Restrictive Covenants and Trade Secret Protection Covenants in Sale of Business Transactions July 10th, 2011Employment Georgia Restrictive Covenant Act RESTRICTIVE COVENANTS AND TRADE SECRET PROTECTION COVENANTS IN SALE OF BUSINESS TRANSACTIONS by Alex Woollcott I. Georgia’s New Restrictive Covenant Act • On May 11, 2011, Georgia Governor Perdue signed into law Georgia’s new Restrictive Covenant Act (the “New Act”). While restrictive covenants ancillary to employment relationships are clearly the primary focus of the New Act, there are provisions in the New Act directly relevant to restrictive covenants ancillary to the sale of a business. • Case law prior to the New Act liberally enforced restrictive covenants ancillary to the sale of a business. The New Act, interestingly enough, suggests a more restrictive standard of enforceability of sales of business restrictive covenants than the pre-existing case law at least in a couple of respects. • The New Act permits restrictive covenants that apply to the “Seller” of a business interest. “Sale” is defined in the New Act as “any sale or transfer of the good will or substantially all of the assets of a business or any sale or transfer of a controlling interest in a business, whether by sale, exchange, redemption, merger, or otherwise.” • A “Seller” of an interest in a business is “any person or entity” that is “[a]n owner of a controlling interest [in the business or] … [a]n executive employee of the business who receives, at a minimum, consideration in connection with [the] …sale.” [emphasis added.] • On the one hand, the New Act fails to sanction restrictive covenants being required of minority shareholders, business founders (who are no longer executive employees or controlling shareholders), or minority, non-executive shareholders who receive a highly substantial sum of money in the sale of the business. On the other hand, the New Act doesn’t go so far as to prohibit minority shareholders from being required to give restrictive covenants to the buyer of a business. It is unclear whether this is a drafting error in the statutory language. Moreover, it is unclear whether individuals or entities that are not within the statutory definition of “seller” are governed by the pre-existing case law (which, unlike pre-Act case law regarding covenants ancillary to an employment relationship, sanctioned broad enforcement of sale of business related restrictive covenants). The legislature could have expressly stated that covenants from minority, as opposed to controlling, shareholders would not be enforced, but it didn’t. Therefore, the better interpretation is that the pre-New Act common law governs the enforceability of covenants from individuals or entities that don’t fall within the New Act’s definition of “sellers.” II. Restrictive Covenants Ancillary To Sale of Business Transactions A. Factors to consider in determining whether restrictive covenants should be required from sellers in a particular acquisition. 1) Prevalence of competition within the particular industry 2) Prevalence of competition within the geographical area 3) Likelihood that selling shareholders and/or key employees would affiliate with or form a competing enterprise 4) Role of goodwill in the business 5) Role of covenants in the terms of the sale and the economics of the sale B. Who should give covenants? 1) Controlling equity holders in the seller 2) Executive employees of the seller 3) Closer cases: (a) minority shareholders (b) non-shareholders who receive substantial consideration in the sale (c) founders of the seller’s business C. Overview of three types of restrictive covenants 1) No-compete covenants A purchaser in a sale of business transaction often expects the selling equityholders (for convenience, I will refer to them as “selling shareholders”) to enter into agreements not to compete with the purchaser in the restricted line of business in the restricted territory for a period of time (often a number of years) after the closing of the sale transaction. In a transaction structured as a sale of assets, the selling entity, if it is continuing in business after the closing, will also often be required to give a no-compete covenant to the buyer. A purchaser will seek a no-compete covenant in order to ensure that the purchaser obtains the maximum value of and goodwill associated with the acquired business. 2) Customer non-solicitation covenants In sale of business transactions, the purchaser also often requires that the seller agree not to solicit customers and clients of the seller for a substantial period of time after the closing of the sale transaction. The rationale for such a covenant is the purchaser’s right to prevent the seller from eroding the customer and client goodwill and other value associated with the business. These covenants are often referred to as customer non-solicitation covenants. 