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What is the problem with a non-compete clause?

Not all non-compete clauses are created equal, warns Scott Riches, with “cascading clauses” a particular concern.

Mar 25, 2024, updated Mar 25, 2024
There are many problems that can arise with a non-compete clause. Photo: Getty

There are many problems that can arise with a non-compete clause. Photo: Getty

There have been moves to ban them in the United States and Austria, and the United Kingdom along with other European countries is proposing to enhance regulation with mandatory limitations and transparency.

In Australia, Treasury has expressed concern in response to findings in the government’s “2023 Employment White Paper” that non-compete restraints are “potentially hampering job mobility, innovation, and wages growth in industries where they are prevalent”.

Treasury has also announced that in April it will release a discussion paper to consider what, if any, regulatory response is required to deal with the issue of non-compete clauses.

So, with estimates that at least one in five Australian workers’ employment contracts contain non-compete or similar restraint clauses, rising to as high as one-third of the workers in industries such as finance, real estate and utilities according to the Australia Institute, what are they and are they a problem?

A post-employment restraint

Non-compete clauses can take a variety of forms in an employment contract, but no matter how they are expressed they generally attempt to do at least one of two things.

The first is to restrain a former employee from engaging in certain types of work within a defined area.

The second is to restrain that employee from engaging in work for particular categories of competitors.

That restraint will usually then operate for a defined period of time, for example, 12 months from the end of previous employment.

The e61 Institute, which prepared the research that Treasury is relying upon in conjunction with ABS data, says that they are “a clause of a contract, where an employee agrees not to compete with an employer – in a similar industry or area for a period of time – after their job ends”.

Although non-compete clauses in employment contracts are largely unregulated by legislation within Australia outside of New South Wales, according to former High Court justice Dyson Heydon in his book The Restraint of Trade Doctrine, the presumption at common law – which is the law created by court decisions and precedents – is that they are void and unenforceable unless they are protecting a legitimate business interest.

To put that another way, they are generally unlawful, except for when they’re not.

A problem that arises is that the average employee won’t know whether the clause they are subject to meets the “legitimate business interests” test, so even if the clause they are subject to is ultimately unlawful and unenforceable, the chilling effect caused by that uncertainty might just be enough to have those clauses observed by default.

Are non-compete clauses really an issue in employment contracts?

Andrew Stewart, the John Bray Professor of Law at the University of Adelaide, and a leading expert in employment and contract law, seems to think so.

Stewart says “they [non-compete clauses] are an issue and I’ve thought that for a long time”.

In terms of regulation, he says there is a “spectrum of ways that they are dealt with across the world, and Australia falls somewhere in the middle” with the current position being that they are considered “valid as long as they are reasonable”.

But not all non-compete clauses are created equal.

Some are straightforward and relatively easy to understand, drafted in a way that makes it clear what the employee is restrained from doing, in what geographical area, and for how long.

Others, such as those commonly referred to as “cascading clauses” make the interpretation of the restraint much more difficult for employees, and for that matter, employers.

A cascading clause is one that is drafted with a series of restraints that “cascade” from the broadest restriction down to the narrowest.

They are generally used to provide fall-back positions in the clause so that if a court rejects the broadest restriction as unenforceable, one of the narrower ones may still be held valid.

They might, for example, start with a 12-month restriction that is then reduced to six months, three months, and so on, if the previous time frame is considered unreasonable.

The same principle can also be applied to the geographical restraint. It might start out providing that the employee is restrained from working in a particular industry globally, reducing to a nominated country, then state, or capital city.

It is with these types of “cascading” clauses that Stewart sees the biggest issue, largely because they are drafted to “make it impossible to know what restraint they [the employee] are subject to once they leave”.

And it is that issue, coupled with data that now suggests “widespread use including in industries where you just wouldn’t expect to see them, such as child care” which he says is worthy of a regulatory response.

What can be done?

Some jurisdictions around the world are moving to ban the use of non-compete clauses in employment contracts, such as in the US, where according to the Treasury in a seminar paper released last year, the Free Trade Commission “estimates that without a non-compete restriction, American workers could earn nearly $300 billion more in wages”.

But suppose a regulatory response does come in Australia. In that case, it may be more likely that it is targeted at restricting their application and content, perhaps like the position in the UK where they have proposed to limit the duration of non-compete clauses and provide better and more detailed guidance on how they apply.

Further reforms may also include prohibiting using restraints with lower-paid workers or requiring compensation to be paid to workers in exchange for an agreed restraint.

To do that though, Stewart says “we need much more research than we have now” as the available data suggests that the use of the clauses sits somewhere between “relatively unusual and half the workforce”, so to provide any robust solution would “require us to have a much better idea about which end of the spectrum it is closer to.”

Scott Riches is an employment lawyer and former union official. He is also director principal of Capacita.

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