A Non-Compete Clause Is Not Better Just Because It Is Broad

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

When drafting and reviewing contracts, I sometimes see broad non-compete obligations. These are provisions that prohibit joining a competitor for two years after leaving, operating a competing business oneself, or being involved in similar services. In addition to contracts with employees and outsourcing contractors, they are also used in contracts with officers and founders and with sellers in M&A transactions.

It is natural for a company to want to protect its trade secrets, customer base, and proprietary know-how. Startups in particular run their businesses with a small number of people sharing in-depth information, so the departure or independence of key members can easily have a direct impact on business operations.

However, a non-compete obligation does not necessarily become more effective the more broadly the prohibited scope is defined. If an excessively broad restriction is imposed, its effect may be denied by a court or similar body when a dispute arises, and the claim may not be upheld when it is needed.

The Framework for Assessing Post-Employment Non-Compete Restrictions

For post-employment non-compete restrictions on employees, the question is whether the restriction violates public policy under Article 90 of the Civil Code, taking into account workers' interests such as the freedom to choose an occupation. During employment, certain competitive acts are prohibited based on the duties of good faith and loyalty under the employment contract, but after leaving, the worker's interest in freely choosing work using his or her own knowledge and experience is strongly respected.

For this reason, for a post-employment obligation to be held valid, it is examined case by case whether the company has a legitimate interest worthy of protection and whether the content of the restriction stays within a reasonable range as a means of protecting that interest.

Specifically, the determination is made by looking comprehensively at the company interest to be protected, the employee's position and responsibilities, the work, region, and period covered by the restriction, and whether there is compensation and what it consists of. Simply writing "no moving to a competitor" across the board is not enough; it is essential to work out concretely what is being protected, who is covered, and to what extent the restriction applies.

As a premise, it is important to identify the substance of the company interest to be protected. Make clear what is covered, such as trade secrets, relationships of trust with customers, proprietary sales know-how, development roadmaps, or pricing strategies. A subjective reason, such as that it would be inconvenient for the business if someone moved to a competitor, tends to be hard to accept as a legitimate basis.

At the same time, whether that information is objectively managed is also in question. To receive protection as a trade secret under the Unfair Competition Prevention Act, the three requirements of confidentiality management, usefulness, and non-public nature must be met. If the information is left on a shared drive that anyone can view, or the company cannot track whether it is being taken out, there are limits to protecting it through contractual provisions alone. Also check access rights, measures to prevent information from being taken out, and confidentiality agreements (NDAs), and consider who actually needs to be subject to a non-compete obligation.

Narrowing the Scope of the Restriction and the Persons Covered

A non-compete obligation is not necessarily a provision to be imposed uniformly on all employees. New graduates and general staff differ greatly from sales managers and senior management in both the confidentiality of the information they handle and their influence on the business. Determine individually whether the person actually has access to the information to be protected and whether the position gives a reasonable basis for imposing the obligation.

At startups, information tends to be shared company-wide because of the small headcount, but imposing a uniform restriction on everyone for that reason can work against recruiting. Conditions that excessively restrict a candidate's career may affect his or her decision, so a realistic approach is to separate roles, applying confidentiality obligations and prohibitions on taking information out according to job duties and projects involved, and to narrow down who is subject to the non-compete.

It is also essential to make the prohibited work, the period, and the region concrete. The expression "any business competing with the Company" appears to cover a broad range, but the work covered, the degree of involvement, and the geographic scope tend to be unclear. For SaaS and internet services, setting a geographic restriction is difficult, so narrowing the scope of work and the customers covered is effective.

As for the period, a uniform prohibition for several years after leaving makes it hard to explain its necessity and appropriateness. Consider a period based on how quickly the information becomes obsolete and how long customer relationships continue. For example, for a SaaS sales manager, prohibiting sales activities toward existing customers the person handled during employment for a certain period may fit the reality better than uniformly prohibiting moving to any competitor. For an engineer, a possible approach is to restrict, in a targeted way, work on undisclosed technologies or the development of specific features the person was involved in during employment.

Compensation also requires careful consideration. Since the restriction limits the choice of occupation after leaving, the payment of allowances to make up for that disadvantage, an increase in severance pay, the grant of stock options, and the like are taken into account as factors in assessing validity. The absence of compensation does not immediately make the restriction invalid across the board, but it is a factor in assessing validity together with other circumstances.

Points to Note for Officers, Founders, and Outsourcing Contractors

The non-compete issue is not limited to ordinary employees in an employment relationship. For officers, founders, and outside contractors, the underlying legal relationships each differ.

For a sitting director, Article 356 of the Companies Act, as a rule, requires approval of the shareholders' meeting when engaging in a competing transaction. In a company with a board of directors, it becomes a matter for board approval under Article 365 of the same Act. Where a founder also serves as a director, the response must take into account this provision, the duty of loyalty, and conflicts of interest. A founder does not automatically owe a post-departure non-compete obligation merely by virtue of being a founder, so if such an obligation is to be imposed, it should be properly agreed in a shareholders' agreement or investment agreement. Investors want to prevent the risk of a competing business being launched, while excessive restrictions narrow the founder's next venture, so a balanced design is important.

In M&A transactions, it is common to impose a non-compete obligation for a certain period on the founder who is the seller. This is because the business value would be impaired if the same business were launched immediately after the acquisition. In this case, because there is substantive consideration in the form of the sale price, the restriction tends to be accepted more broadly than for employees, but the reasonableness of the work, period, and region covered is still scrutinized.

On the other hand, non-compete restrictions on outsourcing contractors, people working on a side-job basis, and outside advisors require a different approach. External talent often works on the premise of dealing with multiple companies in parallel, and a broad non-compete restriction makes it difficult for them to accept the engagement at all. Depending on bargaining power and the strength of the restriction, issues such as abuse of a superior bargaining position, which is prohibited under the Antimonopoly Act, may arise. That said, a non-compete restriction on a freelancer does not automatically violate the Act on Ensuring Proper Transactions Involving Specified Entrusted Business Operators (Freelance Act). For external talent, carefully providing for strict confidentiality, ownership of rights in deliverables, and a prohibition on directly soliciting the customers they handle may better serve the purpose than a non-compete.

Practical Checks When Designing the Clause

When introducing a non-compete clause into a contract, rather than being preoccupied with how strong the wording looks, confirm that it is designed so that its validity will be recognized in an actual dispute:

• Which of trade secrets, proprietary know-how, customer relationships, and so on is to be protected
• Whether the information concerned is managed so as to have confidentiality management, usefulness, and non-public nature
• Whether the person covered is in a position to access that confidential information on a daily basis
• Whether the same restriction is being imposed uniformly on all employees
• Whether the prohibited business, duties, customers, and acts are specifically identified
• Whether the restriction period is reasonable in light of how quickly the information becomes obsolete and the person's responsibilities
• Whether you can explain the reasonableness of the geographic scope of the restriction
• Whether the restriction is balanced against compensation such as allowances, severance pay, or shares
• Whether the purpose could be achieved through confidentiality and non-solicitation of customers and employees
• Whether the provisions are separated according to differences in position, such as employees, officers, founders, and outsourcing contractors

To make the clause work in practice, it is essential to link it not only to the contract wording but also to day-to-day operating procedures, such as internal access rights, rules for returning loaned items and data upon departure, and how customer information is actually managed.