Mergers & Acquisitions: Post-Employment Restrictive Covenants In the Acquisition Context
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Your company is about to acquire a considerably smaller firm. You have completed your due diligence and have concluded that
there is a compelling product fit between the two organizations, a sound geographic mix, and some potential synergies between
the talents and skills of your management team and several of the key managers in the company you are acquiring. You had your
Vice President of Human Resources review the employment agreements of these key individuals and were advised that they have
standard noncompetition, non-solicitation, and confidentiality agreements with their existing employer. Your VP of HR advised
that the post-employment restrictive covenants are enforceable.
Shortly after the acquisition has been completed, four of the most promising employees of the acquired company resign. Worse yet, you now learn that they have joined your principal competitor. Do you have any recourse? Will the postemployment restrictive covenants these employees had with the firm you acquired provide your company adequate protection?
Although the hypothetical above provides a number of important facts that will influence the outcome of these questions, additional information is required to answer them with confidence. Moreover, as explained further below, the inquiries being posed retrospectively should have been explored in advance, before the acquisition closed.
First and foremost, you need to know whether the postemployment restrictive covenants contained an assignment clause. In other words, did the employees, when they executed the non-competition agreements and other post-employment restrictive covenants, agree that the agreements would be enforceable by a successor corporation? Is the assignment clause a part of the restrictive covenants and is it written in clear and understandable language? If these questions cannot be answered affirmatively, you may have no recourse whatsoever.
Courts around the country have been examining the issue of the assignability of post-employment restrictive covenants for some time. Although the results are not unanimous, and depend on the state law where the dispute arose, there is a growing body of case law holding that unless there is a specific assignment clause, the agreement is not enforceable by the acquiring firm.
This outcome appears to be driven by several rationales. Many courts begin with the general proposition that personal services contracts (such as employment agreements) are not enforceable. Thus, as these courts have concluded, the subsequent employer can neither force the employee to continue working for it nor prevent the employee from working for other firms. For example, the Ohio Court of Appeals observed in late 2002, "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." Cary Corp. v. Linder, No. 80589, 2002 WL 31667316 (Ohio Ct. App. November 27, 2002). See also, Hess v. Gebhard & Co., 808 A.2d 912 (Pa. 2002) (covenant not to compete contained in an employment agreement is not assignable to the purchasing business entity in the absence of specific assignability provision); Reynolds & Reynolds v. Hardee, 932 F. Supp. 149 (E.D. Va. 1996) (employment agreement is based on mutual trust and confidence; non-compete is not assignable).
Even in jurisdictions where courts are unwilling to proclaim unequivocally that post-employment restrictive covenants are unenforceable by a successor firm, there often is increased skepticism about the validity of restrictive covenants when the acquiring company is seeking to enforce them. Courts generally recognize that such covenants are anti-competitive, constitute a restraint of trade and inhibit employee mobility. Judges often are looking for ways in which to limit the enforceability of restrictive covenants, and the absence of an assignability clause in the agreement may provide that justification.
Even where these initial hurdles can be overcome, many courts find it inequitable to enforce post-employment restrictive covenants against an employee who did not bargain for it with the successor corporation. Courts have recognized that an employer is well situated to re-negotiate a new agreement with the employee at the time the acquisition occurs. For example, the Pennsylvania Superior Court emphasized,
"Strong policy considerations underlie the conclusion that restrictive covenants are not assignable. Given that restrictive covenants have been held to impose a restraint on an employee's right to earn a livelihood, they should be construed narrowly; and absent an explicit assignability provision, courts should be hesitant to read one into the contract. Moreover, the employer, as drafter of the employment contract, is already in the best position to include an assignment clause . . .. Similarly, a successor employer is free to negotiate new employment contracts with the employees . . . or secure the employee's consent to have the prior employment contract remain in effect."
All-Pak, Inc. v. Johnston, 694 A.2d 347 (Pa. Super. Ct. 1997).
