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Enforceability Of Restrictive Covenants After A Change In Control

by: Anthony Limitone, Jr.

The termination of employees after the change in control of the employer raises a number of questions regarding the enforceability of non-compete agreements and similar restrictive covenants. Several factors affect the enforceability of the restrictive covenants. The two most important are 1) the structure of the transaction leading to the change in control , and 2) the terms of the agreement embodying the restrictive covenant. The circumstances surrounding the employee's termination will, to a lesser extent, affect the restrictive covenant's enforceability. This article will discuss each of these factors.

Purchase and Sale of Stock

Frequently, a purchaser acquires control over an employer by purchasing a controlling number of the employer's shares of stock. In this situation, the acquired company continues under its old name, but is controlled by a new owner. When confronted with this type of transaction, the Third Circuit held in Zambelli Fireworks Manufacturing Co., Inc. v. Wood, that the new owner employer could enforce any non-compete or non-solicitation clause because there had been no change in the corporate identity of the employer. This conclusion rested on the "basic tenet of corporate law that a change in stock ownership is merely a transfer of shareholder rights which does not, in and of itself, normally affect the existence of the corporate entity".3  Although Zambelli was decided under Pennsylvania law, the result should be the same under New Jersey law. The court in Department of Transportation v. PSC Resources, Inc.,4 said that:

Where a corporation is acquired by the purchase of all of its outstanding stock, the corporate entity remains intact and retains its liabilities, despite the change of ownership.

The conclusion probably is no different when the original employer is a partnership and some of the partners sell their partnership interests to an existing partner or to a third party. In New Jersey, a partnership is a legal entity separate and distinct from its partners. 5 Moreover, a transfer of a partner's transferable interest in the partnership does not by itself cause dissolution and winding up of the partnership business. 6 Therefore, the transfer of the partnership interest would be analogous to the transfer of corporate shares and have no effect on the enforceability of the restrictive covenants.

With respect to limited liability companies, two Pennsylvania courts have held that a transfer of a member's interest to a different person does not affect the enforceability of an employee's non-compete agreement. The courts found that the purchase of membership units of an LLC was analogous to a sale of corporate sales, and therefore the identity of the employer did not change.7  Although there are no New Jersey cases in point, there is every reason to believe that this State's courts would reach the same conclusion since in New Jersey an LLC is an entity separate and distinct from its members.8

Sale of Assets

The sale of assets creates a more complicated situation. When there is a sale of assets, the seller transfers some or all of its assets to the purchaser. Some or all of the seller's employees also start to work for the purchaser. Therefore, the purchaser becomes the new employer of the seller's employees. The seller, however, continues in existence and remains responsible for its liabilities.

The terms of the employment contract as well as the terms of the contract of sale will have a decisive effect on the enforceability of any restrictive covenant when there is a sale of assets. In any sale of assets, the employment contract will be treated as an asset of the seller which has to be assigned to the buyer if the buyer is going to have any right to enforce it. Therefore, the first question that must be answered is whether the employment contract permits the assignment of the contract. In some employment contracts, the contract stipulates that the employee may not be assigned except with the consent of the employee; this type of clause frequently appears in employment contracts for physicians and veterinarians. When an employment contract contains this type of clause, the employer may not assign the contract as part of a sale of assets absent the employee's express consent. 9 On the other hand, when the contract is silent or expressly allows the assignment, New Jersey's courts will permit the assignment.10

Although the contract of employment may permit its assignment, the next question is whether the seller has in fact assigned the contract. The answer depends upon the terms of the contract of sale. If the contract of sale provides for the sale or assignment of all of the seller's assets, courts will treat the seller's rights in the restrictive covenant as part of the assigned assets even though not mentioned expressly. 11  However, if the contract of sale provides for the transfer of some, but not all, of the seller's assets, then a court will probably find that the restrictive covenants were not assigned unless expressly mentioned.

The case of Woodbridge Medical Associates, P.A. v. Berkley 12 is instructive in this regard. In Woodbridge, the owners of a medical group called Woodbridge Internal Medical Associates, PA ("Internal") created a new separate professional association called Woodbridge Medical Associates, PA ("WMA"). Shortly after the formation of WMA, Internal's owners transferred Internal's fixed assets to WMA at net book value without compensation to Internal. Internal, however, retained all of its accounts receivables so it could satisfy its existing liabilities. Upon the effective date of the sale, Internal ceased its operations, and its employees immediately began working at WMA. Internal, however, did not assign to WMA any of the contracts it had with its employees or shareholders; those contracts contained a variety of restrictive covenants which barred Internal's employees from setting up a competing practice.

