COVENANTS NOT TO COMPETE
by E.J. Leverett Jr., Ph.D., CPCU, CLU,
Peter Shedd, J.D., and
James Trieschmann, Ph.D., CPCU, CLU
Abstract: When an agency is sold, frequently an agreement is signed that limits the rights of the seller to compete with the buyer of the agency. These covenants not to compete have serious tax and legal implications, which are not discussed in this article.
The sale of an agency is a complex transaction, and the allocation of the purchase price to the various segments of the sales contract increases the need for careful negotiation. Any sales contract should include a specific dollar figure allocated to goodwill, fixed assets, the book of business (expirations), and the covenant not to compete. How these allocations are made in the contract have considerable impact on the taxes owed by the buyer and the seller, and consequently on the agency's value. Each of these allocations could be the subject of a separate article; this article is concerned only with the allocation and enforceability of the covenant not to compete.
DEFINITION
A covenant not to compete (sometimes referred to as the 'noncompetition agreement') is, in essence, an agreement that restricts the seller's right to compete with the agency sold. The buyer negotiates for this covenant to get an adequate opportunity to win the loyalty of the agency's existing customers. The seller may agree to this restrictive agreement, albeit hesitantly, to facilitate the sale of the agency. These bargaining positions place the buyer and seller in adversarial roles, which can lead to a court action. Such litigation is typically the result of the buyer and seller taking opposite positions with respect to the enforcement or taxation of a covenant. A finding that a covenant not to compete is invalid can devastate the agency purchaser's ability to conduct business. In addition, such a finding can create adverse tax implications to the buyer and seller. This article highlights areas of covenants not to compete, about which the parties should be aware.
TAX IMPLICATIONS
Rules involving the tax treatment of covenants not to compete are simple as long as the parties understand the tax treatments of such covenants and goodwill. Goodwill is considered a capital asset, and the seller is permitted to treat the amount assigned to goodwill at favorable capital gains rates. Unfortunately, the buyer is denied any tax deduction because goodwill is thought to have an indeterminable useful life.
On the other hand, any consideration that the seller receives in return for agreeing not to compete must be treated as ordinary income. The buyer can capitalize the amount of the purchase price allocated to the non-competition covenant and is entitled to a tax deduction for the life of the covenant.
From this brief explanation of the differing tax treatments, the seller and buyer will have opposite interests when negotiating the sale. If the buyer is to prevail, a reasonable amount of the purchase price must be allocated to the covenant not to compete, and the covenant must be reasonable in all aspects. If an excessive amount is allocated or if the covenant is improperly drafted, that portion of the purchase price will be allocated to goodwill. The following segment of this article discusses some of the legal issues that help distinguish a covenant not to compete from goodwill.
LEGAL ISSUES BETWEEN COVENANTS AND GOODWILL
The goodwill of an agency generally represents the value of the agency as a going concern. The value depends on such factors as the ability of the seller to compete for the business (this requires good health and an age commensurate with competing) and whether the person continues with the agency at the same location. It also must take into account whether these people have the ability to service the account (separate files) and whether the agency is profitable enough to allow the payment of salaries.
If the restrictive covenant is effective, it serves to guarantee the buyer's enjoyment of goodwill. The problem presented by differentiating between a non-competition agreement and goodwill is compounded by the vagueness of the standards that the courts have adopted. Among these standards are severability, economic reality, intent, valuation, refutation, and ancillary issues.
Severability. The courts generally look favorably upon part of the sales price being allocated to a restrictive covenant only if they find that the covenant is severable from all other assets. The court must be convinced that the covenant was a separate item and actually bargained for between the buyer and the seller. If its purpose is to ensure the beneficial enjoyment of goodwill, the covenant is considered to be a nonseverable, nondepreciable asset.
This severability standard has come under criticism because of the fundamental assumption that the covenant cannot be severed from goodwill. Indeed, the severability test conflicts with legal authorities. Corbin in Contracts indicates that the definition of a legally enforceable restrictive covenant is a close association with goodwill. In addition, Mertens in Law of Federal Income Taxation indicates that the function of the restrictive covenant is to protect the assets transferred and thus they cannot be severable. The application of a severability test therefore seems inappropriate.
