Editor’s note: This article is one of a series that covers buy/sell arrangements for agency valuation and tax issues, shareholder internal buy/sell agreements, related estate planning, employment contracts, and non-competes. It’s part of a unique pre-publication book that gives you practical street-level understanding of one of the most significant financial events in the life of your agency.
CHAPTER 4: COVENANTS NOT TO COMPETE IN THE SALE OF AN AGENCY
Intellectual property protection is critical in the sale of an agency. For an agency, this property is the agency’s book of business. No buyer is going to buy an agency whose owner and employees are free to take all of the agency’s confidential information, leave immediately, and use the money the buyer just paid them to set up shop across the street and compete.
As discussed in the previous chapter, an employment agreement or a shareholders buy/sell agreement can include various levels of a non-compete. In the sale of an agency, the purchase and sale agreements might also include a non-compete.
The permissible provisions and enforceability of non-competes vary by state. However, a nearly universal factor is the amount paid in exchange for the non-compete. The higher the consideration, the more extensive the non-compete can be. When an agency is sold the consideration is quite high – which means the non-compete provisions can be extensive. It’s common for a non-compete covenant in an agency sale to run for five years, even in a state where the same prohibitions could only be enforceable for six months under standard employment law.
Non-compete agreements also have tax implications for both the buyer and the seller, and the tax rules are different in an agency sale than for an employee who leaves.
Given the critical importance of non-competes in selling an agency, and the importance of the associated tax rules, it’s essential for agency owners to understand their role in an agency sale.
Three Components
A so-called “non-compete” consists of three possible components:
- First: Non-disclosure of confidential information and trade secrets (be careful not to recite “only trade secrets” – definitions under state law might be narrower than you intend to cover; while “confidential information” is generally not defined statutorily, and might be far broader);
- Second: Non-piracy of key accounts and/or other employees or independent contractor producers; and
- Third: Non-compete by territory or category of accounts.
Enforceability
Although the law tends to look askance at non-competes because they constitute restrictions on an individual’s opportunity to make a living, the notion that they’re “not enforceable in my state” is incorrect, especially in an agency sale context. To be enforceable, the agreement must be (i) reasonable in all respects, and (ii) supported with timely and legally sufficient consideration, in view of the rights given up.
Reasonableness. A “reasonableness” standard applies across the board; i.e., restrictive covenants must be no broader than necessary to protect the agency’s business. Note that this is counter-intuitive for the agency owner! For maximum enforceability, the agency’s principals must resist their tendency to draft non-competes that are as lengthy and comprehensive as possible – in fact, they should do just the opposite by making them as reasonably short and limited in scope as possible, while still protecting the business.
Scope: Generally, an employer cannot totally preclude employees from utilizing their “trade skills” at another agency somewhere else. Consider scope from two perspectives in a general business context: (i) is this restraint necessary to protect the business and goodwill of your agency; and (ii) is the degree of restraint greater than needed to protect them. It’s critical to define carefully the exact activities of a departed employee that might harm your agency the most, and narrow your restraints to these alone.
For instance, a “confidentiality” or “non-disclosure” provision might be enough for support staff, a “non-piracy” might suffice for producers, and a comprehensive “non-compete” might be needed for a selling agency principal. Note that, even in an agency sale context, it’s common for a departing agency principal to come under a non-piracy agreement, rather than a fully comprehensive non-compete.
Length: Although this varies by state, one to three years for departing CSRs or producers is generally the maximum enforceable in most states, depending on the risk to the agency posed by such a person departing, etc. A longer time, perhaps five to seven years, might be reasonable either for agency principals who would receive substantial compensation in a buyout, or for a producer selling a book of business to the agency upon departure.
The acceptable length will depend on the state, with the timing of the agreement and the consideration received in exchange for the agreement as significant factors in enforceability.
Geographic constraints: These must be reasonable under the facts and circumstances. Such constraints are easier to challenge under reasonableness guidelines, and often don’t add much real protection in any event. To reduce the risk of a successful challenge, we usually forego geographic constraints, at least at the employee level, and focus on the first two restraints above in a “non-piracy” agreement; i.e., go ahead and work for a competitor, but don’t take our confidential information or our existing customer accounts.
