Competition clauses in contracts in and outside employment

| Insight

Many companies need to protect themselves from competing business through restrictive covenants in employment relationships. We often see restrictions on competition in agreements other than in employment relationships, typically in shareholder agreements or share purchase agreements. Different rules apply to competition clauses in and outside of employment. In employment relationships a detailed regulation in the Working Environment Act ("WEA"), Chapter 14 A, applies. Outside employment relationships, the Norwegian Contract Act applies.

The different sets of rules have led to uncertainty in cases where the employee is also a shareholder in the company. This was the situation in a recent judgement from Borgarting Court of Appeals rendered 2 April 2020 (LB-2019-29891). The court stated that a non-compete clause in a share sale agreement was considered invalid because of the rules in the WEA Chapter 14 A. Before we look closer at the judgment, we will first present a few starting points that apply to restrictive covenants in and outside of employment.

The general duty of loyalty in employment relationships

Employees have a general duty of loyalty to the employer. The duty applies as long as the employment relationship lasts, also during the notice period. The duty of loyalty means that the employee is obliged to act loyally to the employer’s interests in the employment relationship. Either starting, participating in, or otherwise promoting competing activities will as a starting point be regarded as disloyal. Depending on the circumstances, this may provide grounds for termination or dismissal of the employee.

When assessing whether an employee has breached the duty of loyalty, the employee’s position, the possibility of using trade secrets and internal information, what type of business it is and the extent of the activity must be assessed. The duty of loyalty is according to case law stricter for an employee in a managing or superior position than a lower level employee.

Competition clauses in employment contracts

During the employment, separate rules regarding competition clauses apply, cf. the WEA Chapter 14 A. When an employment relationship ends, the duty of loyalty normally also ceases and this is where the need for competition clauses arises. The purpose of a competition clause is to restrict an employee’s right to take up a position with another employer or to start, run or participate in another business after the termination of the employment relationship. The employer may also protect itself against solicitation of the employer’s customers, through so-called non-solicitation clauses.

The rules in the WEA Chapter 14 A stipulate i.a. a maximum duration of 12 months for non-compete and non-solicitation of customers clauses, mandates certain procedures and the provision of information, as well as financial compensation if a non-compete clause is invoked by the employer. Furthermore, the rules prohibit the employer from entering into agreements with other companies that prevent or limit the employee’s opportunities to take up employment in another company. If the conditions in the WEA are not fulfilled, the clauses will be considered invalid, and the company will not be able to invoke them against the employee.

According to the WEA, the employer may choose whether a non-competition or non-solicitation of customers clause shall be invoked. The employer is obliged to consider the actual need for protection against competition in the event of resignation. The employer must have a «particular need» for protection against competition, and cannot invoke the restrictions beyond what is strictly necessary.

When considering whether the restrictions shall be invoked, the employer must assess the employee’s position in the company and the duration of the employment relationship. Furthermore, the employer must assess whether the employee has insight and knowledge of the employer’s activities, which justifies restrictions. Employees who does not have a superior, managerial or particularly trusted position will, as a main rule not have the insight and knowledge of the company that can justify a non-competition clause. According to the preparatory works of the WEA, a non-competition clause shall not be invoked if the employee has been employed for six months or less upon termination of the employment.

Although the WEA allows for non-competition and non-solicitation of customer clauses to be invoked for a maximum period of 12 months, the employer must consider whether the restrictions should be invoked for shorter period of time due to the requirement of a «particular need» for protection against competition.

Upon written request from the employee, the employer is obliged to provide a written statement of whether and to what extent a non-competition clause will be invoked. The statement shall be given within four weeks after the request. The same apply for non-solicitation of customers, upon which the statement shall specify which customers the non-solicitation clause applies to. Furthermore, a non-solicitation of customers clause may only apply to customers the employee has had contact with or has been responsible for during the last 12 months prior to the statement. If a compliant statement is not provided, the restrictions will lapse. Furthermore, it is important to be aware that the employer cannot invoke a non-competition or non-solicitation of customers clause in the event of termination due to redundancy or downsizing.

In our experience, the strict legal requirements entail that employers in practice choose not to invoke the restrictions. Due to the strict procedural requirements and the right to compensation for non-competition clauses, it is not considered cost effective compared with the benefit of invoking the restrictions.

Temporarily lay-offs

Thousands of employees are today temporarily laid off as a result of the Covid-19 outbreak. Many have found themselves in a financially difficult situation due to the long processing time for receiving unemployment benefits. Employees may thus feel compelled to look for work elsewhere, including at competing companies.

During a temporarily lay-off, the employee is still considered an employee of the company. This means that the duty of loyalty also applies to temporarily laid-off employees. Furthermore, a non-compete clause in the employment contract will continue to apply while the employee is laid off.

Consequently, employees who are temporarily laid-off may, as a general rule, not take a job with a competing company as long as the employment relationship lasts without conflicting with the duty of loyalty. Our recommendation to laid-off employees in such situations is to try to resolve the situation through dialogue with the employer. In many cases, the parties can agree on a solution that is acceptable to both parties, e.g. that the employer accepts temporary work with a competitor where there is little risk that such work will damage the employer’s business.

