2.com; 770-771-6811) or visit FH2.com to learn more about how the attorneys at Friend, Hudak & Harris can help.

 

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[1] For additional discussion about the language of the Rule, see FTC Noncompete Rule: Is My Noncompete Unenforceable?  See Non-Compete Clause Rule, 89 Fed. Reg. 38342, 38342–506 (May 7, 2024) [to be codified at 16 C.F.R. pt. 910]. The Rule is available at https://www.federalregister.gov/documents/2024/05/07/2024-09171/non-compete-clause-rule.

[2] Memorandum Opinion and Order at 1–2, 26–27, Ryan LLC v. Federal Trade Commission, No. 3:24-CV-00986-E (N.D. Tex. August 20, 2024).

[3] See Memorandum Opinion and Order at 12–23, Ryan LLC v. Federal Trade Commission, No. 3:24-CV-00986-E (N.D. Tex. July 3, 2024).

[4] Memorandum Opinion and Order, supra note 2, at 26.

On May 7, 2024, the Federal Trade Commission (FTC) published a final rule effectively banning the use of many non-competition clauses (the “Rule”).^[1] The Rule will become effective on September 4, 2024 (“Effective Date”) barring intervention by any of the Federal District Courts currently considering legal challenges to the Rule.^[2]

Currently, non-competition clauses in employment agreements, as well as standalone non-competition agreements, are subject to varying degrees of enforceability depending on state law.^[3] Given the FTC’s perceived failure of the existing “case-by-case and State-by-State approach,” the FTC introduced a proposed rule in January 2023 to proactively govern the enforceability of non-competition agreements at the federal level (the “Proposed Rule”).^[4]

The FTC believes that implementation of the Rule will allow employees to pursue better employment opportunities, increase competition for workers, increase wages, and bolster entrepreneurship and innovation.^[5] The FTC estimates the Rule will increase workers’ earnings in the aggregate between $400 billion and $488 billion per year.^[6] In Georgia, specifically, the FTC estimates that 3 million workers will be covered by the Rule and experience an increase in total earnings of over $2 billion per year.^[7]

The Rule requires employers to: (1) discontinue the use of non-competition agreements for certain workers, and (2) notify employees subject to existing non-competition agreements of their rescission and invalidity, where the existing non-competes do not qualify for one of the limited exceptions to the Rule (see below for more details).

• The Rule effectuates this change by deeming it an “unfair method of competition”^[8] for an employer to enter into or enforce a non-competition agreement with certain workers.^[9] Worker is defined broadly to include employees, independent contractors, externs, volunteers, etc.^[10]
• In addition to the prohibition on new non-competition agreements, the Rule also requires employers to rescind existing non-competition agreements via notice to employees by the Effective Date.^[11] The Rule prescribes a methodology for delivering the notice and provides model language.^[12]

Under the Rule, a non-competition agreement means a standalone agreement or contractual term within a broader agreement (e.g., an employment agreement) that prohibits a worker from, penalizes a worker for, or functions to prevent a worker from seeking or accepting employment, or operating a business, after the conclusion of the worker’s employment with the employer.^[13] The FTC intends this to be a functional test, applying not only to those contractual terms labeled “non-competition” within an agreement, but also to those terms that have the same effect as a non-competition agreement.^[14]

The Rule has a few limited exceptions:

• Senior executive exception: For senior executives, the Rule only prohibits entering into and enforcing non-competition agreements entered into after the effective date of the rule.^[15] Senior executive is generally defined as a worker in a policy-making position, including, for example, a president or CEO, who receives total annual compensation in excess of $151,164.^[16]
• Sale of a business exception: Non-competition agreements are permissible in conjunction with the sale of a business, of a person’s ownership interest in a business entity, or of all or substantially all of the assets of a business.^[17] The sale of the business must be “bona fide,” meaning the transaction must not be entered into for the purpose of evading the Rule.^[18]
• Existing cause of action exception: The Rule also excepts enforcement of non-competition agreements after the effective date if the cause of action related to non-competition agreement accrued prior to the effective date.^[19]

Additionally, the definition of non-competition agreement under the Rule  excludes other types of covenants restricting a worker’s post-employment actions like non-disclosure or non-solicitation agreements.^[20] Further, the FTC’s rules do not apply to certain types of entities, including certain non-profits.[21] Accordingly, the Rule does not wholly prohibit the use of non-competition agreements in all scenarios.

The Rule is currently subject to litigation questioning its enforceability.^[22] On July 3, 2024, a Texas federal court granted a preliminary injunction challenging the Rule’s enforceability, holding that the plaintiffs were likely to succeed in establishing that the FTC lacked authority to issue the Rule and that the Rule is unlawful under the Administrative Procedure Act.^[23] Notably, the Ryan LLC v. Federal Trade Commission preliminary injunction only enjoins enforcement of the Rule for the plaintiff and plaintiff-intervenors in that case.^[24] All other employers subject to the Rule will be required to comply with the Rule’s requirements unless and until a nationwide injunction is issued.^[25] A nationwide preliminary injunction could come from the Ryan court, which will enter a final, appealable decision before August 30, 2024, or from a Pennsylvania federal court considering a challenge to the Rule, which is expected to issue a decision before the end of July.^[26]

Pending a decision regarding the Rule’s enforceability, employers must evaluate whether they are: (a) required to provide notice to employees and contractors subject to  existing non-competition agreements of those agreements rescission and invalidity; and (b) limit the use of non-competition agreements going forward.

If you need assistance in assessing your business’s responsibilities under the Rule, please contact Andrew Hazen (ahazen@fh2.com; 770-771-6818) or Anne Marie Simoneaux (asimoneaux@fh2.com; 770-771-6811) or visit FH2.com to learn more about how the attorneys at Friend, Hudak & Harris can help.

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[1] Non-Compete Clause Rule, 89 Fed. Reg. 38342, 38342–506 (May 7, 2024) [to be codified at 16 C.F.R. pt. 910] [hereinafter Final Rule]. The Final Rule is available at https://www.federalregister.gov/documents/2024/05/07/2024-09171/non-compete-clause-rule.

[2] Final Rule at 38342.

[3] Non-Compete Clause Rule, 88 Fed. Reg. 3482, 3493–94 (Jan. 19, 2023) [hereinafter Proposed Rule]. The Proposed Rule is available at https://www.federalregister.gov/documents/2023/01/19/2023-00414/non-compete-clause-rule.

[4] Final Rule at 38343; Non-Compete Clause Rulemaking, FTC (Jan. 5, 2023), https://www.ftc.gov/legal-library/browse/federal-register-notices/non-compete-clause-rulemaking.

[5] Final Rule at 38433.

[6] Id.

[7] Id. at 38505.

[8] 16 C.F.R. § 910.2(a). Under the Federal Trade Commission Act, “unfair methods of competition” are unlawful. Final Rule at 38348. The Act gives the FTC authority to make regulations carrying out this provision, and the FTC cites this as its authority to define this new category of unfair competition. Id.

[9] 16 C.F.R. § 910.2(a).

[10] 16 C.F.R. § 910.1.

[11] 16 C.F.R. § 910.2(b).

[12]  Id.

[13] 16 C.F.R. § 910.1.

[14] Final Rule at 38361.

[15] 16 C.F.R. § 910.2(a)(2).

[16] 16 C.F.R. § 910.1.

[17] 16 C.F.R. § 910.3(a).

[18] Id. at 38438.

[19] 16 C.F.R. § 910.3(b).

[20] Final Rule at 38634.

[21] Final Rule at 38357.

[22] See Bryan Koenig, Chamber OK’d To Intervene Against FTC Noncompete Rule, Law360 (May 10, 2024), https://www.law360.com/articles/1835663/chamber-ok-d-to-intervene-against-ftc-noncompete-rule.

[23] Memorandum Opinion and Order at 12–23, Ryan LLC v. Federal Trade Commission, No. 3:24-CV-00986-E (N.D. Tex. July 3, 2024).

[24] Memorandum Opinion and Order, supra note 23, at 32.

[25] Id.

[26] See id.; Koenig, supra note 22.

