A Snapshot Of The Evolving Restrictive Covenant Landscape

This article was originally published in Law360 on April 8, 2024, and is republished here with permission.

In recent months, noncompete agreements have become a hotly contested topic in the realm of employment law. It seems that new precedent emerges on this topic week after week, leaving employers and deal-makers alike concerned about the effectiveness and enforceability of these all-important restrictive covenants.

By way of background, noncompetition and nonsolicitation covenants are commonly used by employers in employment agreements and by deal-makers in conjunction with mergers and acquisitions. The covenants are practices that have long been a cornerstone of business that aim to safeguard a company’s proprietary information and business advantage.

Given the importance of these covenants and their use in varied contexts, it is imperative that they be drafted in compliance with the law as it stands today. Otherwise, employers and deal-makers are left with an agreement that is all bark and no bite.

This article will highlight recent trends in the regulation and enforcement of noncompetition and related nonsolicitation covenants, and will provide guidance on drafting such provisions within the context of stand-alone employment agreements and merger or acquisition transactions.

Where do we currently stand with noncompete regulation and enforcement?

FTC

Last year, the Federal Trade Commission made its intention known and proposed a rule that would effectively ban noncompetes, making it an unfair method of competition for an employer to enter into a noncompete — and an overly broad nonsolicit that may be deemed a noncompete — with a worker.

The rule applies to independent contractors and anyone who works for an employer. It is likely not applicable in most sale contexts, as the rule provides a limited sale-of-a-business exception. The rule does not apply to sale-of-a-business noncompetes when they are executed with a substantial owner, partner or member — i.e., someone with at least a 25% ownership interest in the business.

The exception does not carve out sale-related noncompetes with individuals owning less than 25%, and therefore such noncompetes would be void under the proposed rule. The comment period for the FTC’s proposed rule ended in April 2023, and we anticipate the FTC will issue its final rule sometime this spring.

State Law

Several states have enacted significant limitations on noncompete agreements, while others have banned them outright. Some considerations are discussed below.

Limitations on Low-Wage Workers and Exemptions for Certain Workers

Some states, like Georgia and Oregon, only allow noncompetes with employees who meet a certain compensation threshold, or otherwise meet certain supervisory or exempt-like duties and responsibilities. In addition to the limitations on noncompetes, Illinois also prohibits nonsolicits with employees who do not meet a certain compensation threshold.

Advance Notice Requirements

Colorado law requires that employees receive advance notice of the restrictive covenants prior to starting employment. Other states, like Massachusetts, have similar requirements.

Limitations on Duration and Geographic Scope

Several states have specific constraints regarding scope as it relates to employee restrictive covenants.

For example, Delaware requires that the restrictive covenant be reasonable in geographic and temporal scope. Specifically, courts analyze whether the provision is essential to the protection of the employer’s interests.

Other states like Louisiana have more specific requirements, where an employer must list the specific parishes where such activity will be prohibited.

These limitations even vary for states that have sale-of-a-business exceptions. For example, North Dakota bans employee noncompetes and provides a sale-of-a-business exception. However, the territory and time period for the sale-related restrictive covenant must be reasonable.

Some states, like Georgia, also require a defined geographic scope for nonsolicitation covenants.

Penalties

There are several states, such as California, Colorado and Illinois, that impose penalties for improperly requiring employees to sign noncompete agreements.

Noncompete Ban

States like California and North Dakota ban such agreements in the employment context but provide sale-of-a-business exceptions.

A recently vetoed Maine bill, L.D. 1496, would have been the latest state legislation to ban employee noncompetes with limited exceptions. The bill passed the state’s House and Senate before being vetoed by the governor, who cited previously enacted limitations on noncompete agreements and a lack of evidence that they are being abused in Maine.

What should be considered when drafting restrictive covenants in the context of mergers and acquisitions?

1. Consider governing law.

As a general rule, and subject to exceptions, restrictive covenants should be drafted to comply with the laws of the state in which the restricted party resides or works.

Deal-makers often include sale-related restrictive covenants in the purchase and sale agreement itself, and oftentimes the governing law for that agreement is chosen based on how business-savvy the courts within a certain jurisdiction are — e.g., Delaware.

Many times, where the restricted party resides or works does not align with the governing law chosen for the purchase and sale agreement. As such, parties should consider kicking the sale-related restrictive covenants to a separate agreement, governed by the law of the states in which the restricted party resides or works.

Especially in light of recent Delaware court opinions where it became apparent that sale-related restrictive covenants will not automatically be governed by the drafters’ choice, the governing law is crucial to enforceability.

2. Narrowly tailor the scope.

The restricted territory in a sale-related noncompete should generally be limited to the jurisdictions in which the target company does business. Many deal-makers attempt to tie the geographic scope of restrictive covenants to jurisdictions that the buyer is in.

The jurisdiction of the buyer is appropriate for a stand-alone, employment-based restrictive covenant agreement — and may need to be even more narrowly tailored depending on the state law — but is not the best practice for sale-related restrictive covenants.

Much like the considerations for restricted territory, restricted business should generally be tailored to the seller’s operations at the time of closing. Any forward-looking plans for the business should be captured in a stand-alone employment-based restrictive covenant agreement.

Typically, the restricted period tied to sale-related restrictive covenants ranges from three to five years, with five years being very common. For employment-related restrictive covenant agreements, the restricted period is completely dependent on the applicable state law.

Conclusion

Given the pace at which the legal landscape in this area changes, employers and those involved in mergers and acquisitions must remain mindful of updates.

This will ensure all agreements, whether related to the sale of a business or specific to employment, are compliant with federal and state standards.