Economic Reality. The enforceability of the covenant depends on whether the covenant has been negotiated between the two parties and has a business reason for being in existence. In other words, courts have stated that there must be economic reality for the covenant's existence. Such covenants are enforceable only when the seller actually could compete with the buyer. For example, a terminally ill 85-year-old seller of an agency that has experienced a down-trend in its business for the past five years is not deemed to be in the position of actually competing with the buyer.
Intent. Courts generally interpret contractual obligations in a manner to accomplish the perceived intent of the parties. If an agreement as written is contrary to the parties' intentions, it will not be enforced. If the intent of the agency's purchaser is to restrict the seller from competing unfairly and if such a covenant is agreed to by the seller and is clearly written, the covenant will be enforced to reflect this. Although the parties may clearly express their intent, their agreement to include a covenant not to compete must satisfy the economic need for the covenant, as stated in the preceding paragraph.
Valuation. For any contract to be valid, there must be valid consideration. Consequently, a negotiated value of the covenant must be placed in the contract. There must be a valuable consideration; the amount allocated to the covenant must also be reasonable. Courts generally refuse to enforce a covenant in which the consideration allocated to the covenant grossly exceeds the value of the seller's agreeing not to compete. Consequently, the allocation of a large percentage of the purchase price to the covenant, even though the seller is willing to accept the allocation, could result in the courts rejecting the amount as unreasonable.
Refutation. Courts in general have indicated that for a covenant to be enforceable, the time period of restraint must be reasonable, as must the territorial restriction. Furthermore, it must be reasonably concluded that the restrictive covenant is necessary to protect the buyer's interest.
Consequently, the tax court would probably refute any covenant not worth the allocation amount, not negotiated, or not having a relationship to business reality.
Ancillary Issues. To be enforceable, the covenant not to compete must be ancillary or incidental to a legal contract. In addition, it must be reasonable with respect to the time and place of the restrictions against competition. To prove that the covenant is reasonable, the buyer must demonstrate that the restraint placed upon the seller is no more restrictive than is necessary to protect the buyer. There also must be a showing that the covenant does not interfere unreasonably with the interest of the public. These additional issues are discussed below under the heading 'Construction of the Covenant.' Before discussing these issues, however, let's discuss the question of which party has the burden of proving the validity of the allocation of part of the purchase price to the covenant not to compete.
BURDEN OF PROOF
A noncompetition covenant that has not been allocated a value in the contract does not necessarily mean that a deduction cannot be taken. It is, however, a strong indication that no allocation was intended, and strong proof would be needed to overcome this omission. The courts have developed two rules in deciding the binding effects of a contractual allocation or its absence: the Strong Proof Rule and the Danielson Rule.
Strong Proof Rule. In the case of Wilson Athletic Goods Manufacturing Company, 222 F.2d 355 (7th Cir. 1955), no dollar amount was allocated to the covenant. Wilson indicated that it would have been unwilling to purchase the business without the restrictive covenant, and it would not have paid the price it paid without the restrictive covenant. The court indicated that its responsibility was to determine the intent of the contracting parties, and that it was immaterial whether the contract did or did not define a specific valuation in the contract. This resulted in the Strong Proof Rule. The thrust of this rule was that 'strong proof' must be introduced to overturn or establish a dollar figure for the restrictive covenant. The crucial factor is whether the purchaser of the agency genuinely intended that an allocation be made for the restrictive covenant regardless of whether the allocation was specified in the agreement. The Strong Proof Rule was given further support in Schultz v. Commissioner of Internal Revenue, 294 F.2d 52 (9th Cir. 1961).