3) Seller/personnel non-solicitation covenants Another type of restrictive covenant is known as an employee non-solicitation covenant or anti-piracy covenant. This kind of restrictive covenant prohibits the seller, for a period of time after the closing of the sale transaction, from attempting to lure away employees and other personnel of the acquired business to a competing business. Just as in the case of the other two types of restrictive covenants, employee non-solicitation covenants are designed to help ensure that the purchaser receives the full value of the acquired business, which in many cases is heavily dependent on the transition or continuation of certain key employees of the business. D. Enforceability of restrictive covenants ancillary to the sale of a business 1) Different standard of review from a pure “employment” context The New Act changes the landscape of Georgia restrictive covenant law, and, at a high level, should lessen the differences in enforcement of sale of business covenants and employment covenants that existed prior to the New Act. Under prior law, Georgia courts strongly disfavored enforcement of restrictive covenants because of their status under the Georgia Constitution as unreasonable restraints of trade. A morass of sometimes inconsistent case law over the years tried to address the competing needs of, on the one hand, employers that use restrictive covenants to protect their business interests and, on the other hand, individuals who have an interest and need to move around the marketplace and ply their trade. Georgia courts have always been much more inclined to enforce restrictive covenants that are “ancillary to the sale of a business” than those that are not associated with a sale transaction – such as covenants that are purely ancillary to an employment relationship. Sale of business covenants, even with the New Act, will still be more likely to be enforced than restrictive covenants ancillary to an employment relationship, since in an employment context the resulting restraint on trade (i.e. in essence, the net loss to the economy by a post-employment restriction) is often keener than in the sale of business context. As noted earlier, the New Act, perhaps unintentionally, creates a more restricted class of individuals and entities that can be required to give restrictive covenants to the buyer of a business in conjunction with the sale. In a sale of business context, the buyer of a business has paid the seller for the value and goodwill associated with the acquired business and, therefore, it would be unfair for the seller, at least for some period of time after the closing of the sale transaction, to engage in the restricted line of business or to solicit the seller’s former customers or employees. A second rationale for liberal enforcement of covenants ancillary to the sale of a business is that the sellers are often paid substantial amounts for their interest in the selling entity and for agreeing not to compete with the business that is being sold. A third rationale for more lenient scrutiny of sale of business covenants (though to me a less persuasive one) is that the disparities in bargaining power often present in an employer/employee context are typically not present in the sale of business context. This rationale makes some broad assumptions about bargaining power that are not necessarily true in all cases: namely, that employees do not have substantial bargaining power relative to their employers when negotiating employment agreements; and that selling shareholders of a business always have substantial bargaining power relative to the buyers of the business. The New Act could have clarified some of the flawed assumptions underlying the prior law but, in terms of sale of business covenants, which clearly were not the main event of the New Act, the legislature did not do so, and, ironically, may have introduced some confusion into the one area of covenant law (sale of business context covenants) that was relatively free from ambiguity. 2) Courts can “blue-pencil” covenants in sale context Before the New Act, Georgia courts could not “blue pencil” or partially enforce an otherwise unenforceable covenant in an employment context covenant. Courts, however, have always been able to blue pencil or partially enforce restrictive covenants that are ancillary to a sale of business. The New Act now allows blue penciling in employee-employer covenants although the New Act does not mandate that courts blue pencil. Thus, there is still the risk that a court could determine that under the circumstances a covenant is crafted in an unreasonable manner and that the court will not reform it through blue-penciling. This is particularly likely to be the case if blue-penciling (i.e. striking provisions) would not salvage the overbreadth of the covenant. What isn’t particularly clear in the New Act is what the permissible parameters are around blue-penciling. The New Act authorizes Georgia to modify the scope of covenants that the court determines are otherwise too broad to be enforceable, but one must pay heed to the definition of “modification” – “the limitation of a restrictive covenant to render it reasonable.” (emphasis added by author.) It is not clear whether a court can, in effect, rewrite all or part of a covenant to make it enforceable. I believe that the proper and safe interpretation is that the legislature did not intend to give Georgia courts the authority to re-write or re-craft an unenforceable covenant if this can’t be done through blue-penciling (i.e. striking out the language that renders the covenant unenforceable). E. Prevailing test for reasonableness The touchstone for enforceability of restrictive covenants in Georgia, whether they are ancillary to a sale of business or an employment context, is “reasonableness.” As noted above, the court’s scrutiny of the reasonableness of a sale of business covenant will be much less strict than the scrutiny of an employment based covenant. With respect to a no-compete covenant, courts focus on three parameters – the covenant’s restriction, duration and territorial limitation. The casualty rate in Georgia courts for sale of business restrictive covenants is relatively low. Purchasers have the opportunity to focus much more on negotiating a broad set of covenants than worrying about having a covenant ruled unenforceable, which can easily be avoided with a reasonable degree of diligence in drafting. 