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Restrictive Covenants: Potential Impact on Private Equity Acquisitions of Statutory Limitations

Restrictive Covenants: Potential Impact on Private Equity Acquisitions of Statutory Limitations

A private equity sponsor and its counsel considering a portfolio acquisition1 need to assess the potential impact of statutory limitations on restrictive covenants in three regards.

First, almost every private equity acquisition requires that the owners of the target company enter into restrictive covenants for the benefit of the acquisition vehicle. For this reason statutory limitations on restrictive covenants should be analyzed both to ensure that an exception allowing for restrictive covenants entered into by sellers in connection with such an acquisition exists, which should be the case, and to ensure compliance with any conditions to the application of such an exception.

Second, any incumbent or new management team members or other key employees will typically be required to sign new or amended employment agreements. In this regard, statutory limitations should be analyzed to determine whether the restrictive covenants desired to be included in such employment agreements, or that are already included in existing employment agreements that will be left in place, are fully enforceable.

Third, the due diligence investigation of employment or independent contractor agreements containing restrictive covenants and stand-alone restrictive covenant agreements of the acquisition target should include an assessment of the potential effect of any applicable statutory limitations on the enforceability of such covenants.

THE STATUTORY LANDSCAPE

State legislatures in a growing number of states have adopted or are considering adopting to legislation with respect to restrictive covenants. Although almost all of the legislation either

1 Such an acquisition might be of a new portfolio company by one or more of the private equity funds managed by the sponsor or of a bolt-on or roll-up company by one of the sponsor’s existing portfolio companies. The focus of this article is on state statutory limitations that may impact an acquisition of either type in which all, or a significant portion, of the operations and employees are in the United States. However, the same investigation and analysis would be required with respect to potentially applicable statutory limitations imposed by foreign jurisdictions, whether at the country level or at the provincial or other political subdivision level. And, while the focus of this article is on statutory limitations on restrictive covenants, the effect of common law limitations also of course needs to be investigated and analyzed, either in states without limiting or enabling statutes or in states with such statutes as to issues regarding the interpretation or applicability of such statutes in or to specific circumstances.

2 For a discussion of one example of a state legislature that is considering adopting limiting legislation, see the discussion of the Massachusetts legislature’s efforts in “Restrictive Covenants: A New Level of Scrutiny”, available at http://www.martinllp.net/831762/assets/files/News/17797894.PDF.

prohibits or otherwise limits the enforcement of restrictive covenants imposing non-compete (and, in some cases, non-solicit) obligations on employees and certain other individuals, other legislation is much more in the nature of an enabling statute permitting the enforcement of restrictive covenants, provided certain conditions are met as to the covenants in question.3 Although, at least superficially, limiting statutes are viewed as pro-employee and enabling statutes are viewed as pro-employer, the underlying motivations for and the effects of such legislation may in at least one regard be quite similar: creating an environment intended to be pro-employment, either by being more attractive to employees wishing to reside or work in the state or by being more attractive to employers wishing to relocate to or stay in the state.4 Whether either type of legislation actually achieves the desired result is beyond the scope of this article, but does present a fascinating question of whether two types of legislation, which are essentially polar opposites, can achieve the same desired result. The effects of various other factors on the employment profile of any particular state, or of two states in comparison, likely makes the analysis of such a question quite complex, if not futile.

LIMITING STATUTES

Although a 50-state study of statutory limitations on covenants not to compete and certain other restrictive covenants is beyond the scope of this article,5 states with limiting statutes include California, Colorado and Utah, and states in which such legislation is being or recently has been considered include Massachusetts and Washington.6 While the starting point for the investigation and analysis of the enforceability of restrictive covenants in the context of a private equity acquisition should always start with the determination of whether any state limiting statutes are applicable, the analysis should never end with the language used in the statute itself, but should include the investigation and analysis of case law interpreting and applying the

3 One example of such a state enabling statute is that of the State of Georgia, a state whose common law was well known to be very harsh with respect to the enforceability of non-competition covenants. The efforts in Georgia to ameliorate the effects of that common law included not only the adoption of the statute in question, O.C.G.A. § 13- 8-50, et seq. (applicable to certain contracts entered into on or after May 11, 2011), but also the enacting of an amendment to the Constitution of the State of Georgia allowing the Georgia legislature to adopt the enabling legislation.

4 See, for example, the introductory language to the Georgia enabling statute, set forth in O.C.G.A. § 13-8-50:

The General Assembly finds that reasonable restrictive covenants contained in employment and commercial contracts serve the legitimate purpose of protecting legitimate business interests and creating an environment that is favorable to attracting commercial enterprises to Georgia and keeping existing businesses within the state. Further, the General Assembly desires to provide statutory guidance so that all parties to such agreements may be certain of the validity and enforceability of such provisions and may know their rights and duties according to such provisions.

5 For an excellent and comprehensive recent 50-state study, see “Fifty State Survey on Covenants Not to Compete” published by the Association of Corporate Counsel, compiled by the GreenbergTraurig law firm.
6 It is no coincidence that all of the states identified have strong venture capital and start-up company orientations. language of the statute in question. Questions that should be addressed in any analysis include the following:

• Does the statute apply only to persons residing or working in the state or to persons working for an employer based or located in the state. In the modern age of telecommuting/working remotely, the analysis of this question alone can prove a daunting task.
• Does the statute override a contractual choice-of-law provision purporting to apply a different jurisdiction’s law or a choice-of-forum provision requiring any dispute to be resolved other than in a court of the state.
• Does the statute extend to covenants not to solicit, or not to interfere with relationships with, customers or other persons or entities, such as other employees.
• Does the case law create any implied exceptions to the applicability of the statute.
• Does an unenforceable restrictive covenant affect the enforceability of the agreement in which it appears, beyond just the enforceability of the restrictive covenant itself.
• Does requiring an individual to sign an illegal restrictive covenant expose the employer to statutory or tort liability.
• Does the statute apply only to employees, or does it also apply, for example, to individuals who are independent contractors and who are providing services normally provided by employees.

Perhaps needless to say, the legislative landscape with respect to the enforceability of covenants not to compete and other restrictive covenants is a minefield of potential problems in the context of private equity acquisitions, and one that has an ever-changing terrain. For further information, please contact Chris Martin at cmartin@martinllp.net or at (203) 973-5221.

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