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Business Booms Where Employee Noncompetes Are Banned, Fed Study Infers, But Use in U.S. Grows – Newsletter 5

Charles H. Martin Contract Law and Public Policy

ID-100259397Dear Readers,

I. What Are Employee Noncompete Agreements, and Why Are They Important?
II. Richmond Fed Study Ties Detroit Auto Boom to Michigan Ban on Employee Noncompete Agreements
III. Richmond Fed Study Ties Silicon Valley Boom to California Ban on Employee Noncompete Agreements
IV. Arguments for Employee Noncompete Agreements
V. Arguments Against Employee Noncompete Agreements
VI. Increasing Use of Noncompete Agreements by Employers

VII. Conclusion

“By 1914, the Dodge Brothers quit the Ford Motor Company and set out on their own.” – Chrysler Group 2014 television commercial

I. What Are Employee Noncompete Agreements, and Why Are They Important?

This newsletter is a follow-up to my first newsletter, “Your Facebook Status Update Could Cause Your Old Employer to Sue You. It concerns employee contracts containing post employment “noncompete” agreements (also called covenants not to compete) that prohibit a worker from competing with a former employer, usually within a specific geographic area, and for a specific period of time.

Noncompete agreements are usually only one part of a larger employment agreement that is given to an employee (usually on a “take-it-or-leave-it” basis) before or after they begin work. State contract law governs these agreements. See “50 State Survey Chart of Noncompete Laws” by Beck Reed Riden. Most U.S. states allow noncompetes that are “reasonable” in terms of scope of activities prohibited, geographic area covered, and time period of prohibited competition. See Part A, Chapter 7 d) ii) of Every1’s Guide to Electronic Contracts. Only three states, California, North Dakota and Oklahoma, prohibit all employee noncompete agreements. You could say that these three states consider all noncompetes to be unreasonable.

Many know the general story of the founders of Intel Corporation, Robert Noyce and Gordon Moore. They left the employment of Beckman Instruments in 1957 and its idiosyncratic leader, Nobel Prize winner and transistor co-inventor William Shockley, to found Fairchild Semiconductor. After a decade of pioneering work that was turbocharged by the NASA lunar program, Noyce and Moore founded Intel in 1968 and began the era of personal computing.

The ability of Noyce and Moore to first leave Beckman and then leave Fairchild, and of their “spinouts” to  immediately compete with their former employers, without the threat of being sued for breach of contract by them, is only one factor in the success of Silicon Valley. The possible preeminence of a state law ban on employee noncompetes as an enabler of high growth rate industrial “spinouts” (created by former employees, unlike “spinoffs” created by the former employer) is inferred, however, in a new study.

II. Richmond Fed Study Ties Detroit Auto Boom to Michigan Ban on Employee Noncompete Agreements

The November 2014 Economic Brief of the Federal Reserve Bank of Richmond asks “Does Enforcement of Employee Noncompete Agreements Impede the Development of Industry Clusters? (David A. Price) By “industry clusters” the author means “the concentration of specialized industries in particular localities”, such as the semiconductor-driven computer hardware and software industries of Northern California. The article analyzes research on “the extent to which enforcement of noncompetes may suppress the formation of industry clusters by restricting labor mobility and entrepreneurship.”

Michigan banned enforcement of employee noncompete agreements from 1905 to 1985. Only California, North Dakota and Oklahoma also prohibited noncompetes during this period. The Michigan ban was inadvertently repealed in 1985 by a replacement of its state antitrust statute with a uniform (among states) law that did not mention the unusual 1905 Michigan statutory noncompete ban. See “Mobility, Skills and the Michigan Non-Compete Experiment” (Marx, Strumsky and Fleming). The Richmond Fed article looks at the fast growth of the automobile industry in Detroit in the early 20th century, and its correlation to the Michigan state law prohibition on noncompetes.

In the 1890s, New York and Chicago had more auto manufacturers than Detroit, but by 1920 Detroit firms had 70 percent of the auto manufacturing market. Many of the ultimate survivors of the large number of Detroit automakers existing in 1905 came from 59 company spinouts, such as Chevrolet, Chrysler and Lincoln, which were spun out from General Motors, and the Dodge Brothers Motor Car Company, which was spun out from Ford Motor Company. On November 14, 1914, John and Horace Dodge (who had been suppliers to and then shareholders in Ford Motor Company) rolled out their first car. By 1917, Dodge was the fourth-largest U.S. automaker.

