How To Make Sure Restrictive Covenants Survive A Restructuring

By Paul Greco

Imagine a successful emerging-growth life sciences company. It develops some great new technologies, recruits talented sales reps, and cultivates relationships with healthcare providers who find those technologies to be useful advances for patient care. Careful to protect the goodwill it is developing with these providers, the life sciences company decides to use restrictive covenants — i.e., noncompetes, in the popular vernacular — to ensure the sales reps cannot compete for a period of time after changing jobs and potentially transfer the value of burgeoning customer relationships to some new employer.

Now imagine that the company attracts the attention of an industry veteran that wants to make this company part of its corporate family. When the two companies combine, lawyers will take care to structure the transaction so that the emerging-growth company’s restrictive covenants survive the deal. After all, there is a well-defined body of law in most states about the effects that corporate transactions can have on restrictive covenants, and everyone involved wants to be certain that the covenants’ protections are not lost by the acquisition.

Imagine that the veteran continues to grow over time until its corporate organization becomes inefficient. Perhaps to consolidate operations, reduce expenses, or minimize tax liability, the veteran decides to reorganize. In the reorganization, the veteran transfers all the sales employees of the former emerging growth company (and current corporate subsidiary) to a newly created subsidiary that is designed to house the veteran’s sales force. In the process, these employees now start working for a new company within the same corporate family.

After this reorganization, life for the sales reps probably does not change much; they will still be selling the same products, to the same customers, under the supervision of the same sales management. Even so, it would likely be a serious oversight if the veteran failed to consider what effect these internal corporate transactions might have had on the restrictive covenants for the employees who were affected by the reorganization.

THE IMPORTANCE OF AN ASSIGNMENT CLAUSE

Restrictive covenants are fragile instruments. Because they are restraints on trade, states that enforce them usually put limitations on the right to do so. One common limitation is that the rights created by the covenants are personal between the employee and the employer, meaning that when the employer changes, the rights guaranteed by the restrictive covenants do not move to the new employer without the employee's consent. Consent is most often obtained by having an assignment clause in the restrictive covenant agreement that allows for transferring the rights to another entity.

When an assignment clause is absent and two unrelated companies combine, the deals are typically structured so that an assignment is unnecessary. There are lots of ways to do so that are beyond this article’s scope. However, the point is simply that the combining entities plan the transaction so that it does not result in employees working for a “new employer” such that either an assignment would be necessary or the restricted periods in the covenants would begin when employment by the “old employer” ended.

An internal corporate reorganization requires the same care. This is true because corporate formalities matter. Though affiliated, the different companies that comprise a corporate family are still distinct legal entities. In the same way that their separate existences usually protect one affiliate from being responsible for the liabilities of another corporate family member, their separate existences also usually mean that one affiliate cannot claim the contractual rights of another family member, either. Thus, internal corporate reorganizations still require attention to make sure that restrictive covenant rights transfer in a manner that is consistent with state corporate and restrictive covenant law.

4 TIPS TO HELP YOUR RESTRICTIVE COVENANTS SURVIVE

Here are a few tips to increase the likelihood that restrictive covenants will survive after an internal corporate reorganization:

• Include an assignment clause in a restrictive covenant agreement that permits the employer to transfer the agreement to another entity without further consent. A simple solution, an assignment clause grants the original employer the right to assign the contract containing the restrictive covenants to another entity. Care should be taken in drafting the assignment language to ensure that it is not unduly limiting. For example, some assignment clauses provide that assignments are only permitted to the purchaser of substantially all the employer's assets, a scenario that may not apply in internal corporate transactions. However, if drafted properly, an assignment clause would permit a corporate family to move the agreements among affiliates as necessary for an internal reorganization.

• Consider making departure from a corporate family — as opposed to termination of employment with the current employing entity — as the triggering event for starting a restricted period. This may have the effect of suspending the onset of any restricted period even if there is a change in employers as part of the reorganization. Although, by itself, it would not change what entity possesses the right to enforce the agreement. For example, a restrictive covenant agreement might define the "Employer" as "Company A and its parents, subsidiaries, and affiliates, now or hereinafter existing." If so defined, then a covenant which provides that the employee may not compete "for one year following the termination of employment by the Employer" would not begin until after the employee leaves the organization. However, it is important to recognize that this change only affects when the restricted period begins. By itself, it neither changes what entity owns the contractual right to enforce the covenants, nor authorizes assignment of that right to another entity within the corporate family. Moreover, if the business of the original employing entity changes after the reorganization — such as becoming part of a different division of the organization that makes different products which are sold to different customers — then the original employer might lose the ability to enforce the covenants when the time comes because it lacks a protectable interest, another common requirement for enforcing restrictive covenants in most states.

• Make corporate affiliates intended beneficiaries of the restrictive covenants. This may give the new employing affiliate the right to enforce the restrictive covenants even if the agreements were not properly assigned. Note, however, that an intended beneficiary clause alone probably would not delay the start of a restricted period if the employing entity changed during a reorganization.

• Execute new covenants and provide new consideration when necessary. The option of starting over again with clean agreements supported by whatever additional consideration is required by local state law can be a sound plan for making sure that the covenants are consistent with the needs of the new organization. State laws can vary dramatically about what kind of new consideration is required, and depending upon the state, acceptable consideration can be anything from a promotion to mere continued employment. However, the benefit of new agreements is that they can be tailored to the legitimate interests of the corporate family as they exist after the reorganization, and the closer the nexus between the restraints chosen and the interests they protect, the easier enforcement becomes.

Restructuring the organization of a corporate family is just one way companies try to position themselves to meet the demands of the today's competitive life sciences market. Ensuring the survival of restrictive covenants is a critical part of the process. With the proper steps, these important protections can survive the restructuring to serve the needs of the new organization well into its future.

PAUL GRECO is an attorney in the Philadelphia office of Fisher Phillips, a national labor and employment law firm.