Recent Illinois Case Highlights Important Distinctions Between Restrictive Covenants in the Sale-of-Business and Employment Contexts
Executives and former owners of a business are often retained after a sale of the business to assist in the transition of the company. Making sure that the deal documents are appropriately drafted and that these individuals execute proper restrictive covenant contracts are important steps to protecting key business assets.
In a recent decision from the federal court in Chicago, the court in Harris v. Central Garden & Pet Co. (Chang, J.) analyzed whether certain restrictive covenants were ancillary to the sale of a business or, instead, ancillary to an employment relationship. This is an important distinction because covenants that are ancillary to the sale of a business are subject to lesser scrutiny and are more readily enforced than covenants associated with an employment relationship. The court held that the covenants in question were ancillary to an employment relationship and thus subject to a more stringent analysis. Under that analysis, the court determined the covenants to be unenforceable because the employer could not show any protectible interest in confi dential information.
The decision highlights some important points in drafting sale-of-business agreements in which entities may wish to retain top talent post-closing. The decision is also helpful in addressing steps all employers can and should take to safeguard their interests in what they deem to be confi dential information.
In 2004, Central Garden & Pet Company (Central) purchased the assets of New England Pottery (NEP). Geoffrey Harris—who in 1999 had sold the assets of his company to NEP but remained an employee of NEP—became an employee of Central immediately after Central closed on its acquisition of NEP. Upon becoming employed by Central, Harris signed a restrictive covenant agreement with Central. Harris later resigned from Central but continued to work in the same industry. Harris fi led a lawsuit against Central seeking a declaration that his restrictive covenants were unenforceable, and Central countersued based upon Harris’s breach of those covenants.
The court fi rst analyzed whether the restrictive covenants were ancillary to Harris’s employment relationship with Central (as Harris argued), or whether they were ancillary to Central’s acquisition of NEP’s business (as Central argued). If the former, Central would need to prove that the restrictions were reasonable in duration, geographical area and scope of prohibited activity and that it has a protectible interest in either near-permanent customer relationships or confi dential information. If the latter, Central would need to establish only that the restrictions were reasonable in duration, geographical area and scope of prohibited activity. The court found in favor of Harris on this point based on the fact that Harris’s restrictive covenant agreement was not a condition precedent to Central’s purchase of NEP. The asset purchase agreement did not incorporate Harris’s agreement, nor did it identify the agreement as a prerequisite to closing the deal. Thus, the court held, Central was obligated to complete the purchase of NEP regardless of whether Harris agreed to become employed by Central and sign the agreement.
The court then considered whether Central had met its burden of demonstrating a protectible interest, a showing Central was required to make since the covenants were ancillary to its employment relationship with Harris. Central claimed a protectible interest in its confi dential information— specifi cally, its pricing structure, cost information (including the cost of products purchased from suppliers), design specifi cations, and materials and suppliers. The court ruled in Harris’s favor on this point as well. In reaching this conclusion, the court held Central could not show that Harris possessed “confi dential” information because the company did not take suffi cient steps to protect that information. For example, although other Central employees had access to this alleged confi dential information, only Harris was required to sign an agreement with restrictive covenants. In addition, although Central’s employee handbook included a confi dentiality provision, it contained no description of what information Central considered confi dential. Moreover, Central’s suppliers were not required to keep confi dential the details of their business dealings with Central.
Judge Chang’s opinion is instructive in two key areas of restrictive covenant law:
- With respect to sale-of-business restrictive covenants, purchasers who wish to retain top talent should ensure that the acquisition documentation cites as a condition precedent to the closing of the deal that certain employees will be required to sign restrictive covenant agreements (which may be attached to the deal documents) and that the deal may be terminated if the employees do not sign. Signing key employees to restrictive covenant agreements thus becomes a pre-closing condition, and later enforcement of those agreements, if necessary, should be easier for the reasons mentioned above.
- With respect to employee restrictive covenants, employers who wish to claim a protectible interest in confi dential information must do more than simply have employees sign agreements with nondisclosure provisions. That is only one step in establishing the “confi dentiality” of important business information. Much more must be done, including ensuring that all employees with access to confi dential information are signed at least to nondisclosure agreements; restricting access to confi dential information; marking documents and electronically stored information as confi dential; including nondisclosure clauses in supplier and vendor agreements; ensuring the return of confi dential information from departing employees; enforcing restrictive covenant obligations when the need arises; and many other things that may be unique to a particular employer’s business.