Nevada Supreme Court Clarifies Enforceability Of Restrictive Covenants When Employer Is Acquired
Written by: Edgar Carranza
Tough economic climates often bring with them opportunities for companies to acquire competitors that can benefit their organization. More often than not, the competitors have restrictive covenants with their employees that sought to protect the competitor and its proprietary interests. At the time the restrictive covenants were signed, the agreement was between the employee and his then employer, and in some cases occurred many years before the anticipated acquisition. After the competitor has been acquired, the employees normally decide whether to stay with the new company or leave for potentially greener pastures. These decisions can occur at the time of the acquisition or some time thereafter. In cases where the employee decides to leave, what does a departing employee owe the acquiring company? Can the acquiring company enforce the restrictive covenants against the employee? Does it matter whether the competitor was acquired by merger or an asset purchase transaction? The Nevada Supreme Court has clarified the issue and announced that the answer is dependent on the transaction involved in acquiring the company.
In HD Supply Facilities Maintenance, Ltd. v. Bymon , a successor corporation attempted to enforce a restrictive covenant that it acquired as part of a merger with a prior company against a former employee of the prior company and his current employer. The case was filed in the United States District Court in the District of Nevada and the former employee moved to dismiss the action on the grounds that the restrictive covenant was unenforceable because he did not consent to assignment the restrictive covenant to the successor corporation. The former employee relied on Traffic Control Services v. United Rentals a Nevada Supreme Court decision that held that “absent an agreement negotiated at arm’s length, which explicitly permits assignment and which is supported by separate consideration, employee noncompetition covenants are not assignable.” In that case, the company was acquired as part of an asset purchase transaction. The Nevada Supreme Court in Traffic Controls did not differentiate between the different types of vehicles under which a company could be acquired.
Because of the different facts involved in the acquisition, the federal court in HD Supply certified the question to the Nevada Supreme Court for guidance as to whether its decision in Traffic Control would be the same if the acquisition was part of a merger rather than an asset purchase. The Nevada Supreme Court disagreed with the former employee and found that in the context of a merger, the successor corporation can enforce restrictive covenants against former employees without the requirement of an arm’s length agreement to permit the assignment and separate consideration. It based its distinction on the legal differences between an asset purchase and merger.
The decision in Traffic Control was a narrow one based on the non-assignability rule grounded in the common law of contracts. In essence, the Nevada Supreme Court reasoned that restrictive covenants are personal in nature. That is they are personal to the employee since deciding whether to refrain from competition with an employer after termination is based on an individualized assessment of that particular employer’s character and personality. And because replacing a former employer with another party in the covenant could fundamentally change the nature of an employee’s obligation, noncompetition covenants could not be assigned without employee consent. By conditioning the assignability of the covenant on consent, the decision protects against unbargained for changes in the scope of the restraint, i.e. barring a covenanting employee from competing against his former employer. As a protection under contract law, the rule logically applies to the contractual setting of an asset purchase transaction because in an asset purchase transaction the transaction introduces into the equation an entirely different entity (the acquiring business).
However, in a merger context, the surviving entity includes the prior employer with whom the employee entered into the restrictive covenant. Thus the danger of an unbargained for change in the scope of restraint is not present. As the HD Supply Court noted, Nevada has recognized the legal distinctions between mergers and asset purchases in different contexts. Given these distinctions in other context, it is logical to continue the distinction in the setting of restrictive covenants.
The Traffic Control decision and subsequent HD Supply decision have significant ramifications in the arena of restrictive covenants and business acquisitions in Nevada. Care should be taken both prospectively when entering into restrictive covenants and retrospectively by an acquiring company in an asset purchase setting.
First, any company/employer should insure that when entering into restrictive covenants with its employees, it provides for the potential sale of the company down the road. The Traffic Control decision makes three requirements for the assignability of a restrictive covenant: 1) expressed consent by the employee; 2) an express assignability clause be negotiated; and 3) separate consideration for the assignment. Even if there is no intention to sell the company at the time of the covenants, it is best to comply with the requirements in case the economic climate changes.
Second, no harm will come if the above requirements are followed and the company with whom the covenants have been entered later opts to merge with another. As held in HD Supply, the surviving entity will be able to enforce the restrictive covenants against the employees as the employer with whom the covenants were entered into, in effect, is part of the new company.
Finally, an acquiring company should insure that when negotiating an asset purchase of a competitor, any restrictive covenants entered into with employees meet the requirements that will allow the selling company to assign the covenants. Without such efforts, it may negotiate for covenants that it will not be able to enforce.