Illinois may not get a resolution any time soon to whether an employer is required to prove that a non-compete covenant must support a recognized, legitimate business interest. By now, lawyers and commentators are fully aware of the Fourth District’s ruling in Sunbelt Rentals, Inc. v. Ehlers and its repudiation of a decades-long test used to determine the validity of non-competes. Though that test had a somewhat bizarre development, courts throughout Illinois recognized it.

Applying the test in practice perversely has made litigation more expensive for employees, as cases frequently devolved into lengthy discovery disputes over the so-called protectable interest and whether it was threatened. Often times the concept of “reasonableness” gets lost in the shuffle. Still, many employers lost cases after failing to prove a legitimate business interest was at stake.

But Ehlers settled his case with Sunbelt Rentals, and so there won’t be a decision from the Illinois Supreme Court any time soon on the inter-district conflict. For now, that means that outside of the Fourth District, courts are still applying the legitimate business interest test. District Judge Gettleman recognized as such this week in Aspen Marketing Services v. Russell, when he denied a motion to dismiss a non-compete suit. Gettleman expressly noted the ruling in Sunbelt Rentals and declined to apply it, noting that the Illinois Supreme Court and other Illinois courts outside the Fourth District haven’t weighed in.

On a separate note, the idea of challenging the validity of a non-compete on a motion to dismiss is rarely a good one. Almost invariably, this results in an early loss for the defendant, since the concept of “reasonableness” cannot be examined under the pleadings alone. Unless there is some obvious defect (such as a nationwide covenant when the contract specifies a very limited area of responsibility), lawyers ought not to count on dismissal of a non-compete claim until at least summary judgment.

One of the most high-profile non-compete disputes in the Chicago area has resulted in a victory for Citadel Investment Group and a set-back for two executives who defected to start their own high-frequency trading firm.

In a 36-page memorandum opinion and order Judge Mary K. Rochford enjoined Mikhail Malyshev and Jace Kohlmeier from violating non-compete restrictions contained in their Citadel employment agreements for the balance of the nine-month term. Effectively, this means that both Malyshev and Kohlmeier may be free to compete as soon as February of 2010, since the court refused to extend the non-compete term on an equitable basis for the period in which the defendants were in breach.

The case involves a shadowy, but highly profitable, business known as high-frequency trading (HFT). In essence, HFT relies on powerful computers to enter trade orders (often without human intervention), with algorithms deciding on specific aspects of the trade such as how much to buy, when, and at what price. HFT is a relatively new phenomenon, but it yields enormous profits. A disproportionate amount of equity trading volume is conducted by HFT firms.

Citadel itself invested heavily in HFT. It paid off - Citadel’s HFT unit reaped earnings of $1.15 billion in 2008. Malyshev and Kohlmeier were instrumental, key employees for Citadel’s HFT group. Neither had HFT experience prior to joining Citadel. For quite some time, each considered leaving to start his own proprietary trading firm. And each had a non-compete agreement, barring employment with a “Competitive Enterprise” for a period to be selected by Citadel upon departure, ranging from 0 to 9 months.

Upon their departure, Citadel elected the maximum 9-month period and paid Malyshev and Kohlmeier to sit on the sidelines. No surprise, there, given their access to proprietary information and involvement in recruiting R&D talent to Citadel. However, both ex-employees formed Teza Technologies and hired 15 employees, essentially daring Citadel to file suit.

It did. Citadel pursued each aggressively and sought preliminary injunctive relief. The court dispatched with a number of the arguments raised by the defense. Given that one of the defendants deleted a fair amount of Citadel information (despite a court order not to do so), the court really did not have to address whether a legitimate business interest supported the non-compete. The adverse inference it could draw about the document deletion was more than enough to demonstrate the defendants had access to and attempted to use Citadel’s confidential information.

The defendants also seemed to challenge the non-compete due to the fact that they really weren’t actively trading, but merely preparing the firm’s trading infrastructure to compete eventually. However, nothing in the non-compete allowed the defendants to wash their hands of liability based on this “preparing to compete” theory, and the theory itself ignored the fact that HFT firms depend heavily on building infrastructure. By getting a headstart in developing a trading platform, the defendants were essentially entering the market much faster than they agreed to under their employment contracts.

The most important feature of the decision, though, concerned the length of the injunction. And it is here where the defendants probably were able to take some solace in defeat. The court refused to extend, or equitably toll, the non-compete period for the time in which the defendants were in breach. The court looked at the Second District Appellate Court’s decision from two years ago to hold that, under Illinois law, a contract must specifically provide for an equitable tolling, or extension, remedy. Otherwise, the court will not imply the term under the contract.

