On Target

Welcome to MJ Hudson’s monthly On Target, where you’ll find useful tips and insights to ease you through your M&A transactions.

This month we focus on non-compete covenants in management employment agreements and the common pitfalls associated with them.

Restrictive Covenants: Management Non-Competes

What are restrictive covenants?

A key focus in a buyer’s legal due diligence for the acquisition of a business will be the review of the employment (aka service) agreements of the target’s key directors and managers.

A buyer will want to ensure that, if a manager leaves the business, the relevant agreement prohibits that individual from, among other things, competing with the target’s business, unfairly dealing with its suppliers and customers, and poaching its employees. The relevant provisions – ‘restrictive covenants’ – apply for a defined period after the individual ceases to be employed in the business. If the existing restrictive covenants are inadequate, a buyer should seek to agree new agreements, or amendments to the old service agreements, with effect from completion.

Of these restrictive covenants, the non-compete provision (which is the focus of this article) is often seen as the most critical. However it is also the most restrictive for the employee, and so may prove the most difficult to enforce.

Is a non-compete enforceable?

The starting point in the UK is that restrictive covenants are void as a matter of public policy because they amount to a restraint of trade. It follows that, for these covenants to be enforceable, they must go no further than is reasonably necessary to protect the relevant business’s legitimate interests.

Key drafting factors that will shape whether such a covenant is enforceable include:

  • Duration of the restrictive covenants:
    This must be proportionate to the employee in question, in the context of the business. Where an employee has access to a great deal of confidential information and/or influence over customers, suppliers or employees a longer period of restriction may be appropriate. This may be more likely with senior employees but could also be the case for key front line sales employees. As a broad rule of thumb, restrictive covenants that apply for more than 3-6 months after an employee’s termination will only be enforceable for staff who have the characteristics outlined above. At present restrictions of more than 12 months are generally considered unlikely to be enforceable against UK employees, no matter how senior or influential. In general the period of restriction should correspond to the length of time that the employee’s influence over customers, suppliers, and other employees would last, or the shelf life of the confidential information.
  • Description of the business:
    The broader the scope of the restricted activity, the less likely it is to be enforceable, unless it genuinely reflects the employee’s activities and capacity to damage the business’s interests. So it is important that the definition of “business” (which the employee is agreeing not to compete against) is clear and relevant, and only catches activities which are undertaken at the relevant time and by the employee you are seeking to restrict. For example, if the target’s business at the time of drafting is developing gaming software, a restrictive covenant that prevents an employee from developing any software might be considered disproportionate and therefore unenforceable.
  • Geographical coverage:
    Historically, it has been a key drafting principle that restrictive covenants should apply to activities within a defined geographical area. However, if a target business has a genuinely global market, this may not be appropriate. Any geographical area should be defined with respect to the coverage of the business at completion, although it may be possible to draft the definition widely to also encompass territories in which the business subsequently becomes active. A buyer should beware of defining geographical coverage unnecessarily widely, or the restrictive covenant may be unenforceable. However the key will be to draft the definition so that unnecessary territories can be deleted, for example rather than stating the US as a whole, list the relevant states (see next section for more information).

What happens if just one of many factors, (e.g. duration), is too onerous?

An English court will generally not rewrite a restrictive covenant (or contract generally) because that would involve imposing its own view of the appropriate commercial terms on the parties. An English court might be willing to strike out some aspects of the covenant if doing so would not affect the operation or effectiveness of other provisions (what is known as the “blue pencil” test), and if such striking out is anticipated or even intended by the parties.

In order to encourage a court to do this, a “severability” clause is often included, stating that any part of the restrictive covenant that is found to be void should fall away without impact on the remaining provisions. Alternatively, the severability clause might suggest that the offending aspects should be considered as automatically amended in whatever way would make them enforceable. While this is clearly less drastic than striking out, it also requires significant court intervention which might not be forthcoming (see comment above).

As a result it is best to focus on drafting your non-compete in a way that is enforceable from day 1.

Do the same factors apply to non-compete covenants in sale and purchase agreements and shareholders’ agreements?

Yes, the same factors will apply, but the courts have typically tolerated a greater level of restriction. This is because, unlike agreements between an employee and employer, SPAs and shareholders’ agreements are typically bespoke and negotiated commercial agreements between parties of more equal bargaining power, and are just one part of a larger bargain for which the individual is being paid, compensated or offered a valuable opportunity (such as share ownership). As a result the scope and period of the covenants are often between six months and three years, however where this type of restriction starts from some undefined future date (i.e. the date on which an individual ceases to be a shareholder) they may still be considered to go beyond what is reasonably necessary to protect the Company’s legitimate business interests.

Other points to note

  • Asset purchases:
    If the purchase of a business is structured as an asset rather than a share purchase, there will usually be additional issues to consider, such as the effects of the TUPE regulations and whether the relevant definitions in the covenants are still appropriate given the business may have been “carved out” of a wider organisation. The ongoing enforceability of covenants in the context of a TUPE transfer involves complex legal issues, which generally require specialist advice.
  • Group Companies:
    Non-compete covenants should be drafted to apply in respect of the activities of all group companies of a target business which will continue to be relevant post acquisition, not just the company whose shares or assets are being acquired, to the extent appropriate in light of the relevant employee’s activities. This is particularly important for senior employees who may have roles across multiple group companies.
  • Casual workers and Consultants:
    The anti-competitive nature of non-compete covenants means they are unlikely to be appropriate for (and may be unenforceable against) casual workers or consultants who are engaged on a non-exclusive basis. They may also raise questions about the true employment status of a worker.
  • Alternatives to restrictive covenants:
    Given the difficulties of enforcing restrictive covenants, purchasers may wish to consider alternative ways of protecting the target business if a key employee leaves after the transaction. One option is to introduce so-called “garden leave” provisions into key employees’ contracts. These entitle the employer to keep an executive away from the office or on restricted duties during their notice period. They are usually easier to enforce than covenants, although they have the downside that the employee will continue to be entitled to be paid whilst on garden leave.

With special thanks to Sophie White, Partner at Abbiss Cadres LLP who provided expert employment law input for this article. Abbiss Cadres is a professional services firm providing employment, pensions, incentives and immigration law, tax advice, people consulting and communications services.

Is this brief too brief? Want to know more about restrictive covenants in employment agreements? (of course you do) Expert legal advice is on hand from MJ Hudson’s M&A team. Just contact any of the On Target team (details below) or your usual MJ Hudson M&A contact, and we’ll gladly help.

Next Month: Tech sector focus

 

 

DEAL OF THE MONTH

MJ Hudson’s M&A and Private Equity transactions team acted as English legal counsel to Cognovia Capital on its disposal of Interlock Medizintechnik GmbH to Water Street Healthcare Partners. MJ Hudson previously advised Cognovia Capital on the acquisition of Clinipak Limited, the UK arm of Interlock.

 

On Target is produced by MJ Hudson’s M&A and Private Equity transactions team. We provide expert legal advice to sponsors, managers and investee/target companies on domestic and cross-border M&A transactions. We work across the full spectrum of private market investments, from venture and growth investments to buyouts. Clients praise our entrepreneurial approach, commercial outlook and dedication to getting the deal over the line, regardless of the obstacles.