Quirky Question No: 197:

We recently acquired a small company. We felt it would be a good fit for our considerably larger enterprise in part because we picked up a geographic sales territory in the Midwest that we previously were not covering very effectively.

We did not spend a ton of time scrutinizing the key employees’ contracts as part of our due diligence process but we generally familiarized ourselves with their agreements. We were pleased to see that the employees we considered most important to the future success of the business we acquired had restrictive covenants that would tie them up for three years if they resigned their employment.

After we acquired the company, we imposed our standard comp plan on all of the acquired company’s employees. For some folks, this resulted in a salary increase; for others, not so much. We also changed the benefit plans around a bit, admittedly not in ways the employees are excited about.

We are less than six weeks into our ownership of this company and four of the key employees quit to join a significant competitor. When we contacted them to advise that they were in breach of their employment agreements, their lawyer responded immediately by stating that the agreements had long since expired, and that there was no assignment provision in the contracts. This can’t be correct, can it?

Roy’s Analysis of Quirky Question # 197:

Although not the news I suspect you would like to hear, the answer to your inquiry is “Yes, that could be correct.” Before I address the reasons why, let me reiterate a few of the basics.

First, I’ll start with one of my standard mantras – in the employment law arena, it makes a huge difference where the dispute arises. In addition to the complex federal scheme of employment statutes, there is an overlay of 50 states’ statutes and common law. As I’ve pointed out in other Blog posts, the location where the dispute arises can be outcome determinative.

Second, the general point above is painfully true in the area of post-employment restrictive covenants. While you need not be concerned about a federal statutory scheme regulating this area (there isn’t one), state laws vary widely, both procedurally and substantively. Thus, as I’ve pointed out before, in states like California and North Dakota, the courts repudiate restrictive covenants except in the narrowest of circumstances. Other states (about 19) regulate this area by statute. The remaining states have varying attitudes towards post-employment restrictive covenants, ranging from healthy skepticism to full acceptance. Although you have not identified your location, I will assume that you are not located in a state where restrictive covenants are repudiated. If you are, my affirmative responseabove to your question needs several exclamation points – you will have a problem enforcing the agreements.

Third, even in states where courts are willing to enforce restrictive covenants, many judges are skeptical about their legitimacy. As many courts have pointed out, restrictive covenants inhibit employee mobility, restrain trade, and limit competition. As a result, when courts are assessing whether to enforce such covenants, they link enforceability to a legitimate corporate interest. Absent a company’s ability to articulate a legitimate corporate interest, the likelihood of enforcement diminishes. Of course, there may be any number of laudatory and legitimate interests that these kinds of restrictions are designed to prevent. It is difficult, based on the facts you shared, to provide you much guidance on these points. Just keep in mind that your company will need to advance a legitimate interest for these limitations.

Fourth, assuming that you are in a state that will enforce these covenants and that your company can articulate a legitimate corporate interest, the restrictions then are scrutinized on the basis of “reasonableness.” Typically, the reasonableness inquiry consists of three related components – substance, geography, and time. So, for example, if your restriction read, “Employee agrees that he/she may not work in any capacity for the next century anywhere in the galaxy,” the prospects for enforceability will diminish. But, in contrast, if the substantive restriction is carefully crafted, if the time period is limited thoughtfully (moving beyond two years is potentially problematic in many jurisdiction), and if the geographic restriction is closely linked to the areas where your company does business, the prospects for enforcement significantly improve.

Fifth, post-employment restrictive covenants are contracts. Unsurprisingly, then, the contract language is critical.

With those preliminaries in mind, let me provide a few reactions to your fact pattern.  There are a couple of pieces set forth in your factual description that make me somewhat uneasy, when judged from the perspective of enforcing your agreements. As you note, the restrictions imposed by the company you acquired last for three years. In my experience, that temporal limitation is pushing the boundaries of what courts are likely to find acceptable. Of course, this depends on the nature of the business and other variables not discernable from your factual description. For example, did the employees possess some unique skill sets, largely learned during employment with your firm? Are they attempting to take those unique skills to a competitor who is trying to short-circuit the time needed to train employees to perform in a near-identical function? When they depart, are they likely to be using confidential or proprietary or trade secret information to get your competitor up to competitive speed? To the extent that any of these questions are answered affirmatively, you may have a more compelling argument for enforcement. You also may be able to pursue other claims, such as claims for breach of fiduciary duty and/or misappropriation of trade secrets.