Danielson Rule. The Danielson Rule is actually an extension of the Strong Proof Rule. The court, in Commissioner of Internal Revenue of Danielson, 378 F.2d 771 (3d Cir. 1967), indicated that it could not be bound by mere legal form. The Danielson Rule indicates that a party can challenge the tax consequences of an agreement only by presenting proof that would be admissible to alter that agreement or to show its unenforceability because of mistake, undue influence, fraud, or duress. In effect, the court applied contract law to determine whether the contract was valid and enforceable.
The court's ruling seems to be in conflict with the economic reality test as well as the common law substance versus form doctrine. The commissioner advocated the adoption of the Danielson rule to ensure consistent tax treatment of both parties. Extension of the Danielson Rule would permit the IRS to examine the substance issue, but this rule prevents a party from disavowing negotiated business arrangements for tax reasons.
CONSTRUCTION OF THE COVENANT
A number of factors should be considered in the use of a covenant not to compete. First, there should be a need for the covenant other than for tax reasons. Second, the covenant should be separately negotiated between buyer and seller. Third, it should be reasonable. Fourth, the consequences of the failure of the covenant should be examined.
Need For The Covenant. The first thing that should be examined in the need for a covenant is whether or not the restrictive covenants can be enforced considering the rules of the local governing laws. If local laws are such that it would be extremely difficult or impossible to enforce the restrictive covenant, the only reason for having one would be for taxes. Under these circumstances, it is almost certain that such an agreement should be rejected. Since local laws (including state statutes and community ordinances) can have a profound impact on noncompetition agreements, a complete understanding of these local laws is essential. The advice of local counsel can be invaluable.
The second issue that must be considered is whether the seller is a risk to the buyer if the covenant is broken. The seller must have the ability to compete, or the covenant itself is a tax covenant rather than a restrictive covenant. An insurance agent, as a rule, would have a fairly high degree of ability to compete. This ability can be reduced, however, by old age or other factors. Even if competition is possible, consideration must be given to the consequences of using the former agency name, the files, and other such items that would enable the seller to compete.
For example, an 86-year-old man who is terminally ill and whose insurance files are in a jumble is unlikely to compete with anyone. Consequently, it is unlikely that a covenant not to compete is needed. The enforceability of a covenant under such circumstances is not great.
The third consideration is whether or not the value of the purchased business would be reduced if indeed the seller did compete. The buyer of the agency should attempt to evaluate the benefits and cost over a period of time, and what the lost earnings would be if a covenant were not obtained from the seller. For example, would the value of the business be reduced if the seller or one or more shareholder/employees competed for the insurance business? If this projected reduction in value is determinable, it is a good approximate value to allocate to the covenant in the sales contract. However, this valuation is obviously complex and thus difficult to determine.
There seems to be a great misunderstanding on the part of the seller or producer leaving an agency concerning his ability to transfer the existing business to a new competitor to be established by the seller. Research has demonstrated that persons competing for the business never are successful in moving anywhere near as much of the business as they think they will be able to move. This comes as a result of apathy on the part of the customer, tight markets, and re-underwriting of risks that are renewable with the existing company but not necessarily eligible as new business to another company.
After examining the desire and ability of the seller to compete, the remaining provisions of the contract should be considered. For example, if the seller can compete and wants to, negotiations for the covenant should occur.
Negotiation. If a covenant not to compete is to be a part of the sales contract, discussions about it should take place as early as possible in the negotiations. When the validity of restrictive covenants comes before a court, the court will look for evidence that the covenant and the price allocated to that covenant were bargained for on a separate basis and took place early in the discussion of the sale.
The absence of discussions of a covenant not to compete during the negotiation process is a reasonable indication that the covenant was not dealt with separately by the individual parties. This conclusion is further strengthened if the purchase price is established before consideration of the covenant or if the contract is later amended to provide such a covenant. Consequently, if the buyer can indicate that the subject of the covenant was introduced at the inception of negotiations and was bargained for until it was included in the final agreement, the buyer should be able to satisfy the intent requirement.
