Key employees of a company may be bound by restrictive covenants that are included in an agreement to sell the entity, but do not reference them individually.
A court should consider whether the restrictive covenant of a key employee was a significant element of the transaction and necessary to protect the good will of the business.
Restrictive covenants that are given in connection with the sale of a business may be broader than those given by an employee to an employer, and are more likely to be considered reasonable if they were an aspect of the transaction.
In some circumstances, an executive who received a portion of the proceeds of the sale of a business may be bound by the restrictive covenants that were part of the deal, even if he had not negotiated the covenant individually with the purchaser in a decision involving a pharmaceutical rebate company.
The decisions we consider here frame an often relevant distinction between a restrictive covenant that is part of the sale of the business and a restrictive covenant that is part of a purely employment relationship. Here, the time period applicable to the restriction was three years, which may have been unenforceable against an employee but was reasonable when it was part of a sale of the business in which the defendant benefitted personally.
Executive with ‘Bonus on Sale’ Agreement
The defendant in this decision was James Larweth, an executive in the pharmaceutical rebate business, in which drug companies compete to have their products included on lists of preferred medications. Insurance companies receive rebates and engage pharmaceutical benefit management companies. The executive worked in an even narrower area of the business, “carve out” pharmaceutical rebates.
The case was before the court on motions for summary judgment in which the former employer, plaintiff Magellan Health, Inc. sought to establish liability for breach of the restrictive covenants and the imposition of an injuction. (Opinion here) The case was decided by a federal court in Florida, but largely applied Connecticut law. The injunction was granted and was affirmed by the 11th Circuit Court of Appeals. (Opinion here)
Executive was former Vice President
Larweth initially worked for Magellan as a vice president. He left Magellan and joined another company, called CDMI. There, he executed an employment agreement with a “bonus on sale” provision as well as restrictive covenants. Magellan bought CDMI for $300 million in 2014, of which Larweth received a bonus of $12 million. As part of the transaction, Lawreth executed an agreement that referenced and amended his CMI employment agreement. He became a vice president with Magellan, a position he held until 2018.
After leaving Magellan, Larweth started competing businesses that began to compete for the same contracts as Magellan and hired away two Magellan employees. Lawreth filed suit first, alleging he was the victim of a smear campaign. Magellan counterclaimed asserting claims under the employment contract.
Larweth challenged the length of the restriction (three years) as unreasonable. The court began by noting that restrictions on competition given at the time of a sale of a business are more readily enforceable than those that are part of an employer-employee relationship. Citing a 1918 decision of the Connecticut Supreme Court, the trial judged that that In the context of a sale, the law affords “a large scope for freedom of contract and a correspondingly large restraint of trade.” He also disputed that the bonus was intended to secure any future performance.
Restrictive Covenants Associated with Sale of Business
The court noted an employee like Larweth may be bound by a restriction against competition, even if the individual obligation is not memorialized in the agreement.
[A] direct contractual obligation memorialized in the sales agreement itself is not required. Instead, “it is well settled [in Connecticut law] that an agreement not to compete will be considered to have been given in connection with the sale of a business even if the covenantor is not the seller, if the covenant was reasonably necessary for the protection of the good will of the business.” … “[i]f the covenantor was active in the management of or intimately involved with the business, … the covenant will be considered to have been given in connection with the sale of the business.”
Magellan’s evidence was undisputed, the court held, that Larweth was a key employee and that securing his restrictive covenant was a key element of the negotiations associated with the sale. The period of time, viewed from this perspective was reasonable.
The trial court went on to analyze the remaining elements necessary to determine whether the restrictive covenant was enforceable. Magellan had a protectible interest in its customer relationships that made the restrictions reasonable in prohibiting the solicitation of customers and direct competition. The prohibitions in Larweth’s agreements – direct and implied — were reasonable, the court concluded.
Larweth sought to defend the case in part by arguing Magellan had waived the restrictive covenant through selective enforcement. The court, relying on a New Jersey decision, held that selective enforcement of restrictive covenants with former employees was not consider a waiver of the employer’s rights. Quoting the New Jersey decision, the judge reasoned:
[That] suggestion would require an employer to enforce every restrictive covenant, without regard to cost-effectiveness or individual circumstances. This is impractical and unfair, not only to Plaintiffs, but to other former employees, particularly here where the other former employees have not launched a collective effort that represents as great a competitive threat to [the employer] as [the defendants].
Contact us if you face similar issues or have questions on the enforcement of restrictive covenants.