This, of course, does nothing to mitigate the defendants’ damages during the non-compete period. But it does serve as a cautionary tale for counsel in drafting non-compete clauses. Unless an equitable tolling remedy is clearly contained in the contract, the court will not agree to extend it even if the defendants were in breach leading up to the injunction order.

The Fourth District Appellate Court of Illinois has just made it substantially more difficult for employees to break their non-compete agreements.

Justice Steigmann authored an opinion that built upon his special concurrence two years ago in Lifetec, Inc. v. Edwards, a case where he called into question the applicability of the so-called “legitimate business interest” test used by Illinois courts to analyze restrictive covenants. This time around, Steigmann succeeded in convincing his robed colleagues to abandon the test altogether, overturning a number of Fourth District cases in the process. The decision does nothing to alter the test in other districts, and each of those still uses the test which is widely believed to be employee friendly.

By way of brief background, Illinois courts have essentially used a two-part analysis to determine whether a non-compete agreement is valid. First, it must be reasonable in scope. Second, it must protect a legitimate business interest. The second part of the test demanded an employer show that it had an interest in misuse of confidential information or near-permanent customer relationships acquired through the employee’s association with the employer. This is not a marked departure from what other states require, though some would argue Illinois is fairly narrow in not recognizing other types of business interests, such as special training. However, Justice Steigmann could not find Illinois Supreme Court authority for part two of the test.

By reviewing Supreme Court precedent, Steigmann is correct in that the Court never formally adopted the test which has been used for years by all five district appellate courts. He casually neglects to mention that in the past 60 years, the Court has taken on a grand total of six non-compete cases, and several of those looked at covenants outside the employment context. His analysis is not entirely accurate because his discussion also neglects to confront one of the Court’s leading precedents, House of Vision v. Hiyane. That case was authored by Justice Schaefer, probably Illinois’ most famous jurist.

In House of Vision, the Court specifically discussed at length the interest of a business in protecting customer relationships. It even distinguished prior precedents (also cited by Justice Steigmann) where the Court noted that in a sale-of-business non-compete, the legitimate interest to be protected concerned intangible goodwill. Covenants ancillary to a sale of a business are always easier to uphold, and it may well be true that a legitimate business interest is virtually presumed in such circumstances. But it seems illogical that the Court would discuss a legitimate business interest in connection with a sale-of-business covenant, and then deem the test inapplicable to more problematic employment covenants. Steigmann has assured us the Court will have to take an employment non-compete case soon to resolve the tension between the Fourth District and the rest of the state’s appellate courts.

Justice Steigmann’s analysis defaults to the reasonablenes test he cites from what he considers binding precedent: an employer must show that the covenant is no greater than is necessary for its protection. As applied to the facts involving Sunbelt Rentals and Neil Ehlers, the court concluded the 50-mile non-compete was reasonable even though the employment agreement also contained a well-drafted client non-solicitation clause.

It’s hard to see, though, how a court can determine whether a covenant is “no greater than is necessary for its protection” without analyzing what business interest it seeks to protect in the first place. The legitimate business interest test fills that vacuum and allows a court to fashion an appropriate restraint, or strike one entirely if the employer can’t articulate the need for a restriction.

In many jurisdictions, non-compete agreements contained within a shareholder’s agreement are evaluated under a much less stringent rule-of-reason analysis. Illinois, for instance, is a state fairly employee-friendly when it comes to non-compete covenants, but decidedly less so when those covenants are found in shareholder or LLC operating agreements.

The idea here is that those who have an equity stake in a venture need to secure the loyalty of those similarly situated to themselves. It goes without saying there is a much lower likelihood that a shareholder-employee will be tricked into making a desperate decision only to be shackled later on under circumstances that seem manifestly unfair.

But in Lampman v. DeWolff, Boberg & Associates, the Fourth Circuit (applying South Carolina law) did not give any deference to a non-compete covenant contained in a shareholder’s agreement and found that its overbroad provisions rendered it unenforceable as a matter of law.

Lampman was an employee and shareholder of DBA performing management consulting services. Along with others, he signed a shareholder’s agreement in 2004. That agreement contained a restrictive covenant which provided that a shareholder could not directly or indirectly engage in “Competition” with DBA for a period of three years. The definition of “Competition” ultimately was critical to the court’s ruling:

“Competition shall mean…serving in any capacity, job or function…for any Person that analyzes, designs, modifies, and implements management systems to improve productivity, quality, service and capacity levels that generates quantifiable financial savings, and where such services are competitive with or similar to those that such Shareholder rendered during his employment with [DBA].” The covenant also contained a non-exclusive list of competitors to whom the covenant specifically applied.

