Jan 31, 2012

Legitimate Business Interest Test for an Enforceable Covenant Not-to-Compete Affirmed by the Illinois Supreme Court

In Reliable Fire Equipment Co. v. Arredondo, 2011 IL 111871, ¶¶ 42-43, the Illinois Supreme Court attempted to clarify a split among the Appellate courts over the appropriate standard for enforcing non-competition agreements in Illinois.

The Background

In Reliable Fire, an employer sued two former employees and their newly formed company based on an alleged breach of non-competition restrictions in their employment agreements. Id. at ¶ 1. The former employees had signed agreements not to compete with the employer for one year after their termination, which included Illinois, Indiana, or Wisconsin. Id. The employees also agreed not to solicit any sales or referrals from the employer’s customers or referral source, or to solicit other employees to leave their jobs with the employer. Id. Notwithstanding these agreements, the employees left their employment and started a rival business, allegedly breaching all aspects of their non-compete agreements. Id. at ¶¶ 4-7.

The former employees filed a counterclaim, and sought a declaratory judgment on the enforceability of the restrictive covenants. The circuit court ruled that the restrictive covenants were unenforceable because the employer had failed to prove a legitimate business interest to justify enforcement of the covenants. On appeal, a “sharply divided panel” upheld the decision. Id. at ¶¶ 8-9. In 2009, the Illinois Fourth District Appellate Court in Sunbelt Rentals, Inc. v. Ehlers, 394 Ill. App. 3d 421 (2009) found that the requirement of demonstrating a legitimate business interest was merely a “judicial gloss” and held that a covenant not-to-compete should be enforced when its time and territory restrictions are reasonable. This decision diverged from other Appellate districts, which required the showing of a “legitimate business interest”. The Illinois Supreme Court sought to clarify whether Illinois recognized the legitimate business interest requirement of an enforceable restrictive covenant. Id. at ¶ 15.

The Decision

The Supreme Court in Reliable Fire began by reciting a general rule that contracts in total and general restraint of trade are void because they injure the individual promisor as well as the public at large. Reliable Fire, 2011 IL 111871, ¶ 16, citing Hursen v. Gavin, 162 Ill. 377, 379-80 (1896). A restrictive covenant, however, will be enforceable if it contains a reasonable restraint and is supported by consideration. Id. citing Storer v. Brock, 351 Ill. 643, 647 (1933). The Court noted that a “reasonable restraint” generally involves the consideration three factors: (1) the covenant is no greater than is required for the protection of a legitimate business interest of the employer-promisee; (2) it does not impose undue hardship on the employee-promisor; and (3) the covenant is not injurious to the public. Id. at ¶ 17.

The court then tracked the evolution of Illinois courts’ use of these rules, noting that it “has repeatedly recognized the three-dimensional rule of reason, specifically including the element of legitimate business interest of the promisee.” Id. at ¶ 24. Thus, the Reliable Fire Court expressly overruled Sunbelt,[1] and reaffirmed that Illinois courts will “continue to recognize the legitimate business interest of the promisee as a long-established component in the three-prong rule of reason.” Reliable Fire Equipment Co. v. Arredondo, 2011 IL 111871, ¶ 30.

The court recognized that while this three-pronged inquiry develops a legal standard, the analysis was still “unstructured.” Id. at ¶ 33. It noted the difficultly in determining reasonableness due to the unique nature of each case. However, the Court noted that restraints were usually justified on the ground that the employer had a legitimate business interest in restraining an employee from appropriating the employer’s confidential trade information or former customer relationships. Id. at ¶ 34. Other courts, notably Nationwide Advertising Service, Inc. v. Kolar (“Kolar”), 28 Ill.App.3d 671 (1975), attempted to formulate a sort of “legitimate business interest test” based on a weighted list of factors. Id. at 673 (listing the factors). Numerous “tests” had been developed in subsequent cases to determine if the “test” in Kolar had been met. See Reliable Fire Equipment Co. v. Arredondo, 2011 IL 111871, ¶ 38 (listing line of cases following Kolar and implementing its test).

However, in Reliable Fire, a concurring justice from the appellate decision argued that analyzing covenants with reference to the totality of the circumstances to determine if the employer has a protectable interest was a far superior approach to the rigid legitimate business interest test. His theory was that this would lead to results more in line with the true considerations of a particular case. Id. at ¶ 39. The Illinois Supreme Court agreed. It rejected any notion that a “test” could summarily determine the reasonableness of an agreement not to compete. Rather, the Court ruled that those factors were simply aids in determining the employer’s legitimate business interest. Id. at ¶ 42.  The Court noted, though, that all appellate court precedents would remain intact, but only as “nonconclusive examples of applying the promisee’s legitimate business interest, as a component of the three prong rule of reason, and not as establishing inflexible rules beyond the general and established three-prong rule of reason.” The court rejected the Kolar test, and ruled:

whether a legitimate business interest exists is based on the totality of the facts and circumstances of the individual case. Factors to be considered in this analysis include, but are not limited to, the near-permanence of customer relationships, the employee’s acquisition of confidential information through his employment, and time and place restrictions. No factor carries any more weigh than any other, but rather its importance will depend on the specific facts and circumstances of the individual case.

Reliable Fire Equipment Co. v. Arredondo, 2011 IL 111871, ¶ 43.

Since it found that the lower courts had misapplied the law, the court reversed the judgment against the employees and remanded to case with instructions to further proceedings consistent with its opinion. Id. at ¶ 47.

The Impact

The Reliable Fire specifically overruled the Sunbelt Rentals decision holding that employers must demonstrate that they are seeking to protect a “legitimate business interest” when enforcing a non-compete. But, the Supreme Court provides little guidance to employers as to what constitutes a legitimate business interest. The Court held that prior precedent in Illinois discussing legitimate business interests remain good law. As a result, employers may still rely on cases discussing the protectable interests to demonstrate that a covenant is reasonable. The Court expressly provided that there is no formulaic test for determining a legitimate interest. Employers should take care to identify the interest that is being protected and to craft restrictions which are no broader than necessary to protect that interest.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client Alert authored by: Ryan A. Haas, Esq.

[1] The court also overruled Steam Sales Corp. v. Summers, 4-5 Ill.App.3d 442 (2010) as it misconceived Illinois precedent, deviated from the ruling in this case, and propagated Sunbelt’s error. Reliable Fire Equipment Co. v. Arredondo, 2011 IL 111871, ¶ 30.