Another variable that bears upon the likely enforceability of a temporal restriction that judges may perceive as too long (and consequently unfair to the employee) is whether your jurisdiction permits “equitable modification.” The simple concept here is that somewhere in the employment agreement containing the restrictive covenants, the parties have expressed the sentiment that they want the court to modify the agreement if the terms do not appear reasonable on their face. So, for example, one way to equitably modify a too-lengthy time period would be to shorten it, dropping three years to two years or even one year.

Regardless of whether the parties have expressed the desire for this type of equitable revision in the contract, however, some jurisdictions don’t permit the courts to re-write the parties’ agreement. The basic notion here is that it is up to the parties (employer and employees alike) to get this issue right when the contract is drafted. If the contract is unenforceable as written, it is not the responsibility of the judge to re-write it to comport with his/her perception of what the parties originally wanted. Again, this variable highlights the importance of understanding thoroughly the nuances of your jurisdiction with regard to restrictive covenants.

Another factor that is potentially troubling stems from the relative sizes of the company you acquired and your firm. As you point out, your firm acquired a “small company.” I’m not precisely sure what small means to you (those characterizations are somewhat subjective), but I’ll assume the business your firm acquired was operating in a confined geographic area with a limited number of employees. Similarly, you point that your company is a “large enterprise.” (Same comments regarding the ambiguity of that term.)

I focus on those points because they potentially bear upon both the substantive and geographic restrictions of the contract. For example, assume the contracts of the company you acquired, stated: “Employee agrees not to engage in any competitive activities with the Company in any of the locations where the Company currently is doing business or has concrete plans to do business.” Let’s assume further that the “small company” your firm acquired did business in one state and one state only. But, let’s also assume (reasonable based on the facts you related) that your firm does business nationwide. As you can see, whereas an employee might have been willing to agree not to work in a single state for a specified duration, the equation changes when the restriction applies nationwide. Further, whereas an employee may have been willing to agree not to compete for a period of time in the narrow substantive area on which his/her employer focused, the analysis might be quite different if the new enterprise has a diverse product line and numerous additional substantive areas to which the restriction would apply.

Lastly, as you note, your company has adjusted both the compensation and the benefits for which the employees of the acquired company are eligible. As you observed, not all of the affected employees benefited from these changes. In short, your company has changed some key aspects of the employment bargain. I have written on this topic previously and will not repeat my earlier observations here. (Use the Category Index above to locate the earlier articles.) The bottom line is that the more the employment bargain has changed, the less likely the courts are to enforce the restrictive covenant.

Another key issue I referenced in the preliminary observations above is that these matters involve questions of contract interpretation. As such, the language of the contract is essential to the outcome. Let me illustrate with a recent decision. In the case of Acordia of Ohio LLC v. Fishel, et al., Slip Opinion No. 2012-Ohio-2297 (May 24, 2012), the Ohio Supreme Court addressed a fact pattern that may provide some insights into your situation. In Acordia, the court considered whether the ability to enforce a non-compete transfers by operation of law to a surviving company, when the company that was the original party to the agreement later merges with another company. The Ohio high court found that the surviving company could not enforce the agreement post-merger.

The agreement involved in the Acordia case stated, “For a period of two years following termination of employment with the company for any reason, I will not . . . perform any services relating to insurance business . . . .” The trial court noted the fact that the agreement did not contain language referencing successors and assigns: “It is significant that this agreement of non-competition does not contain language that extends to other employers, such as the company’s ‘successors and assigns.’”