Timely and Legally Sufficient Consideration
Although there’s no definitive test of what constitutes adequate “consideration” to make a non-compete binding, however, some general guidelines may be helpful.
A reasonable pre-hire signed non-compete will generally be enforceable without any additional consideration, as long as employment was conditional upon signing the agreement. Getting the job itself is part of the consideration. New restrictions on an existing employee, even one who has only worked for a short time, would require new consideration, such as a meaningful promotion, discretionary raise, or cash bonus, or adding a “no-cut” guarantee of employment for several years.
Restrictive covenants between the owners of the agency are a different matter. The reciprocal nature of the burdens and benefits will often result in enforceability of a non-compete embedded in their shareholders buy/sell agreement even though they only made the agreement after being together for years.
Non-competes are highly state-specific, and states vary widely on protecting employers in this arena. For example, in some states, merely promising to retain an employee and continue their training for a minimum period might suffice. In other jurisdictions, it’s enough to inform all employees that their continued employment will depend on signing at least a non-disclosure/confidentiality agreement, which would be set forth in a signed agreement that would allow the employer to follow through by terminating those who refused to sign. In the best-case scenario, an existing employee should enjoy reasonable “fresh” consideration in exchange for giving up rights they would otherwise enjoy to compete freely in the marketplace.
Agency Value
It’s important to appreciate that failing to protect an agency’s intellectual property by non-competes with key employees and/or partners could significantly reduce the value of your agency to a future buyer. In one major Washington State case, a court reduced the value of an independent agency by two-thirds for having poorly drafted and not fully enforceable non-competes with key producers who left the agency1.
In our opinion, all employees with access to critical confidential information should sign employment contracts containing at least confidentiality provisions. Some courts have even held that failure to cover some key employees destroys the “confidentiality envelope” surrounding valuable information and is a “disclosure” of this information, thus eliminating its “protectability” and invalidating non-competes of other employees who were in fact covered by such agreements.
In most agency sales, the buyer considers adequate protection of the seller’s confidential information itself, as well as post-sale protection against competition by the seller’s key employees to be essential to the sale. We’ve seen sales fall apart because there was no adequate protection of this information, nor any way to protect it.
Tax Deductibility
The buyers often sign both personal and corporate non-competes in a business sale context. Consideration can be prepaid in one lump sum, or stretched out over years; however, in either event the buyer must write it off for tax purposes over 15 years, regardless of the timing or schedule of payments.
The 15-year amortization of consideration given for a non-compete in a business sale context is different from the write-offs allowed for non-competes in a simple employment context. Restrictive covenants in an employment context can often be written off when paid, or over a much shorter number of years.
Reciprocity
Reciprocal non-competes binding the buyers can also be very important and are usually overlooked. Without one, consider what might happen if the seller repossesses the agency and the defaulting or bankrupt buyer still has much of the agency’s confidential information in his head or copied in some format (after all, he or she has now been dealing with seller’s key customers and vendors for a couple of years)...and no non-compete! The original seller has the agency back, but if the defaulting buyer has an unrestricted right to compete, the agency will be worth much less.
NOTE: A buyer’s bankruptcy will not nullify a reciprocal non-compete
Copyrights
For a novel way to provide potentially extensive protection, consider copyrighting your customer list. Registration of a work is no longer required to obtain copyright in the U.S., nor is placing a copyright symbol on this material. However, placing a copyright notice on a “work” disallows the defense of innocent infringement.
Registration is required before filing an infringement suit in federal court. Statutory damages and attorney’s fees can be claimed only on registered works registered prior to infringement, or within three months of publication. You don’t need to register copyright until you wish to file suit to enforce it against someone.
Copyright gives you an entirely new layer of protection, one that’s not disfavored under the law, as are non-competes. Examples of ways to display this notice might include:
- having a copyright notice come up on every employee’s monitor when they turn on their computer;
- if you have an office manual, stating clearly in bold all-cap, underlined italics everything that you wish to consider copyrighted, including all customer account information;
- including a copyright notice in the footer and the cover sheet on any hard-copy printouts, you can even have this “marker” embedded by your software so that anyone attempts to delete it or tamper with it, the marker itself will thenceforth indicate that it has been tampered with; and
- including “dummy” data in your client database with your home (or your mother’s) address. If any mailed solicitation arrives from a departed producer, you’ll know that the source of this contact was protected material. This can also be very useful when attempting to prove violations of more traditional confidentiality or non-disclosure agreements.