Thus, in addition to concerns about the equities of allowing a successor corporation to enforce an agreement to which it had never been a party, several courts have adopted the All-Pak court's analysis, finding that enforceability of restrictive covenants following the acquisition is precisely one of the issues that should have been addressed before the acquisition closed. These courts have concluded that having foregone the opportunity to address this issue at a time when the parties could have bargained openly and in good faith, it would be unfair to allow the successor corporation to enforce the pre-existing restrictive covenants.
Minnesota Law
In Minnesota, courts are somewhat more tolerant of restrictive covenants than in some other jurisdictions (e.g., California, Colorado or North Dakota). Even here, however, many judges have been quick to point to the anticompetitive, restraint of trade, reduction in employee mobility concerns that have lead courts in other jurisdictions to repudiate restrictive covenants altogether. If, however, the post-employment restrictive covenants are fundamentally sound, with reasonable geographic, temporal and substantive restrictions, and if the agreement contains an explicit assignment provision, it may be enforceable by a successor corporation.
For example, in Saliterman v. Finney, 361 N.W.2d 175 (Minn. Ct. App. 1985), the Minnesota Court of Appeals evaluated a case involving the acquisition of a small dental office. After the business was purchased, one of the dentists who worked there resigned and opened a competing practice nearby. That dentist, however, had a post-employment restrictive covenant, which included an explicit assignment clause. The Court of Appeals found the limited restrictive covenant (a several-mile radius) was enforceable by the successor corporation. The Saliterman decision hinged on the nature of the business (a dental practice) where patient good will was deemed critical and the geographic restriction was extremely limited. Moreover, the court did not have to evaluate whether to enforce the non-compete in the absence of an assignment provision. It is unclear, therefore, whether the Saliterman decision has any applicability beyond its narrow facts, especially given Minnesota courts' skepticism about the enforceability of post-employment restrictive covenants.
A very recent case from the United States District Court for the District of Minnesota concluded that Saliterman should be construed narrowly. In Inter-Tel, Inc. v. CA Communications, Inc., et al., Civ. File No. 02-1864 (D. Minn. December 29, 2003), Judge Magnuson found that Saliterman was limited to the context where there was an explicit assignment provision in the post-employment restrictive covenant. The Court held that "in Minnesota . . .a finding of assignability likely depends on the language of the contract." The Court went on to observe that "Minnesota courts are historically reluctant to enforce covenants not to compete, because such covenants decrease competition and restrict the employee's ability to earn a living." Judge Magnuson, therefore, concluded that where the contract does not provide for assignment, a Minnesota court "would likely construe the language of the contract against the employer and find the assignment void." As with some of the judicial analyses described above, the Court also noted that the successor corporation could have negotiated this issue at the time of the acquisition. Judge Magnuson held that "Inter-Tel's failure to ensure that the restrictive covenants were assignable is fatal to its claims seeking to enforce those covenants."
In sum, although Minnesota law on this issue is not crystal clear, the better judicial analyses require an assignment provision for the post-employment restrictive covenants to be enforceable by a successor corporation. Certainly, the prudent attorney will address this issue at the time of the acquisition, not in a post-acquisition dispute designed to remedy an unanticipated and undesired result.
Other Issues
Even if a post-employment restrictive covenant contains an appropriate assignability clause, the due diligence inquiries should not end there. There are other potential pitfalls that may adversely affect the enforceability of such restrictive covenants. Briefly summarized, these issues include the following:
First, you should examine whether there was adequate consideration for the restrictive covenant. If the underlying agreement would not have been enforceable by the company that was acquired, it will not be enforceable by the successor corporation.
Second, you need to explore whether the acquired corporation uniformly used restrictive covenants. To the extent that the acquired company was inconsistent with respect to obtaining restrictive covenants, this too may undermine their enforceability. Again, if they would not have been enforceable by the acquired company, there is little likelihood that they could be enforced by the successor entity.