 

 

 

When engineer Anthony Levandowski announced in January 2016 that he was leaving Google for Uber, his employer was not happy. Levandowski was not just any engineer. As the head of Google’s efforts to develop a self-driving car, he was a Silicon Valley superstar, and now he was taking his considerable talents to Google’s chief rival in the race to develop a truly autonomous automobile.

Google was not going to take the defection lying down. Not long after Levandowski departed, Google sued Uber seeking $1.85 billion in damages and an injunction that would severely limit the work Levandowski would be able to do for Uber. Although the case eventually settled (during trial) for just a fraction of what Google originally sought, the wreckage was widespread: Levandowski was left unemployed, Google received $250 million worth of Uber stock, and both parties owed their attorneys tens of millions of dollars in legal fees.

The remarkable thing about Levandowski’s case is that Google never alleged that Levandowski had breached a non-compete agreement. They couldn’t, because he never had one. Non-competes are completely unenforceable in California.

The Levandowski case serves as a reminder that an employee and his future employers are bound by a web of legal obligations even when the employee is otherwise free to leave his current employment and go to another employer of his choosing.

The Duty of Loyalty and Other Limits on the Privilege to Compete

Most businesses are familiar with the doctrine of at-will employment. It provides that, generally, an employer can terminate an employee at almost any time and for almost any reason. (There are notable exceptions, such as terminating for an illegal or discriminatory reason.) The principle goes both ways. Employees are generally free to leave for greener pastures wherever they can find them. On top of that is the “privilege to compete,” which allows a company to compete against others in the open market for scarce customers, resources, and even talented employees. These doctrines are reinforced by states’ longstanding public policies against non-compete agreements and other “restrictive covenants.” This animosity toward limiting competition often renders any attempt to contractually bind an employee from jumping ship substantially – or even completely – unenforceable. Together, these doctrines help create an economy where the competition among companies for good employees is just as stiff as the competition for good customers.

But even against that background, neither the at-will employment doctrine nor the privilege to compete are unlimited. Both are restricted in ways that create potential risks for employers and the talent they seek to recruit.

As an initial matter, all workers – even the rank and file – have a “duty of loyalty” to their employers. The duty of loyalty is not as restrictive as the “fiduciary duty” that binds officers, directors, and other essential personnel, but it has “teeth” nonetheless. At its core, the duty of loyalty means an employee cannot compete against her employer or otherwise actively work against her employer’s interests. In practice, this typically means that an employee can plan to compete against her employer, but she cannot in fact compete against her employer while she is still employed.

To illustrate: George works for an advertising agency, but he dreams of having his own agency one day. While he is still working for his current agency, can he form an LLC, rent office space, and print business cards in anticipation of the day he finally strikes out on his own? He can. But can he take his clients out to lunch to discreetly inform them of his plans and solicit their business for his future agency? He cannot. The former is merely planning to compete against his current employer. The latter is actually competing against his current employer, and that is forbidden by the duty of loyalty.

Hiring a Competitor’s Employees – “Wrongful Means” and Employee Raiding

In addition to the duty of loyalty, the law recognizes that a business has a legally-protectible interest in an existing relationship between it and its employee, even when the relationship is at will, and the law will punish a third party’s attempts to induce a breach of loyalty or wrongfully interfere with that relationship. As a result, these obligations create some risk for the prospective employer, who must take care not to contribute to an employee’s breach of his duty of loyalty or otherwise interfere with the current employer’s rights.

So what can you do to hire away employees from another business? In Georgia and many other states, a prospective employer (Employer B) will be protected from liability when recruiting from a competitor (Employer A) if the following conditions are met:

• The relationship between the employee and Employer A concerns a matter involved in the competition between Employer A and Employer B;
• Employer B does not use any “wrongful means” to recruit the employee;
• Employer B’s actions don’t create or continue an “unlawful restraint of trade” (that is, they are not intended to help Employer B create a monopoly for its goods or services); and
• Employer B’s purpose is at least in part to advance its own interest in competing with Employer A.

It’s the second prong – the use of “wrongful means” – that most commonly causes issues. What exactly are wrongful means? They are often described as actions that are wrong on their own, even outside the context of recruiting – such as using fraud or defamation. But cases involving such obviously wrongful means are not particularly common. The following scenario is both more common and less obvious.

Imagine that our adman George has decided he would rather not go out on his own after all. What he really wants to do is join a better agency, and his valuable book of business has landed him an offer with his current agency’s biggest rival. Of course, both George and the new agency expect George to bring his clients with him when he leaves. But George can’t serve those clients all on his own, and he would like to bring some additional talent with him to the new agency. So after putting in his two weeks’ notice – but before he actually leaves his employment with the company – he sets about recruiting some key members of his team to come with him and, with the new agency’s permission, extends formal offers of employment.

Is this allowed? Usually not. George is still an employee of the first agency, and by recruiting the first agency’s talent he is benefitting the new agency at the expense of his own employer. In short, George is violating his duty of loyalty to the first agency. But the new agency’s hands are not clean either. It has knowingly used George as a double agent to recruit talent from a competitor. This is the kind of “wrongful means” that the law forbids.

A special situation arises when one company “raids” another by hiring away a large portion of its employees at one time. As in a case where only one employee is hired, the central question is usually whether the hiring company used any wrongful means in its efforts to recruit. The problem in a case of mass hiring comes when the hiring party’s efforts are so successful that the mass defection leaves the competitor unable to function. In these cases, some courts have found that the crippling of the competitor is itself wrongful and therefore prevents the hiring company from claiming the protection of the privilege to compete.

It is often remarked that this is especially true if “other circumstances are present.” Unfortunately, few courts explain what those other circumstances may be, creating a zone of uncertainty for companies that aggressively recruit from their competitors. In the end, special care must be taken before recruiting a group of employees to leave a competitor en masse.

The Trade Secrets Trap

The special knowledge that makes a recruit highly desirable often includes special knowledge about his employer. For this reason, claims that a company used wrongful means to hire from a competitor are often accompanied by accusations that the competitor’s trade secrets have been stolen. These claims often directly implicate the hiring company as a co-conspirator. Google’s lawsuit against Uber, for example, turned largely on allegations that Uber used Levandowski to steal Google’s trade secrets.

A trade secret is generally defined as having four qualities: One, it must be information. Two, the information must derive economic value from the fact it is secret. Three, the information must not be generally known. And four, the information must be the subject of reasonable efforts to maintain its secrecy.

The subject of what is and is not a trade secret could never be adequately covered in a single article. But for the purposes of hiring from a competitor, one characteristic should always be remembered: Trade secrets may or may not be the subject of a confidentiality agreement. Trade secrets are protected by state and federal law, so the fact that a new hire is not bound by a confidentiality agreement with her former employer does not, by itself, mean she does not possess any trade secrets that could create liability for the new employer.

Furthermore, liability for the theft (or misappropriation) of trade secrets is not limited just to the individual who actually pilfered the information. It also extends to any person who acquires or uses the information knowing that it was wrongfully obtained in the first place – or even simply having reason to know that the source of the information (i.e., the new hire) had a duty to a third party (i.e., the former employer) to keep it secret. This principle creates some measure of risk when hiring an employee who may possess sensitive information.

Difficult problems arise when a departing employee does not actively “take” his former employer’s trade secrets but, rather, simply possesses his former employer’s trade secrets only in his memory. It’s fair to say, though, that the typical suit over trade secrets involves much more concrete claims. The jilted employer often alleges that the former employee left with copies of his former employer’s files. These days, it is not uncommon to read allegations that, prior to his departure, the employee downloaded valuable files to a thumb-drive, sent them as attachments to a personal email account, or even photographed files with a smart phone.

Not all files contain trade secrets, of course. Nevertheless, an employer should never encourage or facilitate a new hire’s removal of files from his former employer.

