Independent insurance agencies, like many businesses engaged in the sale of products and services to the public, rely heavily upon the efforts of their producers to service the agencies’ existing customers as well as to bring new customers — i.e., policyholders — to the agency.
The producers are insurance agents licensed through the Pennsylvania Department of Insurance. They are typically employees of the agency, although they may be independent contractors.
Insurance agencies, like most employers, invest substantial resources in the training of their employees and the marketing of their services in an effort to build a substantial customer base, or “book of business.” However, when an agent develops a personal relationship with an insured, he will frequently expect and/or encourage the insured to follow him to his/her new place of employment.
To address this risk, many agencies, like other businesses that rely on the efforts of sales personnel, require producers to sign employment contracts containing restrictive covenants at the time of their hire. The purpose of a restrictive covenant is to protect the employer’s business and prevent employees from using the confidential information gained through their employment to take the company’s clients if the employee decides to leave or is terminated.
Generally, restrictive covenants fall into three categories:
• Nonsolicitation agreements preclude former employees from soliciting any present or prospective business of their former employer.
• Nondisclosure agreements (or “nonpiracy agreements”) prevent employees from disseminating confidential and proprietary information to competitors of the agency.
• Noncompete agreements prohibit former employees from competing with their prior employer for a specified period of time and within a specified geographic area.
In many instances, all three types of covenants appear in the employment agreement.
In difficult economic times, these restrictive covenants may appear harsh because they prevent individuals from obtaining employment for which they are suited despite diligent efforts to secure a job. Recent trends show that Pennsylvania courts subject noncompete agreements to a higher level of scrutiny than the other types of restrictive covenants, particularly when prevailing economic conditions do not favor individuals seeking employment.
Restrictive covenants are disfavored because they serve as a “restraint on trade” by restricting an employee’s freedom to work and earn a living. Despite this disfavor, Pennsylvania courts will enforce a noncompete agreement to the extent that it is reasonably necessary to protect the business interests of the employer.
To be enforceable, the noncompete must be:
1. incident to an employment relationship between the parties
2. supported by adequate consideration
3. reasonably necessary for the protection of the employer; and
4. reasonably limited in duration and geographic extent.
In essence, the covenant must be written to reasonably protect the business of the employer but not to punish the employee. In the insurance context, the courts have recognized that the employer’s business interests may include matters such as trade secrets, goodwill, customer relationships and confidential customer lists.
When examining the temporal and geographic scope of the noncompete for reasonableness, Pennsylvania courts look to the interest the employer is seeking to protect. The covenant must be tailored to protect that specific interest and nothing more. When the restraint is for the purpose of protecting customer relationships, the duration will be reasonable only if it is no longer than necessary to put a new employee in place and allow that new employee to prove his or her effectiveness to the agency’s customers.
In the insurance context, this may be limited to a renewal cycle, which can encompass a period of 12 to 18 months.
As with the durational aspect, the geographic scope must only be as wide as necessary to protect the employer’s interest. In the insurance context, this means that an employer can only reasonably restrict an employee from competing in the areas he or she had previously serviced and built relationships with clients.
Furthermore, courts will also consider whether existing competitive agencies are located in the same geographic area. If multiple competitive agencies are already in place in the area restricted by the covenant, courts will subject the covenant to a higher level of scrutiny.
In addition to a reasonableness analysis based on geographic and temporal scope, the court may consider other factors in balancing the interests of the agency against the interests of the producer, such as:
• the situation of the employee and his/her family
• whether the employee is handicapped or disabled
• whether it will force him/her to give up the work for which he/she is best trained
• the length of time the employee was employed, and
• the reason the employment relationship ended.
It also is important to note that if the scope of the noncompete is unreasonable, Pennsylvania courts may exercise the power to modify the agreement. Pennsylvania is known as a “blue-pencil” state, which means that a court will change an agreement in order to make it reasonable, then enforce it after the changes.
In the context of noncompete agreements, Pennsylvania courts have often modified the temporal and geographical scope of agreements. However, when employers use their superior position to force overly broad restrictive covenants on employees, courts have shown a willingness to strike the whole agreement.
To sum up, in the current economy, the reasonableness of a restrictive covenant is the key to its enforcement. Pennsylvania courts have recognized that restrictive covenants can prove especially harsh in tough economic times and have shown a willingness to modify or nullify unreasonable restrictive covenants.
Employers should identify the interests they are truly trying to protect and narrowly draft fair agreements to protect those interests. The proper goal is protection of the employer’s legitimate business interests and not the elimination of competition or punishment of the former employee.
A partner with Nauman, Smith, Shissler & Hall LLP, J. Stephen Feinour represents independent insurance agencies, in addition to large and small companies, nonprofits and individuals in business, real estate and litigation matters.