Introduction to Covenant Agreements
Covenant agreements are vital components of many business and employment relationships, but they often remain misunderstood until a legal dispute arises. Simply put, a covenant agreement is a legally binding commitment in which one party agrees to do or not do a particular thing. Covenant agreements can take the form of non-competition covenants, which are also more commonly known as non-compete agreements or non-compete clauses. They also may involve agreements not to solicit customers, employees, or contractors of a business. In other words, a covenant is an agreement that is intended to restrict how a party may conduct their future business activities. These agreements are potentially enforceable under certain circumstances as long as reasonable limitations are placed on the duration, scope, and geographic area of the restrictions.
The purpose of a covenant agreement between a company and its employees – and often between a company and a business partner or co-owner – is to protect the company from potential damage or loss that could be caused by a key employee or business owner leaving to work for a competitor. Such losses can occur when an employee leaves and takes customer contacts and/or proprietary information to a new company that is in competition with the former employer. Or, an owner of a business with multiple owners might leave the company and begin doing business with the same customers, suppliers , or contractors as the departed owner’s new business does. In both of these example scenarios, the competitive employment of the individual who leaves the agreement would harm the business that the person departed (i.e. the former employer) and possibly benefit the business that the departing individual joined (i.e. the new employer). Because this situation is not uncommon in the business world, many companies use covenant agreements to protect themselves from the potential of competitive harm. Thinly veiled in their language, though, are the otherwise unenforceable threat of a negative job reference and the economic incentives for the employee to comply with a covenant agreement.
Sometimes, a covenant agreement can be signed between individuals who are the owners of a new or closely-held business. Under this type of circumstance, a covenant agreement may restrict what owners can do to try to compete with each other during the period in which they are owners. Similar to sign-on bonuses for employees, the purpose of having such an agreement is to prevent owners leaving the arrangement for the purpose of competing with each other. Just as the restriction of a covenant agreement can be stronger between a company and its employees than it would be between two competitors, it is possible to enforce a covenant agreement imposed on business owners who are not in competition with each other but who are still bound by agreement in the name of protecting the interests of their ownership business.
What Is Involved in a Covenant Agreement?
The precise requirements of covenant agreements can vary from company to company, and industry to industry. However, there are numerous common elements generally contained in a covenant agreement. These elements include: (i) the parties to the agreement; (ii) the effective date; (iii) the party to benefit and/or be subject to its terms; (iv) the general terms and conditions of the agreement; (v) the scope of its coverage; (vi) the duration; and (vii) owner of and time/terminability of any particular Section, paragraph or other provision. Other common elements may include definitions, representatives and notices, and, in some instances, the law and jurisdiction governing disputes, as well as the means of an aggrieved party enforcing its rights.
Common Types of Covenants in Agreements
It’s important to consider what types of covenants will be included in a covenant agreement. There are different types that apply to different circumstances.
Affirmative covenants. Affirmative covenants require the agreement of both parties that the covenantor will do something within a specific timeframe or at regular intervals. Some common affirmative covenants follow:
Negative covenants. Unlike affirmative covenants, negative covenants only require one party to agree not to do something. Negative covenants can often be the most important covenants in an agreement. Depending on what each party is willing to restrict, different negative covenants may be more or less significant. Some examples of negative covenants are as follows:
Covenants regarding enforcement. In covenant agreements, it is often required to hold the covenantor liable for the covenants regardless of the covenantor’s actions or inactions. The covenantor’s liability can be limited further by restricting it to intentional breaches only. For example, one common covenant requires the covenantor to hold the covenantee harmless from and indemnify the covenantee against any damages that result from any breach of the covenant by the covenantor. A failure to hold the covenantor liable would not be ideal for the covenantee because the covenantee would not be protected from any harm caused by the covenantor’s breach, even unintentional.
The preceding examples are just some of the most common covenants that one would encounter in a covenant agreement.
