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RESTRICTIVE COVENANTS IN EMPLOYMENT AND SALE OF BUSINESS CONTEXTS: PROTECTING YOUR INTERESTS

by Gary Ettelman, Esq. and Keith B. Hochheiser, Esq.

You own a large, successful alcohol beverage distributor. Every day you rely on a few key people to help make and implement decisions that effect your company’s profitability, as well as hundreds of employees. One day, your most valued manager abruptly resigns, and you later find out that he went to work for your biggest competitor. Can you prevent him from sharing your company’s business information with his new employer? Can he contact all of the accounts he serviced for you in an attempt to get them to change brands? Or imagine, you agree to purchase your biggest competitor’s company. With your competition out of the way, you tell yourself, your profits will soon go through the roof. You imagine yourself on the deck of your new 60 foot Hatteras. However, your dreams sink to the ocean floor when you find out that your former competitor is starting a new alcohol distributor that substantially overlaps with your territory. Is the seller allowed to immediately start a new, competing business?

Don’t Ignore the Need for a Restrictive Covenant

Neither of these scenarios is completely hypothetical. Disputes between an employer and a former employee are common, as are those between the buyer and seller of a business. Unfortunately, once litigation begins, no one is a clear winner. Between attorney’s fees, attending depositions, and going to court, even if the court gives you everything you ask for you may find your self with a Pyrrhic victory. The best way to reduce the costs of litigation in either scenario is to include a restrictive covenant in all employment and purchase agreements. From the perspective of an employer, or the buyer of a company, including a restrictive covenant in an agreement is like taking a daily vitamin—a low cost and painless way to protect yourself from a far more critical condition down the road. On the other hand, excluding a restrictive covenant may lead to the loss of a valuable employee, and whatever information and relationships he tries to take with him. Or, if you are buying a business, a covenant prohibiting the seller from competing with you for a certain amount of time is the only way to make sure that you are acquiring a business and loosing a competitor.

Draft Carefully

Although, as we contend, restrictive covenants are necessary in employment and sale of business contexts, care must be taken to be sure that the restrictive covenant you are relying on will be enforced by a court in the event of a dispute. In other words, the most beautifully and elegantly crafted restrictive covenant is worthless if a court finds it vague, unreasonable, or otherwise unenforceable. Then, at best, you will be left with the court’s view of what, if anything, is an appropriate restriction. Therefore, it is necessary to discuss why restrictive covenants are necessary, and how to make sure that a court will enforce your restrictive covenant.

Why You Need a Restrictive Covenant

Restrictive covenants are necessary to protect the goodwill that you have developed with your customers. For example, imagine a person that we will call Manager has worked his way up through your company for 15 years. He is now the manager of your biggest account. Manager has been working with many of the same retailers for a decade. He knows which quantity and type of products they want, as well as their spouses, children’s names, and a variety of miscellaneous information that creates the basis of a unique relationship. If Manager is lured away by a competitor who wants Manager to sell his brands, the retailers may feel more loyalty to Manager than to your brand. However, the restrictive covenant will prevent this from happening by preventing Manager from working for your competitor in the same territory. Although Manager might be able to accept a job that would have him work in a different territory, a restrictive covenant would also prevent him from disclosing information about your company to his new employer. Therefore, your company should implement a standard restrictive covenant agreement to be signed by every high level employee at your company. This agreement can often times be incorporated into a employment agreement. At a minimum, the agreement should outline the employee’s duty to not disclose your company’s confidential information, such as customer lists, or compete with you or try to take your customer’s from you, for a certain time, and in a certain geographic area.

Similarly, a restrictive covenant contained in a purchase agreement must set out the kind of business the seller may or may not work for or create, as well as the temporal and geographic limitations of the restriction. Just like in the scenario above, the seller of a business usually has a large amount of goodwill between himself and his customers. When you buy his business, a large part of the price is for this goodwill. However, if the seller turns around and tries to reenter the market, you may find that the goodwill you acquired could become worthless overnight. Therefore, as you negotiate a purchase agreement, be sure to specifically set out the kinds of businesses that the seller may start or join. The restrictive covenant should set out the length of time as well as the geographic scope for which competition is forbidden.

