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Restrictive covenants in M&A transactions: corporate and labour perspectives

Restrictive covenants usually consist of more than one specific obligation – the most common being non-compete and non-solicitation obligations – designed to preserve, in an M&A transaction, the buyer’s benefit of acquiring (or investing in) a business that will not, for a given period following closing, lose part of its value as a result of sellers’ competition.

In a number of M&A transactions, especially those involving startups, the greatest asset pursued by the investor is the staff behind the target company, embodied either in the founding shareholders or in certain key employees. In these cases, keeping those strategic players out of the competing market is essential for the project’s consummation and success, besides directly reflecting in the amount that the buyer is willing to pay for the business. It is reasonable to expect, then, that, after the closing, the sellers, and possibly their key staff, will not engage in, or conduct, a parallel business or activity that competes with the acquired company, nor solicit other employees of the company. In order to prevent sellers and staff from doing so, it is essential to include restrictive covenants in the transaction documents.

Although having similar contents and purposes, the restrictive covenants applicable to founding partners or sellers should not be treated in the same way as covenants applicable to the target company’s employees. As the vulnerable party in the employment relationships, the employees are protected by specific labour laws in Brazil which, among other benefits, ensure the free exercise of the profession as a way to provide their livelihood. As a consequence of these protective rules, employees can only be prevented from acting in a business that competes with their previous employer if they are satisfactorily compensated by the former employer (among other conditions). The founding partner, in turn, is not an employee of the target company, but rather an employee of its owner and is fully capable of negotiating the terms of the transaction on par with the investor and is free, therefore, to agree on the non-competition conditions and limits, provided that certain parameters are observed.

If, on the one hand, the restrictive covenants limit the freedom of the parties subject to these obligations, and on the other hand such rules enable several transactions to be closed and the involved players to be well compensated, establishing clear and balanced boundaries is the secret to avoiding challenges or unexpected issues throughout the course of the relationship.

Corporate perspective

Free competition is a fundamental principle of the Brazilian legal system, expressly protected by the Brazilian federal Constitution. In light of this – and the restraints a non-compete provision imposes on the sellers, as well as the overall negative impacts it may have on competition – courts and antitrust bodies in Brazil have been giving more attention to them. If the provisions go beyond certain parameters, they may be challenged by sellers and disregarded by competente authorities.

As a general rule, restrictive covenants impacting sellers in Brazil should be based on two main pillars: first, ensuring that the buyer meets the necessary conditions for stabilising the business, recovering its investment and taking advantage of the benefits of the acquisition; and second, reasonable time and geographical limits appropriate to the characteristics of the relevant market.

As to the time limitation, Brazilian authorities tend to consider up to a five year term as reasonable for covenants not to compete. But of course, the definition of a reasonable time limitation, applicable to each situation, varies according to the relevant characteristics of the transaction. Specific conditions of the markets involved, potential effects on competition and the actual need for investment in each deal (for example, long or short-term investment) may impact the authorities’ understanding and acceptance of different time limitations.

Regarding the delimitation of geographical space, the generic area normally applicable to any M&A transaction closed in Brazil is the entire national territory. However, each market involved in the transaction has its own specific geographical boundaries and Brazilian authorities normally do not consider it reasonable to treat them in the same generic way.

Considering that M&A transactions in Brazil are subject to a pre-closing review by antitrust authorities, non-compete covenants in general should be structured in light of the above parameters. If the Brazilian authorities consider the restrictive covenants to be capable of limiting or otherwise harming free competition, they will most likely not approve the transaction (or will at least require the provisions be adjusted and restricted in order to pass it).

Also, restrictive covenants that are unreasonably broad in scope, geographically wide or extremely long may be challenged and narrowed in their application, or even declared unenforceable, by Brazilian courts.

Finally, an important aspect to be considered is the difficulty with which the courts and antitrust authorities in general have to assess the actual damages caused to the buyer by the seller failing to comply with restrictive covenants, and the extension of the losses and damages to be indemnified in these cases. In order to mitigate this risk, it is advisable that buyers include in the M&A agreement pre-established penalties for noncompliance with restrictive covenants, as an attempt to discourage sellers from defaulting on their obligations.

Labour perspective

From a labour standpoint, the obligations most commonly found in restrictive covenants are obligations that the employees already have during their employment agreement, such as non-compete, non-solicitation and non-disparagement clauses, among others, under penalty of termination for cause. For this reason, restrictive covenants become an issue in M&A transactions when it comes to their enforceability in the post-employment period of the target company employees or even of the seller, when the seller continued in the business as an employee following the transaction.

Although statutory labour laws do not address the issue of restrictive covenants in employment agreements, the labour courts have confirmed that the restrictive covenants are valid and enforceable in the post-employment period as long as they are reasonable. Accordingly, restrictive covenants cannot be more burdensome to one party in the contract than any others.

Considering that the non-compete covenant can be more burdensome for the employee, the labour courts included four additional requirements for a non-compete covenant to be enforceable following the end of the employment agreement: (i) reasonable geographic limitation; (ii) reasonable time limitation; (iii) clear definition of competition and/or applicable restrictions; and (iv) indemnification for the non-compete period.

The labour courts have a different perspective from the Brazilian authorities when analysing the covenant from a corporate perspective. The labour courts believe that the geographic limitation should be the minimum necessary, being the equivalent to the locations where a former employer has a business or can prove to have an interest in a prospective business. Broader geographic limitations, such as national, continental, or all of the Americas, for example, would be considered too broad and invalid unless the company actually had businesses in all these locations.

Regarding time limitations, the Brazilian labour courts have a slightly different approach than the corporate side, as they will expect the time allowed to be the minimum required to allow the information to which the employee had access to become ‘old’, or no longer relevant and capable of harming the former employer’s business. This means a limit of two years for the labour courts, unless proven otherwise by the interested party.

Additionally, the covenant language must include a clear definition of what actions by a former employee would constitute competition and must indicate applicable restrictions, such as a list of the company’s competitors or the positions in which the former employee cannot be engaged during the restricted period.

Finally, the covenant must provide for an indemnification to compensate former employees for the limitation of their ability to work or perform other economic activities to earn a living. It is important to note that the concept of consideration, as it exists under US contract laws, does not exist in Brazil. Therefore, the employment offered to the employee, as well as the remuneration paid during employment, would not class as sufficient compensation for the non-compete covenant. The indemnification must be equivalent to the non-compete obligation, which is usually equal to one month’s salary for each month of the non-compete obligation, although there are examples of lower indemnification that were considered valid by the labour courts.

In conclusion, in the context of an M&A transition it is relevant to determine not only whether the target company employees have restrictive covenants in place, but whether such covenants will meet the requirements to be enforceable in a post-employment context. The same concern should be addressed when it comes to including such restrictive covenants in place for the sellers, when, and if, they become employees of the business after the closing of the transaction.