Non-Compete Clause: What is it and How Does it Work?

Authors: Gianluca Pecora & Zeinab Farhat, Progressive Legal

1 in 5 Australian workers have a non-compete clause in their employment contract, according to an Australian National University survey.  

Although non-compete clauses are said to be innately unfair legal agreements, the more you understand them, the better you can protect your rights as an employee, or enforce your rights as an employer.

This article will consider: what are non-compete clauses, determining validity, cascading clauses, red flags and key takeaways.  

What are non-compete clauses? 

Non-compete clauses are a form of restraint of trade which commonly appear in Employment Contracts to restrict former employees from competing for business with their former employer.  

Non-compete clauses account for trade secrets and confidential information that may allow a former employee to act against the business interests of the former employer – especially if working for a competitor. They also prevent former employees from utilising relationships with clients or suppliers for the benefit of a competitor.  

The enforceability of a non-compete clause will be fact specific and its ultimately a matter for a Court to consider.

Common non-compete clause purposes 

Non-compete clauses can cover a variety of matters related to former employees competing with former employers. Non-compete clauses often restrict former employees from: 

• creating a competing business; 
• being employed by a competitor business within a certain proximity and time-period after employment; 
• revealing trade secrets or confidential information to competitors;  
• preventing former employees from hiring current employees; and  
• engaging work from clients of the former company.

Limitations of Non-Compete Clauses

Non-compete clauses cannot restrict former employees from using skills and experience gained during their employment. This is distinct from confidential information or relationships gained throughout the employment.  

They also cannot prevent former employees from never working in the same industry again, or overly burden a former employee’s ability to earn a living. 

There are also various considerations for determining whether a non-compete clause can be validly enforced.

The position in New South Wales

The position in New South Wales differs from the position of the other States and Territories. New South Wales is the only State which has its own legislation pertaining to restraint of trade clauses, as provided for in the Restraint of Trade Act 1976 (NSW) (“the Act”).  

Section 4 of the Act covers the extent to which a restraint of trade is valid: 

section 4(1) provides that “a restraint of trade is valid to the extent it is not against public policy, whether it is in severable terms or not”; 

section 4(2) provides that s 4(1) does not affect the invalidity of a restraint of trade by reason of any other reason, other than public policy;  

section 4(3) provides “where, on application by a person subject to the restraint, it appears to the Supreme Court that a restraint of trade is, as regards its application to the applicant, against public policy to any extent by reason of, or partly by reason of, a manifest failure by a person who created or joined in creating the restraint to attempt to make the restraint a reasonable restraint, the Court, having regard to the circumstances in which the restraint was created, may, on such terms as the Court thinks fit, order that the restraint be, as regards its application to the applicant, altogether invalid or valid to such extent only (not exceeding the extent to which the restraint is not against public policy) as the Court thinks fit and any such order shall, notwithstanding sub-section (1), have effect on and from such date (not being a date earlier than the date on which the order was made) as is specified in the order”.

However, the common law rules regarding ascertaining the validity of a restraint of trade clauses remains the same across Australia. If an employer is trying to prove that its restraint of trade clause (non-compete clause) is enforceable, then it will have to be able to demonstrate that: 

1. first limb: it has a “legitimate protectable interest”; and  
2. second limb: that the restraint is “no more than reasonable” to protect the legitimate interest?  

Determining validity

Legitimate protectable interest

Legitimate protectable interests include goodwill and trade secrets or confidential information. 

Consider how protective Coca-Cola are of their strictly confidential ‘secret formula’. Even if the formula is a marketing ploy, it may attach goodwill as a protectable interest. 

Goodwill

In Findex Group Limited v McKay [2019] FCA 2129, the Federal Court considered goodwill to be business value created by “good name, reputation, and connection of a business…., introduction to old customers and agreed absence from competition.” Such abstract capital may be damaged if former employees solicit former clients belonging to former employers, or if other competitive conduct occurs post-employment.  

Trade Secrets or Confidential Information

Trade secrets and confidential information are crucial to the competitive edge many businesses hold. They have been recognised as legitimate protectable interests because their exposure to competitors may assist in poaching clients, replicating business models or technology or utilising valuable research. All of these cost money to develop and can create real financial detriment and promote unfair competition if leaked to a competitor. 

Confidential information is information outside the public domain, including:  

• customer lists and details; 
• pricing lists; 
• business plans and strategies; 
• policies and practices; 
• contract terms or expiry dates; 
• business pricing models; 
• secure codes and algorithms; 
• research; 
• formulas and recipes; 
• market research; 
• financial information; 
• employee training materials; and 
• data. 

