27.05.2020

The Downside of Non-Compete Clauses for Firms

CHEN, Tai Yuan | ZHANG, Guochang | ZHOU, Yi

Non-compete clauses in employment contracts are widely used in countries like the US to forbid certain employees, such as CEOs and specialised technicians, from working with the competition when their contract is terminated. The aim is to safeguard employers’ proprietary information and investment in human capital. But research by Tai-Yuan Chen, Guochang Zhang and Yi Zhou shows these clauses may backfire depending on how tightly they are enforced – and be detrimental to long-term firm performance.

The authors looked at three US states – Florida, Louisiana and Texas – where the enforceability of non-compete clauses altered between 1992 and 2004. Enforceability was decreased by the Supreme Courts of Texas and Louisiana (the latter in 2001) but tightened by the legislatures of Florida and Louisiana (in 2003). This provided an opportunity to compare the before-and-after effects on firm expenditure and performance.

“Since non-compete clauses constrain opportunities for future employment and thus increase the cost of dismissal and job switching for managers, we expected them to have a significant impact on managers’ investment and financial reporting practices,” the authors said. The findings bore that out.

Managers in firms facing tighter enforcement displayed an increased likelihood of meeting or beating earnings targets, which they did by reducing spending on discretionary expenses such as research and development and advertisement.

The authors also explored whether strict enforcement motivated managers to engage in “managerial myopia”, meaning they put a greater on short-term performance and made cut-backs to boost reported earnings even at the expense of long-term profitability, or “interest alignment”, meaning they worked hard to make efficient use of resources and cut back on wastefulness, which would reduce agency costs and increase firm value and thus help them keep their job.

The results showed managerial myopia was the key motivator.

“Firms that cut research and development expenses displayed lower innovation output – they had fewer patent applications. There was also a smaller, narrower impact from innovation as measured by citations and claims per patent. Cutting back on advertising and other related expenses also led to declines in market share and future profitability. Significantly, these types of real activity management led to lower stock returns in future years,’ they said.

The results were more pronounced in firms operating in more localised industries, where non-compete provisions are likely to have a stronger effect. They were also more pronounced among CEOs who had lower ability and shorter tenure with their current employers, as they had limited career opportunities.

“An important message is that a firm’s economic activities and financial reporting behaviour depend not only on the terms stipulated by employment contracts, but also on the legal framework within which the contractual terms are enforced,” the authors said. “Although non-competes are widely adopted in employment contracts to protect employers’ intellectual property and human capital, such benefits are not without cost.”

CHEN, Tai Yuan

Associate Dean (MBA Programs), Professor
Accounting