Buyer and Seller Beware: The Assignability of Contracts in the Context of M&A

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It’s the morning of closing and excitement is in the air.  You are a few hours away from acquiring your first pest control company which will add a nice chunk of sales and technical expertise to your current operations.  So far, you’ve done everything by the book.  You and your advisors have negotiated a fantastic price for the target, you’ve completed extensive due diligence and your attorney has advised that all you need to do now is show up at the closing, sign a few documents and fund the deal.

A week after the trouble-free closing you receive a desperate call from your manager who informs you that three of the key employees from the target (the company you just acquired) have tendered their resignations.  While on your way back to the office you get an email on your Blackberry from an old friend in the industry who tells you that your three former employees are now working for your biggest rival, and will most likely be stealing the same customers that you just wrote a check for the week before.

When you hear that, the pit in your stomach grows, but then it hits you, as you say to yourself, “well, thank God they are all under non-competition, non-solicitation and confidentiality agreements…. At least they won’t be able to steal business from me.”

Many an inexperienced acquirer have uttered those very same words, only to find out that the agreements that were in place at the time of the acquisition are not worth the paper they are printed on.  In this situation, when you made the acquisition, your attorney advised you to structure the transaction as an asset purchase, as opposed to a stock purchase.   He reasoned that not only will you be able to write-up the acquired assets and get better tax treatment, you will also be able to avoid any hidden liabilities that might not have been uncovered in diligence.  Your VP of HR reviewed the key employees’ employment, non-solicitation and non-competition agreements prior to the closing and advised you that they are standard and enforceable in the state.

Can you enjoin these employees from competing against you and soliciting your recently acquired customers?  Do you have any recourse under the agreements that these employees  signed with their former employer, and that you believed would be transferrable to you?

The situation above, while hypothetical for the purposes of this article, is based on an actual incident that I just learned about from an attorney here in Philadelphia.  Although the acquirer was not a pest control company, it was a residential services company that operates in a very similar fashion to a pest control company and therefore it is very relevant to all acquirers and sellers in the pest control industry.

In order to answer the questions raised above, we need to delve a little deeper into the fact pattern of the case.  Needless to say, however, these are all questions that should have been asked prior to closing the deal, not a week later when the acquirer has a million dollars on the line.

In the US, the question of enforcement of assigned contracts depends entirely on state law (or provincial, cantonal, etc, depending on what country you are in).  In this situation, under PA state law, the acquirer seems to have absolutely no recourse whatsoever and will be losing a lot of money.   Depending on your state (or country), non-competition and non-solicitation agreements might be entirely unenforceable as a matter of public policy (such as California), however the general theme of the assignability of contracts, whatever those contracts may be, in the context of an M&A transaction might still apply to you.

In the example above, the acquirer purchased the target’s assets, which is the same way that the extreme majority of pest control acquisitions are structured.   Under an asset purchase, contracts need to be assigned to the acquirer, whereas under a stock purchase, the acquirer is buying the target’s stock and therefore most, if not all (unless there is a change of control provision), of the target’s contracts stay in force.

In a 2002 case, the PA Supreme Court opined, “We hold that a restrictive covenant not to compete, contained in an employment agreement, is not assignable to the purchasing entity, in the absence of a specific assignability provision, where the covenant is included in a sale of assets”  This view however, should not be surprising, as most courts tend to view covenants not to compete as contrary to public policy in that they act in “restraint of trade.”

So by taking the cautious approach and acquiring assets and not stock, the acquirer needs to make sure that there is valid assignability language in the original agreements executed by and between the employees of the selling company and the selling company.  In an asset purchase, you are not buying the employment relationship, per se, you  must hire the employees of the selling company upon consummation of the sale.  Therefore, if any employment contracts do not have an assignment clause, the courts will often view those to be unenforceable.  In late 2002 the Ohio Court of Appeals opined that, “the employment relationship is a personal matter between an employee and the company who hired him and for whom he chose to work. Unless an employee explicitly agreed to an assignability provision, an employer may not treat him as some chattel to be conveyed, like a filing cabinet, to a successor firm.” Cary Corp. v. Linder, No. 80589, 2002 WL 31667316 (Ohio Ct. App. November 27, 2002). See also, Reynolds & Reynolds v. Hardee, 932 F. Supp. 149 (E.D. Va. 1996) (employment agreement is based on mutual trust and confidence; non-compete is not assignable).

The PA Supreme Court offers further guidance, “…. it is the employer that drafts an employment agreement that is executed by both parties for the benefit and protection of the employer.  It is a simple matter for the employer to insert an assignment clause into the agreement at the time that the agreement is drafted to cover future contingencies, such as those that occurred here.  The failure of an employer to include specific provisions in an employment contract will not be judicially forgiven or corrected at the expense of the employee.” Hess v. Gebhard & Co., 808 A.2d 912 (Pa. 2002).

