Ancillary to Sale of a Business or Employment Agreement

Restrictive Covenants Ancillary to the Sale of a Business or an Employment Agreement

In a sale of a company or substantially all its assets, it is common for company founders and key executives, sales people or other important employees to be retained after the acquisition to assist in the transition of the company. It is also common for these people to sign restrictive covenants, i.e., non-competition, non-solicitation and confidentiality agreements, all of which are routinely part and parcel to the acquiring company’s ability to protect its acquired assets and interests going forward. Our discussion regarding consideration for such contracts is here.

Whether such restrictive covenants are ancillary to the sale of a business or an employment contract matters, legally, to determine if a court will enforce them in the event of an alleged breach. The distinction is important, because if ancillary to the sale of a business, courts generally scrutinize these contracts far less and enforce them more frequently than if part of an employment contract.

The central question raised by the distinction between ancillary to a sale of a business or an employment contract is whether the party seeking to enforce the restrictive covenant has a legitimate business purpose or in related contexts, any protectable interest in confidential information that is ostensibly protected from disclosure. Our discussion of legitimate business purpose to support the enforceability of a restrictive covenant is here.

The factual scenario that can raise a blurred distinction between ancillary to the sale of a business or an employment agreement usually looks something like this:

A purchases B. Smith, B’s founder, becomes an employee of A as part of the acquisition terms. Upon becoming A’s employee, Smith signed a restrictive covenant and confidentiality agreement with A. Smith later resigns but continues working in the same industry. Smith files a declaratory judgment suit seeking a declaration that his restrictive covenants and confidentiality agreement were unenforceable. A counterclaims against Smith based upon his breach of the restrictive covenant and confidentiality agreement.

(An equally common procedural scenario would be A sues Smith as plaintiff to enjoin Smith from working and competing in the same industry and disclosing confidential information, and Smith counterclaims seeking a declaratory judgment of non-enforceability). Our discussion on injunctions and emergency relief in business disputes is here. Our discussion about enforcing restrictive covenants limited to the industry for which they are intended is here.

The court must analyze whether the restrictive covenants were ancillary to Smith’s employment relationship with A (as Smith will surely argue), or whether they were ancillary to A’s acquisition of B’s business (as A will surely argue). If ancillary to Smith’s employment relationship with A, then A must prove that any restrictions on Smith are reasonable in duration, geographical area and scope of prohibited activity, and that it has a protectable interest in either near-permanent customer relationships or confidential information.

If ancillary to A’s acquisition of B’s business, then A must establish only that the restrictions were reasonable in duration, geographical area and scope of prohibited activity. This is the difference between the leniency courts tend to show restrictions ancillary to a business sale versus an employment agreement.

An important threshold factor a court could consider to determine to whether a restriction is ancillary to a business sale or employment agreement is whether Smith’s restrictive covenant was a condition precedent to A’s purchase of B. In other words, did A’s purchase agreement with B incorporate Smith’s agreement, and did it identify Smith’s restrictive covenant as a prerequisite (condition precedent) to consummating the acquisition? Or, was A contractually obligated to complete its purchase of B regardless whether Smith would agree to become A’s employee and sign a restrictive covenant?

A court would also consider whether A can demonstrate a protectable interest, i.e., a legitimate business purpose, on the possibility that the covenants are ancillary to its employment relationship with Smith. No doubt A will claim a protectable interest in its confidential information. Here, as to confidentiality, the court’s threshold inquiry would be does Smith in fact possesses “confidential” information, and whether A made adequate efforts to protect what it claims is confidential information. For example, although A’s employees might have access to this alleged confidential information, on A’s acquisition of B was Smith the only person required to sign an agreement with restrictive covenants and confidentiality obligations?

Another related inquiry would be to scrutinize A’s employee handbook to see if it includes a confidentiality provision that would bind other employees and not just Smith, or whether the employee handbook contains any description of the information A alleges is confidential. Similarly, were A’s suppliers required to keep confidential the details of their business dealings with A?

The foregoing is by no means an inclusive analysis of how to distinguish between restrictive covenants ancillary to the sale of a business or an employment agreement, but these are the kinds of scenarios and inquiries that arise on a regular basis in this kinds of disputes.

The attorneys at DiTommaso Lubin have over thirty years of experience defending and prosecuting non-compete, trade secret and restrictive covenant lawsuits. We are committed to fighting for our clients’ rights in the courtroom and at the negotiating table. Conveniently located in Chicago and Elmhurst, Illinois, we have successfully litigated non-compete and trade secret and covenant not to compete cases for clients all over the Chicago area. To schedule a consultation with one of our skilled attorneys, you can contact us online or give us a call at 630-333-0333.