August 2009 Newsletter

Are Restrictive Covenants Enforceable?

Yes, restrictive covenants are enforceable and they are important to protect the goodwill, trade secrets, and other confidential and proprietary information of your business. They can be used in business acquisition agreements, buy-sell agreements and employment contracts to ensure that you receive what you bargained for. If the counterparty breaches the covenant, you can obtain an injunction requiring the counterparty to refrain from such unfair competition and the soliciting/stealing of your employees, customers and/or potential customers. This is in addition to such other remedies as the law or equity may provide.

In business acquisitions, buy-sell agreements, and employment contracts, much of the danger is the counterparty’s detailed knowledge of the confidential and/or proprietary information of your company, including without limitation, customers, prospective customers, procedures, policies, pricing, personnel lists, strategies, manuals, programs and all other confidential documents which are not in the public domain. This can be dangerous as these individuals can create a new company using your business model and secrets or can be hired by a competitor at an increased compensation level to provide such confidential business intelligence and undermine your existing business’ trade secrets, connections and customers which have been established and are maintained at a great expense.

To ensure restrictive covenants are enforceable, the covenant needs 1) to have adequate consideration and 2) to have reasonable restrictions as to time, scope and geography. As with any contractual agreement, there needs to be adequate consideration for it to be enforceable. There just needs to be something of justifiable value to induce a counterparty into signing a covenant. The purchase price of the entity or the commencement of the new employment is usually adequate consideration.

What is a reasonable restriction depends on the type and nature of the business. The time, scope and geographical restrictions must only be as broad as necessary to protect the entity’s interests, but not create an undue hardship on the counterparty.1 For instance, in a tri-county local computer sales business, a reasonable restriction may be to restrict a departing owner or employee from soliciting your customers and operating or being employed by another competing computer business within the tri-county operation of the original business for eighteen (18) months. However, a five (5) year, five (5), state restriction on any computer related business is too broad. If a restriction is unreasonable, courts will generally alter the agreements by reducing or narrowing the time, scope or geographic region. However, there is the danger the courts may limit the restriction much more narrowly than the outer limit of what a reasonable restriction may be.2

It would be wise to place certain terms within the agreement that, while not conclusive, may aid in ensuring enforceability and a speedier enforcement of a restrictive covenant. First, the restrictive covenant should explicitly state the adequate consideration given for the covenant. Second, the party should acknowledge and agree that the terms of the restrictive covenant are reasonable and do not place an undue hardship on him with respect to his time, scope or geographical region restrictions. Third, the party should acknowledge and agree that the knowledge, skills and ability he possesses at the time of the commencement of the covenant are sufficient to permit said party to earn a livelihood satisfactory to him without violating any provision of the covenant. Fourth, in terms of enforcement, it should be agreed a breach is per se irreparable damage requiring an immediate preliminary injunction. Last, there should be a waiver of the requirement that the enforcing party post a bond in cash or otherwise in relation to any injunctive remedies.

In summary, restrictive covenants are essential to most businesses and enforceable. If not, you may find yourself supplying a competitor with the necessary knowledge to start or successfully operate a competing business that cuts into a significant portion of your market and thus your profits.

If anyone has any questions or inquiries concerning this subject matter, do not hesitate to contact us. Feel free to email us your questions or comments concerning this newsletter.

1 John G. Bryant Co., Inc. v. Sling Testing and Repair, Inc., 471 Pa. 1 (1977); Capozzi v. Latsha & Capozzi, P.C., 797 A.2d 314 (Pa. Super. 2002); Wainwright’s Travel Service, Inc. v. Schmolk, 347
Pa. Super. 199, 203-05 (1985); Reporting Services Assoc., Inc. v. Veritext, L.L.C., 2003 Phila. Ct. Com. Pl. LEXIS 66 (2003); Kendall v. Metz, [2001 WL 1751247 (Pa. Com. Pl. 2001); Fres-co System USA, Inc. v. Bodell, 2005 347 U.S. Dist. LEXIS 28140 (E.D. Pa. 2005).

2 In other words, if a court would accept up to a 2 year limit normally, and a restriction has a 5 year limit, the court may narrow the time frame to 1 year. This being well under 2 years.