Owners of closely held businesses1, whether an S corporation, limited liability company or partnership should always be attentive to and be familiar with the operations of the company, as well as the rights, duties, and obligations they have as owners, especially during a business divorce. This latter point includes making sure the company has an executed shareholder agreement or operating agreement in place. These agreements typically include buy-out clauses and valuation provisions for an orderly transition of ownership interest when an owner leaves the company, whether voluntarily or involuntarily. Such provisions normally include restrictive covenants protecting the company against anti-competitive behavior, such as recruitment of customers and/or employees by the departing shareholder member.
In the business divorce context not every company relationship ends upon the retirement, disability, or death of a co-owner. Alternatively, when a co-owner departs from a company there is a likelihood they will plan to compete in the same industry or profession. Therefore, as part of the business divorce and dissolution process, effective and enforceable restrictive covenants are necessary. The precise terms and language of the covenant(s) need to be clear and unambiguously stated in the company’s shareholder agreement or operating agreement.
Restrictive covenants pertaining to the buy-out of a partner in a business divorce typically include: (1) a covenant not to compete for a certain duration of time and defined geographical area; and (2) a non-solicitation covenant(s). A non-solicitation covenant is designed to prevent the departing owner from recruiting current employees, customers, or clients for a specified time period. Clearly, such restrictive covenants are designed to protect the interests of the company, and therefore derivatively protect the co-owner of the company from any competition by the departing shareholder/member.
While the corporate law and employment law of New Jersey generally disfavor restrictions of competition such as a non-compete or non-solicitation clause, such covenants have been held to be enforceable against a departing shareholder/owner where the terms of the covenants are reasonable in scope. An analysis as to the “reasonableness” of the terms of a restrictive covenant include: (1) that the restraint be no greater than that required for the protection of a legitimate interest of the company; (2) the terms of the restriction do not impose any undue hardship on the departing owner/shareholder; and (3) the terms of the restriction will not impose any injury to the public interest.
In addition to the reasonableness of its terms, a restrictive covenant in an operating agreement or shareholder agreement is viewed by the courts as a bilateral contractual term negotiated between the company owner(s) in good faith and at arm’s length. Consequently, to be enforceable a non-compete and/or non-solicitation clause(s) must provide adequate consideration from the company to the shareholders/owners. The agreement should clearly specify that the valuation and payment of the buy-out to the departing shareholder/member serves, in part, as agreed to consideration for the restrictive covenant(s). These factors are critical because if the terms of the restrictive covenant(s) are not properly tailored then when the company tries to enforce the terms against a departing owner/member, the restrictions might not be enforced by the court in the litigation of the business divorce. Therefore, the proper drafting of the restrictive covenants in the shareholder agreement or operating agreement is key.
If you have any questions or wish to discuss the subject of this article, business divorce, shareholder rights and obligations or any issues related to business law, please contact Timo thy Lyons, Esq., Co- Chair of the Business Litigation Department of Jardim, Meisner and Susser. Mr. Lyons represents and counsels business owners through all phases of a company’s life cycle, including business litigation matters. Mr. Lyons can be contacted at (732) 978-1919 and via e-mail tlyons@jmslawyers.com