Conclusion

Non-compete agreements and other restrictive covenants are often a concern when hiring new employees, especially those with specialized skills and abilities. Even in the absence of a restrictive covenant, however, employees and their suitors are still bound by rules that arise solely from the law. Employers must be mindful of these non-contractual restrictions when recruiting potential employees.  If you have any questions about this article or need assistance in assessing your business’s rights with respect to a prospective employee or a departing employee, please contact Ben Byrd at bbyrd@fh2.com or (770) 399-9500 to discuss further.

You have finally found a prospective employee who meets all of your search criteria and is a superstar (or prospective superstar) in the field.  You want to move forward with the hiring process on an expedited basis.  You extend a generous offer, which is promptly accepted.  And then you discover, one way or another, that this individual has a restrictive covenant agreement (a “Covenant Agreement”) with a prior employer.  What should you do?  What if you don’t find out about the Covenant Agreement until after you have hired the individual?

Covenant Agreements are becoming ever more common and they come in many forms.  This article will familiarize you with Covenant Agreements generally and will provide you with guidance regarding what you can do to protect yourself from legal liability and business disruption.

I.  LIABILITY AND DISRUPTION: RISKS TO YOUR BUSINESS

A.  What is a Covenant Agreement? Let’s be clear about what we are talking about.  For purposes of this article, a Covenant Agreement is a contract between your (prospective) employee and a current or prior employer that restricts the activities of the employee after the employment relationship terminates.  The restrictions can take many forms and the terms vary significantly from one Covenant Agreement to another.

Covenant Agreements are often referred to as “non-competes” or NDAs (short for “non-disclosure agreement”) and some are indeed just that.  Non-competes include terms that restrict an employee from engaging in activities that compete with the prior employer.  NDAs restrict the use of the former employer’s confidential information and trade secrets.  In most cases, however, Covenant Agreements include a number of different restrictive covenants so, if a prospective employee tells you he or she has an NDA with a prior employer, do not assume the document is indeed “just” a non-disclosure agreement.

Indeed, the majority of Covenant Agreements include at least two and often several different post-employment restrictions on conduct, such as provisions restricting the employee from:

• contacting customers, suppliers, and/or employees of the prior employer;
• saying or otherwise communicating damaging or negative information about the prior employer;
• using materials that the employee developed with the prior employer;
• keeping information or documents acquired in connection with the prior employment; and
• using information acquired in connection with the prior employment.

Also, Covenant Agreements are not necessarily separate, stand-alone agreements.  They may be included in the terms of another, broader agreement, such as an employment agreement or a separation agreement.  Covenant Agreements may also be embedded in equity and bonus award agreements, transaction agreements, and deferred compensation agreements.  In short:  when assessing whether a prospective new hire is bound by a Covenant Agreement—and, if so, what restrictions apply to the new hire—do not depend on the “label”; review the document itself.

B.  Why Do I Need to be Concerned? I’m Not a Party to the Covenant Agreement.  It is basic contract law that a party to a contract can pursue its remedies against the other party to the contract in the event the other party breaches the agreement.  Clearly, a former employee who breaches a Covenant Agreement is liable for whatever damages are imposed by law or contract.  But how can a Covenant Agreement impact a subsequent employer who isn’t a party to the Covenant Agreement?  The answer is:  it depends on a number of factors, but the following is a brief summary of the possible ways a Covenant Agreement can disrupt the business of—or even create legal liability for—the subsequent employer.

Injunctions Against the Employee.  Practically without exception, Covenant Agreements permit the former employer to seek an injunction.  An injunction is a court order preventing the former employee from engaging—either temporarily or permanently—in the conduct that the former employer alleges is a breach of the Covenant Agreement at issue.  For example, if the employee has allegedly breached the Covenant Agreement by working for his or her current employer, the injunction can bar the employee from continuing such employment.  If an employer is relying on the skills and contribution of that employee, an injunction can be very disruptive.

Legal Claims Against the Current Employer.  A former employer that is a party to a Covenant Agreement has many causes of action that it might allege against the current or future employers even though there is no contract between the two employers.  These include: tortious interference with a contractual relationship; intentional interference with business relations; inducement to breach; civil conspiracy; misappropriation of trade secrets and proprietary information; conversion; and unfair competition.

It is important to note that, in some instances a candidate’s behavior may be actionable even in the absence of any Covenant Agreement. In most jurisdictions, employees have a common law duty of loyalty (and often a fiduciary duty) to act in the best interest of their current employer, even after tendering a notice of resignation. Violation of this duty of loyalty can result in substantial damages against the employee and, to the extent a subsequent employer is found to have assisted the employee in breaching his duty of loyalty, there is potential exposure to the new employer for aiding and abetting the employee’s breach.

C.  What Can an Employer Do? Whether the hiring employer will be directly liable to the former employer is largely predicated on the hiring employer’s intent and good faith, and whether it actually benefitted from the new hire’s unlawful conduct. Being able to show the following can provide a powerful defense for the hiring employer against this liability:

• The hiring employer took diligent steps to determine at the pre-hire stage whether the employee was subject to post-employment restrictions.
• The hiring employer was advised by legal counsel that, by hiring the employee, it would not interfere with an existing contractual restriction.
• The hiring employer instructed the new hire that he or she was not expected or permitted to (1) use or disclose any trade secrets or confidential information belonging to his or her former employer, (2) improperly divert business opportunities belonging to the former employer, or (3) engage in any other conduct that would breach his or her Covenant Agreement.
• The hiring employer instituted internal protocols to ensure against the inadvertent use or disclosure of the former employer’s trade secrets or confidential information.
• The hiring employer continued to monitor the new hire’s conduct to ensure continued compliance with any post-employment restrictions that the former employer imposed.
• The hiring employer used due diligence to ensure that it did not benefit from the new hire’s use or disclosure of the former employer’s trade secrets or confidential information.

II.  INVESTIGATE COVENANT AGREEMENT ISSUES DURING THE INTERVIEW PROCESS

Ask the Candidate If He or She Is Subject to Any Covenant Agreements.  The first thing an employer should do is ask a prospective employee whether he or she is subject to any Covenant Agreement.  This should be thoroughly vetted well before a decision is made regarding hiring the individual.  If the employer engages in adequate due diligence before it hires a candidate who is subject to a Covenant Agreement and makes a reasonable hiring decision based upon such due diligence, it would be very difficult for the former employer to assert any of the causes of action indicated above against the new employer.  (This, however, would not allay the possibility that the candidate would be enjoined from working for the new employer, in whole or in part, temporarily or permanently.)

Keep in mind that, as a general rule, restrictions imposed by Covenant Agreements may extend for a period of two years after employment terminates and in certain cases even longer.  Therefore, you should inquire not only about a candidate’s current or immediately prior employer, but also about earlier employers. The take away here is that when you endeavor to determine whether a candidate is a party to a Covenant Agreement, be sure to ask the right questions and review all agreements between the candidate and its prior employers.

If the Answer is “No” – “I Don’t Have A Covenant Agreement” and Other Tall Tales.

Going back to the facts described in the first paragraph of the introduction above, let’s assume that you asked the prospective superstar-employee whether he or she is subject to a Covenant Agreement and he or she says, “no.”  That should not be the end of your inquiry for a number of reasons.  First, strange as it may seem, employees often forget that they have signed Covenant Agreements.  Second, if the Covenant Agreement is embedded in another agreement, they might not realize that they are subject to one.  Third, the employee may unilaterally decide that although he or she has a Covenant Agreement, employment with you would not breach it and that therefore not disclosing it to you would do no harm.  Fourth, the prospective employee may want the job you are offering badly enough or believe the risk of enforcement is low enough that he or she decides to not disclose the fact that he or she is a party to a Covenant Agreement with a prior employer.

If the candidate affirms that he or she is not subject to any Covenant Agreement and you decide to hire him or her, then, as a pre-requisite to employment, require him or her to sign a notarized statement verifying that he or she is not subject to any Covenant Agreement with any current or former employer and stating that this verification is a pre-condition to the hiring decision, and that if the foregoing proves to be false for any reason, he or she would be subject to immediate termination of employment and be solely liable for any costs and expenses you incur if any action is brought against you because of it.

If the Answer is “Yes.”

