Quirky Question # 104, Restrictive Covenants in Acquisition Context

Quirky Question # 104:

We are a high tech company. We use various post-employment restrictive covenants with many, though not all, of our employees. For our engineers, our senior managers and other select employees, however, we require non-competition, non-solicitation and non-disclosure agreements.

Because of the recent success of one of our software products, we are receiving serious inquiries from two potential suitors. They want to know whether our restrictive covenants will continue to bind our key employees in the event of an acquisition. I’ve always assumed that the employees would continue to be bound but there is nothing in the agreements themselves that addresses this context. Any thoughts on whether we will be able t bind our key employees to the same restrictive covenants they have with us in the event our company is acquired?

Dorsey’s Analysis:

As discussed in other Quirky Question analyses, one mantra when addressing other employment law issues, the first question that needs to be explored when considering restrictive covenants is what state’s law applies. The law of restrictive covenants varies widely from state to state. Some states, such as California and North Dakota, largely repudiate post-employment restrictive covenants, including non-competes, except in very limited circumstances. Other states regulate this substantive area by statute. Still others largely accept these contractual agreements among employer and employee.

In Minnesota, for example, courts will enforce reasonable post-employment restrictive covenants when linked to a legitimate corporate interest. Recognizing that restrictive covenants are anti-competitive, restrain trade and restrict employee mobility, however, courts examine these agreements carefully. As the Minnesota Supreme Court stressed more than 40 years ago, non-competes are “looked upon with disfavor, cautiously considered, and carefully scrutinized.” Bennett v. Storz Broadcasting Co., 134 N.W.2d 892 (Minn. 1965). Minnesota courts evaluate post-employment restrictive covenants to ensure that they are supported by adequate consideration, and are geographically, temporally and substantively reasonable.

In light of these general principles, even before turning to your specific question about the assignability of the restrictive covenants used by your firm, I recommend you evaluate the following key issues.

First, where do your employees who have restrictive covenants work? Do they all work in one state or are you confronting a situation where various states’ laws might apply? Do the states where your affected employees work accept or reject restrictive covenants? Are there important statutory or common law limitations that will govern the interpretation of these contract provisions? If, for example, as alluded to above, some of these employees live and work in California, you may not need to consider the question of whether the covenants would be enforceable by a successor corporation because they probably would not be enforceable by your company. (A corollary inquiry is whether, even for your hypothetical California employees, your employment agreements have choice of law provisions, i.e., contract terms that specify which state’s law will govern the interpretation of the contracts. I’ll reserve the issues surrounding the validity of these provisions for another day, but note that it is important to your analysis.)

Second, assuming your employees are working in a state that does not repudiate post-employment restrictive covenants, the next fundamental inquiry for your consideration is what important corporate interests support your company’s restrictive covenants? Based on the facts you set forth, it would appear that your company considers carefully whether particular employees should be asked to execute the restrictive covenants. As you noted, your company only asks your “engineers, senior managers, and other select employees” to execute the restrictive covenants. This suggests to me that you should be able to articulate the reasons why your company considers it important for these individuals to sign agreements with these types of post-employment restrictions. But give some thought to how you would express these ideas.

Third, again as referenced above, did you provide your employees consideration for executing the restrictive covenants? If they were informed of the restrictions when they first sought employment, the job offer and subsequent employment can constitute sufficient consideration. If, however, the request to one or more of your employees was an afterthought, and your company did not present them with the employment agreements containing the restrictions until after their employment commenced, you need to assess whether sufficient consideration was provided to support these contract provisions. If not, again you may not have an agreement that your company, let alone a corporate successor, could enforce.

Fourth, are the terms of the restrictive covenants reasonable? What is their geographic scope? What is their duration? What types of jobs would the restrictions prevent your employees from taking? The more onerous the burdens imposed on your employees, the more skeptical courts are likely to be about their enforceability. Once again, these issues should be evaluated before you even consider the impact of the potential acquisition on your employees’ restrictive covenants.

If, after exploring each of the issues addressed briefly above, you have concluded that the post-employment restrictive covenants would be enforceable by your company, the next part of the analysis is the one on which your question focused – Would the restrictions be enforceable by the successor company? Like other aspects of contract analysis, the first place to begin the evaluation is the contract itself. What specifically does the contract state about successors, if anything? What specifically does the contract state about the rights of your company to assign the agreements? What language was used in the contract regarding the nature of these “personal services” agreements? Looking at the specific contract language is the starting point for your analysis.

Here, you stated that “there is nothing in the agreements themselves that addresses the [acquisition context].” This could be problematic. Courts that have rejected enforcement of restrictive covenants when the underlying contract lacked an assignment provision focus on various factors to justify their decisions.

First, they point to the personal nature of the contractual obligations set forth in the agreement. For example, in CaryCorp. v. Linder, 2002 WL 31667316 (Ohio Court App. Nov. 27, 2002), the court observed, “The strong policy considerations in All-Pak [an earlier decision] recognize that the employment relationship is a personal matter between an employee and the company who hired him and for whom he chose to work. Unless an employee explicitly agreed to an assignability provision, an employer may not treat him as some chattel to be conveyed, like a filing cabinet, to a successor firm.”

Second, courts have pointed to the fact that the employers typically draft the employment agreement, with no input from the employees. In this context, courts are reluctant to read terms into the agreement that the employer failed to include. This is a factor that likely will militate against the enforcement of your agreements by a successor company.

Third, courts look to the specific underlying facts to evaluate the equities of the situation. For example, you stated that your firm is a software company. Let’s assume (arbitrarily) that your start-up has 75 employees and operates in just one state. Your employees may have been willing to sign a restrictive covenant that restricted their employment options in that state. Let’s assume further that the acquiring company is a national software firm that does business in all 50 states and internationally. In that context, the language of your geographic restriction may take on far greater implications and be far more limiting for your employees. In this context, a court may be far more reluctant to enforce a geographic restriction linked to the locations where your company’s potential successor does business.

Fourth, as referenced above, restrictive covenants constitute a partial restraint of trade and are anti-competitive. Courts often look for reasons not to enforce these restrictions. The absence of a clear assignment provision, included as part of the agreement at the inception of an employee’s employment, is an easy way for a court to reject enforcement of the agreement by a successor company.

In short, given the absence of an assignment provision in your employment agreements, it would be imprudent for your company to represent to the potential acquirer of your firm that the restrictive covenants will bind your key employees. This is not likely to be true.

But, don’t despair. There should be multiple ways to assuage the concerns of your company’s suitors on these issues. Regardless of the absence of contract assignment language, there remain a number of legal protections for any acquiring company. For one thing, your employees have fiduciary duties to your company, primarily linked to their duty of loyalty and their duty of confidentiality. For another, most (though not all) states have adopted the Uniform Trade Secrets Act, that justifiably restricts your employees’ ability to share your proprietary and confidential trade secret information with others. To the extent that the potential acquiring companies are concerned about protecting your company’s proprietary information, these interests should be protected.

Finally, there is no reason why the acquiring company should not be able to prepare new post-employment restrictive covenants for your existing employees. This will enable them to create contracts that are consistent with any agreements currently in place at the acquiring company for similarly situated employees. And, in these agreements, suggest that they include an assignment provision.