Non-competition agreements in employment contract and shareholders’ agreement

In a limited liability company, it is in the interest of the company and its shareholders that the shareholders working for the company do not engage in competing activities with the company. It is also in the interest of the company that its employees do not engage in activities that compete with the company’s business. On the other hand, the right to earn a living through freely chosen work is one of the constitutionally protected rights, which can only be restricted by legislation. This imposes certain limitations to the extent to which non-competition agreements can be freely negotiated.

The Limited Liability Companies Act itself does not contain provisions that prohibit shareholders of the company from engaging in competing activities with the company. The Employment Contracts Act includes provisions regarding non-competition, but according to the law, incorporating these into an employment contract requires a particularly weighty reason. It is common for non-competition agreements among shareholders to be stipulated in a shareholders’ agreement.

It is quite common for companies to commit employees by granting them company shares through, for example, a share issue based on their employment. In this way, employees who become shareholders through the issuance of shares not only enter an employment contract but also become parties to a shareholders’ agreement that binds them.

Since the Employment Contracts Act, which applies to employment contracts, is an act that protects the position of employees and is partially mandatory, it is necessary to assess the extent to which the mandatory provisions of the Employment Contracts Act restrict the freedom of contract between shareholders. If a shareholder is in a regular employment relationship with the company, and a non-competition agreement has been agreed upon in the shareholders’ agreement, interpretation issues can easily arise regarding the extent to which such non-competition agreement binds the employee.

General information about non-compete clauses

Non-competition agreements can be categorised based on their temporal dimension into restrictions related to the duration of the contractual relationship and post-contractual non-competition agreements binding the parties after the termination of the contract. Provisions regarding the duration of the agreement or post-agreement periods related to non-compete clauses cannot be derived from the Limited Liability Companies Act, whereas the Employment Contracts Act directly regulates non-compete clauses during the validity of an employment relationship. Due to the loyalty obligation incorporated into the Employment Contracts Act, employees shall not do work for another party or engage in such activity that would, taking the nature of the work and the individual employee’s position into account, cause manifest harm to their employer as a competing activity contrary to fair employment practices. Because of the mandatory nature of the Employment Contracts Act, this provision regarding non-competition agreements during the employment relationship automatically binds a shareholder who is also an employee of the company.

In shareholders’ agreements, the validity of non-compete clauses is tied to share ownership, while in an employment contract, the validity of a non-compete clause is linked to the duration of the employment relationship. The temporal duration of non-compete clauses in shareholder agreements after the termination of the contract typically ranges from one to three years. The Employment Contracts Act sets a time limit of 12 months after the termination of the employment for non-competition agreements, and incorporating a non-compete clause into an employment contract requires particularly weighty reasons.

It is common for post-termination non-competition agreements, in particular, to be associated with more legal challenges than non-competition agreements during the term of the contract. In addition to the temporal dimension of the non-compete clause, it is advisable to precisely define the geographical scope and the scope of competing activity in the agreement governing the non-compete clause.

Non-compete clauses in employment contracts

According to the Employment Contracts Act, for a particularly weighty reason related to the operations of the employer in the employment relationship, an agreement made at the beginning of or during the employment relationship (agreement of non-competition) may limit the employee’s right to conclude an employment contract on work to begin after the employment relationship has ceased with an employer which engages in operations competing with the first-mentioned employer, and also the employee’s right to engage in such operations on his or her own account.

The amendment to the Employment Contracts Act as of the beginning of 2022 expanded the employer’s obligation to compensate the employee for the post-employment non-compete period, known as the restriction period. If the agreed restriction period is up to six months, the employer must pay the employee compensation equivalent to 40 percent of the employee’s salary for the restriction period. If the agreed restriction period is more than six months, the compensation for the restriction period must be 60 percent of the employee’s salary. The restriction period can be agreed upon for a maximum of one year after the termination of the employment relationship.

The compensation must be paid within the restriction period using the payroll periods observed during the employment, unless otherwise agreed after the termination of the employment contract. In a non-competition agreement concluded in the employment contract, a provision may be included specifying a contractual penalty for the employee’s breach of the non-compete clause, with a maximum amount equivalent to the employee’s salary for the six months preceding the termination of the employment relationship.

The purpose of the regulation on non-compete clauses in the Employment Contracts Act is to safeguard the free movement of labour and prevent unnecessary restrictions on work. If share ownership is contractually tied to employment in the shareholders’ agreement, or if the role of a shareholder is effectively equivalent to that of an employee based on an overall assessment, the provisions of the Employment Contracts Act regarding non-compete clauses may apply to the situation, regardless of the provisions in the shareholders’ agreement or the shareholder’s role. The matter must be assessed on a case-by-case basis, taking into account the specific circumstances.

