Following the publication of its Smarter Regulation policy paper, the UK government has now also published its long-awaited response to the consultation on measures to reform non-compete clauses in contracts of employment together with a detailed impact assessment. The consultation, which opened in December 2020, proposed two main options for reform: 1) mandatory compensation for non-compete clauses; and 2) an outright ban on non-compete clauses. While the government’s objectives for reform remain the same (specifically driving growth and promoting competition in the economy through greater labour market mobility), the government does not intend to pursue either of the previously proposed options. Instead, the government has opted to introduce a statutory limit on the duration of non-compete restrictions imposed on employees after their employment ends.
If this proposal is enacted, it will mark a significant shift in the way that employers manage business protection risks within their organisations. This article summarises some of the key risks, current uncertainties and potential actions for businesses to consider.
The government’s proposed reform is to introduce a statutory limit of three months on non-compete clauses in employment contracts, which broadly operate to prevent employees working for competitors after their current role ends. This was one of the “complementary measures” considered in the government’s consultation. For further information about the original consultation, see our Law-Now – Non-compete clauses: changes afoot prompted by COVID-19.
The government’s response describes its proposed reform as a “bold action”. Certainly it differs from established and proposed approaches in other jurisdictions that were reflected in the main options for reform considered in the consultation.
The mandatory compensation option, which is a well-established model in other European jurisdictions such as Germany and Italy, was rejected by the UK government. This was on the basis that it would apply a substantial direct payroll cost to businesses who use non-compete clauses at a “critical juncture in our economic recovery”.
The government also rejected an outright ban on non-compete clauses because of the potential risks and unintended consequences of that approach. An outright ban is the model proposed by the US Federal Trade Commission, which we looked at in our Law-Now – A global move towards banning employment contract non-compete clauses? Reconsidering business protection options. The UK government refers to unacceptable downsides to this option, including a loss of investor confidence, the tightening of internal controls on information sharing and reducing employer investment in training and upskilling workers. The government also considers that it would present an unnecessarily high risk of disputes and litigation shifting to other restrictive covenants and other areas of law such as intellectual property and trade secrets.
Other restrictive covenants, such as non-dealing and non-solicitation clauses, would not be affected by the proposed reform. However, it is likely that in response to these proposals many employers will in fact look to impose or strengthen other restrictive covenants as well as implementing other business protection measures such as longer notice and paid garden leave periods. The government’s response does not address the possibility that the combined effect of those other measures might amount to a non-compete clause “by the back door” and whether that would be prohibited too.
Scope of proposed reform
The government’s response makes clear that the proposed reform would apply to non-compete clauses in contracts of employment and ‘limb (b) worker’ contracts only. Limb (b) workers are those who are not employees but work under contracts for services.
Non-compete clauses in other types of agreement such as partnership agreements, Limited Liability Partnership (LLP) agreements and shareholder agreements, where the balance of bargaining power is more equal, are intended to be unaffected by the proposed reform. However, that may not always be entirely clear cut. For example, following the Supreme Court decision in Clyde & Co LLP v Bates van Winkelhof that an LLP member was also a worker and therefore entitled to protection against detrimental treatment under the whistleblowing regime, it would seem at least possible that a non-compete clause in an LLP agreement lasting more than three months could be unenforceable against an LLP member who is also a worker.
The response does not address whether the reform would apply to non-compete clauses in other types of arrangement such as consultancy agreements and non-executive director appointments. Based on the government’s response, it is expected that those arrangements would be excluded too, although employment status is often a challenge in consultancy arrangements in particular where contractual terms may not reflect the reality of the working relationship. Where a consultant is found to be a worker, or even an employee, would that render any non-compete clause in a consultancy agreement lasting more than three months unenforceable?
Nor does the response expressly address whether indirect restraints contained within deferred remuneration schemes, equity arrangements or long-term incentive plans, where a non-compete clause is frequently factored in to “good leaver” definitions, would be caught by the statutory limit. Given the suggestion in the impact assessment that the proposed reform may lead employers to find other ways to protect their business interests, including via indirect restraints, it is likely that the government does not intend those arrangements to be caught either.