Ask for a copy of the Covenant Agreement and have it reviewed by legal counsel who is knowledgeable about Covenant Agreements and the law implicated by them.  Your legal counsel should provide you with an assessment of whether the Covenant Agreement is enforceable, along with a plain English translation of what the Covenant Agreement prohibits, including the time limits, geographic scope, and the precise activities prohibited if the Covenant Agreement is enforceable and enforced.  Be sure to give your attorney enough specific information about what activities the prospective employee would perform for your company, if hired by you, so your attorney can advise you as to whether the prospective employee would violate the Covenant Agreement by working for you.

If you and your attorney determine that a candidate would be in breach of a Covenant Agreement by working for you and that the former employer is likely to sue, you can avoid that liability completely by not hiring the individual.  However, the issues are most often not so black-and-white.  In this case, you would need to consult with your attorney to weigh various factors to arrive at the decision as to whether to hire the candidate, including, for example: (i) the risk (and potential cost) of litigation and the potential disruption to your business (including the risk that your new hire will be enjoined from working for you, either temporarily or permanently); (ii) the likelihood that the former employer will be successful in enforcing the Covenant Agreement and your business’s potential liability for money damages; and (iii) any steps you can take to minimize or avoid a claim that the new hire is violating the Covenant Agreement.

III.        MANAGING COVENANT AGREEMENT ISSUES

Because Covenant Agreements are so common these days, there is a high likelihood that any new hire will be subject to a Covenant Agreement.  Even if you have determined that the anticipated scope of duties the candidate will perform for your business isn’t likely to violate a Covenant Agreement, you should still implement policies—whether in your standard employee manuals, offer letters, and/or employment agreements—to demonstrate your expectation that your employees will comply with their obligations to prior employers, such as a prohibition on the unauthorized use or distribution of property, confidential information, or trade secrets of a third party.

However, if you and your legal counsel determine that a candidate is subject to an enforceable Covenant Agreement, and that the position for which the candidate is being considered might be construed as requiring the candidate to violate the terms of that Covenant Agreement, there are a number of things you can do to minimize the risk of litigation if you decide to proceed with hiring the individual.  Possibilities include: (i) if feasible, restructuring the position so that the duties and responsibilities do not run afoul of the Covenant Agreement (or at a minimum), placing the new hire in a temporary position that does not violate the Covenant Agreement for the duration of any contractual restriction period; (ii) asking the former employer to waive the restrictions or negotiate restrictions that both of you can live with; or (iii) structuring the new hire’s work to insulate him or her from departments or projects involving confidential information or clients for which the new hire might possess competitively valuable information belonging to his or her former employer.  Also, the hiring employer should consider whether it should leave itself an “out” by requiring the candidate to acknowledge and agree that if litigation is threatened or arises over any Covenant Agreement, it reserves the right to terminate the candidate or alter the candidate’s job requirements.

Lastly—and regardless of the steps you may have taken to avoid or minimize the risk that your new hire is violating a Covenant Agreement—there is always a risk that the prior employer will nonetheless suspect a violation or threaten legal action against you.  As such, there are actions you should take after hiring an employee who is subject to a Covenant Agreement if you receive a “cease and desist” letter or any other communication regarding the terms of the Covenant Agreement from the former employer.  Proper management of this situation can reduce, limit, or eliminate your potential liability in connection with an employee’s Covenant Agreement with a prior employer.  You should contact your attorney immediately, both to formulate a strategy for responding to the prior employer and to ensure that you are taking the proper internal steps to preserve evidence that may become important if the matter proceeds to litigation.

If you have any questions or would like additional guidance regarding restrictive covenant agreements or other employment law issues, please contact Suzanne Arpin at SArpin@fh2.com or (770) 399-9500.

Many employers require employees to sign arbitration agreements as a condition of their employment.  Under those agreements the employee gives up his/her right to sue in court over job-related issues such as wrongful termination, breach of contract, and discrimination, and agrees to pursue such legal claims against the employer through arbitration.  These agreements often go further to provide for individualized arbitration proceedings, which means that claims pertaining to different employees will be heard in separate arbitration hearings – thereby precluding employees from bringing collective or class actions regarding workplace claims.  The use of mandatory, pre-dispute arbitration agreements has increased significantly over the past two decades.  A 2017 survey by the Economic Policy Institute showed that approximately 60 million private-sector, nonunion employees in the United States are subject to mandatory arbitration in their employment agreements, and almost 25 million of those agreements include a class action waiver.

The issue of whether these class action waivers are enforceable has been a contentious issue.  Although the Federal Arbitration Act (“FAA” or “Arbitration Act”) generally requires courts to enforce arbitration agreements as written, the FAA contains a so-called “saving clause” that permits courts to refuse to enforce arbitration agreements “upon such grounds as exist at law or in equity for the revocation of any contract.”  Employees have argued that the FAA’s “saving clause” nullifies the enforceability of an arbitration agreement if that agreement violates some other federal law.  Specifically, until the United States Supreme Court decision discussed below, federal courts disagreed whether arbitration agreements containing a class action waiver violate the National Labor Relations Act (“NLRA”), thus rendering them invalid and unenforceable.  On May 21, 2018, the Supreme Court resolved this issue, holding that agreements requiring employees to arbitrate claims on an individual basis are enforceable.  Here’s what you need to know.

Some Differences Between Arbitration and a Court Case

An arbitration differs from a court case in a number of ways, including:

• An arbitration is not heard and decided by a judge or jury, but by a neutral and independent “arbitrator” agreed to by the parties, and who is paid by one or both sides to listen to the evidence and witnesses, and issue a decision, which is called an “award.”
• The arbitration process generally limits the amount of information each side can get from the other, which oftentimes gives the employer an advantage because the employer is usually the one in possession of most of the documents and information relating to the employee’s case.
• Arbitrations are less formal than court trials, which can make the process easier for all involved, especially employees who are not used to litigation.
• Arbitration cases are generally heard and decided much more quickly than court cases, which can take several years from start to finish, and arbitration is usually less expensive.

How We Got Here

Until a few years ago, both courts and the National Labor Relations Board (the “NLRB”) seemed to be generally in agreement that arbitration agreements (including ones that required individualized proceedings) were to be enforced according to their terms.  However, in 2012 the NLRB ruled in D.R. Horton, Inc., 357 N.L.R.B. 2277 (2012), that arbitration agreements containing class action waivers violated Section 7 of the NLRA, which guarantees workers the rights to self-organize, to form labor organizations, to bargain collectively, and to “engage in other concerted activities for the purpose of collective bargaining or other mutual aid or protection.”  In its ruling, the NLRB found that agreements requiring employees to arbitrate their claims on an individual basis violated the NLRA, rendering these agreements invalid and unenforceable.

Since the NLRB’s decision, federal appellate courts have split on the issue.  Some circuit courts, including the Seventh and Ninth Circuits, agreed with the NLRB, while other circuit courts, including the Fifth Circuit, found such class action waivers to be enforceable and not in violation of the NLRA.

The Epic Systems Case

Against this background of conflicting decisions by various federal courts and the NLRB, on May 21, 2018, the United States Supreme Court held, in a 5-4 decision, that agreements requiring employees to arbitrate claims on an individual basis are enforceable.

The case, Epic Systems Corp. v. Lewis, 584 U.S. ____ (2018), consolidated three different cases on appeal from the Fifth, Seventh and Ninth Circuits.  In each of these cases, an employer and employee had entered into a contract providing for individualized arbitration proceedings to resolve employment disputes between the parties.  Nevertheless, the employee plaintiffs in each of these cases sought to litigate Fair Labor Standards Act and related state law claims through class or collective actions in federal court.  To avoid enforcement of the class action waivers under the FAA, the employees argued that, by requiring individualized proceedings, the arbitration agreements at issue violated Section 7 of the NLRA, which under the FAA’s saving clause rendered the arbitration agreements unenforceable.  The employer defendants, on the other hand, argued that the FAA protects agreements requiring arbitration from judicial interference, and that neither the FAA’s saving clause nor the NLRA demands a different conclusion.  A majority of the Supreme Court agreed with the employers.

