A restrictive covenant imposed on employees of payroll services provider ADP is overbroad and might put forth undue hardship, the U.S. Court of Appeals for the Third Circuit has ruled.

ADP's restrictive covenant agreement (RCA), which prohibits former employees from soliciting the company's clients for a one-year period after leaving, constitutes an impermissible restraint on trade under New Jersey law, the appeals court said Friday. But the appeals court overturned rulings by two U.S. District Court judges who concluded that the RCA is unenforceable. The RCA furthers legitimate business interests and otherwise complies with the state's public policy, the appeals court said, sending the pair of consolidated cases back to District Court for judges to “blue pencil” the covenants, reducing their scope to more reasonable terms.

ADP imposes its RCA on high-performing marketing personnel who meet their sales targets and are eligible to participate in a stock-option award program. A less-restrictive tier of restrictive covenants, including a sales representative agreement and nondisclosure agreement, is imposed on all of the company's employees. They prohibit, among other things, soliciting any ADP clients or prospective clients with which the employees were involved for a one-year period after leaving the company.

The Third Circuit issued its decision in suits filed by ADP against Nicole Rafferty and Kristi Mork, former employees who left to work for a competitor, Ultimate Software Group. ADP sought preliminary injunctions against both, seeking to enforce the RCA as well as terms barring former employees from soliciting any clients or prospective clients for a year after leaving the company.

In the Rafferty case, U.S. District Judge Jose Linares of the District of New Jersey concluded the RCAs were unenforceable per se. He reasoned that because ADP does not require its employees to enter into an RCA, its purpose is not to protect its legitimate business interests but to decrease competition. Linares also said the RCA may impose an undue hardship on Rafferty because it applies to all of the company's current and prospective clients, whether or not Rafferty had contact with them.

In ADP's case against Mork, U.S. District Judge Claire Cecchi adopted Linares' reasoning, concluding that the company had not shown a substantial likelihood of success on the merits for its claims under the RCAs.

ADP appealed. At the Third Circuit, Judges Thomas Hardiman, Cheryl Ann Krause and Stephanos Bibas ruled that both tiers of restrictive covenants further legitimate business interests and comply with the state's public policy. Finding the judges below had relied on “an erroneous view of the applicable law,” the appeals court overturned their denial of a preliminary injunction. The panel ordered the cases returned to District Court for a “blue pencil” review. By rejecting a choice between enforcement and invalidation, that approach seeks to fulfill a restrictive covenant's lawful objectives while nevertheless ensuring that such agreements do not unreasonably hinder competition or employee mobility, Krause wrote for the panel.

New Jersey courts rejected the practice of invalidating overbroad restrictive covenants outright in 1970 when the Supreme Court, in Solari Industries v. Malady, permitted the partial enforcement of restrictive covenants where consistent with public policy.

The appeals court concluded that the RCA is not a per se unenforceable restraint on trade and that the covenant should be at least partially enforced after applying four factors from Solari: whether ADP has a legitimate business interest in imposing the RCA in exchange for participation in its stock option award program; whether any such interest is negated because the RCA, imposed on a subset of ADP employees, is layered on top of a less-restrictive covenant levied on all company employees; whether the breadth of the RCA imposes a level of hardship on employees so great as to render it unenforceable; and whether, on balance, the RCA is injurious to the public.

Conducting its review, the panel found that ADP's business interests are strong enough to warrant enforcement of the RCA. The judges acknowledged Rafferty and Mork's countervailing interests, including that they “have acquired skill and expertise while working at ADP that have become part of their person and now belong to them as individuals for the transaction of any business in which they may engage.” But absent any evidence of bad faith, these circumstances warrant a tailoring of restrictions through the blue pencil process, the court said.

Determining the blue penciling of the RCA requires a balancing of the employer's need for protection and the hardship on the employee that may result, the court said. The panel acknowledged that enforcement of the RCA would impose some hardship on former ADP employees who want to market themselves in the same field they were in before, the court said. The question is whether that hardship is undue when balanced against the legitimate interest of the employer, the court said.

John Schmidt Jr. of Lindabury, McCormick, Estabrook & Cooper in Westfield, who represented the plaintiffs, did not respond to a request for comment about the ruling. Timothy Lowe of McDonald Hopkins in Bloomfield Hills, Michigan, who represented ADP, declined to comment on the ruling.

ADP's RCA was before a different panel of the Third Circuit in 2017 when the court ruled that employees who checked a box on the company website after reading terms of the stock award program, including the noncompete clause, were bound by those terms.