One other important question is whether employers would be able to impose longer non-compete clauses via settlement agreements, given that at least some of these by statutory definition will be neither employment contracts nor contracts for services. New or amended restrictive covenants are often agreed in this context in return for financial consideration, although settlement agreements are not mentioned in either the government’s response or its impact assessment. This would seem an obvious loophole and may yet be addressed in any draft legislation. Even if not addressed, it is possible that the courts would be reticent to enforce such restrictions given the public policy applied to employment contracts and contracts for services.
Importantly for investors, and again contrary to the proposed ban in the US, the proposed UK reforms do not currently appear to impact non-compete restrictions imposed on employee shareholders in share purchase agreements and/or earn-out agreements. These restrictions typically apply from the date of completion of the sale of shares or when earn-out targets are met and the courts generally allow those types of restrictions to apply for a much longer period of time than post-termination restrictions in employment contracts. This will be welcome news particularly for private equity and venture capital investors who expect to be able to protect the goodwill in which they have invested.
Where uncertainty on these issues remains in any implemented legislation, we will no doubt see an increase in disputes and further litigation. Employer strategies to protect their business interests notwithstanding the statutory limit, such as increasing notice periods and imposing longer garden leave, may also come under further scrutiny via the courts. Despite the government’s concerns about increased costs for businesses in some of the options on which it consulted, there will of course be increased costs in paying staff for longer notice and garden leave periods, where organisations opt for that approach.
Although the government’s response does not say whether the proposed reform would apply retrospectively, the accompanying impact assessment suggests that it would on the basis that the government “would make all” non-compete clauses that are longer than three months unenforceable, and that the existing common law approach would continue to apply for non-compete clauses that are three months or less. The starting point would therefore be that such clauses are unenforceable unless they go no further than necessary to protect a legitimate business interest (such as confidential information and workforce stability).
The government’s impact assessment identifies a risk that, as a result of reform, some businesses might perceive three-month non-compete clauses as an ‘industry standard’. While the government anticipates that employers will continue to adopt a multi-factorial assessment of whether or not to impose non-compete clauses (including sector, business model etc) rather than applying a three-month restriction by default, the government commits to considering whether further guidance in response to that potential risk is necessary.
Timeframe for implementation?
A timeframe for implementation is as yet unknown. The response confirms that the government will bring forward legislation to introduce the statutory limit “when parliamentary time allows”. There is no relevant employment bill currently before Parliament, which means that the reform probably has a long legislative journey ahead of it. With the possibilities of: (i) a general election towards the end of next year; and (ii) a change in governing party with a new legislative agenda, it is unclear whether there is the political impetus to enact this change in the medium term.
Implications for employers
As outlined in our previous Law-Now – Government announces multiple post-Brexit employment law reforms, the UK government’s reform of non-compete clauses in employment contracts is a proposal only at this stage and employers do not need to make any immediate changes to employment contracts. It will, however, be important for businesses to continue to keep a close watching brief on this proposed reform because the implications for business protection measures are significant.
In the meantime, employers may wish to start shoring up (both for new joiners and existing staff) their contractual arrangements, policies and practices to ensure that there is sufficient protection of trade secrets and confidential information when key staff leave. Some of these considerations are summarised in our Law-Now – A global move towards banning employment contract non-compete clauses? (cms-lawnow.com), and they remain highly relevant following the government’s recent announcements. However, advice should be taken on how to implement some of these changes, especially since imposing changes to post-termination restrictions is not always straightforward and the process can vary depending on the governing law of the contract. Companies with employees in more than one jurisdiction may also want to consider the governing law and jurisdiction of their employment contracts, to try to take advantage of more beneficial legal regimes and fora.
Finally, it is also worth remembering that the aim of the legislation is to encourage innovation. However, start ups and disruptors will still be vulnerable to larger companies with deeper pockets funding litigation and buying out other disincentives for an employee to move. Also large companies will be left more vulnerable to their expensive know-how walking out the door and will spend lots of time looking for other means of holding onto it. So it remains to be seen whether the Government’s aim will be achieved by this change.