Copyright law may also allow you into federal court. It’s possible to recover multiple damages, plus attorney fees if prohibited actions were intentional by the employee, and/or even against the new agency employer if this employer participated as an enabler in your employee’s piracy and utilization of your confidential information.
Enforcement/Litigation
In an agency sale context, the buyer should state in the agreements a right-of-offset and deduction against any remaining money owed to the seller in case either the seller’s personal non-compete or that of the seller’s corporation is violated.
In an employment context, the employer should have attorney fee provisions in virtually any non-compete. However, be careful about litigating in this arena – it can be extremely expensive, stressful, and move at lightning speed. You could be in court immediately, having already spent more than $15,000 in attorney fees on your side alone. It’s possible under certain conditions to obtain a temporary restraining order (“TRO”) almost overnight. If vengeance is the only real issue, it’s generally better to “cool it” and try for a negotiated settlement of some kind such as the employee and/or his or her successor agency buying out those restrictions or limiting the restriction in scope in some way (perhaps only to a list of a few key target accounts), etc.
Consider providing agency-paid cell phones for key producers. Their phone records on agency-paid lines for periods before their termination can show that they were making repeated calls (on your nickel!) in bad faith to their next employer in preparation for stealing your trade secrets; this provides evidence that’s difficult to prove otherwise of “tortious interference in your contractual relationships” by the producer’s next employer.
Legislative Protection
Several bodies of law also protect an agency’s trade secrets even in the absence of written protections.
The Uniform Trade Secrets Act (UTSA) gives civil protection through injunctive relief and damages (only a few states have criminal law sanctions).
The little-known federal Economic Espionage Act of 1996 (EEA) provides severe punishment –including imprisonment, fines, and criminal forfeiture of property – for major cases of theft of trade secrets.. It protects all forms of business information, tangible or intangible, no matter whether or how stored if the agency has taken reasonable measures to keep this data secret and the information generates independent economic value through being not generally known or readily ascertainable to the public (a standard that’s easy for agencies to meet). The EEA defines theft of a trade secret as the intent to take it, knowing that such taking will injure the owner, taking, diverting or receiving it, knowing that it was misappropriated without authorization. The EEA provides that whoever is guilty of stealing trade secrets can:
- face up to 10 years in prison;
- If it’s an organization, be fined up to $5 million; and/or
- forfeit the stolen trade secrets, or anything derived from them, as well as property “used, or intended to be used, in any manner or part to commit or facilitate the commission of such violation.”
Under other federal statutes that include similar language regarding criminal forfeiture of property, such as RICO (commonly referred to as the “racketeering act”) courts have ordered forfeiture of an entire business, even though only its storage area was used in violation of this law. The courts have also determined that the criminal forfeiture provisions of RICO are mandatory. If the Justice Department chooses to enforce this federal law vigorously, staff, employees, other agencies and/or their principals could face severe penalties for misappropriating trade secrets they knew were covered by a non-compete.
Conclusion
Not only are non-competes enforceable if reasonable and supported by timely and legally sufficient consideration’ in many instances, they might be essential in preserving the value of your agency. Some buyers won’t even consider buying an agency that’s unprotected.
If your agency isn’t well protected already, it’s not too late. Act NOW!
(1) For a comprehensive discussion of an agency being judicially devalued by two-thirds due to its failure to have in place adequate non-competes with its three key producers who left to form another agency and were sued by their former employer, see Ed Nowogroski Ins., Inc. v. Rucker, 137 Wn.2d 427, 436-37, 971 P.2d 936 (1999).
Larry Morrison, CLU, ChFC, is president of the Business Transition Network (Arlington, WA), a firm specializing in agency evaluation, purchase, mergers, and business succession planning. You can reach him at (866) 475-9992 (toll free); or e-mail: [email protected].
Gary E. Jacobson, JD, a partner at Vander Wel, Jacobson, Bishop & Kim, PLLC (Bellevue, WA), offers expertise in the legal aspects of agency evaluation, purchase, mergers, and business succession planning. You can reach him at (866) 498-0008, toll-free; e-mail: [email protected]; or visit www.vjbm.com.