Guidelines for the Effective Agreement of Non-Compete Clauses

Non-compete clauses are aN integral part of sale and purchase Agreements, cooperation agreements, AND EXECUtiVE and employment contracts. This article outlines the contractual possibilities, the Legal limits, and what to do where there is a breach of contract.

What are non-compete clauses?

There are different types of contractual non-compete arrangements. Non-compete clauses prohibit directors, board members, and employees from working for a direct competitor while employed or from competing with the company/employer in another form without the company’s consent. In cooperative agreements, non-compete clauses prohibit the parties from using the other party’s know-how or customer information to compete with them. Non-solicitation agreements ensure that neither party poaches employees from the other party. In certain circumstances, such contractual non-compete clauses can form collateral agreements to supply or cooperation agreements, contracts for the sale and purchase of a company, and outsourcing agreements.

Statutory non-compete provisions also exist. Section 88 of the Stock Corporation Act (AktG) prevents members of the management board from competing with the company without the consent of the supervisory board. For directors of limited liability companies, this rule is not enshrined in statute but derives from their fiduciary duty, i.e., their obligation of loyalty towards the company due to their position on the management board of the company. This principle also applies with some differences to certain shareholders (e.g., personally liable partners of a general partnership (OHG) and limited partnership (KG), or majority shareholders of a limited liability company (GmbH)). However, such statutory non-compete provisions end with the termination of the board or shareholder position.

Once their activities for the company cease, managers, members of the board, and employees are generally free to change companies, compete against the company, and even poach customers or employees. Companies may therefore wish to prevent managers and strategically important employees from working for the competition or competing with the company after the end of their employment (so-called post-contractual non-compete clause). Such contractual clauses may be broader in scope for directors than employees.

Conditions for effective contractual non-compete clauses

Non-compete clauses must be clear and self-evident. The object and scope must be clearly defined.

The primary object and purpose of a non-compete clause should be the protection of the legitimate interests of the benefitting company. Such clauses are permissible provided the freedom to carry out professional activities and the freedom to compete are not unduly impaired. In addition, the non-compete clause must be limited in object, duration, and geographic scope.

The case law has developed guidelines for the objective and geographical limits of post-contractual, non-compete clauses. Geographically, a non-compete clause must be limited to the company’s field of activity. Where a company is only active in a region, the non-compete clause may only apply to this region. Where the company is active throughout Germany or Europe-wide, the geographic scope will be correspondingly broader. On duration: any non-compete clause may only apply for two years after the end of the employment relationship.

If agreements with employees exceed these limits, the objective and/or geographic application and/or duration will be reduced to preserve validity, i.e., the maximum permissible scope will be considered valid. However, post-contractual non-compete clauses for directors and managers and non-compete clauses between companies will be invalid where they exceed the objective or geographical limits. Where a non-compete clause only exceeds the permissible duration, it may be reduced to the maximum permissible duration to preserve validity.

The limits of post-contractual non-compete clauses

While activity-based, non-compete clauses prevent managers or employees from performing certain activities, company-based non-compete clauses prevent them from working for (certain) competing companies, suppliers or customers. The limits of activity and company-based non-compete clauses are fluid. However, a prohibition against working for a competitor in all respects is probably invalid because, in most cases, it would result in an inadmissible occupational ban.

When managing directors leave a company, there is a danger that they will entice customers away from the company. Therefore, instead of prohibiting the director from performing certain activities, they will be prohibited from using the company’s customer base. Such agreements are permissible when they are limited to customers with whom the company had business relations within the last three years.

Companies may not issue a blanket prohibition preventing an outgoing director from investing capital in a competitor. However, a company may agree on a non-compete clause with majority shareholders, who can exercise influence over the management and operative business of the company.

Is compensation necessary?

To compensate an (ex-)employee for the limitations imposed by a post-contractual non-compete clause, the law provides that the company shall pay the employee financial compensation (see § 74 (2) of the Commercial Code (HGB)). Compensation should be equivalent to at least 50% of the most recent contractual remuneration per month. If the employment agreement contains a two-year, post-contractual non-compete clause and the employee earned EUR 5,000/month in the month before their employment was terminated, the employer must pay the employee compensation of at least EUR 2,500 per month for two years.

