Penalty for Breach of a Non-Compete Covenant: An Exception to the Prohibition of a Penalty Only Against the Employee
A non-compete covenant prohibits employees from competing on their own or a third party's behalf in the same field of activity as their former employer for a certain period of time after the termination of an employment contract. By the execution of a non-compete covenant, the employer aims to eliminate the risk of incurring a loss by preventing the information obtained by the employee about the business organization, production process and customer environment during their work from being used after the end of the employment relationship.[1] Even if an employee undertakes a non-compete obligation, there is a risk that the employee may not fulfil it. In case of breach of a non-compete covenant, it can be quite difficult for the employer to calculate the damages arising from such a breach. In practice, therefore, such agreements often include penalty clauses. As per article 420 of the Turkish Code of Obligations No. 6098 (“TCO”), nonreciprocal penalty clauses in employment contracts designated only against the employees are invalid. In this article, the validity of non-compete covenants and penalty clauses stipulated for its breach, as an exception to the prohibition of penalty only against the employee, are examined through the decision of the 11th Civil Chamber of the Court of Cassation dated 6.1.2020 and numbered 2019/2294E. 2020/40K.
Review of the Decision of the Court of Cassation
The validity of a penalty clause set forth in a non-compete agreement executed between an employer and its employee was the subject of a decision of the 11th Civil Chamber of the Court of Cassation dated 6.1.2020 and numbered 2019/2294E. 2020/40K. In this lawsuit brought by the employer against the employee, an employment contract and a separate non-compete agreement were signed between the parties on 09.09.2013. Following the termination of the employment contract by the employee, the employee started to work in a third company operating in the same field of business. The employer filed a lawsuit, asserting that the employee directed the customers of the plaintiff company to the employee’s new employer and caused the plaintiff company to incur losses, and therefore breached the non-compete obligation. The employer requested the collection of a penalty amounting to TRY 250,000 as indicated in the non-compete agreement.
The court of first instance resolved that the employee breached the non-compete covenant and the request for penalty was appropriate. Having said that, the court reduced the amount of the penalty by one tenth from TRY 250,000 to TRY 25,000, on the grounds that the balance between the amount of the penalty and the non-compete obligation could not be determined, and the benefit of the defendant and the pecuniary damages of the plaintiff could not be determined as well.
The defendant appealed. The regional court of appeal held, contrary to the court of first instance’s decision, that as the non-compete covenant acted as a penalty clause only against the employee, it was invalid under article 420/1 of the TCO, which states that a penalty clause in an employment contract designated only against the employee is invalid. Accordingly, the penalties in the employment contracts shall be reciprocal and the employer shall also undertake a counter obligation in return for the penalty clause imposed on the employee.
The plaintiff then appealed against the decision of the regional court of appeal. The 11th Civil Chamber of the Court of Cassation overruled by majority the decision of the regional court of appeal, stating that “in cases where a non-compete obligation is designated in an employment contract, it should be accepted that the contract includes both an employment contract that is valid during the continuation of the employment relationship and a non-compete covenant that stipulates obligations after termination of the employment contract; therefore, it is not possible to apply Article 420 of the TCO to the non-compete covenant executed between the parties.” The Court of Cassation emphasized that article 420/1 of the TCO only concerns the penalty clauses set forth in employment contracts, and that the non-compete obligation included in the employment contract was a separate contract which should not have been evaluated within the scope of article 420/1 of the TCO.
This decision of the 11th Civil Chamber of the Court of Cassation includes a dissenting opinion. The dissenting opinion stated that the rationale of article 446/2 of the TCO, which allows an employee to be relieved from a non-compete obligation contradicts with the rationale of the provisions of the TCO regarding penalty clauses which stipulates that no fault or loss is required for the collection of the penalty, and the employer may only demand compensation by proving the employee's fault and the damage the employer suffered; therefore, the decision of the regional court of appeal should be upheld.
Although there is a dissenting opinion to this decision, according to the Court of Cassation’s precedents, penalty clauses indicated for the breach of a non-compete covenant are valid even if they are designated only against the employee and the employer has not undertaken any obligation in return. Academics who have written on this subject also agree that article 420/1 of the TCO should be interpreted in accordance with the purpose of protecting the rightful interest of the employer, as this constitutes the basis of the non-compete obligation. Therefore, article 420/1 of the TCO should not be applied to non-compete covenants.[2]
Validity Conditions of Non-Compete Covenants
As per article 444 of the TCO, an employee may undertake an obligation not to compete in writing which will prevent the employee from competing with their employer in any way after the termination of the employment contract, especially by establishing a competitor business, working in another competitor business or engaging in any other kind of interest relationship with a competitor business. For the non-compete covenant to be valid, the employee must have access to the employer's customer portfolio or production secrets, or have the opportunity to obtain information about the employer's work, and at the same time, the employee's use of this information must be of a nature that will cause significant harm to the employer. Non-compete covenants executed by the employees who do not have access to the customer portfolio, production secrets or information about the employer's activities are invalid. What is considered as a production secret is examined by the court on a case by case basis.