A trade secret is a type of confidential information that is commercially valuable because it gives the owner an advantage against competitors.  

Famous example of trade secrets are: 

• Coca-Cola’s Coke Syrup Formula; 
• KFC’s Original Recipe; 
• McDonald’s Big Mac Special Sauce; 
• Google’s Search Algorithm; and  
• WD-40’s Multi-use Product Formula.

Reasonably necessary

The second requirement of valid non-compete clauses is that the restriction they impose must be no wider than is reasonably necessary to protect the interest. 

There are several commonly considered criteria that the Court may consider when determining what is reasonable. 

Nature of Former Employee’s Role

A junior staff member will most likely know less about company strategies, trade secrets and the other confidential information listed earlier, compared to an executive staff member. Although seniority may be a relevant indicator, the relevant consideration is how likely the former employee is to have access to substantial business knowledge.  

In determining this, the Courts have previously considered – alongside seniority – the confidentiality of the information that the former employee would have been expected to acquire and use (DP World Sydney Ltd v Guy [2016]), as well as the level of relationship the former employee will be expected to develop with customers and clients.  

Competitors may leverage the relationships of new employees to poach clients that are loyal to individual executives – rather than the previous company. Such a transfer of goodwill is extremely valuable to companies.

Case example: Tullet Prebon (Australia) Pty Ltd v Simon Purcell [2008] NSWSC 437  

In this case, the defendant was a broker who acted as the face of the company for many clients. To facilitate these relationships, the company invested a considerable amount into building customer connection between the defendant and clients – including funding a substantial expense account for the defendant to meet with clients in semi-social situations.  

The Court held that in such cases, former employees are not entitled to treat the client as their own upon leaving the company.  

The case also demonstrates that developing goodwill can be expensive, which is relevant to considering the degree to which a non-compete clause is reasonably necessary to protect the interests of the company. An employee’s degree of seniority and knowledge about sensitive business information is directly relevant to how restrictive a non-compete clause can be. 

Proximity

Often, non-compete clauses will limit former employees from working for competitors within a certain geographical radius to the former employer. Such restraints must be limited to the area in which the employer conducts business and not be excessively large.  

In the past, companies have attempted to enforce non-compete clauses that are Australia-wide. The court in AECI Australia Pty Ltd v Convey [2020] QSC 207 found that this distance “extended well beyond the sphere of AECI’s competition”.  

Although it is plain to see why restricting a former employee from working within the same country would be unreasonable, the same rule applies to much smaller distances. The important lesson is to consider the actual geographical scope of the former employer’s competition. 

To assist in increasing the enforceability of proximal limitations on competition, often the non-compete clause will include a cascading clause which decreases the geographical limitation in each subsequent clause. For example, if not enforceable for a 30km radius, then a 20km applies, and so on.  

Period of Restraint

Often non-compete clauses will have terms that attempt to restrict former employees from working for competitors for a period of time post-employment. 

It is accepted that such terms cannot restrict competitive employment for an unlimited length of time. When determining what is a reasonable period to protect the interests of a former employer, consideration must be given to the length of time expected for personal customer connections and knowledge about confidential information and trade secrets to diminish (Habitat 1 Pty Ltd v Formby [No 2] [2017] WASC 33). 

Cascading Clauses

Courts have the ability to sever non-compete / restraint of trade clauses where such clauses are classified as being unreasonable. Cascading clauses are clauses which contain a subset of clauses which provide variations for the restraint. The reasoning behind such clauses is such that the Court will read the provision down, and each subclause is its own severable provision. Cascading clauses assist the employer in being able to enforce a non-compete.  

Red flags

Common terms that fall outside of the law include: 

• terms that apply to information that the former employee may obtain after more than a reasonable period after employment; 
• terms that restrict working within a very large proximity to the employer; 
• terms that are highly restrictive of junior staff or staff who are unlikely to have access to sensitive business information; 
• terms that extend beyond a reasonable time period after employment ends; and 
• terms that overly burden a former employee’s ability to earn a living. 

Key Takeaways

Non-compete clauses are extremely common in employment contracts. However, it is important to have a basic understanding of the legal framework which may prevent their enforceability.  

When drafting non-compete clauses or interpreting your obligations once employment ends, it is important to consider the following: 

1. whether the company has a legitimate protectable interest, such as: goodwill; and trade secrets or confidential information; 
2. the degree to which restricting former employees is reasonably necessary to protecting that interest, considering: 
3. employee seniority and access to sensitive business information;  
4. proximity of subsequent competitive employment to the former employer; and  
5. the period of time between employment ending and competitive employment beginning. 

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