Shortly after the transfer of assets, a disaffected group of WMA's doctors and administrative employees quit WMA and established a competing practice. WMA sought an injunction which would enforce Internal's restrictive covenants. The trial court refused to grant the injunction. The appellate court affirmed, and held that those contracts had not been assigned to WMA notwithstanding the transfer of the fixed assets. It concluded this phase of its analysis by saying

And, because the record clearly demonstrates that [Internal] continued to exist following the transfer of interests and the formation of WMA, the judge correctly rejected the contention that WMA had succeeded to those assets and liabilities of [Internal] that were not actually transferred or assigned.13

The court also rejected the plaintiff's claim that the transfer of assets, employees and general business operations constituted a de facto merger.14

Mergers and Consolidations

In a merger, usually a larger corporation absorbs a smaller corporation. Although the smaller corporation goes out of existence, the larger corporation survives. In a consolidation, two corporations pool their operations into a new amalgamated corporate entity; in this situation, both of the original corporations go out of existence.15

An assignment of assets is usually part of the merger documents. Therefore, the analysis involved in determining whether the surviving corporation can enforce the restrictive covenant will be the same as the analysis involved in the sale of assets. Thus, two questions must be answered. First, does the employment contract permit its assignment? Second, was there an effective assignment of the employment contract?

The Effect of the Assignment on the Employee's Employment With the Acquired Corporation

It is important to note that a sale of assets terminates the employment relationship with the seller even though the employee starts working for the successor employer in the same position and at the same salary without break. The Appellate Division announced this rule in Adams v. Jersey Central Power & Light Co.16 In Adams, Jersey Central Power & Light ("JCP&L") had sold its natural gas business to a company called New Jersey Gas Company ("New Jersey"). The buyer had no former connection with the seller, and neither the union nor the employees were parties to the sale. After the sale closed, JCP&L employees became employees of New Jersey but continued in the same jobs they formerly held with JCP&L.

The question before the Appellate Division in Adams was whether the employees were entitled to severance pay under the collective bargaining agreement which provided that JCP&L employees were to receive severance pay if they were "... permanently released from employment because of reasons beyond the control of the employee ...." Therefore, the court had to determine if and when the employees' employment with JCP&L terminated. The court held that the employees were entitled to severance pay from JCP&L because their employment with it had terminated when New Jersey purchased JCP&L's gas business and its former employees started working at New Jersey. The court gave the following rationale for its decision:

Defendant argues that what happened to plaintiffs was not a release from employment but merely a transfer of employers without a single hour's loss of pay or change of job or work location. This is factually true; it is equally true that they could no longer work for defendant with which they had the contract. It was fortuitous that New Jersey was willing to accept plaintiffs' services and that defendant was willing to make a successful effort to place them there. Plaintiffs were in no way bound to work for New Jersey. They could not continue in defendant's employ even if they wished. Their choice was to become an employee of New Jersey or seek work elsewhere .17

The result would be the same in the case of a merger or consolidation. In either situation, the employee is employed by a new employer. Therefore, when a merger or consolidation occurs, the employee's relationship with the original employer terminates. A comparison of the Employer Tax ID number on the pay stub before and after the acquisition would be the easiest way to prove this.

This principle is important because almost all non-compete clauses prevent employees from working for a competitor during the 12 months, or some other period of time, after the termination of employment. The clock would appear to start running from the time of the merger or sale of assets. Therefore, if the duration of the non-compete agreement were one year, and the employee was terminated six months after the merger, the new employer would be able to enforce the restrictive covenant for only six additional months.

In J.H. Renarde, Inc. v. Sims,18 the Chancery Division was faced with a similar fact pattern. In that case, the restrictive covenant barred employees from working for a competitor for a period of nine months after the termination of their employment. The sale of the business, with an assignment of the restrictive covenants, occurred in 1993. The defendant employees resigned in 1998 and promptly opened a competing business. The buyer sued for an injunction, which the trial court granted.

In reaching its decision, the court considered only whether the restrictive covenants could be assigned. It did not discuss whether the sale of assets terminated the defendants' employment with the seller or whether the nine-month period began to run from the date of the sale. The decision in J.H. Renarde, Inc. would be correct only if the sale of assets did not constitute a termination of the employment relationship between the seller and the defendants. However, as previously discussed, under Adams v. Jersey Central Power & Light Co.19 the sale of assets terminated the employment relationship between the seller and the defendants even though they started working immediately for the buyer in the same position and at the same salary.

This result is not changed by the contractual provision which states that the agreement is binding on the successors and assigns of the parties. This contractual term does not extend the duration of the employment relationship beyond the sale of assets. Rather, it merely gives the purchaser the right to enforce the restrictive covenants up to the day those covenants expire after the termination of employment. For example, in J.H. Renarde, Inc., the buyer could, for a period of nine months after the sale, prevent the employees from working for a competitor. But, nine months after the sale, the restrictive covenant would expire by its own terms and the buyer would be unable to prevent employees from working for a competitor. The buyer, however, could easily avoid this result by having the employees sign a new restrictive covenant.

Other Factors Affecting Enforceability After A Change In Control

After a change in control, many of the employees from the acquired company find the new "corporate culture" uncongenial and resign as a result. This raises the question whether that change in corporate culture would invalidate any non-compete or non-solicitation agreements. The answer depends upon the nature and extent of the changes in working conditions.

