In this article we will look at what restrictive covenants are, how they are used in M&A transactions in the US and UK and whether there are any changes on the horizon that may alter this approach in the future.
What are restrictive covenants and how are they used in M&A transactions?
Restrictive covenants (sometimes referred to as "post-termination restrictions". "post-closing covenants" or "non-competes") are often included in employment agreements and SPAs. In the M&A context, these provisions impose restrictions on the seller, with the aim of protecting the goodwill of the target and preventing the seller from competing with the target for a defined period following completion. Typical restrictions include:
- non-compete: which is intended to prevent the seller from engaging in activities that compete with the business being sold;
- non-solicitation: which is intended to stop the seller from seeking business from specified clients/customers or prospective clients/customers;
- non-dealing: which usually prohibits the seller from having any dealings with clients/customers or prospective clients/customers;
- non-poaching: which prevent the seller from employing, engaging or enticing certain colleagues to join a competing business; and
- non-interference: which prevents the seller from seeking to divert supplier relationships away from their business that has been sold, typically for the benefit of a new one.
Is the approach the same on M&A transactions in the US and UK?
It is standard market practice on both sides of the Atlantic to include restrictive covenants in SPAs. The restrictions in SPAs are generally far more extensive than those found in employment agreements on that basis that such clauses are necessary to protect the goodwill of the business for the buyer.
In US style SPAs the post-closing covenants typically include an agreement not to solicit clients/customers, suppliers and employees of the target, a non-compete covenant and a confidentiality provision. The non-solicitation covenants are usually given for a period between one and two years, while the non-compete covenant is given for a longer period between three and five years.
The approach is similar in UK style SPAs, and buyers expect sellers to agree to similar restrictive non-compete and non-solicitation covenants; depending on the nature of the transaction, specific non-dealing and non-poach covenants may also be included in a UK style SPA.
However, there is a large body of case law on restrictive covenants in the UK and it is well established that any post-termination restrictions that go further than "reasonably" necessary to protect a "legitimate business interest" will be void for being in restraint of trade and unenforceable. "Legitimate business interests" can include protecting confidential information and trade secrets, client contacts, goodwill, relationships with customers and suppliers and maintaining a stable workforce. Precisely what is "reasonable" will depend on the circumstances of each transaction, and particular consideration should be given to the duration, scope and geographical reach when drafting restrictive covenants in the M&A context.
In view of the above, in a UK style SPA the non-solicitation of employees covenant is often limited in its scope to "key employees" only. In addition, the geographical scope of the covenants is often narrower than in a US style SPA and it is unlikely for the non-compete covenant to given for a period of more than three years, as depending on the circumstances of the business being sold and what may be considered "reasonable" in the circumstances, any longer-term provisions are likely to be unenforceable.
Will standard market practice change?
Recently restrictive covenants have come under intense scrutiny on both sides of the Atlantic with governments and regulators placing greater focus on them and clamping down on their use – although to date this has primarily been in the context of employment agreements. As scrutiny of these provisions increases, transaction teams will need to review their use, navigate safe-harbours and explore new ways to protect goodwill.
US ban on non-competes
In the US, the Federal Trade Commission (FTC) announced a nationwide ban on non-compete clauses in April 2024 and published a final rule. The final rule is scheduled to come into effect 120 days after it was published in the Federal Register, on 7 May 2024, meaning that it will become effective on 4 September 2024. The final rule imposes a national ban on all employers from using non-compete clauses in contracts with all workers at any level (subject to certain exceptions). Notably, in the M&A context there is an exception which permits non-competes entered into in connection with a "bona fide sale of a business".
However, the future of the final rule is uncertain as it faces strong statutory and constitutional challenges which may delay the effective date. In addition, the US election takes place on 5 November 2024 and this may also have an impact on the approach to non-competes. It is widely believed that if the US Presidency remains Democratic, efforts to restrict non-competes will accelerate while the opposite is likely to be the case if the Presidency swings back to Republican.
Will the UK follow suit?
In the UK, the Government announced plans to limit restrictive covenants in employment and worker arrangements to just three months, but the proposals would not apply to other agreements such as partnership agreements, LLP agreements, SPAs and shareholder agreements. Following the recent general election, it is unclear whether these proposals will be taken forward by the new Labour government. Indeed, Labour's plans for employment law do not mention non-competes, and pushing forward the out-going government's proposal is unlikely to be a priority.
The UK's Competition and Markets Authority (CMA) has also demonstrated an appetite for enforcement against no-poaching that violates competition law. Following an announcement in July 2022 of an anti-trust investigation into alleged wage-fixing for freelance technical staff, in February 2023, the CMA issued a brief guidance document to help employers avoid unlawful poaching, wage fixing and information sharing.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.