Legislation Highlights the Down Side of Corporate Non-Compete Rules

admin   March 12, 2010   Comments Off on Legislation Highlights the Down Side of Corporate Non-Compete Rules

In an unsuccessful attempt to get my home wireless network to work, I have spent more money on consultants than it costs to buy a new computer. I now know what they mean about the knowledge economy. In fact, you might call my encounter with my insufficiently geeky consultant an encounter with the “knowledge about” the knowledge economy. In other words, because of my lack of knowledge about the universe of computer consultants, and my inability to predict the skillfulness of my consultant, I made inefficient use of the input — knowledge — that is the stock in trade of the knowledge economy. While I am fuming about my home office expenditures, members of the General Assembly are being asked to consider a bill that hints, probably unintentionally, at a policy change that could enhance “knowledge about” knowledge among Maryland businesses, and thereby enhance growth in the state. 

Economists talk about “perfect markets” and “perfect profit-maximizing firms,” even though they recognize that neither exists. These models are seen as analytical tools, a means of teasing patterns from less than perfect real world facts. Some economists, however, argue that positing a perfect market, even as an analytical tool, is flawed because it assumes away an essential dynamic in the construct: information (or the relative lack thereof). 

Markets are never perfect, and firms are never perfectly profit maximizing because of the cost of acquiring sufficient information to make perfectly rational choices. Economists call this the problem of “search cost.” For example, I can’t check out every late model Honda Accord in the Sunday classifieds before making the best deal available on used Hondas. The search cost in time would be too great. 

Models of perfect markets and profit-maximizing firms are problematic because they assume away an essential value in how markets function and how firms make decisions. Buyers and sellers enter the marketplace at some place on the information curve, but never at the top of the curve because they can’t afford the cost of the search to get there. Firms never “maximize” profits, because they can never possess enough information to ensure a course of action that guarantees the maximum profit. That doesn’t mean that buyers, sellers and business managers don’t keep trying. There is no alternative in business to the search for an informational advantage. 

What form does this search take? Sellers search for information about buyers by hiring a sales force. Firms attempt to narrow the range of possible outcomes of their business decisions by accumulating proprietary information in the form of trade secrets, patents and market research. 

Having paid dearly for information in their quest for competitive advantage, firms use non-compete covenants to protect that advantage. 

Therein lies the significance of House Bill 234, sponsored by Del. Brian K. McHale (D-Dist. 46) of Baltimore and others. The bill provides that a non-compete covenant cannot be enforced against a broadcast industry employee. It is aimed at TV and radio stations that use covenants to prevent the poaching of popular newscasters and other pretty faces. 

While the bill is narrowly focused, its underlying premise touches on how much help courts and the legislature should give businesses in their effort to accumulate and hoard commercially valuable information.

Courts uphold non-compete covenants that are reasonable as to time and geographic scope on the premise that businesses have a right to prevent departing employees from providing customer lists, confidential formulas and business strategies to the competition. Courts attempt to balance the employer’s interest in protecting its intellectual property rights against the right of individuals to freely choose employment opportunities. 

Ideally, a covenant should be fashioned around a firm’s intellectual property interests. Non-compete obligations that implicate no intellectual property rights and that look as if they are intended to prevent the competition from getting a leg up tend not to be enforced. 
Furthermore, in sectors of the economy experiencing rapid technological change, such as the computer industry, the trend is away from enforcement of covenants that are aimed at informal knowledge. 

This knowledge — industry gossip, informal personal relationships — is sometimes referred to as “tacit” knowledge. It may be fresh — and therefore valuable — but it is not organized into trade secrets, patents or other intellectual property. 

So let’s boil this down: At one extreme, non-competes aimed at protecting intellectual property tend to be enforced. At the other, non-competes that restrain labor mobility and that do not implicate any property rights tend not to be enforced. (In that sense, one could argue that McHale’s bill is merely declaratory of existing law.) 

In the middle are non-competes involving tacit knowledge — commercially valuable information that does not rise to the status of intellectual property. The common law of “it depends” applies to non-competes intended to limit the dissemination of tacit knowledge. 

In fact, more than the fate of a wayward programmer depends on which rule applies. A Stanford law professor argues that Silicon Valley has grown much faster in the past two decades than the Route 128 high-tech corridor near Boston because non-compete covenants are enforced in Massachusetts, but not in California. He notes that wealth- and innovation-creating tacit knowledge spills over between firms as much as or more through job-hopping engineers and scientists than through conferences and articles posted on the Internet. 

n other words, employee mobility between geographically clustered firms increases the value of clustering, despite the cost of putting up with job-hopping employees. That, the professor says, is why the tech sector in California out-competes the Route 128 corridor in Massachusetts. 

So, whither Maryland in the race for the next big thing in technology? 

Given its strength in life sciences — its research universities, government agencies and commercial sector — Maryland is without question in the running for Master of the Universe if life sciences prove to be the next big thing. Perhaps our legislators should take a break from the slots and incur the search cost of reading about Silicon Valley’s secret of success at 74 New York L. Rev. 575. 

© Maryland Gazette. Reprinted with permission.