Some mandatory limitations are stipulated in the law regarding the scope of the non-compete covenant. These limitations are as follows.[3]
- Restriction on geographical area: For the non-compete covenant to be valid, it must be limited in terms of geographical area. The geographical scope may not exceed the boundaries of the employer's field of activity.[4] Non-compete obligations designated to cover the whole of the Republic of Turkey are considered invalid, and are limited by the Court of Cassation as they may endanger the economic future of the employee and infringe their constitutional right of freedom to work. Hence, while restricting the non-compete obligation geographically, a city or a region may be determined where the employer is mostly performing its activities.
- Restriction on duration: The duration of the non-compete covenant may not exceed two years, except for under special circumstances and conditions. The restriction on duration is directly related to the employee's ability to access the employer's customer portfolio or production secrets, or to obtain information about the employer's work. The wider the employee's access to customer portfolio and production secrets, the longer the duration of the non-compete can be.
- Restriction on scope: Non-compete covenants should not cover the employer's field of activity as a whole, but should be directly related to the concrete task of the employee that is carried out by them at the employer's workplace.[5]
Pursuant to article 445/2 of the TCO, judges may at their own discretion decide to restrict a non-compete covenant in terms of scope, location or duration by evaluating all circumstances in an equitable manner and considering whether the employer has undertaken any counter obligation, or declare it null and void if it would jeopardize the economic future of the employee.
Consequences for the Breach of Non-Compete Covenant
Article 446 of the TCO sets forth that the employee who breaches a non-compete obligation is obliged to compensate the employer for all of the losses that they incur as a result. As noted above, a penalty clause is usually inserted in non-compete agreements due to the potential difficulties of calculating the damages suffered by the employer due to the employee's behavior. Another purpose of the penalty clause is to deter employees from breaching their agreements.
It is beneficial to adopt a moderate approach while determining the amount of penalty to be stipulated in the non-compete agreement. Pursuant to article 180 of the TCO, even if the employer has not suffered any damage due to the employee's breach, the employee is obliged to pay the penalty. However, article 182 of the TCO requires that the judge may automatically reduce a penalty amount that they deem excessive. For the penalty to be reduced, payment of the penalty must be due. In other words, if the employee has not yet breached and the employer is not entitled to request the penalty, the employee may not claim reduction of the penalty and the judge cannot automatically make such a reduction.[6]
In practice, however, courts have reduced the amounts of these penalties in many cases, due to the widespread practice of stipulating exorbitant amounts. As a matter of fact, the court of first instance in the decision that is the subject of this article found the penalty set as TRY 250,000 in the non-compete agreement to be exorbitant and reduced it to TRY 25,000.
An employee who does not want to fulfill their non-compete obligation may clear their debt by paying the penalty amount determined in the non-compete covenant to the employer, unless otherwise stipulated in the contract. On the other hand, if the employer's damages exceed the penalty amount, the employee is obliged to compensate for the damages exceeding the penalty amount as well (article 446 of the TCO).
Conclusion
Article 420/1 of the TCO sets out that penalties designated only against the employee, which do not impose any counter obligation against the employer, are invalid. The penalty clauses stipulated for the breach of a non-compete covenant only against the employee constitute an exception to this fundamental rule of Turkish labor law. Reasons such as a non-compete obligation being a contract in itself and protecting the employer's rightful interests are stated for the creation of this exception. Although penalty clauses intended for the breach of non-compete covenants are valid, in cases where the employer cannot prove damages, exorbitant penalties will be significantly reduced by the judge; therefore, a reasonable approach is recommended when determining the penalty amount.
- Soyer, M. Polat: Olay ve Görüş: İşverenin Değişmesi – Rekabet Yasağı Sözleşmesi, p. 369 – 370. (https://hukuk.deu.edu.tr/wp-content/uploads/2020/01/P.Soyer-21.pdf) (Access date: 13 March 2022)
- Baycık, Gaye: “İş Hukukunda Cezai Şart”, İş Hukukunda Genç Yaklaşımlar III, 2018, p. 8. (Doğan Yenisey, Kübra: “İş Hukukunda Cezai Şart”, İş Hukukunda Güncel Sorunlar, Kadir Has Üniversitesi Hukuk Fakültesi, 2012, p. 23.) (https://www.lexpera.com.tr/literatur/derleme-makaleler/is-hukukunda-cezai-sart-1-cezai-sartin-gecerliligi-8-15-1/1) (Access date: 16 March 2022)
- The employer is not obliged to pay any consideration to the employee with respect to the non-compete covenant under Turkish law.
- Süzek, Sarper: “Yeni Türk Borçlar Kanunu Çerçevesinde İşçinin Rekabet Etmeme Borcu”, İÜHFM C. LXXII, S. 2, 2014, p. 461.
- Süzek, Sarper: p. 461.
- Süzek, Sarper: p. 464.
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