The FAA’s Saving Clause Did Not Apply to the Employees’ Claims 

The FAA “requires courts ‘rigorously’ to ‘enforce arbitration agreements according to their terms, including terms that specify with whom the parties choose to arbitrate their disputes and the rules under which that arbitration will be conducted.’”  Nonetheless, the Court noted that the FAA’s saving clause, by its terms, “allows courts to refuse to enforce arbitration agreements ‘upon such grounds as exist at law or in equity for the revocation of any contract.’”

The employee plaintiffs in Epic Systems argued that the FAA’s saving clause creates an exception for cases like theirs, where the arbitration agreement (arguably) violates some other federal law.  In its Horton decision the NLRB found that requiring employees to arbitrate their claims on an individual basis was a violation of the NLRA.  The employees in Epic Systems argued that the saving clause applied because the NLRA renders their class and collective action waivers illegal, and in their view, “illegality under the NLRA is a ‘ground’ that ‘exists at law … for the revocation’ of their arbitration agreements, at least to the extent those agreements prohibit class or collective action proceedings.”  The Court rejected this argument, holding that in permitting courts to refuse to enforce arbitration agreements “upon such grounds as exist at law or in equity for the revocation of any contract . . . ”, the FAA’s use of “any contract” limits the saving clause only to generally applicable contract defenses, such as fraud, duress, or unconscionability, and not to defenses specific to arbitration contracts (such as the employees’ claims that arbitration agreements requiring individualized proceedings are unlawful under the NLRA).

 The NLRA Does Not Conflict with the FAA

But the employees were not done yet.  Following the NLRB’s decision in Horton, they argued that Congress nonetheless intended Section 7 of the NLRA to render employee class action waivers in arbitration agreements unlawful, even though such class action waivers would otherwise be enforceable under the FAA.  That is, in cases like theirs, the NLRA overrides the FAA.  The Court noted that when confronted with two Acts of Congress allegedly touching on the same topic, the Court must strive to give effect to both.  To prevail in this case, the employees must show a “clear and manifest” congressional intent to displace one Act with another.

After a lengthy and comprehensive analysis of Congress’ intent, the Court held that there is no conflict between the NLRA and the FAA.  The NLRA “secures to employees rights to organize unions and bargain collectively, but … says nothing about how judges and arbitrators must try legal disputes that leave the workplace and enter the courtroom or arbitral forum.”  Focusing specifically on the language of Section 7 of the NLRA, the Court found that “the term ‘other concerted activities’ should, like the terms that precede it, serve to protect things employees ‘just do’ for themselves in the course of exercising their right to free association in the workplace, rather than ‘the highly regulated, courtroom-bound ‘activities’ of class and joint litigation.’” (Emphasis added.)  Moreover, the Court noted that Congress has shown it knows exactly how to specify certain dispute resolution procedures, or to override the FAA; however, Congress has done nothing like that in the NLRA, which is further evidence that Section 7 does nothing to address the question of class and collective actions.

In short, the Court found that Congress intended Section 7 of the NLRA to grant employees certain rights to act together in the workplace – but did not intend to extend those rights to judicial or arbitral proceedings already governed by the FAA.  As such, the Court held that the NLRA does not “override” the FAA or render employee class action waivers in arbitration agreements illegal or unenforceable.  Justice Gorsuch concluded:

The policy may be debatable but the law is clear: Congress has instructed that arbitration agreements like those before us must be enforced as written.  While Congress is of course always free to amend this judgment, we see nothing suggesting it did so in the NLRA – much less that it manifested a clear intention to displace the Arbitration Act.  Because we can easily read [the FAA and the NLRA] to work in harmony, that is where our duty lies.

What Does This Mean for Employers? – The Pros and Cons of Class-Action Waivers

An employer that does not already utilize mandatory arbitration agreements with class and collective action waivers should consider whether implementing this type of agreement makes sense for its business.  While the Epic Systems decision made it clear that mandatory arbitration agreements with class and collective action waivers are enforceable (at least in the context of federal law), employers still must weigh various factors to decide if such agreements are right for them.

• From a cost standpoint, for most employers the ability to prevent class and collective actions has a lot of appeal.
  • For wage and hour claims, the purported class can be extensive, the time and cost to defend against such claims can be substantial, and if the employees are successful the employer is required to pay the employees’ reasonable attorneys’ fees.
  • And even if the underlying claims are not strong, employees may use the class or collective action procedure as a vehicle to increase costs and try to force settlement with the employer.
• However, the cost of defending dozens of individual arbitrations, each likely based on the same theory, can also be substantial.
  • The Supreme Court has held that employees may not be required to pay “prohibitive” costs in pursuing their federal employment rights, which often means that the employer will bear most of the burden of the arbitration costs, such as the filing fees, administrative fees, and the arbitrator’s fee. The employer would be required to pay these fees for each individual claim filed by an employee covered by a class or collective action waiver.
  • In addition, under the American Arbitration Association’s Employment Arbitration Rules and Mediation Procedures, with the exception of a $200 capped filing fee, the employer is responsible for all costs associated with an arbitration arising from an employer-promulgated arbitration plan.
• Employers should also consider the impact on employee morale of requiring arbitration agreements with class and collective action waivers. Many employee-side commentators have decried the Epic Systems decision as undermining employee rights.
• It should be noted that employers may face some uncertainty concerning state statutory and common law contract interpretations that may invalidate the terms of arbitration agreements, despite Epic Systems.
  • For example, several states have recently enacted limits on arbitration agreements that relate to sexual harassment claims, and some state courts have imposed exacting contractual wording requirements before enforcing arbitration clauses that waive the right to proceed with a court action.
  • Because of the uncertainty regarding whether a nonfederal law can override the FAA, employers should consider back-up contractual jury trial waivers in their arbitration agreements, if the governing state law permits pre-litigation jury trial waivers.
• It should also be noted that the Epic Systems decision does not preclude lawsuits challenging arbitration agreements on general contract grounds, such as fraud, duress, or unconscionability, so employers should continue to be diligent about the general enforceability of their arbitration agreements.
  • In particular, employers should ensure that their arbitration agreements provide for due process and are not subject to claims that the terms are unconscionable and therefore unenforceable.

If you have further questions regarding the topic of this article or need help implementing the right dispute resolution mechanism for your business, please contact Patrick Jones at pjones@fh2.com or (770) 399-9500.

Your business is growing and fortune is shining. Out-of-state opportunities are increasing. Perhaps you are considering expanding operations. If you haven’t already, you’re likely to end up serving the world’s sixth largest economy[i]—California.  And who wouldn’t want to be in California? It has nearly 40 million consumers.

Before heading out with your sunscreen and order book, there are a few intricacies of California law that any out-of-state business—as well as any business already operating in California—should keep in mind when doing business involving California-based employees or parties.[ii]

1.  Contract Law.

a.  Restrictive Covenants. Employers would do well to take Section 16600 of the California Business and Professions Code seriously when it says:

. . . every contract by which anyone is restrained from engaging in a lawful profession, trade or business of any kind is to that extent void.[iii]

Section 16600 is the cornerstone of California’s strong public policy favoring worker mobility over employers’ restrictive covenant protections. It prohibits non-compete and employee non-solicitation restrictions in employment agreements, and probably most customer non-solicitation restrictions.[iv] The law covers:

• employees living in California working for out-of-state employers;
• out-of-state workers of California companies; and
• out-of-state workers working in California for out-of-state companies.

That’s broad.

Naturally, over the years employers have attempted various tactics to avoid Section 16600. One popular approach is for out-of-state employers to have their employment agreements with California-based employees governed by out-of-state laws and decided in out-of-state forums that are willing to enforce such restrictive covenants. California recently responded to these tactics with a legislative counterpunch. Effective for agreements entered into or renewed in or after 2017, employment agreements that deprive a California resident working in-state from the protections of California’s laws by use of out-of-state choice of law, out-of-state litigation forums, or arbitration provisions are now voidable, unless the employee was represented by counsel in negotiating the agreement.[v]  Out-of-state employers now face a dilemma. Do they include out-of-state governing law and dispute resolution provisions for their in terrorem effect (knowing that they are likely unenforceable) or do they make sure the employee has his or her own legal counsel, and risk educating the employee about the valuable protections of California law that he or she may be giving up in signing the agreement? Stay tuned.