Spinouts made up almost half of all new Detroit automakers in this period, and almost four times the number of any other state. An earlier Richmond Fed analysis attributed about one-third of the Detroit car industry clustering to spinouts of other carmakers. See “Explaining an Industry Cluster: The Case of U.S. Car Makers from 1895-1969“, Economic Brief (October 2012).

III. Richmond Fed Study Ties Silicon Valley Boom to California Ban on Employee Noncompete Agreements

U.S. semiconductor manufacturers were concentrated in New York, Los Angeles and Boston in 1956. None were located in Northern California where William Shockley opened his Beckman Instruments laboratory. Fairchild Semiconductor was founded by eight employees whom Shockley had recruited as Beckman’s first staff, but who then left as a group after one year because of their dissatisfaction with Shockley’s leadership.

From Fairchild’s 1957 founding to 1976, at least 29 Silicon Valley semiconductor startups (“Fairchildren”) were founded by entrepreneurs who had worked for Fairchild. See “Covenants Not to Compete, Labor Mobility, and Industry Dynamics” (Franco and Mitchell). By 1975, Silicon Valley semiconductor makers produced 43% of industry output. The top five Silicon Valley semiconductor companies were Fairchild and four of its spinouts.

The importance of California’s prohibition on enforcement of employee noncompete agreements has been inferred from the divergent trajectories of the Silicon Valley and the Boston Route 128 technology clusters. Both areas have large, elite university engineering departments and access to venture capital. Nevertheless, “In 1965, Route 128 had approximately three times more technology employment compared to Silicon Valley. But by 1975, Silicon Valley’s employment had quintupled, while Route 128 had only tripled, resulting in 15 percent higher total employment in Silicon Valley. From 1975 to 1990, Silicon Valley had tripled Route 128’s new job creation.” (Franco and Mitchell)

IV. Arguments for Employee Noncompete Agreements

The main economic arguments in favor of enforcement of noncompete agreements are that: 1) they give employers an incentive to invest in training the workers bound by those agreements, and 2) they give incentives to invest in existing companies, because noncompetes are an easier way to protect an employer’s intellectual property and customer relationships than patent and trade secret law enforcement. The significance of these arguments might be inferred from the lawsuit against some Silicon Valley companies (that was settled for $324.5 million) that, in place of noncompete agreements, had an illegal agreement to not recruit employees away from each other. Google even refused to accept applications from Apple employees. See “Apple, Google, Intel and Adobe Settle The Employee Ripoff Suit” by Tim Worstall, Forbes.com, May 24, 2014.

Some research has identified venture capital availability as a larger factor than noncompete agreement prohibitions in facilitating creation of startup companies, and in increasing the number of patents and employment. See “Non-Compete Covenants: Incentives to Innovate or Impediments to Growth” (Samila and Sorenson). The Silicon Valley innovation of distribution of stock options as an employee recruitment tool is also a factor in the success of California startups. Other research has found that successful spinouts in states that enforce noncompete agreements tend to grow faster than spinouts from states that do not enforce noncompetes. These successful spinouts also came from smaller parent firms than spinouts in states that ban noncompete agreements.

V. Arguments Against Employee Noncompete Agreements

The main economic arguments against the enforcement of noncompete agreements are that : 1) noncompetes discourage employees from investing in their own skill development, because they believe that they will not reap the full benefits of that investment apart from their current employment, 2) noncompetes limit the diffusion of knowledge among an area’s firms, 3) noncompetes limit the pool of skilled workers, 4) noncompetes depress the wages of skilled workers, 5) noncompetes discourage skilled workers from entering a region, and 6) noncompetes deter workers from starting spinouts during the period they are in force. The last effect might be a cause of some of the previous effects, in that spinouts have been found to perform better than non-spinout startups, on average, across a range of industries. See David A. Price.

An analysis of patent data from 1975 to 2005 found a “brain drain” of patent holder employees from states that enforce noncompetes to those that do not enforce them, with the largest exodus by the highest-performing inventors. California will not enforce noncompetes against employees who leave an employer in an enforcing state and move to California. This evidence of the disadvantage of enforcement of noncompetes for states wanting to retain high-technology innovators includes the period when Michigan shifted in 1985 from a state than banned noncompetes to a state that enforced noncompetes. See “Regional Disadvantage? Non-Compete Agreements and Brain Drain” (Marx, Singh and Fleming).

VI. Increasing Use of Noncompete Agreements by Employers

Non-technology companies increasingly require employees to accept noncompete agreements as a condition of their employment. This is the case even where those employees are at the lowest levels of the organization chart and have few or no specialized skills or knowledge. Employees are being rejected for jobs, and are rejecting opportunities to start new businesses based only on the fear of being sued for violating noncompete agreements.