The provisions of the Employment Contracts Act cannot be bypassed if the shareholder meets the criteria for an employment relationship as defined by the Employment Contracts Act, and the employee is not engaged in the direction of the enterprise, corporate body or foundation or an independent part thereof or to have an independent status immediately comparable to such managerial duties. However, if the shareholder owns a majority of the company’s shares and exercises effective control over the company, the Employment Contracts Act is unlikely to apply to the situation. Instead, the non-compete provisions in the shareholder agreement should be assessed based on general contract law principles.

Non-compete clauses in a shareholders’ agreement

In a shareholders’ agreement, it is generally possible to negotiate non-compete clauses more freely than those included in the employment contracts. Non-compete clauses in a shareholders’ agreement can have a longer duration than those in employment contracts since the temporal scope of non-compete clauses in a shareholders’ agreement is not restricted by the provisions of the Employment Contracts Act governing non-compete clauses.

However, non-competition agreements included in shareholders’ agreements should be justifiable in terms of duration, substance, and geographical scope. Concerning the non-compete clause, it may also be appropriate to agree that it does not bind all parties to the shareholders’ agreement in the same manner. It is customary for the non-compete clause not to bind shareholders who are merely investors in the company. When assessing the justifiability of the non-compete clause for shareholders, consideration should be given to whether the non-compete is justified, taking into account the position of an employee-shareholder in the company or the extent of their share ownership. In practice, shareholders’ agreements often stipulate that a shareholder terminating their employment with the company is obligated to divest their shares upon the termination of the employment. Therefore, the non-compete clause in the shareholders’ agreement for employee-shareholders is, in a way, tied to the termination of the employment.

Ambiguous situations arise when a shareholder in the shareholders’ agreement is an employee with a small ownership stake in the company, often referred to as a minority shareholder, who lacks effective control over the company. In the case of these shareholders, it is necessary to examine how the Employment Contracts Act might impact the non-compete clauses agreed upon in the shareholders’ agreement.

If an individual in an employee position is bound by a non-compete clause in a shareholders’ agreement, the inclusion of a non-compete provision in the shareholders’ agreement cannot circumvent the mandatory provisions of the Employment Contracts Act. In this case, the non-compete clause in the shareholders’ agreement must be considered as a non-compete clause in accordance with the Employment Contracts Act, and the mandatory provisions and restrictions of the Employment Contracts Act regarding non-compete clauses will apply. If it can be argued that the employee is acting independently and holds a significant level of control within the company, the evaluation of the non-compete clause will not fall under the provisions of the Employment Contracts Act regarding non-compete clauses. Instead, it will be within the framework of the limitations set by Section 38 of the Law of Contracts Act. According to the Law of Contracts Act, a contract under which a person, in order to prevent or restrict competition, has undertaken not to engage in a certain activity or not to conclude an employment contract with another person engaging in such activity shall not bind the party who has made such a promise to the extent that it unreasonably restricts his/her freedom.

The general principle of contractual freedom applicable to shareholders’ agreements is not absolute, as the Employment Contracts Act may impose certain restrictions on the extent to which extensive non-compete clauses can be imposed on certain shareholders who are in an employee position. Considering a hypothetical scenario where an employee-shareholder’s employment in the company is terminated for production or economic reasons and is subject to a one-year non-compete clause according to the shareholders’ agreement. According to the Employment Contracts Act, a non-compete clause does not bind the employee if the employment is terminated due to reasons attributable to the employer. In such a case, the mandatory provisions of the Employment Contracts Act would likely be in favor of protecting the rights of this employee-shareholder, and the non-compete clause included in the shareholders’ agreement would not bind the shareholder. In summary, non-compete provisions in a shareholders’ agreement are binding on employee-shareholders to the extent that they do not violate the content requirements set by the Employment Contracts Act for non-competition agreements.

On the other hand, the viewpoint that the mandatory provisions of the Employment Contracts Act regarding non-compete clauses would limit the contractual freedom of the parties in a shareholders’ agreement can be questioned, for example, by considering that the parties to the shareholders’ agreement and the employment contract are different entities. The parties to an employment contract are the employee and the company, while the parties to a shareholders’ agreement are the shareholders of the company, with the employee committed to the non-compete clause possibly being one of them. It is common for the company to be a party to the shareholders’ agreement, but this is not always the case.

The matter is open to interpretation, and there are no precedents in legal practice regarding the binding nature of non-compete clauses in a shareholders’ agreement in light of Employment Contracts Act. For this reason, including non-competition agreements in both employment contracts and shareholders’ agreements requires a case-by-case assessment, taking into account the specific circumstances and characteristics of each case. The temporal and geographical scope, as well as the extent of non-competition agreements, should be considered on a case-by-case basis.

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