Employers still thinking they can get around Section 16600 would be wise to consider Section 17200 of the Business and Professions Code. Section 17200 makes it an unfair trade practice to attempt to enforce a provision prohibited by Section 16600.

b.  Trade Secrets. So, in the face of California’s strong public policy favoring employee mobility over employers’ restrictive covenant protections, what can an employer do? Answer: protect its trade secrets and confidential information.

California protects trade secrets,[vi] including perhaps the most valuable item for many employers—customer lists.[vii] In fact, some restrictions in employment agreements that operate very much like non-competes and customer non-solicitations have been enforced by California courts under the so-called “trade secrets exception” to Section 16600, where those provisions were deemed to protect against unfair competition by misappropriation of the employer’s trade secrets and confidential information.[viii] So, employers should take note: they might get a second bite at the restrictive covenant “apple” if they word their agreements appropriately.

c.  Commission Plan Agreements. California requires employers to provide employees receiving commissions and performing services in California with written commission plan agreements.[ix] Such agreements must describe how commissions are computed and paid. Employers must also collect signed acknowledgments of receipt from employees for such agreements. Failure to comply bears penalties of $100 for the first violation and $200 for subsequent violations, per employee per pay period.[x] That adds up.

2.  Community Property. California is a community property state.[xi] In California, community property is any property (other than a gift or inheritance) acquired or debt incurred by either spouse, between marriage and permanent separation. Further, quasi-community property is property that would have been community property, had it been acquired while either spouse was domiciled in California. At the time a divorce is filed in California, each spouse has a one-half interest in each separate item of community property and each item of quasi-community property.

Why should a business located outside of California be concerned about California’s community property law? Consider the situation of a married entrepreneur living outside of California who incorporates his 100%-owned, closely-held business outside of California. Things are going so well that he decides to temporarily relocate to California to oversee a West Coast expansion. During the relocation, his spouse files for divorce—in California. Even though the company was formed outside of California, all of its stock is held in the name of the entrepreneur and all of the stock was issued when the entrepreneur was not a California resident; at divorce in California his spouse owns a one-half community property interest in all the stock of the out-of-state corporation. It matters not that the couple had no intention to move to California when the business was started or during its growth. Now, consider that the corporation receives an unsolicited offer to purchase the business. The entrepreneur wishes to accept the offer. The spouse does not. What happens?

In the absence of an agreement, there is a stalemate. The entrepreneur cannot obtain the approval of a majority of the company’s outstanding stock to approve any merger or asset sale, or a direct sale of a majority of the outstanding stock. Moreover, the company would be deadlocked in any shareholder vote where the two spouses cannot agree.

To avoid a situation like this, companies (even those incorporated outside of community property jurisdictions like California) should consider having the spouses of all shareholders sign carefully-drafted shareholder agreements, even when those spouses do not hold shares and do not live in community property states. Such agreements should certainly be put in place before any shareholder or their spouse moves to California, even temporarily.

3.  Employment Law. California’s public policy protecting workers has caused it to adopt numerous laws that are outside of the mainstream of most other states. Here are just a few examples.

a.  Independent Contractors vs. Employees. For employers, independent contractors hold several advantages over employees. In California, for independent contractors, employers do not have to: (a) pay payroll taxes; (b) comply with minimum wage, overtime, meal periods, and rest breaks; (c) comply with vacation rules; (d) provide workers’ compensation insurance; or (e) make unemployment or disability insurance payments or social security contributions. These advantages provide a strong incentive for employers to categorize workers as independent contractors instead of employees—even if they may not be.

California counterbalances this incentive in several ways. First, California law establishes various rebuttable presumptions that workers are employees and not independent contractors.[xii] In such cases, the burden is on the employer to rebut the presumption that the worker is an employee and to prove that he or she is an independent contractor. Adding to an employer’s difficulty in establishing that a particular worker is an “independent contractor,” is the fact that there is no single definition of, or test for, the term in California. Different tests apply for different situations.[xiii] Second, California law makes persons vicariously and individually liable for advising employers to willfully misclassify workers as independent contractors, rather than employees.[xiv] Third, the burden of proving that a particular worker is an independent contractor shifts to the employer once the worker shows he performed any service for the employer.[xv] These and other principles should make any employer, and its executives, very careful when attempting to classify California workers as independent contractors, rather than employees.

b.  Minimum Wage. California’s minimum wages (note the plural) are higher than the current $7.25 federal rate. In California, the state’s minimum is $10 for employers with less than 25 employees and $10.50 for employers with 25 or more employees. (It will increase to $15 by 2022.) Cities, however, can set their own minimums that are above the state’s. Examples include: San Francisco ($14 effective July 1, 2017); Oakland ($12.86); and San Jose ($10.50).

c.  Vacation. While California does not require mandatory paid vacation, employers offering vacation are prohibited from adopting policies requiring employees to “use or lose” accrued vacation days.

d.  California Leave Laws. Under certain conditions, California provides up to six months of paid leave for the birth or adoption of a child. Separate from paid family leave, California also provides numerous grounds for employees to demand unpaid leave, including participation in a child’s school activities and meeting with the child’s teachers. Leave time can be up to 40 hours in a 12-month period. Employers must, therefore, be careful before terminating employees for absence, lest such absences be protected under leave laws. They should always check the law before disciplining or terminating any employee for absences.

e.  The California Family Rights Act (“CFRA”) and the federal Family and Medical Leave Act (“FMLA”). California affords greater rights than the FMLA for pregnancy, pregnancy disabilities, and bonding leave time. The FMLA requires allowing up to 12 weeks to be taken in the first year, but such leave must be taken all at one time. CFRA allows 12 weeks to be taken in the first year in as many as five two-week chunks, plus two additional one-week chunks of time.

f.  Non-Exempt (Hourly) Employees. Hourly employees are entitled to these privileges in California.

• Meal periods. Employers must provide an unpaid meal break of not less than 30 minutes for each six-hour shift, and must provide a second 30 minute unpaid meal period if the employee works more than 10 hours per day.[xvi] During the meal break an employer cannot exercise control over the employee’s activities, nor can an employer require that the meal break be spent on the employer’s premises.
• Rest breaks. Employers must provide paid rest breaks of: (a) ten minutes for every shift lasting between 3.5 and six hours; (b) 20 minutes for shifts lasting between 6 and 10 hours; and (c) 30 minutes for shifts between 10 and 14 hours.
• Day of Rest. Workers cannot be forced to work for seven consecutive days in the same work week.
• Overtime. Overtime in Calfornia is calculated on a daily and weekly basis.  Overtime rates kick in after the 8^th hour in any day and 40 hours in the week.[xvii] Out-of-state workers temporarily working in California are covered by the same rule.[xviii]

g.  Paid Sick Leave. Employers are required to provide paid sick leave for exempt and non-exempt employees.[xix] Sick days accrue at the rate of one hour per 30 days worked, but not less than 24 hours (three work days) for any 12-month period. An employer’s comparable paid time off policy can satisfy the paid sick leave obligation.

h.  Final Pay. Employers are required to immediately pay all wages due to an employee who is discharged or quits.[xx] Willful failure to pay such wages timely incurs a daily penalty of one day’s wages for each day such payment is late.

Conclusion: Employers incorporated or located outside of California need to be aware of California’s laws, particularly when they employ workers based in or temporarily assigned to California. Knowing these laws can prevent a host of unwelcome surprises, as well as the loss of valuable corporate assets.

If you have questions regarding doing business in California or California law, contact Scott Harris at SHarris@fh2.com or (770-399-9500) for more guidance.

---

[i] Chris Nichols, Does California really have the ‘6th largest economy on planet Earth?’ PolitiFact (July 26, 2016), available at http://www.politifact.com/california/statements/2016/jul/26/kevin-de-leon/does-california-really-have-sixth-largest-economy-/

[ii] This article is only a limited sampling of California law and does not include every issue warranting consideration.