Third, you should evaluate whether the restrictive covenants were enforced. If the company you are acquiring routinely obtained but rarely enforced its noncompetes or other restrictive covenants, you may have a tough argument ahead.
Fourth, you need to consider thoughtfully the equities of the situation. For example, if the company you acquired operated in a limited geographic area (perhaps limited to one state), and if your company is a nationwide enterprise, the geographic restriction that the employee may have considered reasonable when signing the document could have far different implications post-acquisition. Similarly, if the substantive restriction of the original agreement had limited scope, reflecting the limited product line of the acquired company, there may be fundamental inequities in enforcing the substantive limitations of that agreement with respect to a more expansive product line.
Fifth, since the enforceability of restrictive covenants are dependent on state law, you need to examine carefully the laws of the relevant states. Where was the acquired company doing business? Where was the original agreement executed? Where did the employee whose post-employment activities you hope to restrict actually work? Where is the acquiring company located? Where will the affected employee work post-acquisition? These are but a few of the questions that should be explored when trying to assess whether the post-employment restrictive covenants are enforceable.
In sum, care should be given to evaluating whether postemployment restrictive covenants will be enforceable after an acquisition. At a minimum, this evaluation should encompass the issue of whether the restrictive covenant has an assignment clause, and the five other key questions listed above. If there is any doubt about the enforceability of the restrictive covenant, and if certain employees of the company being acquired are deemed critical to the acquisition, this issue should be addressed before the transaction is closed. There are a variety of ways that the acquiring company can protect itself against the risk that key employees might be lost following the acquisition, not the least of which is negotiating a new agreement. If the key employees refuse to execute new agreements, that may be a telling indication of their plans (firm or tentative) following the acquisition. This factor then can be given appropriate weight when determining whether to proceed with the acquisition and if so, at what price.
Disclaimer
©2004 Dorsey & Whitney LLP. This Employment Law Update is intended for general information purposes only and should not be construed as legal advice or legal opinions on any specific facts or circumstances. An attorney-client relationship is not created or continued by sending and receiving this Employment Law Update. Members of the Dorsey & Whitney LLP Labor and Employment Group will be pleased to provide further information regarding the matters discussed in this Employment Law Update.
Shortly after the acquisition has been completed, four of the most promising employees of the acquired company resign. Worse yet, you now learn that they have joined your principal competitor. Do you have any recourse? Will the postemployment restrictive covenants these employees had with the firm you acquired provide your company adequate protection?
Although the hypothetical above provides a number of important facts that will influence the outcome of these questions, additional information is required to answer them with confidence. Moreover, as explained further below, the inquiries being posed retrospectively should have been explored in advance, before the acquisition closed.
First and foremost, you need to know whether the postemployment restrictive covenants contained an assignment clause. In other words, did the employees, when they executed the non-competition agreements and other post-employment restrictive covenants, agree that the agreements would be enforceable by a successor corporation? Is the assignment clause a part of the restrictive covenants and is it written in clear and understandable language? If these questions cannot be answered affirmatively, you may have no recourse whatsoever.
Courts around the country have been examining the issue of the assignability of post-employment restrictive covenants for some time. Although the results are not unanimous, and depend on the state law where the dispute arose, there is a growing body of case law holding that unless there is a specific assignment clause, the agreement is not enforceable by the acquiring firm.
This outcome appears to be driven by several rationales. Many courts begin with the general proposition that personal services contracts (such as employment agreements) are not enforceable. Thus, as these courts have concluded, the subsequent employer can neither force the employee to continue working for it nor prevent the employee from working for other firms. For example, the Ohio Court of Appeals observed in late 2002, "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." Cary Corp. v. Linder, No. 80589, 2002 WL 31667316 (Ohio Ct. App. November 27, 2002). See also, Hess v. Gebhard & Co., 808 A.2d 912 (Pa. 2002) (covenant not to compete contained in an employment agreement is not assignable to the purchasing business entity in the absence of specific assignability provision); Reynolds & Reynolds v. Hardee, 932 F. Supp. 149 (E.D. Va. 1996) (employment agreement is based on mutual trust and confidence; non-compete is not assignable).
