Januar 24. 2023

Non-Compete Covenants in M&A: Current Use, US State Rules, and an FTC Proposal

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Many purchase and sale transactions contain non-compete and other related restrictive covenants. This Legal Update notes some of these covenants, compares US states’ views on the enforceability of non-compete covenants, and discusses the Federal Trade Commission’s (“FTC”) recently proposed rule that would significantly restrict the instances where a non-compete covenant can be applied to a business’s seller/owner who is continuing as an employee of the target, the buyer, or any of the buyer’s affiliates.

Restrictive Covenants in M&A. These covenants range in type and scope and can include some or all of the following restrictions:

  • From and for a period of time after the closing of the transaction, the seller (or the shareholders/owners) and their affiliates (oftentimes referred to as “restricted parties”) cannot “compete” with the target company’s business.
    • The definition of the target’s business is a critical component to the scope of the covenant.
    • The restriction is usually styled as prohibiting direct or indirect competition and prevents a restricted party from controlling, managing, participating in (whether as an officer, director, employee, partner, manager, member, agent, representative or otherwise), consulting with, or rendering services to or otherwise having any financial interest in any person or entity engaging in a competing business.
    • The prohibited activities are bound geographically. For example, if the target conducted business in the United States, and across all 50 states, then the restricted parties would be prohibited from competing anywhere in the United States.
  • From and for a period of time after the closing, the restricted parties cannot solicit the target company’s employees.
  • From and for a period of time after the closing, the restricted parties cannot solicit or otherwise attempt to negatively influence the relationship of the target with any customer, supplier, or other business contact.
  • From and after the closing, the restricted parties cannot disclose any confidential information of the target company.

State-by-State Regulation of Non-Compete Covenants in M&A. It is not only ChatGPT that will tell you that each State has its own views on the enforceability of non-competes. In the table below, we have summarized certain State laws as in effect today.

State General Enforceability1 Enforceability in M&A
California Prohibited subject to a few exceptions. In connection with a sale of a business, or an interest in it, the parties can agree that the seller(s)/owner(s) will not compete with the business in a certain geographic territory. The purpose is to protect the goodwill or ownership interest acquired by the buyer.
Delaware Enforceable to a certain extent. Non-compete covenants must be reasonable in respect of time, geographic area and the advancement of legitimate business interests. These covenants must be designed to protect the buyer’s economic interests and cannot be overly broad.
Illinois Statutory limitations on enforceability. Non-compete covenants or agreements entered into in connection with the sale of the goodwill of a business or an ownership interest in a business are permitted. As in Delaware, the restrictive covenants must be limited as necessary to protect, and be supported by, a legitimate business interest.
New York Enforceable to a certain extent. In connection with a sale of a business, the non-compete covenants must not be more extensive, in terms of scope, time and geographic area, than is reasonably necessary to protect the buyer’s legitimate business interest. The covenants cannot be impermissibly vague or overboard.
Texas Enforceable to a certain extent. The covenants must be ancillary to or part of an enforceable purchase and sale agreement, and the limitations as to time, geographic area, and scope of activity must be reasonable. The covenants cannot impose a greater restraint than is necessary to protect the goodwill or other business interest of the buyer.

 

FTC’s Proposed Non-Compete Clause Rule. On January 5, 2023, the FTC proposed a non-compete clause rule (“Proposed Rule”) to, among other things, ban non-compete clauses between employers and their workers (i.e., employees, independent contractors, and unpaid workers) in many instances. The Proposed Rule would make it illegal for an employer to (i) enter into or attempt to enter into a non-compete with a worker, (ii) maintain an already-existing non-compete with a worker, or (iii) represent to a worker that the worker is subject to a non-compete.

The Proposed Rule notes several distinctions between non-competes entered into in the employer-worker context and those in connection with the purchase and sale of a business, including (i) the relatively equal bargaining power of the parties to a business sale relative to that of an employer-worker relationship; (ii) the need to protect the buyer’s right to the assets, including goodwill, that it is purchasing; and (iii) the proceeds from the sale helping prevent the seller of the business from experiencing any undue hardship. Nonetheless, the Proposed Rule significantly restricts the instances where a non-compete covenant can be applied to a seller/owner who is continuing as an employee of the target, the buyer, or any of the buyer’s affiliates. Going further than even California’s restrictions, no seller/owner who is continuing as an employee of the target, the buyer, or any of the buyer’s affiliates can be bound unless that seller/owner owns 25 percent or more of the target company. This provision is not spelled out in great detail, but the text of the Proposed Rule suggests that any person who is no longer an employee of the target, or who is selling their shares and does not plan on staying on with the new buyer, would be permitted to be bound regardless of their level of ownership. The FTC is seeking comments on the Proposed Rule and, in particular, this 25 percent threshold.

Any non-compete clauses effected pursuant to this 25 percent ownership exception to the Proposed Rule (as it may ultimately land upon enactment) would remain subject to federal antitrust laws and any other applicable laws, including the state laws referenced above.

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Please also see the Mayer Brown Legal Update “US FTC Announces Major Rulemaking to Bar Non-Compete Clauses Across Economy."

 


 

1 States regulate non-compete covenants both in the context of the employer-worker relationship and M&A. This column speaks to both instances.

 

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