[iii] The statute contains three exceptions involving: a sale of goodwill of a business; partners in advance of dissolving or dissolution of a partnership; and agreements among members of a limited liability company.

[iv] See Edwards v. Arthur Anderson LLP, 44 Cal.4th 937 (Cal.2008) (striking down a non-compete, customer non-solicitation, and employee non-solicitation in an employment agreement). But see Loral Corp. v. Moyes, 174 Cal.App.3d 268, 219 Cal.Rptr. 836 (1985) (enforcing a covenant prohibiting a former employee from “raiding” the former employer’s employees).

[v] California Labor Code Section 925.

[vi] California Uniform Trade Secrets Act at California Civil Code Section 3426 et seq. A recently publicized example of the extent to which California protects trade secrets is the partial injunction won by Waymo (a Google affiliate) in its lawsuit against Uber involving self-driving car technology. See Waymo LLC v. Uber Technologies, Inc., No. C 17-00939 WHA, 2017 WL 2123560 (N.D. Cal. May 15, 2017).

[vii] Brocade Communications Systems, Inc. v. A10 Networks, Inc., 873 F.Supp.2d 1192, 1214 (N.D. Cal. 2012) (under CUTSA, “confidential customer-related information including customer lists and contact information, pricing guidelines, historical purchasing information, and customers’ business needs/preferences … is routinely given trade secret protection.”).

[viii] See Kindt v. Trango Systems, Inc., No. D062404, 2014 WL 4911796 (Cal. Ct. App. Oct. 1, 2014) (enjoining former employee’s use of former employer’s customers’ identities under unfair competition theory); see also StrikePoint Trading, LLC v. Sabolyk, No. SACV071073DOCMLGX, 2008 WL 11334084 (C.D. Cal. Dec. 22, 2008) (enforcing restrictive covenants preventing employee from undertaking “any employment or activity competitive with Employer’s business wherein the loyal and complete fulfillment of the duties of the competitive employment or activity would call upon Employee to reveal, to make judgment on or otherwise to use, any confidential information or trade secrets of Employer.”).

[ix] California Labor Code Section 2751.

[x] California Labor Code Section 2699(f)(2).

[xi] The eight contiguous-states girding the United States’ southern and western perimeter in the “Community Property Belt” are: Louisiana, Texas, New Mexico, Arizona, California, Nevada, Idaho, and Washington. The ninth is outlier Wisconsin.  A tenth, Alaska, applies community property if both spouses opt-in.

[xii] When determining whether a worker is an employee or independent contractor for issues including wage & hour, meal periods, rest breaks, and workers’ compensation insurance, the California Department of Labor Standards Enforcement presumes that a worker is an employee. California Labor Code Section 3357. Where a worker performs services requiring a license or provides services for another who is required to have a license, that worker is presumed to be an employee. California Labor Code Section 2750.5 and California Business and Professions Code Section 7000 et seq., respectively.

[xiii] For example, the three-factor test for when a worker performing licensed services is an independent contractor is at California Labor Code Section 2750.5.

[xiv] California Labor Code Sections 226.8 and 2753.

[xv] See Bowerman v. Field Asset Services, Inc., No. 3:13-CV-00057-WHO, 2017 WL 1036645 (N.D. Cal. March 17, 2017).

[xvi] California Labor Code Section 512.

[xvii] California Labor Code Section 510.

[xviii] Sullivan v. Oracle Corp., 254 P.3d 237 (Cal. 2011).

[xix] California Labor Code Section 246.

[xx] California Labor Code Section 203.

Classifying Your Employees as “Exempt” or “Nonexempt”
under U.S. Wage and Hour Laws:

Important – and Potentially Costly – Changes
You Need To Know About

Exempt Employees May Become Nonexempt: What You Should Consider Now

The U.S. wage and hour laws (the “Fair Labor Standards Act” or the “FLSA”) require employers to pay every employee a minimum wage and overtime—unless the employee is exempt from the law.  If an employee is exempt, the FLSA does not apply to or protect such employee.

The FLSA puts the burden on employers to classify employees correctly as either “exempt” or “nonexempt” in accordance with regulations promulgated by the Department of Labor—and the employer can be subject to onerous liability for failing to classify employees properly.

You need to be aware that the Department of Labor has promulgated new regulations that could have a significant impact on whether you choose to—and even whether you are able to—continue to classify certain of your employees as exempt.  As discussed further below, as of December 1, 2016, certain employees may no longer be classified as “exempt” unless they are paid significantly more—meaning you, as an employer, will need to decide whether to:

• increase the employee’s compensation to the new threshold amount in order to continue classifying him or her as “exempt” under the FLSA; or

• re-classify him or her as “nonexempt” and become subject to payment of FLSA-mandated minimum wage and overtime.

This may present a serious challenge for employers with exempt employees who are expected to, and regularly do, work more than 40 hours in a given week to complete the required responsibilities of their positions.

THEREFORE, NOW IS THE TIME TO MAKE SURE:

• you are currently classifying all your employees properly under the FLSA; and

• you identify any of your currently “exempt” who employees will become “nonexempt” on December 1^st, absent an increase in their compensation.

With respect to any such employees who may be subject to reclassification, you then need to decide whether to reclassify them (and pay overtime) or increase their compensation in light of the new regulations issued by the Department of Labor.

I.  Classification of Employees as “Exempt” and “Nonexempt”: A Brief Summary

The FLSA requires that most employees in the United States be paid at least the federal minimum wage for all hours worked and overtime pay at time and one-half the regular rate of pay for all hours worked over 40 hours in a workweek. However, there are a number of categories of employees that are exempt.  Those exempt groups include bona fide:

• executives;
• administrative employees;
• professional employees, both “learned” and “creative”;
• certain computer employees;
• outside sales employees; and
• highly-compensated employees.

Together, the forgoing exempt groups are referred to as the “white collar exemptions.”

The White Collar Exemptions

As a general rule, to qualify for one of the white collar exemptions, employees generally must meet certain tests regarding their job duties and be paid on a salary basis at not less than $455 per week (until November 30, 2016—starting December 1, 2016, this number goes up to $913 per week.)  But, even then, the exemption requirements are not as straightforward as they appear at first glance—for example, a different salary test applies to the “highly-compensated employee exemption”, and the “outside sales employee exemption” is subject only to a duties test and does not have a minimum compensation threshold at all.  So careful attention must be paid to the specific requirements of each exemption when considering whether a given employee is exempt from minimum wage and overtime requirements.

Job titles do not determine exempt status. In order for an exemption to apply, in addition to meeting any applicable threshold compensation requirements, an employee’s specific job duties must meet all the “duties” requirements of the Department of Labor’s regulations (the “duties tests”) for the specific exemption claimed.  For example, simply giving an office worker an “administrative” title does not automatically entitle you to claim that the employee is subject to the “administrative exemption”—as that exemption is only available to administrative employees whose primary duties include the exercise of “discretion and independent judgment with respect to matters of significance.”  Similarly, merely giving an employee a title indicating they are a “professional” does not mean he or she will be entitled to the “professional exemption”—that exemption is reserved for employees whose primary duties include performance of work requiring “advanced knowledge . . . in a field of science or learning . . . customarily acquired by a prolonged course of specialized intellectual instruction.”  The “outside sales employee exemption” is reserved for your sales employees who are “customarily and regularly engaged away from the employer’s place or places of business”—employees who primarily work in your offices to receive and facilitate sales (such as in a call-center or sales department) would not be covered by this exemption.

Nonexempt Employees (Including “Blue Collar” Employees)

Obviously, your employees who do not meet the applicable compensation and duties tests for any available exemptions must be treated as “nonexempt” under the FLSA.  But you should also be aware that certain employees must be treated as “nonexempt” no matter how highly they are compensated.

The white collar exemptions do not apply to manual laborers or other “blue collar” workers who perform work involving repetitive operations with their hands, physical skill and energy.  FLSA-covered, non-management employees in production, maintenance, construction and similar occupations such as carpenters, electricians, mechanics, plumbers, iron workers, craftsmen, operating engineers, longshoremen, construction workers and laborers are entitled to minimum wage and overtime premium pay under the FLSA, and are not exempt no matter how highly paid they might be.

