Protective Covenants – Safeguarding your Secret Sauce
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What is a protective covenant? In general, it is a legal provision in an agreement or legal instrument where one party promises to take or is restricted from taking certain actions or otherwise has certain obligations to protect an interest of another party. Also called restrictive or negative covenants, they can cover a broad range of legal relationships with entirely differing purposes and provisions, including lending relationships, real estate deeds and other recorded instruments, employment relationships, mergers and acquisitions, and other business transactions. This article, however, will focus on those protective covenants more commonly known as noncompetes and non-solicitation and related provisions in the context of business transactions and employment relationships.
Confidentiality and nondisclosure covenants find widespread use from stand-alone confidentiality agreements and nondisclosure agreements or NDAs to protective provisions in employment agreements, equity purchase agreements (e.g., stock or membership interest), asset purchase agreements, consulting agreements, developer agreements, license agreements, and vendor/supplier agreements. Their purpose is to protect confidential information, which if disclosed to a third party or used by the other party, could substantially harm your business, especially if valuable trade secrets are involved. Yet the basis of the confidentiality and nondisclosure covenants is typically the consideration for noncompetition and non-solicitation provisions and confidentiality provisions are almost always associated with noncompetition and non-solicitation provisions. An example of a fairly standard confidentiality provision is as follows:
Except as provided below, Receiving Party and its representatives will not reveal or otherwise disclose any of the Disclosing Party’s Confidential Information for any purpose to any third party or use any Confidential Information or proprietary information of Disclosing Party for any purpose other than the Purpose. Further, Receiving Party and its representatives will not trade on or otherwise use Disclosing Party’s Confidential Information for personal gain or in any way that is detrimental or adverse to the interests of Disclosing Party. If Receiving Party desires to disclose Confidential Information to a third party, Receiving Party may do so only with the prior written consent of Disclosing Party, except as otherwise provided below. Receiving Party will protect Confidential Information with the same degree of care as Receiving Party uses in protecting Receiving Party’s own confidential and proprietary information (but in no event a lesser degree of care than a reasonably prudent person).
If Receiving Party is requested pursuant to, or required by applicable law, regulation, or legal process to disclose any Confidential Information, Receiving Party will notify Disclosing Party so that Disclosing Party may seek a protective order or other appropriate remedy or, in Disclosing Party’s sole discretion, waive compliance with the terms of this Agreement. If no protective order or other remedy is obtained, or Disclosing Party waives compliance with the terms of this Agreement, Receiving Party will furnish only that portion of the Confidential Information which Receiving Party is advised by counsel is legally required and will exercise all reasonable efforts to obtain reliable assurance that confidential treatment will be accorded the Confidential Information.
Covenant not to Compete
A covenant not to compete is a contractual restriction or protection, depending on whose side you are on, in which one party agrees not to start or enter into a profession or business in competition against another party typically for a certain period of time and within a certain geographic area. A covenant not to compete, however, will be subject to the most legal scrutiny as compared to the other covenants discussed in this article in those states where noncompete covenants are enforceable. The primary reason is that most states and courts generally disfavor contracts and arrangements that restrict employee mobility or free enterprise. Even in Texas, which is known to be more of an employer-friendly and business-friendly state with respect to noncompete covenants, The Texas Free Enterprise and Antitrust Act of 1983 states that “Every contract, combination, or conspiracy in restraint of trade or commerce is unlawful.” The counter, however, is that businesses expends a lot resources in recruiting, training, and providing an employee valuable experience, which might only be used against the business if the employee left to work for a direct competitor if no reasonable noncompete was in place. The following is an example of a covenant not to compete in a physician employment context:
In consideration of Practice providing Confidential Information and specialized training to Physician in connection with this Agreement, Physician covenants and agrees that for a period of one year from and after ceasing to be employed by Practice, Physician will not directly or indirectly, on Physician’s own behalf or that of any other person or entity, provide professional medical services to or otherwise affiliate with any competitor of Practice as an owner, member, shareholder, partner, employee, independent contractor, consultant, provider of medical services, management, administrative, or similar services, or in any capacity other than as a consumer of medical care services within a 10-mile radius of any Practice’s office(s) or other facility(ies) where Physician provided medical services on behalf of Practice during the term of this Agreement.
Non-Solicitation of Customers
Non-solicitation of customers and non-interference covenants are essentially an extension of a covenant not to compete substantively having similar effects. Restricting a person from soliciting the customers of a company is another restriction on competition, although more directly tied to the company’s current business as opposed to a more general noncompete provision. Often the provision is tied to only current and future customers, but sometimes past customers or only those customers with which the restricted person worked or about which the restricted person obtained confidential or proprietary information. An example of a non-solicitation of patients provision in the context of the purchase of a dental practice is as follows:
For the consideration discussed in Section 7.01 and in partial consideration of the Purchase Price, each Selling Party covenants and agrees not to, on behalf of themselves or any person or entity, during the Protected Period and within the Protected Area (i) solicit to provide dental services to, either directly or indirectly, on behalf of a Seller Party or any other person or entity, any patients of the Practice; (ii) solicit any professional referral sources of the Practice for any business that could otherwise be referred to Purchaser; (iii) recommend to any patients of the Practice to patronize any other dental practitioner (including a Selling Party) in the same specialty as Purchaser, other than Purchaser; or (iv) solicit, encourage, facilitate, or induce any advertiser, supplier, broker, vendor, agent, sales representative, contractor, consultant, or licensee of Purchaser or its Affiliates to breach any agreement or contract with, or discontinue or curtail his, her, or its business relationships with, Purchaser or its Affiliates.
