By Benjamin (Jamie) Taub, Esq.

In the realm of mergers and acquisitions (M&A), buyers must carefully consider various aspects before finalizing a deal. One critical factor that can significantly impact the success of an acquisition is the post-closing assignability and enforceability of restrictive covenant agreements entered into by the acquired company with its employees prior to the sale. As a buyer, you are potentially investing millions of dollars to purchase a business and you want to take steps to ensure that the acquired company’s employees do not leave post-closing with the business relationships and other goodwill that were just acquired. Restrictive covenants, such as non-compete, non-solicitation, and non-disclosure agreements, serve to protect a company's legitimate business interests by limiting the actions of key employees. This article examines the purpose and enforceability of the pre-closing employee restrictive covenant agreements following an acquisition, provides insights into the legal framework governing their validity, and outlines steps a buyer can take to protect their investment.

Understanding Restrictive Covenants

Restrictive covenant agreements are contractual provisions that restrict certain activities of owners or employees during and after their involvement or employment with a company. These agreements typically seek to prevent competitive activities; solicitation of clients, vendors, or employees; and disclosure of confidential information. In the context of an acquisition, restrictive covenants safeguard the buyer’s interests by preventing acquired employees and former owners from engaging in activities that may harm the business post-acquisition.

As part of the transaction, a buyer will always negotiate these restrictive covenants with the former owners as part of the purchase agreement or separate restrictive covenant agreements. But what about the employees of the acquired company? Many times, a buyer will negotiate additional restrictive covenant agreements with the key employees to be signed at closing. This is most definitely a best practice. However, buyers will sometimes instead rely on the restrictive covenant agreements entered into between the acquired company and their employees pre-closing because they do not want to alert all of the relevant employees of the transaction prematurely. Unfortunately for the buyer, these agreements are not always enforceable depending on the specific structure of the purchase transaction, the relevant state law, and the terms of the restrictive covenant agreements themselves.

Legal Framework and Considerations

The legal framework governing the enforceability of restrictive covenants is complex and can change from one jurisdiction to another. 

The first question is how the sale transaction is being structured and whether the restrictive covenants are being assigned as part of the transaction. In the case of a stock sale where the acquired company is remaining the employer, no contracts are being assigned. The buyer is simply purchasing the ownership of an existing entity, so most of the acquired company’s contracts, including employee restrictive covenant agreements, will generally remain in place and be enforceable. 

However, sale transactions are often structured as asset sales, which buyers find attractive due to the beneficial tax treatment of a stepped-up basis in the acquired assets and the ability to exclude unknown and certain known liabilities from the purchase. In the case of an asset sale, the acquired company’s contracts, including these restrictive covenant agreements, would need to be assigned to the buyer. 

Some states do permit the assignment of these agreements. Indeed, although New Jersey courts have not considered this issue recently, a court previously found that employee restrictive covenants may be assigned to a buyer reasoning that “the purchaser and the employee expect, without new negotiations between them, that the purchaser will honor the employment contract and that the employees, who choose to remain, will honor the promises made to the former employer.” See J.H. Renarde, Inc. v. Sims, 312 N.J. Super. 195, 200-02 (N.J. Super. Ct. Ch. Div. 1998). However, many other states do not automatically allow the assignment of employee restrictive covenant agreements, unless certain conditions are met. For example, in Pennsylvania and other states, such agreements may not be assigned unless the agreements include provisions that they may be assigned in connection with the sale of the company’s assets. Therefore, it should be best practice to either make sure that the restrictive covenant agreements explicitly permit an assignment in the case of an asset sale or the buyer should negotiate new agreements with at least the key employees. 

The second question is whether the restrictive covenants themselves are enforceable as a matter of law. Again, this depends on each state’s applicable law. Generally, courts will balance various factors, including whether the restrictive covenants are reasonable, serve a legitimate business purpose, and violate public policy, and whether the employee has received adequate compensation.

Steps to Protect the Buyer's Investment

Buyers and their attorneys can take several steps to enhance the enforceability of pre-existing restrictive covenants prior to the closing of a purchase transaction, including the following

1. Diligence and Documentation: Conduct comprehensive due diligence to review existing restrictive covenant agreements and assess their enforceability under the relevant state law. Identify any potential gaps or weaknesses and ensure all agreements are properly documented and executed prior to the closing.

2. Negotiation and Updating: To the extent practical, negotiate with key employees to update and strengthen existing restrictive covenant agreements. This can help align their terms with the buyer's interests and address any shortcomings in enforceability. If the seller or any of the key employees are unwilling to renegotiate these terms, this could be a red flag for the buyer.

3. Tailoring to Jurisdiction: Familiarize yourself with the specific legal requirements and precedents governing restrictive covenants in the jurisdiction where the acquired company operates to increase the likelihood of enforcement.

Conclusion
In the world of mergers and acquisitions, protecting the value of an investment is paramount. The enforceability and assignability of pre-closing employee restrictive covenants plays a vital role in safeguarding this investment. It is therefore essential for buyers to consult with M&A advisors and legal counsel as part of the process.

For more information, contact Benjamin (Jamie) Taub at jgt@spsk.com or at (973) 967-3221.