Lessons for the Acquirer

Most sellers do not want acquirers talking to their employees until the acquisition proceeds have cleared their bank accounts.   However, when I advise on the buy-side, under no circumstances would I allow my client to fund an acquisition without determining which employees are staying, which employees are going, and what the employment relationship between the employees (of the seller) and the new employer (the acquirer) will be going forward.   There are some very basic due diligence items in regard to the target’s employees that should be handled during the diligence or legal documentation stages of the transaction, these include:

  • Do the employees have any employment, non-solicitation, or non-competition agreements in place with the selling company?  If they don’t, the solution is very simple, have them sign these agreements prior to the closing of the sale.  The acquirer should work with the seller to make sure all employees sign these agreements.
  • If the seller does have agreements in place, are they presently enforceable by the current employer?  If they are not enforceable by the seller, they are certainly not going to be enforceable by you the acquirer.   Some questions your legal counsel will need to answer are:
    • Was there adequate consideration to induce the employees to enter into the contracts in the first place?  If not, you may need new agreements.
    • Are the covenants overly broad, which will allow the courts to strike down the whole agreement or “blue pencil” the documents thereby limiting their effectiveness?  Again, your attorney may advise you that brand new agreements are necessary.
  • Was the target consistent in the matter in which it obtained restrictive covenants?   If the employees can argue that the selling company was not consistent in obtaining restrictive covenants, this may weaken your ability to enforce them.
  • Did the selling company enforce its restrictive covenants?   If the seller did not enforce its agreements, you shouldn’t expect the court to allow you to enforce them either.
  • Is the geographic scope of the target’s business different than that of the acquirer?   Did the employees execute the agreements in Maryland, but are now working in PA?  Restrictive covenants and employment agreements are state law issues, so make sure that the scope of the agreements are appropriate.  Discuss your operational plans with your attorney and make sure that you are covered.   This is important when operations cross state lines.

This is clearly legal diligence and should be conducted by a competent attorney in that specific jurisdiction.  When you acquire a pest control company, you are “acquiring” an employee base, and if you don’t pay very close attention to these issues, you might as well just give the money away.

If you are contemplating an asset purchase and are uncomfortable with the seller’s agreements, or through your due diligence, you’ve uncovered issues, such as no assignability clause, you need to enter into new agreements with the employees prior to the close of the acquisition.  If the seller won’t cooperate with this, you might need to establish a sizable holdback or escrow to protect your interests, or even revise the purchase price downward to compensate for the increased risks in doing the deal.

Finally, if the employees won’t sign up with you prior to the closing, this should be a big red flag.   If they won’t do it before the closing, you have no assurance that they will do it after, and you need to proceed with extreme caution.   At this point, you need to ask yourself whether or not it makes sense to proceed with the acquisition… and at what price?

Lessons for the Seller

Many of you might not be contemplating an acquisition whatsoever and find yourself solely on the sell-side of the equation, so what’s this got to do with you?

First off, any sophisticated acquirer is going to ask the very same questions that I’ve highlighted in the section above upon the acquisition of your business. If you are in a jurisdiction that recognizes and enforces these covenants and agreements, you might want to consider getting them in place now, before you commence a sell-side process.   Furthermore, If you don’t have non-compete agreements with assignment provisions, you might want to negotiate new agreements with your employees now and provide adequate consideration to them for entering into the agreements.  Remember, this is something that should be done solely through the advice of an attorney who can advise you on such issues as adequate consideration and enforceability.

Final Thoughts

Buyers will want to talk to the target’s employees at the very early stages of the acquisition process and sellers will not want the acquirer talking to their employees at all until the acquirer owns the target.   Buyers and sellers need to find a common ground, usually in the late stages of diligence, where the buyer is able to meet with, at minimum, the key employees of the target.  Seller’s need to feel confident that the deal is all but done before allowing the buyer access to employees and the buyer will not want to invest a lot of time and money into the deal process if the seller’s employees may walk out the door upon the sale.

Through careful planning, a seller can greatly decrease the risks that both sides will face in dealing with employees on the potentially life-changing topic of the sale of their employer.  By working with competent advisors before the sale process to make sure that consistently-obtained, enforceable non-solicitation and non-competition agreements with transfer provisions are in place, the seller will generally have more leverage in holding the acquirer off until much later stages in the acquisition process before getting his or her employees involved.

Waiting until you are on the verge of selling your company, your life’s work, to deal with these issues is inexcusable.   Getting competent M&A and legal advisors involved in the planning stages is your best weapon against sophisticated acquirers, against whom sellers are at a natural disadvantage from the very beginning of the process.

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About Paul Giannamore

Managing Director at The Potomac Company where I head the firm's strategy consulting and investment banking practice focused on the structural pest control and integrated facilities services industries. I write the Pest Control M&A Weekly Commentary and The Potomac Pest Control Executive, newsletters read by thousands pest control professionals in scores of countries (you can subscribe to it below). In a nutshell, I do two things: (1) advise shareholders and senior management of pest management firms on creating value in their businesses, (2) advise sellers on the sale of their businesses. Based in Geneva, Switzerland, I'm a graduate of Cornell University, and I speak Italian, Spanish, Arabic and broken French. Join me on LinkedIn