A summer camp counselor was rejected for a summer camp job, because her previous summer camp employer required her to accept a one-year, 10-mile-radius-of-any-of-the-previous-employer’s-camps noncompete agreement.  A lawn pesticide sprayer was required to sign a two-year noncompete agreement. A textbook editor was required to sign a six-month noncompete agreement. An applicant for an entry-level social media marketing job was asked to sign a one-year noncompete agreement. A college junior had to sign a one-year noncompete as a condition of a summer internship at an electronics firm. A hair salon obtained an injunction to prevent a hair stylist from working for any salon in nearby towns for one year after leaving, even though the stylist was fired by the salon. See “Noncompete Clauses Increasingly Pop Up in Array of Jobs” by Steven Greenhouse, N.Y. Times, June 8, 2014.

A study by Matthew Marx of the M.I.T. Sloan School of Management found that about one-half of U.S. tech sector employees are required to sign noncompetes. Moreover, one-third of those engineers left their chosen industry after changing jobs, presumably because of the negative effect on their job prospects of their noncompete agreement. Seventy percent of the respondents surveyed by Marx were told that they would have to sign a noncompete only after they accepted a job offer, and half were told this only after they started working. See “Matthew Marx: Noncompete agreements and their impact on employees“, October 27, 2011, MIT Sloan Experts.

In April 2014, Governor Deval Patrick proposed that Massachusetts enact a legislative ban on noncompetes. The bill that was introduced applied to existing, as well as future noncompetes. It strengthened trade secret legal protections. The bill was not enacted before the end of the legislative session on July 31, 2014.

VII. Conclusion

Evidence is accumulating that leads to the conclusion that state contract law enforcement of employee noncompete agreements retards the development of high-growth technology and other business startups, limits worker mobility, and reduces worker negotiating leverage for higher wages. State legislative efforts to relax or eliminate the enforcement of employee noncompete agreements, such as those in Massachusetts, face entrenched business interests that lobby against changes to the existing laws allowing enforcement of noncompetes. These interests often overmatch the lobby arguing for relaxed enforcement, composed of venture capital firms, entrepreneurs and unemployed or underemployed workers.

Workers and would-be entrepreneurs are left in most states to depend on the judgment of precedent-following courts as to whether a noncompete is reasonable in its terms. Unlike the law of  California and the two other states that ban noncompetes, the premise of this legal approach is that a noncompete can be shown to be reasonable. Workers are vulnerable in states that enforce noncompetes. They often are not asked to sign a noncompete until they have accepted a job or actually begun work. The mere threat of enforcement of a noncompete by a previous employer can be enough to prevent an employee from leaving for a competing firm. The mere possibility of enforcement can be enough to prevent the hiring of an employee from a firm while their existing noncompete is still in force. Although the terms of a noncompete might eventually be proved to be unreasonable, employees are usually in a worse financial position than are employers to bear the necessary costs of litigation to reach that conclusion.

In October 2014, it was reported that some Jimmy John’s sandwich chain franchisees require their store workers to sign agreements to not work at other shops that earn ten percent or more of their revenue from sandwich sales, if they are located within three miles of a Jimmy John’s location, for two years after leaving the chain.  A group of Democratic Congressmen sent a letter to the federal Department of Labor and the Federal Trade Commission asking them to “investigate this practice, determine the impact these agreements have on both workers rights and free competition, and take any necessary action to deter or prevent such agreements from impacting employees”. See “Jimmy John’s Noncompete Agreement Comes Under Congressional Scrutiny” by Dave Jamieson, Huffingtonpost.com, October 21, 2014.

Perhaps the image of sandwich-makers driven into the underground economy by threats of noncompete litigation will alter the current political and legal balance that tilts in favor of employers shackling employees with noncompete agreements. Otherwise, a public awakening to the effect of employee noncompetes in limiting the dynamism and employment growth of the U.S. economy might be necessary before the balance tilts more in favor of employees and entrepreneurs.

The current Chrysler advertisement referring to the Dodge Brothers of Detroit says that “They may be gone, but they left us the keys.” Is one of those keys a ban on noncompetes?

Best regards,
Charles

P.S. My book, Every1’s Guide to Electronic Contracts, is now available in print at the Amazon CreateSpace Store. It continues to be available in iBooks and Amazon Kindle ebook form.

Charles H. MartinBusiness Booms Where Employee Noncompetes Are Banned, Fed Study Infers, But Use in U.S. Grows – Newsletter 5