In addition, temporarily laid-off employees have a right to terminate their employment with 14 days’ notice. An employee will then be able to take a job with a competitor after 14 days, provided that the employer has not invoked a non-competition clause and pays compensation in accordance with the WEA.

Outside employment: Competition clauses in share purchase agreements, shareholder agreements etc.

Competition clauses that are agreed outside employment relationships, for example agreements between shareholders, share purchase agreements, etc., are governed by the Norwegian Contracts Act § 38. The provision stipulates that restrictions on competition may be legally agreed as long as it does not unreasonably restrict the person’s access to receive income, and it is not considered to go beyond what is necessary to protect against competition. Contrary to the WEA, the provision in Norwegian Contracts Act § 38 does not require compensation and there is no maximum period for a competition clause to be applied. Consequently, the conditions for competition clauses in employment relationships are significantly stricter than for contractual relationships regulated by the Contracts Act § 38. In practice, we see that difficult questions regarding the interpretation of the different rules occur where a shareholder also is employed by the company.  This is described more in detail below.

Recent judgement from Borgarting Court of Appeals (LB-2019-29891)

For persons who are both employees and shareholders in the company, and where competition restrictions have been agreed in a shareholders agreement or share purchase agreement, the question is whether the WEA Chapter 14A applies.

The question is not addressed in the preparatory works of the WEA, and there are few published court judgements that discuss the issue. However, an interesting judgment from Borgarting Court of Appeals has recently been published (LB-2019-29891 dated 2 April 2020).

The case concerned a craftsman who, in addition to being employed, was a shareholder with 23.37% of the shares in the company. The employee and the employer agreed to terminate the employment relationship through a termination agreement, which included a non-solicitation of customers and a non-compete clause. At the same time, the employee agreed to sell his shares in the company, and a non-solicitation of customers and non-compete clause was also included in the share purchase/sale agreement. Both agreements were entered into on the same day.

The termination of employment agreement included the following:

«The employee has no right to contact or take on assignments for someone who is a customer of the Employer as of 31 August 2017. This prohibition shall apply for one year from 31 August 2017.»

The share purchase/sale agreement included the following:

            «COMPETION CONDITIONS

The parties agree that the Seller and the Seller’s representative A have the right to engage in other plumbing activities from 1 September 2017.
The Seller and the Seller’s representative A are nevertheless not entitled to contact or take on assignments for anyone who is a customer of the Company as of 31 August 2017. This prohibition shall apply for one year from 31 August 2017. In the event of a breach of this provision, the Seller shall pay a liquidated damages of NOK 100,000 to the Company for each breach. In addition, the Company and the Buyer may claim compensation for any actual loss that may have occurred. »  

The Court of Appeal stated that the wording in the termination of employment agreement was not in accordance with the WEA Chapter 14 A. Consequently, the competition restriction could not be invoked against the employee.

Thereafter the Court of Appeal assessed whether the rules in the WEA Chapter 14 A, also applied to the non-compete clause that had been entered into in the share purchase/sale agreement.

The Court of Appeal came to the conclusion that the termination of employment agreement and the share purchase/sale agreement were so closely related that they had to be considered to constitute one and the same contractual relationship. This meant that the non-compete clause also was considered to be invalid in relation to the sale of shares based on the rules in the WEA Chapter 14 A.

In its specific assessment, the Court of Appeal referred to the following aspects:

  • The agreements were entered into closely in time (same day),
  • The shares were shares in the company where the employee had worked as an employee,
  • The wording of the non-compete agreements was identical,
  • It was clear that the employee could not own shares in the future, thus the share sale agreement was also linked to the employment relationship in the company; the share sale was a consequence of him leaving the company
  • The shares were sold for NOK 1,225,000, which was the same amount the craftsman had bought the shares for in 2014

The result of the judgment was that the competition clause also lapsed in relation to the share purchase/sale agreement, in the same way as for the employee personally. Furthermore, the company’s claim for repayment of severance pay and claim for liquidated damages were dismissed. In addition, the company was obliged to pay the remaining severance pay, dividend from the company in accordance with the share purchase/sale agreement, and compensation for the employee’s legal costs.

In light of the judgement, we recommend that companies must always specifically consider whether a shareholder who also works in the company could be regarded as an employee in relation to restrictions regarding competition in shareholders agreements, share purchase agreements, etc. The judgment confirms that the link between the agreements must be considered in each case and that several different factors may be important for the assessment of which contractual relationship is most prominent at the introduction of the non-compete clause.

In legal literature, it has been assumed that the size of the shareholding may have a certain significance in the assessment. It is generally assumed that where the employee’s shareholding is small, it points in the direction that the employment relationship is the most prominent contractual assessment. However, the judgment shows that even with larger shareholdings (in the judgment 23.37%), a prohibition regarding competition in a share purchase agreement may be invalid according to the rules of the WEA because it is considered to be closely related to the employment relationship.