1) Scope The “scope” of a no-compete covenant refers to those actions that the seller cannot take during the term of the covenant. A well-drafted no-compete covenant does not simply prohibit the seller from “competing” with the purchaser; instead, it carefully defines what “competing” means. A seller is frequently prohibited from being employed by or affiliated with, consulting with, owning, controlling, managing, advising, funding or investing in a competing business. A well-crafted covenant also carefully defines just what a “competing business” is. Purchasers and sellers often heavily negotiate what it takes for a company to constitute a “competitor” of the purchaser. The New Act provides some guidance by characterizing a competitor as a business that has activities, products, or services that are “the same as or similar to” the other company. Interestingly, a “similarity” standard (at least, as opposed to a standard of “substantial similarity”) would have been too vague for enforcement under the old case law, at least in an employment covenant context. I do not recommend your taking a risk by using a “generic” definition of what a competing business is. 2) Duration The established law in Georgia is that restrictive covenants that are ancillary to a sale transaction can last a very long time. Post-closing covenant durations of five, seven and even ten years have not been uncommon over the years. However, the trend appears to be for somewhat shorter covenants, perhaps a recognition of how fast business changes in an era dominated by global commerce, technology and the Internet. The New Act picks up on this trend by providing that sale of business covenants that are five years or less in length (or such longer period during which the seller is being paid not to compete) are presumed to be enforceable. At the same time, covenants longer than five years (or beyond a longer payment period) are presumed under the New Act to be unreasonable. The New Act provides that a sale of business no-compete covenant will terminate automatically if the business that has been sold terminates or if the seller (and its successors in interest) or the buyer (and its successors in interest) cease to exist. 3) Territory This is the trickiest parameter of a no-compete covenant to draft and negotiate. In an employment agreement context, it is this facet of the covenant that a court is most likely to find to be unreasonable, even under the New Act, although this area is now much less treacherous. Broad geographical territories have rarely posed significant enforceability problems in the sale of business context. The New Act does not change that. It permits the territorial scope to encompass the entire geographic area or areas where the selling business conducts its operations at the time of the sale, including any area where the business’s customers and actively sought prospective customers are located, and including any geographical areas into which the business is reasonably expected to expand. The New Act even expressly states that a worldwide territory might be acceptable if necessary to protect the interests of the buyer or the goodwill of the business that is being sold. Purchasers should be mindful to craft their restrictive covenants on the parameters of the particular business that is being sold, not necessarily the entire business operations of the purchaser. Even in the sale of business context, a court might regard a covenant that restricts the seller from engaging in any line of business engaged in by the purchaser, or from soliciting any customers or personnel of the purchaser to be unenforceably broad. While blue-penciling or partial enforcement may save such a covenant, purchasers are better off tailoring their covenants to the business that is subject to the sale transaction. F. Enforceability of Non-Solicitation Covenants Georgia courts have almost never considered challenges to the enforceability of sale of business customer or employee non-solicitation covenants. The New Act expressly authorizes such covenants, and indicates that a buyer can prohibit the seller from soliciting or accepting business from the business’s customers – including customers at the time of sale or prior to the time of sale, including actively sought prospective customers. The New Act, therefore, permits a very broad class of non-solicitation covenants. Prior to the New Act, many good covenant lawyers would have cautioned the buyer from trying to restrain a seller from “accepting” business from a customer or prospective customer of the company that has been sold. The New Act even permits this in an employer-employee covenant. The New Act would seem to allow a buyer to restrain a seller from soliciting competing business from a company that hasn’t been a customer of the selling business for many years, as long as it constitutes a “prior” customer of the selling business. Buyers can probably safely prohibit sellers from “soliciting or hiring” (as opposed to just soliciting) employees of the business. The New Act permits this, with some qualification, even in the employer-employee context. G. Coordinating restrictive covenants in the definitive sale transaction agreement with those