Even in jurisdictions where courts are unwilling to proclaim unequivocally that post-employment restrictive covenants are unenforceable by a successor firm, there often is increased skepticism about the validity of restrictive covenants when the acquiring company is seeking to enforce them. Courts generally recognize that such covenants are anti-competitive, constitute a restraint of trade and inhibit employee mobility. Judges often are looking for ways in which to limit the enforceability of restrictive covenants, and the absence of an assignability clause in the agreement may provide that justification.
Even where these initial hurdles can be overcome, many courts find it inequitable to enforce post-employment restrictive covenants against an employee who did not bargain for it with the successor corporation. Courts have recognized that an employer is well situated to re-negotiate a new agreement with the employee at the time the acquisition occurs. For example, the Pennsylvania Superior Court emphasized,
"Strong policy considerations underlie the conclusion that restrictive covenants are not assignable. Given that restrictive covenants have been held to impose a restraint on an employee's right to earn a livelihood, they should be construed narrowly; and absent an explicit assignability provision, courts should be hesitant to read one into the contract. Moreover, the employer, as drafter of the employment contract, is already in the best position to include an assignment clause . . .. Similarly, a successor employer is free to negotiate new employment contracts with the employees . . . or secure the employee's consent to have the prior employment contract remain in effect."
All-Pak, Inc. v. Johnston, 694 A.2d 347 (Pa. Super. Ct. 1997).
Thus, in addition to concerns about the equities of allowing a successor corporation to enforce an agreement to which it had never been a party, several courts have adopted the All-Pak court's analysis, finding that enforceability of restrictive covenants following the acquisition is precisely one of the issues that should have been addressed before the acquisition closed. These courts have concluded that having foregone the opportunity to address this issue at a time when the parties could have bargained openly and in good faith, it would be unfair to allow the successor corporation to enforce the pre-existing restrictive covenants.
Minnesota Law
In Minnesota, courts are somewhat more tolerant of restrictive covenants than in some other jurisdictions (e.g., California, Colorado or North Dakota). Even here, however, many judges have been quick to point to the anticompetitive, restraint of trade, reduction in employee mobility concerns that have lead courts in other jurisdictions to repudiate restrictive covenants altogether. If, however, the post-employment restrictive covenants are fundamentally sound, with reasonable geographic, temporal and substantive restrictions, and if the agreement contains an explicit assignment provision, it may be enforceable by a successor corporation.
For example, in Saliterman v. Finney, 361 N.W.2d 175 (Minn. Ct. App. 1985), the Minnesota Court of Appeals evaluated a case involving the acquisition of a small dental office. After the business was purchased, one of the dentists who worked there resigned and opened a competing practice nearby. That dentist, however, had a post-employment restrictive covenant, which included an explicit assignment clause. The Court of Appeals found the limited restrictive covenant (a several-mile radius) was enforceable by the successor corporation. The Saliterman decision hinged on the nature of the business (a dental practice) where patient good will was deemed critical and the geographic restriction was extremely limited. Moreover, the court did not have to evaluate whether to enforce the non-compete in the absence of an assignment provision. It is unclear, therefore, whether the Saliterman decision has any applicability beyond its narrow facts, especially given Minnesota courts' skepticism about the enforceability of post-employment restrictive covenants.