How to Write a Covenant Agreement
There is no one-size-fits-all covenant agreement, and as a result, the drafting process requires careful consideration. Here’s some important factors to consider when drafting a covenant agreement:
Draft with the end in mind. It’s almost always better to seek legal advice before you draft a covenant agreement, but nonetheless, do so with the end goal in mind. In other words, if the covenant agreement needs to be legally binding and enforceable for a specific purpose, let that goal inform the drafting process. Be as precise as possible. Your covenant agreement should be informative regarding the terms of the restriction that the owner seeks to impose on the purchaser or borrower. Vague restrictions are difficult to enforce and even more difficult to interpret in court. As such, when drafting a covenant agreement, make sure that you are as specific as possible and avoid overgeneralizations wherever possible. Anticipate future issues. One of the best things you can do to ensure that a covenant agreement is legally binding and enforceable is to anticipate every possible future issue, and preempt those concerns in the document. Think about how the situation may change in the future, and make sure that the language of the covenant agreement adequately addresses any possible issues that could arise. Seek legal assistance. If you haven’t already, it’s time to involve an attorney in the drafting process. An attorney will be able to foresee any legal concerns that you may have missed and address those concerns in the agreement.
Covenant Agreement Templates
While each of the examples below can be tailored to fit the needs of two specific parties, they all generally utilize the following sections and language:
- Parties and Background – This section contains identifying information on the parties, and may also contain a recitation of the facts leading up to the covenant.
- Covenant Not to Compete – This is often the most important section of a covenant agreement. Here, the covenantor agrees not to compete with the covenantee in some specified manner for some specified period of time after termination of the association between the parties. The language in this section can be nearly identical to a stand-alone covenant not to compete (sometimes referred to as a "non-competition agreement" or "non-compete agreement"). For example, a covenant not to compete in a covenant agreement may provide that the covenantor covenants not to engage in a competing business in a specified geographic market for a specified period (usually between six months and three years).
- Covenant Not to Solicit Employees/Customers – This section, very similar to a stand-alone covenant not to solicit, contains a covenant not to solicit employees and/or customers of the covenantee. Like a covenant not to compete, the language in this section is often identical to a stand-alone covenant not to solicit, except that it is placed within the context of a covenant agreement. A covenant not to solicit customers in a covenant agreement may provide that the covenantor agrees not to solicit the customers of the covenantee for a specified period (usually between six months and three years) within a specified geographic area.
- Attorneys’ Fees – Similar to any other contract, a covenant agreement often contains a provision that provides the prevailing party in any litigation its attorneys’ fees.
- Injunctive Relief – Much like an attorneys’ fees provision , this is common in most contracts. It specifies that the covenantee may seek injunctive relief in the event that the covenantor breaches the agreement.
- Modification – This section of a covenant agreement is often included as a precaution against the possibility that the agreement may need to be modified in the future.
- Severability – Similar to a modification provision, a severability provision is designed to provide that if the court finds one section of the agreement to be illegal, the rest of the contract will not be invalidated.
- Governing Law – A common legal clause that simply states what jurisdiction’s laws will govern the interpretation of the contract.
- Entire Agreement – This section of a contract provides that the written agreement constitutes the entire understanding between the parties. This is commonly referred to as the "merger" or "integration" clause of a contract.
- Choice of Law – Often combined with the governing law provision of the agreement, this simply provides which jurisdiction’s courts have the authority to adjudicate any dispute that arises.
- Choice of Forum – Similar to a choice of law provision, but it can be used to identify the jurisdiction in which the court hearing the case should be located.
- Forum Selection Clause – A choice of forum clause is another equitably-named provision. It simply states that if the case were to be adjudicated in a different jurisdiction, that jurisdiction’s laws should apply.
- Signature Blocks – Often overlooked, signatures and signature blocks are important in evidencing that the parties entered into the agreement voluntarily and knowingly. These oftentimes contain a notary public’s signature, as well as attesting witnesses.
Legal Considerations and Exceptions
The law surrounding covenant agreements varies by jurisdiction. In the United States, employers are advised to confer with a local attorney who can draft a document that complies with local laws and regulations. With regard to non-solicitation agreements, if a departing employee does not actively solicit goods from existing customers, it may be difficult for the employer to prove that the employee violated such an agreement. Moreover, some states only allow a non-solicitation agreement after the employer has adequately trained the employee.