in employment agreements for transferring employees In many sale transactions, key employees of the seller are also major shareholders of the seller. Many of these key employees plan to join the purchaser as part of the sale transaction. Surprisingly, even in this type of situation, some purchasers fail to include restrictive covenants in the definitive acquisition agreement (or in a free-standing restrictive covenant agreement ancillary to the acquisition agreement). Instead, the only restrictive covenants are those found in employment agreements executed at or after the closing of the sale transaction. A purchaser should insist on two sets of covenants – one in the purchaser agreement or a free-standing agreement ancillary to it, and one in the employment agreement between the transitioning employee and the purchaser. If the covenants are only in the employment agreement, there is a good chance that they would be treated as ancillary to the employment relationship and not the sale transaction unless the following can be shown: (i) the employee was a critically important employee of the Seller, (ii) the employee directly shared in the purchase consideration, (iii) the employee was a party to the purchase agreement, (iv) the covenants state clearly that they are ancillary to the sale transaction and are given in consideration of the purchase price that is being paid by the purchaser, and (v) the employee was represented by counsel and had sufficient bargaining power to negotiate effectively the terms of the covenants. While the New Act is significantly less harsh on employment context restrictive covenants than was the case under prior law, the prudent course of conduct in a sale of business is to have dual sets of covenants for key employees that are continuing with the business after the sale. The restrictions in the sale transaction documents (either in the acquisition agreement itself or in free-standing covenant agreements) should key off the date of the closing of the sale rather than any dates or events associated with the employment relationship with purchaser. Otherwise, there is a good risk that the covenants will be possibly be sucked into the still (i.e. post New Act) stricter employment context standard of review. H. Additional drafting techniques and suggestions for purchaser As noted above, the risk of a restrictive covenant ancillary to a sale transaction being deemed unenforceable is relatively low given the courts’ ability to partially enforce or blue pencil covenants and given the broader parameters permissible in the sale of business context. Assuming the purchaser structures the seller’s restrictive covenants in a manner that maximizes the chance they will be deemed ancillary to the sale transaction, there are a number of drafting techniques in addition to those mentioned in the preceding portions of this Outline that the purchaser should follow: 1) Take advantage of Georgia courts’ ability to blue-pencil and partially enforce covenants sale of business context covenants Given that a court is more likely to partially enforce an overbroad covenant than a vague one, the purchaser should draft covenants so that a court could easily sever portions of the covenant that it considered to be overbroad or otherwise unenforceable. For example, consider a no-compete covenant that has a restricted territory comprising “the United States, Canada, Spain and Mexico.” If a court considered this territory unenforceably broad, it could easily “blue pencil” out those countries that render the territory unenforceable. An alternative drafting of the territory – for example, “every country where the Seller is doing business as of the closing date” – might require the court to take more aggressive steps to reform the covenant. Make it easy for the court to blue pencil! 2) Define “competing business” carefully When drafting no-compete covenants, purchasers should pay close attention how they define what a competing business is. Don’t let the latitude of the New Act encourage you from defining a competing business as one that has “similar” products or services (even though the New Act implies that “similarity” is a sufficient basis for identifying a competing company). Often a seller is required not to affiliate with or form a “competing business” during the restricted period. This should certainly include a company that is in the same line of business as the seller at the time of the sale. But it can possibly also include companies engaged in lines of business that the seller expects to enter into in the very near future as an expansion of the business that is being purchased. This is much broader latitude than the draftsperson would encounter in an employment based context. Purchasers and sellers often negotiate the degree to which a “competing company” has to engage in the competitive line of business in order to render it restricted. What if only one percent of a company’s revenues are derived from the competing line or business? The negotiation often centers on the dollar amount of revenue generated from the competing line of business. 3) Define prohibited activity carefully It is equally important for the purchaser to draft the prohibited activities carefully. An unduly narrow or ambiguously defined list of prohibited activities gives the seller license to evade the intended purpose of the covenant. For example, a covenant prohibiting a former executive from “being employed by or serving as a member of the board of directors of a company engaged in the same business as seller” would open the door for the executive to serve as an advisor to or consult with such a company, thereby circumventing the narrowly defined restriction. 