A very recent case from the United States District Court for the District of Minnesota concluded that Saliterman should be construed narrowly. In Inter-Tel, Inc. v. CA Communications, Inc., et al., Civ. File No. 02-1864 (D. Minn. December 29, 2003), Judge Magnuson found that Saliterman was limited to the context where there was an explicit assignment provision in the post-employment restrictive covenant. The Court held that "in Minnesota . . .a finding of assignability likely depends on the language of the contract." The Court went on to observe that "Minnesota courts are historically reluctant to enforce covenants not to compete, because such covenants decrease competition and restrict the employee's ability to earn a living." Judge Magnuson, therefore, concluded that where the contract does not provide for assignment, a Minnesota court "would likely construe the language of the contract against the employer and find the assignment void." As with some of the judicial analyses described above, the Court also noted that the successor corporation could have negotiated this issue at the time of the acquisition. Judge Magnuson held that "Inter-Tel's failure to ensure that the restrictive covenants were assignable is fatal to its claims seeking to enforce those covenants."
In sum, although Minnesota law on this issue is not crystal clear, the better judicial analyses require an assignment provision for the post-employment restrictive covenants to be enforceable by a successor corporation. Certainly, the prudent attorney will address this issue at the time of the acquisition, not in a post-acquisition dispute designed to remedy an unanticipated and undesired result.
Other Issues
Even if a post-employment restrictive covenant contains an appropriate assignability clause, the due diligence inquiries should not end there. There are other potential pitfalls that may adversely affect the enforceability of such restrictive covenants. Briefly summarized, these issues include the following:
First, you should examine whether there was adequate consideration for the restrictive covenant. If the underlying agreement would not have been enforceable by the company that was acquired, it will not be enforceable by the successor corporation.
Second, you need to explore whether the acquired corporation uniformly used restrictive covenants. To the extent that the acquired company was inconsistent with respect to obtaining restrictive covenants, this too may undermine their enforceability. Again, if they would not have been enforceable by the acquired company, there is little likelihood that they could be enforced by the successor entity.
Third, you should evaluate whether the restrictive covenants were enforced. If the company you are acquiring routinely obtained but rarely enforced its noncompetes or other restrictive covenants, you may have a tough argument ahead.
Fourth, you need to consider thoughtfully the equities of the situation. For example, if the company you acquired operated in a limited geographic area (perhaps limited to one state), and if your company is a nationwide enterprise, the geographic restriction that the employee may have considered reasonable when signing the document could have far different implications post-acquisition. Similarly, if the substantive restriction of the original agreement had limited scope, reflecting the limited product line of the acquired company, there may be fundamental inequities in enforcing the substantive limitations of that agreement with respect to a more expansive product line.
Fifth, since the enforceability of restrictive covenants are dependent on state law, you need to examine carefully the laws of the relevant states. Where was the acquired company doing business? Where was the original agreement executed? Where did the employee whose post-employment activities you hope to restrict actually work? Where is the acquiring company located? Where will the affected employee work post-acquisition? These are but a few of the questions that should be explored when trying to assess whether the post-employment restrictive covenants are enforceable.
In sum, care should be given to evaluating whether postemployment restrictive covenants will be enforceable after an acquisition. At a minimum, this evaluation should encompass the issue of whether the restrictive covenant has an assignment clause, and the five other key questions listed above. If there is any doubt about the enforceability of the restrictive covenant, and if certain employees of the company being acquired are deemed critical to the acquisition, this issue should be addressed before the transaction is closed. There are a variety of ways that the acquiring company can protect itself against the risk that key employees might be lost following the acquisition, not the least of which is negotiating a new agreement. If the key employees refuse to execute new agreements, that may be a telling indication of their plans (firm or tentative) following the acquisition. This factor then can be given appropriate weight when determining whether to proceed with the acquisition and if so, at what price.
Disclaimer
©2004 Dorsey & Whitney LLP. This Employment Law Update is intended for general information purposes only and should not be construed as legal advice or legal opinions on any specific facts or circumstances. An attorney-client relationship is not created or continued by sending and receiving this Employment Law Update. Members of the Dorsey & Whitney LLP Labor and Employment Group will be pleased to provide further information regarding the matters discussed in this Employment Law Update.
© 2004 Dorsey & Whitney, LLP
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