A non-interference covenant has similar characteristics of a noncompete as well as non-solicitation and non-disparagement provisions. Its purpose is really to broaden the protection of a noncompete provision as a subpart of the provision or a separate provision from the “covenant not to compete” itself. That being said, most of the covenants in this article really can be construed as noncompete covenants depending on their scope and the state law under which they are being assessed. As with a standard covenant not to compete, the purpose of a non-interference covenant is to protect the business that a purchaser is paying a substantial amount of money to buy from the seller. The following is an example of a non-interference covenant in the context of a stock sale between the purchaser and the selling shareholders:
In consideration of the purchase of the Stock by Purchaser, for a period of five years from and after the Closing Date, each of the Shareholders covenants and agrees that neither it nor any of its Affiliates will, on behalf of themselves or any other person or entity:
(i) persuade or attempt to persuade any potential customer or client to which the Company has made a presentation, or with which the Company has had discussions, not to hire the Company, or to hire another company; or
(ii) in any way interfere with the relationship between the Company and any person or entity which is a customer or client of the Company, or was its customer or client within two years prior to the Closing Date or other business relationship (including making any negative or disparaging statements or communications about the Company).
Non-Solicitation of Employees
Employee non-solicitation or no-hire covenants are often used by employers and businesses to prevent a party with which the employer or business has entered a relationship from taking advantage of the relationship and poaching its employees. These types of covenants will limit a departing or former employee’s ability to encourage other employees to leave a company for a competitor. Businesses such a service providers, consultants and others which gain access to and otherwise work with employees of another business may find the other’s employee as a valuable resource to recruit experienced employee and accordingly will insert non-solicitation provision in their agreements to prevent this at the outset of the relationship. Accordingly, you will often see them in employment agreements, consulting agreements, vender and service provider agreements, and occasionally in confidentiality agreements. The following is an example of an employee non-solicitation provision in the context of an employment agreement between the purchaser and the selling shareholders of a corporation:
In consideration of Company providing Confidential Information and Proprietary Information to Employee in connection with this Agreement, Employee covenants that during the Term and for a period of 12 months immediately following any expiration or termination of this Agreement, Employee will not, either directly or indirectly (a) solicit or take away, or attempt to solicit or take away, any of the employees or independent contractors of Company either for Employee’s own account or on behalf of any other any person or entity; (b) induce or attempt to induce any employee or independent contractor of Company to leave the employment or engagement with Company to work for Employee or any other any person or entity; or (c) otherwise employ or engage any such person within 12 months of their termination of employment or engagement by Company.
Enforceability and Enforcement
Enforceability of protective covenants is state specific. The law varies significantly from state to state and is governed by the common law, statutes, or a combination of both. While covenants not to compete and other protective covenants enjoy some relatively relaxed scrutiny in the context of mergers and acquisitions, they received the most scrutiny in the in the context of the employer-employee relationship. A covenant not to compete in an employment arrangement ranges from entirely unenforceable in California, to having specific statutory requirements for physicians in Texas, including the requirement of a buyout clause for the physician, to perhaps even more employer friendly states like Michigan. Non-solicitation of employees and no-hire provisions, on the other hand, are generally viewed as more reasonable and less burdensome than a noncompete since the departing employee is not restricted from pursuing his or her livelihood. The common theme, however, is that in all cases where a noncompete may be enforceable, it should impose reasonable restrictions in scope, time, and geographic location no broader than necessary to protect a legitimate business interest of the employer and have sufficient consideration. Business interests that may be sufficient for protection include trade secrets, confidential information, specialized training, goodwill, customer relationships, referral sources, and sometimes employee relationships.
Since the laws vary widely from state to state, understanding the law of your jurisdiction is critical in drafting an enforceable noncompete that will adequately protect your business. Although choice of venue and law provisions may help to ensure that a dispute is litigated more favorably an employer, some states, such as California or Louisiana, impose restrictions on these types of clauses and could void their affect. For example, the California legislature enacted California Labor Code § 925, effective January 1, 2017, which applies to all employees who “primarily reside and work in California,” and restricts choice of law and venue clauses in disputes arising in California. Nevertheless, in all cases where a noncompete may be enforceable, it should contain reasonable restrictions on the scope of activity that is to be restricted, the time period during which it will be restricted and the geographic area over which it will be restricted according to the state’s laws at issue.
Notwithstanding the enforceability of a protective covenant, the actual enforcement and issues related to possible enforcement of the covenant have a substantial affect. Like all litigation, enforcement of a protective covenant can be costly to prosecute and to defend. Of course, this effect will way more strongly against the party with fewer resource, which is almost always the employee in an employment relationship and sometimes more often the seller in mergers and acquisitions. This preventive effect can help overcome provisions that may push or even cross the line of enforceability since just the threat of a lawsuit against a party will fewer resources will have a chilling effect.
Protective covenants can be a valuable tool in protecting a business and its interests. And in many cases, it is advisable to use one or more forms of the covenants outlined above depending on the relationship or transaction at issue. If fact, it is arguably “mandatory” to have a covenant not to compete and perhaps non-solicitation provisions if you are the buyer of a business. However, careful consideration of many factors is required, including the state law which applies, the nature of the transaction or relationship, the interests to be protected, what harm you might face if certain actions were not restricted, the necessary scope of the covenant in terms of duration, geographic area, and breadth of activities to be restricted.
For more information on protective covenants, schedule a consult with us at email@example.com.