Along with the lack of any geographic restriction, the italicized phrases gave the court grounds to strike the covenant as unreasonable under South Carolina law. By virtue of that state’s strict blue-pencil doctrine, modification was not possible. The court gave an example of where the covenant would bar Lampman from performing consulting services outside any geographic area where DBA served clients. This in and of itself probably doomed the agreement.

Secondarily, though, the court noted where the covenant prevented Lampman from working for many entities that do not compete in the same marketplace as DBA. In particular, the use of “indirect” competition and the bar on providing “similar” services yielded absurd results. For instance, Lampman could not go work as an employee at Ford Motor if he was charged with analyzing its management operating systems and developing a model for internal cost savings. This example, the court found, highlighted how the covenant went far beyond preventing direct competition with DBA.

It was not clear from the opinion whether DBA sought to prevent Lampman’s employment or merely recoup dividends paid to him after his departure but prior to the time his shares were redeemed pursuant to the shareholder’s agreement. But that is not material.

Practitioners, regardless of the type of transaction, must be scrupulous in examining the language of non-compete covenants in all types of agreements for any indicia of overbreadth. It is best to use hypotheticals and examples to determine whether any non-competitive activity is inadvertently included within the restriction. And using phrases such as “directly or indirectly” or “similar to” or “in any capacity” almost always invites a challenge from an aggrieved employee, or in this case shareholder, on grounds of overbreadth.

Finally, the court in Lampman never discussed whether a less stringent standard of reasonableness should have applied because the covenant was contained in a shareholder’s agreement. Had it done so, the outcome may have been different. But this, too, is a lesson. Courts don’t always appreciate the nuances of the business transaction and may misapply rules that are supposed to pertain to one type of restrictive covenant. That lesson can be a costly one, so it’s best to avoid the problem in the first place.

Forfeiture-for-competition clauses present a different type of restrictive covenant that leaves an employee with a choice to compete at the price of relinquishing deferred compensation or stock option proceeds.

Though there is a divergence of opinion on the issue, the majority of courts hold that forfeiture covenants will not be construed as non-compete agreements and thereby require an overlay of reasonableness. There is, however, a significant minority view. Two recent cases, one from Texas and one from Minnesota, have examined forfeiture clauses under a traditional non-compete analysis.

The Minnesota case contains the most thorough analysis. In Medtronic v. Hedemark, the Court of Appeals of Minnesota examined a forfeiture-for-competition clause in a stock option award agreement. Hedemark’s agreement provided that, if he left to join a competitor within six months of exercising stock options granted to him under Medtronic’s plan, he had to pay back those proceeds on demand. The court granted summary judgment in favor of Medtronic but denied the company’s request for attorneys’ fees.

The case analysis proceeded to examine the forfeiture clause as a restrictive covenant, even though technically Hedemark was free to compete (albeit at a price). The court found that the covenant supported a legitimate business interest in promoting employee loyalty and stable relationships between the sales force and company customers.

The court also found the forfeiture clause reasonable in scope. In particular, the court focused on the degree of control Hedemark retained over the clause’s application. All Hedemark had to do was wait six months from the time the options were exercised to leave and join a competitor. The case does not address at what period of time this may become unreasonable. Finally, the court was not troubled by the lack of a territorial limitation on the forfeiture clause. In Minnesota, non-competes without territorial limits are “often held to be unreasonable.”

Even if viewed as a non-compete, the issue of reasonableness will tend to favor employers in forfeiture-for-competition clauses unless there is an overbroad definition of “competitive business” or if the clawback period stretches on for several years. Illinois has not addressed how forfeiture clauses will be adjudicated, and while the older cases seem to view them as non-competes, more recent decisions (particularly in federal court) are decidedly less sympathetic to the party at risk of forfeiture.

From a drafting perspective, it is critical for companies to consider a couple of points:

(1) State the purpose of the stock award or deferred compensation: to incent future performance and growth with the company;

(2) Provide that the award is equity-based, on top of regular wages and employee compensation;

(3) Maintain a sense of reasonableness, so that the clawback period is not too extensive (6 months is a good guidepost) and the definition of “competitive business” is specific and not overly broad.