In Zambelli 20 the court said in passing that a "... change in corporate culture alone cannot invalidate a legally binding contract." That statement is true as far as it goes. However, the Supreme Court of New Jersey in Karlin v. Weinberg said that where the termination of employment

... occurs because of a breach of the employment contract by the employer, or because of actions detrimental to the public interest, enforcement of the covenant may cause hardship on the employee which may be fairly characterized as undue in that the employee has not, by his conduct contributed to it.21

Therefore, if an employee can show that changes in the terms and conditions of employment implemented by the successor employer constituted either a breach of the employment contract or otherwise contravened public policy, then courts will not enforce the restrictive covenant.

Platinum Management, Inc. v. Dahms,22  is the only New Jersey case that discusses the nature of an employer's conduct that will absolve an employee from compliance with any restrictive covenant. In that case, the court found that the first defendant Dahms had breached his non-compete agreement and duty of loyalty. The court also found that the second defendant Rosenberg had breached his duty of loyalty.

Both Dahms and Rosenberg argued that notwithstanding their own wrongful conduct, they were exonerated from liability because of the employer's wrongful conduct. In Dahms' situation, the court found that the employer failed to pay him a $21,340 override on his bonus. With respect to Rosenberg, the court held that the employer had treated him "shabbily" because Rosenberg properly believed that the employer

... was not using his talents, did not appreciate his efforts for the company, and had treated him unfairly when it fired him in April 1991, (after a leg injury) and then rehired him part time at a substantially reduced salary.23

In considering these defenses, the court held that employees can escape liability from breaches of a non-compete agreement or other restrictive covenant only if the employer's conduct amounted to a material breach of the employment contract.24 Using this standard, the court concluded that the employer's failure to pay the bonus override to Dahms was not a material breach of the contract. Therefore, it entered a judgment against Dahms for the damages the employer incurred. In contrast, the court entered a judgment of no cause in favor of Rosenberg. The court reasoned that the employer's unfair treatment of Rosenberg constituted a material breach of the contract and barred it from any relief against him even though he had undoubtedly engaged in wrongful conduct.25

Conclusion

The enforceability of restrictive covenants after a change in control depends upon a number of factors. These include the structure of the transaction leading to the change in control. Was there a sale of stock or was there a sale of assets? And if there was a sale of assets, what assets were sold? It will also depend upon the terms of the employment contract. Did that agreement prohibit its assignment to a successor employer? Finally, the employer's treatment of the employee after the change in control will be significant. Did the employer's conduct constitute a material breach of the employment contract? Only after these questions are answered can a decision be made concerning the enforceability of any restrictive covenants.

Endnotes

1Corporate transfers usually fall into one of three categories: a sale of stock, a sale of assets, or a merger or consolidation. Wilson v. Fare Well Corp., 140 N.J. Super. 476, 485 (Law Div. 1976).

2592 F.3d 412, 422-3 (3d Cir. 2010).

3Id. quoting Siemens Med. Sols. Health Serv. Corp. v. Carmilengo, 167 F. Supp. 2d 752, 758 (E.D. Pa. 2001).

4175 N.J. Super. 447, 453 (Law Div. 1980).

5N.J.S.A. 42:1A-9(a).

6N.J.S.A. 42:1A-29(a)(2).

7Missett v. Hub International Pennsylvania, LLC, 2010 WL 3704984 (Pa.Super.Ct. 2010); American Homecare Supply Mid-Atlantic, LLC v. Gannon, 2009 WL 6340111 (Pa.Com.Pl. 2009).

8See N.J.S.A. 42:25-23, which provides that members are not individually liable for LLC's debts.

9See Aronsohn v. Mandara, 98 N.J. 92, 99 (1984) where the court observed that contractual rights and obligations were freely assignable unless there was an express contractual prohibition.

10J.H. Renarde v. Sims, 312 N.J. Super. 195, 199-201 (Ch. Div. 1998); A. Fink & Sons v. Goldberg, 101 N.J.Eq. 644, 646-47 (Ch. 1927). Other states will not allow the assignment of employment contracts. See, e.g., Hess v. Gebhart & Co., 570 Pa. 148, 808 A.2d 912, 917-18 (2002).

11J.H. Renarde, Inc. v. Sims, supra; A. Fink & Sons v. Goldberg, supra.

122010 WL 2195760 (App. Div. 2010).

13Woodbridge Medical Associates, P.A. v. Berkley, supra, 2010 WL 2195760 at *3.

14Id.

15Applestein v. United Board & Carton Corp., 60 N.J. Super. 333, 342 (Ch. Div. 1960), aff'd 33 N.J. 72 (1960).

16Adams v. Jersey Central Power & Light Co., 36 N.J. Super. 53 (Law Div. 1955), aff'd 21 N.J. 8 (1956).

17Adams v. JCP&L, supra, 36 N.J. Super. at 66.

18312 N.J. Super. 195 (Ch. Div. 1998).

19Supra.

20Zambelli v. Wood, supra, 592 F.3d at 423.

21Karlin v. Weinberg, 77 N.J. 408, 423 (1978).

22285 N.J. Super. 274 (Law Div. 1995).

23Platinum Management, Inc. v. Dahms, supra, 285 N.J. Super. at 287.

24Id. at 303.

25Id. at 313.