A second factor to consider is the specific dollar value that should be assigned to the covenant not to compete. The buyer should offer what under all the circumstances appears to be a reasonable price for this covenant. Buyers always will be required to satisfy the economic reality test, particularly when they are being asked to justify an express allocation to the covenant in the sales agreement.
An absolute dollar figure should be allocated to the covenant not to compete rather than an arbitrary percentage of the purchase price. If the figure allocated to the covenant is based on a single year's commission -- (1) a percentage of renewal premiums bought from the seller, (2) a percentage of annual fees, (3) or the fair market value of land and buildings-it is evident that the buyer and seller did not separately bargain for the covenant. Under such conditions, the covenant has a significant probability of failure.
The third item that must be dealt with in the negotiation is making certain that both parties understand the tax consequences of allocating part of the purchase price to a restrictive covenant. The fact that one or both parties may be ignorant of the tax effect is not normally determinative. However, the courts have cited a buyer's or seller's tax ignorance as reason to alter a specific allocation to reflect the substance of the transaction. It is dangerous to count on a court to reform the contract because of the parties' ignorance. If the contract is reformed, the amount assigned to the covenant is removed and applied to goodwill, and the unfavorable tax treatment to the buyer may be devastating.
The fourth item of concern deals with tax reporting. The one item drawing the most careful scrutiny from the IRS is the inconsistent reporting of a sales transaction for tax purposes. Both the buyer and the seller should agree to report the transaction for tax purposes in a manner consistent with the sales contract provision. If this is not done, both the buyer and the seller could be drawn into unexpected litigation over the matter. The sales contract should provide at least some protection against this by specifying the respective party's tax treatment. In addition, the agreement should provide a basis for recovering any cost resulting from the IRS disallowing the contract's tax treatment.
Reasonableness. Most jurisdictions will reject the covenant not to compete if it unduly restricts the right to a person's livelihood. This is a difficult proposition because each contract has its own unique qualities. The agreement must be reasonable in its protection of the purchaser and the remaining members of the business. The covenant should:
1. Be reasonable in point of time
2. Be reasonable in the area of restraint
3. Be necessary to protect goodwill
4. Not be an undue burden to the promisor
5. Not be against public policy
The civil court determining the enforceability of a restrictive covenant may examine each of these five points to determine if the contract is reasonable to both parties and to the general public. Unique outside factors may come into play in the area of product, type of service, employee's contact with customers, and other goodwill factors.
Time. The time restriction in the covenant usually is stated in years. What is reasonable is determined by the courts in each specific case, since the amount of time buyers need to be free from competition by the seller varies greatly. As guidelines, it would appear that anything beyond five years has high probability of being declared unreasonable, although some documented circumstances have allowed a 10-year restriction. Four years is more likely to be accepted than five years. Three years is more likely to be accepted than four years. Currently, it appears that the courts are tending to accept and set the norm at three years. A two-year restriction period is better than three in regard to enforceability and a 13-month period is perhaps even better yet. The 13-month period is not really as short as it seems because it effectively gets the parties through two policy-renewal periods. A caveat:
Each case is distinctive, since it has its own set of circumstances.
Territory. Whether the restriction is reasonable in the area of restraint is a more difficult question for the courts to determine. The area of restriction is usually described in a mile radius or a county area. In determining what would be fair to both parties, two additional factors must be considered.
The first is the population of the area of restraint. If the agency is located in a rural area, having a large restricted zone may be justifiable- for example, a 50-mile radius. On the other hand, if the agency is located in a metropolitan area, a 50-mile radius is likely to be declared unreasonable, since it would be quite possible for an insurance agent to return to the business on the opposite side of the city and never come into contact with the customers served by the other agency. The court is likely to determine that the population is sufficiently large to solicit new business without affecting the business that was sold.
The amount of business done in the restricted area should also be considered. If an agency does its business in a centralized location, there is no justification for restricting a large area, where no business is done, just in the hopes of soliciting business at some point in the future. The courts would probably declare this tactic unreasonable and against public policy.
