Worklife 2.0: Employers of record – the sky is the limit? Part 6 – Restrictive covenants

We are considering employers of record (EoRs) in our Worklife 2.0 series (see our previous blog posts here, here, here, here and here). As we have previously explored, an EoR structure enables businesses to hire skilled employees around the globe without the legal and tax complications (and associated delays) that come with setting up a subsidiary or branch abroad. In this post, we will be considering the effect of the EoR structure on the restrictive covenants which the end-user company may wish their employees, particularly senior management, to be subject to.

Restrictive covenants: the background

Whether post-termination restrictions are enforceable or not depends very much on the country or jurisdiction in question.  Non-competes are either already or about to be unenforceable in a number of US states; the UK government has stated an intention to limit non-competes to three months; and it is necessary to pay for post-termination restrictions in a number of countries. 

However, if you are operating in a country where post-termination restrictions are enforceable against former employees, you don’t want to find that you are disadvantaged by using an EoR structure.

In most countries, employers need to ensure that each covenant can be justified on the basis of its commercial interests; covenants which are designed simply to reduce competition and keep the individual out of the workplace will not generally be acceptable. Acceptable business interests typically include: customer/supplier connections; the stability of the employer’s workforce; and the protection of confidential information. This is not the case in all jurisdictions – in Singapore, for example, a non-compete may be difficult to enforce unless the employer can show a business interest apart from protection of confidential information. Without an additional business interest to protect, the courts are likely to find the covenant unreasonable and therefore unenforceable.

Employers also need to ensure that the duration and scope (including territories covered) of each covenant is not excessive. In England and Wales, this has been interpreted to mean a reasonable territorial scope (ideally limited to territories where the employer does business) and a duration of 6-12 months, with the longest duration being suitable only for the most senior employees. In China, however, non-compete covenants can be enforced for up to two years, with a corresponding payment obligation on the employer (discussed further below).

The employer-employee connection

In a traditional employment relationship, the employee works for the employer, or a company in the employing entity’s group, and so the ‘legitimate business interest’ limb of the test is easy to satisfy. In an EoR structure, however, the connection between the employee and the end-user company is interrupted by the EoR. Assuming a standard employment contract, any restrictive covenants in the employment agreement between the EoR and employee will only protect the commercial interests of the EoR, not the end-user company. As EoRs will have employees working in many different businesses across multiple industries, it is difficult to see how a court would find a legitimate business interest of the EoR that justified the EoR imposing post termination restrictions on any of its employees.

One possible solution is for the employee and end-user company to enter into a separate restrictive covenant agreement, creating the direct relationship under which the end-user company can protect its business interests.

Bear in mind that this agreement may require some payment to the employee as consideration for the post-termination restrictions, even in jurisdictions where payment is not normally necessary. For example, payment is not generally required in England and Wales to ensure restrictive covenants are enforceable, where those covenants are included in the employment contract between the employee and employer.  But the agreement would require some form of one-off payment if it is in a self-standing agreement between the end-user and EoR employee.  In other jurisdictions, it may be necessary to pay throughout the covenant period.  In Italy the payment must cover the duration of the covenant. The payment obligation is dependent on the territorial scope of the covenant, with 25-30% of the last annual salary deemed a fair payment for a 12-month non-compete applying only to Italy, while 50% of the last annual salary would be sufficient for the same covenant which covers the whole European Union.  This could be difficult to arrange as a practical matter if the end-user is dependent upon the EoR to facilitate payments to the employee.

Conclusion

The lack of a direct contractual relationship between the employee and end-user company is not necessarily fatal to ensuring employees, particularly senior management or those with access to confidential information, are bound by the same restrictive covenants as the rest of the workforce. Addressing this early in the discussions with EoRs and potential employees will ensure there are no unwelcome surprises once the employee leaves the EoR, with both parties aware of their post-termination obligations.  

With thanks to our colleagues for their international insights: Luca Capone in Italy and Stephanie Chiu in Hong Kong.