4) Make liberal use of non-solicitation covenants Even in the era of the New Act, no-compete covenants will be somewhat more difficult to enforce than non-solicitation covenants, even in a sale of business context, so buyers should take advantage of the broad latitude that buyers have in enforcing non-solicitation covenants. Non-solicitation covenants should take use of opportunities not only to restrain the obligor from soliciting “customers” but also “prospective customers” assuming that some clarification is given as to when a prospective customer is a forbidden target for post-closing solicitation by the seller. And don’t forget that the New Act allows a buyer to restrict a seller from soliciting any “prior” customer. II. Trade Secret Protection and Non-Use and Non-Disclosure Covenants A. Defining Protected Information Confidentiality and trade secret protection covenants are often given only passing attention in sale of business transaction documents. This is unfortunate, because these types of covenants are almost universally enforced by Georgia courts and, as such, if drafted carefully they can provide a powerful supplement to more problematic restrictive covenants. The new Restrictive Covenant Act actually contains some helpful provisions relating to defining information that is confidential or not confidential. While that guidance is framed within the context of restrictive covenants, it should be useful for practitioners who are drafting and negotiating non-disclosure covenants in sale of business transactions. The most important step is to careful define what information is subject to the protections of the covenant. This will vary depending on a number of factors but it often should include most of the following categories, among others: 1) General business information 2) Business and marketing plans, strategies, processes and methods 3) Product/service specific information (e.g. test results, design details) 4) Financial information relating to seller 5) Intellectual property, trade secrets and know-how 6) Strategic relationships 7) Employment information 8 ) Deal-specific information 9) Customer and client information B. Four critical areas of risk in crafting effective covenants 1) Define “disclosure” broadly and ensure that it involves all modes of communicating information (e.g. electronic, digital, written, oral, etc.) whether intentional/purposeful or not. 2) Ensure that the covenant focuses on prohibited uses of the protected information and not just disclosure restrictions. A selling shareholder can do as much damage or more damage by using protected information after the closing than the shareholder would by simply disclosing it to an unauthorized third party. 3) Make certain that your covenants are compatible with applicable common law and statutory laws governing confidentiality of trade secrets and other information. The New Act appears to have eliminated the prior common law’s requirement – possibly unique to Georgia – that non-disclosure covenants not involving trade secrets (as defined in the Georgia Trade Secret Act) had to have a durational limitation. Under the New Act, the duration of a non-disclosure covenant can be for as long as the underlying information remains Thus, it no longer appears necessary for a well-crafted confidentiality covenant in Georgia to differentiate between the duration of prohibitions on disclosing/using trade secrets versus non-trade secret confidential information. Practitioners should never craft your non-disclosure covenants in a manner that “opts out of” broader protection given by common or statutory law. For example, you do not want to limit the duration of your restriction on the use or disclosure of trade secrets since in Georgia the trade secret statute permits an unlimited duration for such restrictions. 4) Non-disclosure covenants often contain a series of exceptions for information that is, in effect, not confidential (e.g. information that is independently developed by the obligor without use of the obligee’s protected information, information that has been released without restriction into the public domain, etc.). Take great care in crafting and in negotiating these exceptions. Many practitioners treat these exceptions as nothing more than boilerplate, but a close analysis of the exceptions makes it very clear that there is a high degree of variation in the scope and articulation of the exceptions. 5) Consider adding a representation and warranty in the confidentiality provisions in your definitive transaction agreements whereby the sellers certify that they have not, prior to the date of signing the transaction documents, disclosed or used any protected information in a manner that would have been prohibited by the covenants had they been in effect at the time of such use or disclosure. 6) Do not ignore the need for all employees and possibly even key contractors to have signed some form of confidentiality agreement in connection with the closing of the sale of business transaction. Often, buyer’s counsel simply require this of selling shareholders or key members of management. Obviously, in a stock deal, if employees are already party to ongoing confidentiality agreements, those employees probably do not need to sign new agreements unless the pre-existing form agreements are clearly deficient in scope.