A piracy agreement and a privacy agreement can reasonably and effectively take care of the competitive problem. The piracy agreement restricts a person's activities dealing with specific customer files that were sold to the buyer, and the privacy agreement indicates that the seller would tell no one about the customers. These agreements reasonably dispose of the territory issue.
Protection Of Goodwill. Any restrictive covenant should be in place because it is needed to protect the goodwill that goes with an agency. If the restriction is there solely for tax purposes, it is not likely to be upheld. Items of goodwill such as the name, location, people in the agency, profitability of the agency, and availability of the files from which to work are factors to consider.
If the person cannot or has no desire to compete, there is no reason to have a restrictive covenant. Furthermore, there's no need for one if there is no goodwill in the agency.
Undue Burden. Does a restrictive covenant place an undue burden on the promisor? No court is going to place an unreasonable restriction on a person's right to make a living. By the same token, courts will not permit unfair competition for something that was properly negotiated, for which a price was paid, and which contains reasonable constraints. Therefore, to hamstring a seller because the buyer has an economic advantage is a fact that can be used later to refute the covenant.
Public Policy. The restrictive covenant should not violate the interest of the public or antitrust laws. If it prevents the public from getting the benefit of fair competition, it is unlikely to be upheld. Restrictive covenants are not designed to allow an agency to have a monopoly and charge unjust fees for its services. If the covenant is a restraint to fair trade, it will be ruled void and unenforceable.
Consequences Of Failure. No matter how carefully a restrictive covenant is drawn, certain circumstances will cause it to be unenforceable. This situation cannot be avoided entirely. The task, therefore, is to draw the contract in the best manner possible considering the five factors mentioned in the 'reasonableness' section above. The consequence of a contract's being thrown out by the courts is that the amount allocated to the restrictive covenant will be transferred to goodwill, with its differing tax ramifications. As a result, a depreciable item suddenly becomes nondepreciable. If the deal was structured on the basis of the tax consequences given by the covenant, the failure can be devastating to the buyer.
It is not uncommon for a court to find some of the provisions of the restrictive covenant to be an unreasonable restraint of trade. Depending on the applicable state laws, a court may have the option of throwing out the entire contract, or it may have the discretionary power to reform the contract to make its terms reasonable. An example of reformation took place in the case of Alexander and Alexander (A&A) v. Drayton, 278 F.Supp. 824, 830 (E.D.Pa. 1974). A&A had precluded Drayton from competition within a 100-mile radius of three major cities for a period of 10 years. Drayton, who was 52 years old, would have to wait until he was 62 to compete, and the court found that to be unreasonable. What's more, the court found that the 100-mile radius restriction from three different major cities was unreasonable and limited it to a single city, Philadelphia, for a period of two years. The court further reformed the contract by stating that it would enjoin Drayton from disclosing the names of the customers and the expiration list to the new employer. These lists were deemed to be trade secrets and were entitled to protection by the court.
The power of courts to reform an overly broad covenant not to compete is based on state law. Some states allow their courts the discretionary power of reformation; other states require that such covenants be declared unenforceable. Even when courts can reform a covenant, it is the prerogative of the court to reform the CONTRACT, and the buyer must bear that in mind. It is more likely that the court will view unreasonable provisions as grounds to refuse to enforce the contract in its entirety.
CONCLUSION
No set of circumstances guarantee the viability of a covenant not to compete. It must be drawn carefully, based on the various factors discussed here. It should be reasonable in time and scope and have economic reality. A seller who signs a negotiated covenant not to compete should be restricted from unfairly competing for that business-but should not be expected to give up the ability to make a living for an indefinite period of time. A time frame of two to three years (concerning the customers that were sold or the agency's customer list) and a restriction on revealing the customers to anyone is the proper direction for a valid and enforceable covenant not to compete. Both parties should understand clearly the tax consequences of a restrictive covenant so that no party is in an unfair position. Reformation is possible, but it is the sole prerogative of the court. The best recommendation for any party (buyer or seller) that wants to draft a covenant not to compete is to seek adequate professional advice.