The Consequences of Misclassification

In recent years, FLSA cases have become very attractive to plaintiffs’ employment lawyers, who began filing lawsuits after realizing that many employers are in violation of the FLSA. These lawsuits often turn into very expensive class actions.

One of the most common mistakes employers make is misclassifying nonexempt employees as exempt.  The penalties are quite harsh and are not very flexible or negotiable.  In addition to back pay, employees may recover what are referred to as “liquidated damages” equal to the pay employees should have received.  In other words, employees can recover double “back pay” damages for unpaid overtime.  In addition, successful plaintiffs are entitled to recover the full amount of their attorneys’ fees which often are more than the double back pay damages.

Part-Time Versus Full-Time: Same Rules Apply.  The same compensation and duty tests apply to part-time and full-time workers.  Therefore, part-time workers must meet the exact same minimum threshold salary and duty tests as full-time employees in order to be exempt from the FLSA.  No proration applies to the minimum threshold salary levels for part-time employees.

II.  The New Regulations: Redefining the White Collar Exemption

In 2014, President Obama directed the Department of Labor to reevaluate and update the regulations defining which white collar workers were subject to overtime laws.  New regulations were published in May, 2016.  Unless Congress acts to change the regulations, they will become enforceable on December 1, 2016.  The Department of Labor estimates that over 4 million additional U.S. workers will be subject to the minimum wage laws and be entitled to overtime pay in 2017 as a consequence of the new regulations.

Key Provisions: New Minimum Salary and Annual Compensation Thresholds

The new regulations focus primarily on updating the salary and compensation levels needed for executive, administrative and professional workers to be exempt.  Currently, to qualify for the white collar exemption, a worker must have the required job duties and either receive a minimum salary of $455 per week or $23,660 per year (the “salary basis test”) or total compensation of at least $100,000 to qualify as a highly compensated employee.

On and After December 1, 2016:

• the threshold salary level for the salary basis test will be $913 per week (or $47,476 annually); and

• the minimum total annual compensation requirement for highly compensated employees will be $134,004 (which must include at least $913 per week paid on a salary or fee basis).

Notable Other Terms of the New Regulations:

• If an executive, professional, or administrative employee’s salary is close to the new salary levels, an employer may use nondiscretionary bonuses or incentive payments (including commissions) to satisfy up to 10 percent of the new threshold salary level. These payments must be made during the year, at least quarterly.  For highly compensated employees, a catch-up payment equal to the amount necessary to meet the annual threshold may be made in the last pay period of the payroll year.

• The salary and compensation levels will be automatically reset every three years, beginning on January 1, 2020.

III.  What Does This Mean for You?

From a Financial and Budgeting Perspective.  The new regulations significantly narrow the scope of the white collar exemption and, thus, significantly broaden the number of employees who are subject to the FLSA.  Employees who were previously “exempt” may soon be “nonexempt” and entitled to overtime pay if they work more than 40 hours a week.  After December 1, 2016, all employees (other than those subject to the outside sales employee exemption) who earn less than $47,476 per year must be classified as nonexempt and be paid overtime at “time and one-half” for all hours worked over 40 hours per week. 

As you plan your staffing and budget for 2017, you should anticipate these changes and determine how best to address them from a business perspective.  If overtime is truly a necessary component of any reclassified employee’s work, you may have to budget for more payroll.

From an Employee Morale and “Business Culture” Perspective.  If you decide to raise salaries in order to meet the new threshold, you will likely have happy employees.  However, if you are instead leaning toward maintaining salaries at their current levels, you should also consider the consequences of reclassifying formerly-exempt employees as “nonexempt.” At first blush, it may sound advantageous to be reclassified as nonexempt and be entitled to overtime pay.  However, such reclassification may be detrimental to employee morale and you will need to address this.

The over-arching concern of the FLSA is that nonexempt employees be paid for time actually worked, and if that time exceeds 40 hours a week, overtime must be paid at time and one-half.  The flip side of this apparently good intention is that employers must very strictly monitor and control the time an employee spends working.  You might consider the effect the following may have on your employees and your established business culture:

• Start times, stop times, breaks, lunch hours, quitting times and, of course, overtime must be subject to rigid rules and carefully monitored. Many exempt employees enjoy a great deal of flexibility with respect to, for example, their lunchtime from day to day, working long hours on a project when they are “on a roll” and choosing when they arrive at and leave work.  This will have to change radically when an exempt employee is reclassified as a nonexempt employee.

• The reclassified employees will be obligated to track their time precisely, incurring annoying recordkeeping responsibilities they did not have before.

• The employer may be compelled to pay a reclassified employee less basic compensation in order to budget his or her overtime pay, which may or may not ultimately be paid. This will create financial uncertainty for the employee.

• If an employer prohibits overtime, the reclassified employee may feel his or her ability to get the work done in the time allowed has been compromised.

All this may feel a lot like a demotion to a reclassified employee.  In order to avoid this, you should communicate early and often with the affected employees and give them training and easy access to designated management so that their concerns can be vetted and addressed.  You should consider doing the following:

• Emphasize that the new rules are law imposed by the US Federal government; they are not your idea. However, you are required to comply.  Reassure reclassified employees of their value to the company and let them know where to go to express their concerns and get answers to their questions.

• Provide training on the new timekeeping requirements and educate employees as to the importance of accurately documenting their time worked –even if it’s something as “trivial” as answering some emails in the evening at home. This is a very hard habit to start.

• Prohibit working “off the clock.” It is common for reclassified employees to decide that they will simply work the hours they need to and not record them if additional hours are required. This is absolutely illegal under the FLSA and if the employer permits it, the employer is liable for substantial penalties, in addition to paying the employee for any applicable overtime.

• Be aware that if your reclassified employees are required to travel, special rules apply to what portions of travel time are compensable and how.

Review Your Policies and Handbooks: Decide Whether Changes Should Be Made.  If your workforce can operate efficiently without overtime hours, consider prohibiting it absent express written authorization from management.  Whatever policy you adopt, be sure to review your handbooks, policies, or notices to be sure your employees are aware of company policy as well as their right to receive approved overtime if they are nonexempt.

Consider Structured Agreements with Reclassified Nonexempt Employees.  To create some predictability for both the employer and the employee, one option is to implement a compensation structure that pays nonexempt employees an annual salary factoring in a certain amount of overtime.  The FLSA permits this—however, there must be an express written agreement in place and regardless of the agreed working hours, if the employee works more overtime than contemplated, he or she must be compensated for it at time and one-half.

Beware of Perceived Discrimination.  If you have employees with the same job title or duties that are paid differently, with some exempt and some nonexempt, be careful.  Although there is no requirement that such a group be classified the same, generally speaking, employees with the same job title who perform the same duties and responsibilities should be paid similarly, unless you can clearly articulate a justification for the difference.  Otherwise, the difference may give rise to a claim of discrimination under various federal laws.

IV.  Do Not Panic: Create an Action Plan Now

Bottom Line: 

As of December 1, 2016, it’s likely that many of your employees who earn less than $47,476.00 per year must be classified as nonexempt and paid overtime at a rate of time and one-half times their regular rate.

Action Plan: 

• You need to evaluate your employee population to determine whether any of your currently exempt employees will become nonexempt on December 1, 2016 absent increased compensation.

• You should take the time to review your work force as a whole to identify any employees who have been misclassified as exempt or nonexempt.

• If any of your exempt employees will become nonexempt on December 1^st under the new regulations, you need to decide what makes sense from a financial and budgeting perspective—should you increase their compensation so that they remain exempt or reclassify them as nonexempt as of December 1, 2016?

• Based on that evaluation, develop an action plan as needed to educate reclassified employees and to make the transition as smooth as possible.

Need Help?  Have Questions?

If you need help or have any questions about properly classifying your employees under the FLSA or about other employment law matters, please contact Suzanne Arpin at sarpin@fh2.com or (770) 399-9500.