Be Careful When Using Liquidated Damages with Your Non-Compete Clause

As I have counseled many clients, a non-compete provision is different than most other contractual terms, because simply having mutual consent and consideration will not automatically render it enforceable for reasons of public policy. Thus, even in states like Massachusetts that are known to enforce non-competes, such restrictions will be deemed invalid unless they are reasonable in time and scope and also are necessary to protect against unfair competition – which occurs when the employee uses the company’s confidential information, trade secrets or goodwill to compete against it. As oxymoronic as it may sound, a non-compete that merely prevents “ordinary competition” will be deemed unreasonable and unenforceable.

While some businesses try to make an end-run around this law by requiring an employee to forfeit some benefit or pay liquidated damages if he/she competes against his/her company, any such requirement will be viewed through the same public policy lens used to scrutinize a formal non-compete provision. Indeed, as the Supreme Judicial Court of Massachusetts noted long ago in Cheney v. Automatic Sprinkler Corp.:

If forfeiture for competition provisions were enforced without regard to the reasonableness of their terms while covenants not to compete were subjected to such a test, overreaching employers would be tempted to rely on the threat of forfeiture as a means of restraining employees from seeking employment with competitors.

Despite that, using a liquidated damages clause to enforce a non-compete can be very effective, if done properly. In this regard, it is important to keep in mind that, for a liquidated damages clause to be viable, the liquidated amount must be a reasonable estimate of the damages that the employer anticipates it would suffer if the employee were to engage in the prohibited conduct – and the burden is going to be on the employer to prove this. Thus, while it may be difficult, it is important to take some time to come up with a “real” estimate of damages and memorialize at least some of the justifications for it in your agreement.

Additionally, it is important to be aware that simply putting in a liquidated damages provision does not mean that you will be barred from also seeking an injunction to prevent the employee from competing against you. Indeed, in a 2010 case, Palladium Group, Inc. v. MacGillvray, the Superior Court of Massachusetts held that one reason the plaintiff-employer was barred from obtaining injunctive relief to enforce a non-compete was because the contract at issue contained a provision stating that the exclusive remedy for a breach was that the employee would forfeit his right to certain deferred compensation. Had the employer not included such a provision, it likely would have been able to obtain an injunction and also may have been awarded its liquidated damages.

In sum, while a liquidated damages provision is not a silver bullet, per se, if properly drafted, such a clause can act as a significant deterrent to an employee who might otherwise decide to test the bounds of a non-compete.