Going one step further, some countries and state courts disallow non-competition agreements altogether. These jurisdictions may have specific requirements for non-competition agreements. Court cases in these jurisdictions establish strict tests of reasonableness that may, for example, require a non-competition agreement to be in writing and state with reasonable particularity the activities to which the agreement applies. Although there is no model for these tests, courts in these jurisdictions have identified the following factors as being critical:
It is evident that the legal implications of covenant agreements can be complex and that therefore, proper steps must be taken in order to ensure compliance with the law.
Frequently Made Covenant Agreement Mistakes Treaties弐and How to Avoid Them
Common mistakes when entering into or drafting covenant agreements include:
Agreement is overly broad or restrictive. This can be a major deterrent to an employer entering into an agreement, an employee attempting to enforce it, or a judge refusing to uphold it. Employers need to ensure that the agreement only restricts an employee from competing to the extent necessary to protect the company’s proprietary interests, or to avoid physically damaging expenses related to a company’s customer goodwill. An employee needs to ensure that the agreement allows him or her to still essentially make a living.
Updating the agreement periodically. A company needs to be diligent to have an agreement in place before hiring an employee, and then periodically update it. Assuming a company will not hire the employee until the contract is signed could be a mistake, and the agreement could become outdated over time.
Allowing for ambiguities in territory to be covered. It is hard to define what territory will be covered by a non-compete or non-solicitation agreement, especially where there is a regional business. A company may be able to enforce the agreement long after the employee has left if it could reasonably claim that the employee’s knowledge of customers could be considered to extend to customers in a certain geographical area. Courts are less likely to enforce an overly broad agreement that covers too wide of a geographical area, but if it is written well to define the geographical area for what customers it would apply to, it may be enforceable.
Employers diversify their businesses. Employers should be aware that entering into a covenant agreement with one party could potentially impact the interests of another separate corporate entity that the party also works for. It is important for the terms of the agreement to strictly spell out which corporate entities the agreements refer to, and the businesses they affect. The enforceability of the agreement can be called into question if a judge finds the agreement was not clear enough, and it is reasonable to find such ambiguity in the eyes of the court.
The restrictions are too long. A company should think critically about what restrictions to place on a departing employee, how long those restrictions should be, and the logic behind it. The restrictions should only be in place to the extent a company needs to protect its interests, and for no longer than required. Outdated or longer restrictions than necessary may be avoided by the company and the court.
Not having the agreement reviewed by a lawyer. It is common for a departing employee to agree to signing a covenant agreement with his or her employer as part of a severance agreement. If an employee has had a lawyer look over the agreement, and is comfortable in signing it, judges are unlikely to find arguments against enforceability of the agreement, such as that it lacked consideration, was not clear enough to be enforceable, or is overly restrictive.
Conclusion and Best Practices
Best practices for creating effective Covenant Agreements are important for all investors. While there are many best practices that guide the investor on the terms and conditions of a Covenant Agreement, the best practice is that all investors should receive the Covenant Agreement in advance of their investment (and well before the signing of a detailed investment transaction document). This approach will ensure that the investor has an opportunity to review the terms and conditions and obtain professional advice on these terms to ensure that they are not onerous. The investor’s representatives (in particular the investor’s legal representative) should be permitted to discuss the terms of the Covenant Agreement with the company’s legal representative or the company’s external legal counsel . If the investor’s representatives have concerns with any of the terms and conditions of the Covenant Agreement, negotiation and change in terms may be required in order to arrive at an acceptable position for both the investor and the company.
During the negotiation process of the terms and conditions of the Covenant Agreement, the investor should ensure that the terms and conditions are aligned with the terms of the investment transaction document, except for matters that are unique and apply exclusively to a specific instrument or class of security.
The article has identified best practices for Covenant Agreements, suggested key terms and conditions that should be included in specific types of Covenant Agreements (specifically exclusivity agreements, confidentiality agreements, non-solicitation agreements, personnel agreements and consulting/next level investor agreements) and provided sample terms and conditions in respect of these agreements.