The View From the Court

Although it may seem easy, implementing a restrictive covenant is not as simple as seems. The key, of course, is to have the restriction stand up in court, or, even better, to have the other party’s attorney advise him that he is bound by your restrictive covenant, and the odds of beating it are about the same as being dealt a royal straight flush at the casino.

Every State allows some kind of restrictive covenant against employees or the seller of a business. However, there can be significant differences in the scope of protection offered by a State. Some States, including California, Colorado, Florida, Louisiana, North Dakota, Oklahoma, and Texas, have statutes prohibiting restrictive covenants except in certain circumstances, or place clear limitations on the scope of an acceptable restrictive covenant. The majority of States, however, follow the common law test established by the courts of their state. This test generally has two parts: (1) whether the enforcement of a restrictive covenant is “necessary to protect against use or disclosure of trade secrets or other confidential information, or solicitation of customers, or when the employee's services are deemed unique or extraordinary”; and (2) whether the restrictive covenant is “reasonable in time and area, necessary to protect the employer's legitimate interests, not harmful to the general public and not unreasonably burdensome to the employee." Put another way, a court will determine whether you have information worth protecting, and whether your way of protecting it is fair. One important caveat, however, is that a court will not enforce a restrictive covenant if the purpose is simply to limit or restrain competition. In other words, the desire to limit ordinary competition is never a valid protectable interest.

Courts across the U.S. are regularly confronted with the scenarios of the kind discussed at the beginning of this article. For example, in a case decided by the Kansas supreme court, a route salesman for a liquor distributor, who was bound by a restrictive covenant, left the distributor after 7 years to join a competitor. The competitor, which had virtually no sales in the distributor’s territory prior to hiring him, hired the salesman to service his old customers, which the distributor tried to prevent by means of an injunction. The distributor argued, among other things, that it had an interest in protecting its customer information. The court stated that the distributor’s business was “highly regulated by a state agency and that there are no secret customer lists nor other trade secrets involved . . . since such matters are of public record.” Nevertheless, the court enforced the restrictive covenant, which precluded salesman from working for a competitor for 1 year. The court recognized that even though the names and addresses of the customers was a matter of public record, the hours that the customer was available, and the names and ordering habits of their clerks, was not. It was also important to the court that the salesman had frequent calls on the customers at their place of business, and that the customers’ primary contact with the distributor was through the salesman. However, it was not a complete victory for the distributor. The geographical scope of the restrictive covenant encompassed an area of 50 miles surrounding his sales territory. The court found this too broad, and reduced the scope to that of the salesman’s original sales territory.

Your Conduct Matters

Although a valid restrictive covenants are routinely enforced in a variety of situations, it is also possible for you, through your conduct, to cause a court to not enforce the restriction. For example, if you are only allowed to terminate an employee for certain circumstances, and you fail to abide by those terms, a court will generally refuse to enforce the restrictive covenant. The same is true in the context of a sale of business. If the seller has agreed, for example, to not open a competing business for a number of years, but the buyer fails to fulfill its obligations, such as making all payments due, a court would likely not enforce a restriction preventing the seller from engaging in conduct prohibited by the restrictive covenant.

Restrictive covenants can be used to effectively prevent a former employee, or seller of a business, from competing. They can also be used to prevent solicitation of customers, or other employees. Covenants that seek to prevent the “poaching” of a key customer, or from inducing other employees to join an employee in starting a new competitive business, are generally less severely construed by courts, because they are seen as less likely to prevent the employee from making his livelihood. In other words, courts will generally find a restrictive covenant that prevents someone from working in the trade in which he is skilled as violating public policy.

Conclusion

As we all know too well, today’s ultra-competitive economy requires the implementation of a variety of techniques to protect your business. Fortunately for business owners, restrictive covenants are an effective and virtually cost-free way to accomplish several objectives. In terms of employees, restrictive covenants can be used to protect the relationships that may exist between a longtime customer and a manager. A restrictive covenant can also prevent a former employee from sharing your business information with his new employer. Finally, if you are purchasing a business, a restrictive covenant is the best means to insure that the seller does not turn around and open a new competing business once your check clears.