Different rules apply to directors. Where a post-contractual clause only prevents customer poaching, the company will not need to pay the (ex-)director compensation. For further reaching post-contractual restraints, compensation will need to be paid as, without it, the non-compete clause will be invalid.

Possible courses of action in the case of a breach of the non-compete clause

If a director breaches the non-compete obligation arising from their fiduciary duty, the company will have several courses of action. First, the company can demand that the director cease and desist the actions in breach. In addition, the company can choose whether to seek damages from the director or the restitution of proceeds (skimmed profits). The latter has the advantage that the company does not need to prove that it would have achieved the same profits.

Securing contractual non-compete clauses with contractual penalties has proven useful in practice. This has the advantage for the company that the amount of the damages and income made by the director as a result of the breach are not in dispute. If a breach of the non-compete clause is shown, the contractual penalty will be due for payment. In addition, contractual penalties – in contrast to damages claims – are payable regardless of fault, as a rule, which means there is no need to provide proof of a culpable breach of the non-compete provision.

Non-compete clauses between companies in cooperation and supply agreements and sale and purchase agreements

Non-compete clauses between companies restrict competition and are subject to antitrust law. However, they are still permissible under certain conditions.

Non-compete clauses are permissible and valid as collateral agreements when and to the extent they are necessary, for example, to protect a contractual partner from the other partner’s disloyal use of know-how or customer information. The decisive question is whether the non-compete obligation is so intrinsic that the cooperation stands and falls with the non-compete clause, i.e., would the parties have agreed to cooperate without the contractually agreed protections against poaching customers and engaging in mutual competition?

If the non-compete clause forbids all competing activities, it will be invalid. It is possible, for example, to prevent the contractual partners from using the other partner’s know-how or customer data to engage in competition, providing the prohibition is limited objectively and geographically, and by duration.

Contracts for the sale and purchase of companies often prohibit the seller from competing with the target business. Non-compete clauses must be limited to those goods (including improved versions and successor models) and services, which form the target’s business purpose.

When drafting non-compete clauses, parties can refer to the definition of competitor in § 4 (1) No. 4 of the Act Against Unfair Competition (UWG), i.e., the direct competitor, to clarify which activities are considered direct competition and are prohibited. Geographically, non-compete clauses should be limited to the area in which the target offered its goods or services for sale and/or to the region in which the target invested before the sale.

The agreement should also include a contractual penalty to penalise breaches of the non-compete clause. The deterrent effect of the penalty will encourage compliance.

What applies to non-solicitation clauses for employees?

Agreements between companies which prevent solicitation or hiring of employees who work for the other party can only be effective when:

1. the conduct of the poaching company is unethical under the Act Against Unfair Competition (UWG). This includes soliciting employees to deliberately hinder or damage competitors.
2. the prohibition against solicitation is not the main purpose of the agreement but merely a collateral clause, which meets the needs of a special relationship of trust between the parties or one party’s need for protection. This will be the case for the sale of a company: the purchaser will have a legitimate interest in preventing the seller from poaching skilled workers immediately after the transaction, reducing the company’s value.

Generally, a non-solicitation provision may have a maximum post-contractual duration of two years. In practice, however, non-solicitation clauses offer only limited protection because it is difficult to prove whether an employee was poached or changed employers of their own volition.

Conclusion

The assessment of whether and to what extent non-compete clauses are permissible always involves a complex balancing of interests. The company’s (legitimate) interests in a non-compete clause must be weighed against the personal interests of the other party in the free exercise of their profession and the general interest in the freedom of competition. The case law provides key principles and guidelines for practice. It is particularly important to note that the object and the scope of any non-compete clause must be clearly defined, and the objective and geographic reach and duration of the prohibition must fall within certain limits. What this means in a specific case will depend on various factors. You should therefore take caution when formulating and drafting contractual non-compete clauses and seek legal advice on this issue.

Dr Birgit Münchbach