Covenants Not to Compete from an Incomplete Contracts Perspective

Abstract

Covenants not to compete (CNCs) are used in employment contracts to prevent an employee from working for other employers, and in so doing pro- tect the firm's investment in human capital. We analyze the motives for including a CNC in employment contracts using an incomplete contracts perspective. We allow for both ecient and inecient breach, and compare covenants not to com- pete with the alternative breach remedies of specific performance and liquidated damages. We conclude that CNCs may be preferable to specific performance and liquidated damages when renegotiation of the contract is not possible, and thus eciency-minded courts should enforce CNCs. With renegotiation, a CNC can lead to both first-best performance and investment, but the eciency of the con- tract will depend on the scope of the CNC, namely how limiting it is in terms of restricting employment. A CNC with too broad a scope will be inecient by allowing a firm to extract quasi-rents from other firms, thus overcompensating the employer for investment. A CNC with too narrow a scope may not allow the em- ployer to appropriately recover his investment in human capital. We argue that courts need to deter parties from agreeing to covenants that are too broad, but also to recognize the eciency of CNCs, in particular when employees are capital constrained and judgment proof.