Even more important, the “company” that was party to that agreement (Frederick Rauh & Company) underwent several transformations since the original contract was entered. It was acquired by Acordia in 1994. Wells Fargo then acquired Acordia in 2001. Following that acquisition, Acordia, Inc. then merged with Acordia of Ohio, LLC (the surviving entity).

Acordia of Ohio, LLC brought a lawsuit for both injunctive relief and monetary damages when several employees who had signed the original agreement containing the 2-year restrictive covenant moved to competitor. Nineteen customers (representing $1 Million in revenue) soon followed. Nevertheless, the trial court denied the company’s motion for a preliminary injunction and granted the employees’ motion for summary judgment. The court found that the parties to the contract had not intended to make the non-compete agreement assignable to a successor.

The intermediate appellate court affirmed. While it noted that non-compete agreements transfer from a predecessor company to a successor company “by matter of law after a merger,” in this case the previous iterations of the company had been “merged out of existence more than two years before the employees left the LLC.” Because the agreements had long since expired, the later successor company had no right to enforce them.

The Ohio Supreme Court affirmed. Like the two lower courts, the Ohio Supreme Court found the absence of a standard “successors and assigns” provision to be significant. The court noted that to enforce the agreements as though the last iteration of the corporation could step into the shoes of the initial company “would require a rewriting of the agreements. By their terms, the non-compete agreements are between only the employees and the companies that hired them.”

Consequently, although Ohio’s high court found that the non-competes had transferred as a matter of law between the predecessor and successor companies as a result of the merger, the agreements were only “enforceable according to their terms.” Because the agreements had expired two years after the earlier acquisition (at which point the employees had ceased working for the “Company” as that term was defined in the agreement), the contract terms were no longer enforceable. As to the specific employees in question, some of the agreements had expired in 1999 and 2001. Because of that fact, the employees were free to join a competitor many years later. Summary judgment for the employees was affirmed.

Practical Pointers

The Acordia case highlights several practical pointers that should be considered in situations of this kind.

First, if your company is involved in an acquisition, and your firm has determined that the success of the acquisition is dependent on the retention of certain key employees, spend a bit more time in the due diligence process on the non-compete issue. Ensure that you understand both the employees’ rights and your company’s rights with respect to the enforcement of post-employment restrictive covenants.

Second, as part of that due diligence inquiry, ascertain whether the original agreements contained language providing for the assignment of the employment contracts to a successor corporation. If not, this issue will have to be addressed, presumably before the merger is finalized.

Third, review the specific contract language very carefully. Determine whether the post-employment restrictive covenants were activated by any prior change in the corporate structure (i.e., a prior merger or acquisition) and, if so, whether the time period during which the restrictions would apply has expired.

Fourth, evaluate the restrictive covenants with respect to the reasonableness of the substantive, geographic, and temporal limitations. To the extent that the scope of these variables are affected by the merger or acquisition itself, consider whether the restrictions would continue to be viewed as “reasonable.” Although not referenced in Acordia, the Ohio Court of Appeals previously had observed, “Unless an employee explicitly agreed to an assignability provision, an employer may not treat him as some chattel to be conveyed, like a filing cabinet, to a successor firm.” Cary Corp. v. Linder, 2002 WL 31667316 at *3 (November 2002).

Fifth, assess whether the company anticipates material changes in the basic terms and conditions of employment, and whether such changes are permitted by the employment agreement. To the extent that there is doubt about whether these changes were contemplated by the original contract, move cautiously.

Finally, and perhaps most importantly, the problems that your firm is experiencing and that the company in Acordia experienced, could have been addressed by entering into new employment contracts, containing appropriate restrictive covenants, with the employees of the acquired company. By doing so, you could ensure that the restrictions were linked to a legitimate corporate interest, that sufficient consideration was provided to support the agreements, and that the contracts met the test of reasonableness. Moreover, with a bit of forethought, you also ensure that the new employment agreements contained a “successors and assigns” clause so that your company could confidently represent to any subsequent merger partner or acquiring entity that the restrictions would be enforceable.