Negative Covenant
It is an agreement that prohibits one party (a person or a company) from engaging in specific actions.
What is a Negative Covenant?
A negative covenant, or a restrictive covenant, is an agreement that prohibits one party (a person or a company) from engaging in specific actions. In other words, it can be seen as a promise that one entity makes not to do certain things.
It can be utilized in the agreements below, serving different purposes based on different contracts:
- Employment Contracts
- Mergers and Acquisitions (M&A)
- Bond Documents
- Land Use / Rent Agreements
For instance, in a real estate purchase, a buyer may sign a restrictive covenant that requires them not to use the property for business, meaning they can only use it for residential purposes.
In contrast, a positive covenant, also called an affirmative covenant, is an agreement that obligates one party to perform certain specified activities.
An example of a positive covenant is a contract between a mortgage lender and a borrower. The former asks the latter to maintain the loan collateral until the loan is fully paid off.
In this article, we first examine the three main types of restrictive covenants. Then, we discuss how restrictive covenants function in the three types of obligations. Lastly, we briefly address the issues with restrictive covenants before going over the key takeaways.
Key Takeaways
Below are some important points summarized from the above article:
- A negative covenant is an agreement that prohibits one party (a person or a company) from engaging in certain actions. It is also known as a restrictive covenant.
- It is the opposite of a positive covenant, an agreement that obligates one party to perform certain specified activities.
- The three main types of restrictive covenants are non-compete, non-solicitation, and non-disclosure agreements.
- A non-compete agreement prohibits one party from directly competing with another party.
- A non-solicitation agreement prevents one party from soliciting employees and/or customers from another party.
- A non-disclosure agreement prevents one party from disclosing another party's proprietary information, trade secrets, innovations, and/or other confidential data.
- Sometimes non-solicitation agreements can be split into two sub-obligations: non-solicitation and non-raiding. Non-solicitation prohibits the solicitation of customers. Non-raiding disallows any recruitment of a company's staff for its competitors.
- These serve different purposes based on different contracts. They are normally utilized in employment contracts, mergers and acquisitions, bond documents, and land use or rent agreements.
- The main issue is that they may be hard to enforce. The enforceability of these restrictive covenants is subject to state law which varies by jurisdiction.
- For tax considerations, a non-compete agreement is treated as an intangible. Therefore, the cost of it as part of a business purchase needs to be amortized over 15 years on financial statements.
Types of Negative Covenants
Negative covenants can be used in individual agreements or implemented as a part of a more significant contract. We discuss the three main types of restrictive covenants:
1. Non-Compete Agreement
A non-compete agreement prohibits one party from directly competing with another party. There is usually a defined period (e.g., five years, ten years, etc.) and geographical boundary written with the agreement terms.
The party who signs the agreement and chooses not to compete would usually be compensated in one way or another by the other party for their potential loss of financial gains.
This agreement is usually utilized in employment contracts or acquisition contracts.
For example, an employee may be required by the employer to sign a non-compete agreement to promise not to start a similar business or work for their competitors if they leave the job.
Another example would be that in an acquisition deal, the target company may be asked to sign a non-compete agreement to ensure that they will not start a new business that competes with the acquirer of the old business after the deal.
It is worth noting that non-compete agreements are illegal in California as the state issued a standing ban on them because of the negative impact these agreements can have on trade and competition.
2. Non-Solicitation Agreement
A non-solicitation agreement prevents one party from soliciting employees and/or customers from another.
Such agreements are usually used in employment contracts. For instance, an employer may require an employee to sign a non-solicitation agreement restricting the employee from soliciting business from the employer's customers if the employee leaves the company.
Many businesses usually ask top executives and personnel who perform important job functions to sign a non-solicitation agreement. In addition, this kind of agreement also may be applied to external consultants or specialists like accountants, engineers, electricians, etc.
Sometimes non-solicitation agreements can be split into two sub-obligations: non-solicitation and non-raiding. Whereas non-solicitation prohibits the solicitation of customers, non-raiding disallows any recruitment of a company's staff for its competitors.
Again, in places like California, it might not be easy to enforce non-solicitation agreements, as specific laws limit such agreements' use. Hence, it's crucial to define the reasonable duration and geographical scope when drafting a restrictive covenant.
3. Non-Disclosure Agreement
A non-disclosure agreement prevents one party from disclosing another party's proprietary information, trade secrets, innovations, and/or other confidential data.
It is generally written in employment contracts and is usually enforceable during and after the employee's tenure with the employer. The purpose of the agreement is to protect valuable information about the business.
Unlike non-solicitation agreements, non-disclosure agreements can also be applied to independent contractors and internal employees.
Even though external contractors don't need to be loyal to a company that hires them, they need to maintain their business secrets if they sign a non-disclosure agreement, as many investments are involved with that company's development.
How Do Negative Covenants Work?
Even though negative covenants are in place to prohibit one party from engaging in activities that diminish the other party's interest, they serve different purposes in different contracts.
This section will further explore how the aforementioned restrictive covenants function in different contracts.
We first examine how employers deploy restrictive covenants in the workplace to protect their investment and intangible assets from potentially disruptive employees.
Then, we investigate how restrictive covenants are used in bond indentures (for bond issues over $5 million) to safeguard bond investor interests.
Next, we touch on how different restrictive agreements are applied in tandem to protect the buyer of the business sold in an M&A transaction.
Lastly, we dive into how developers, landlords, or homeowner's associations use restrictive covenants in real estate to preserve the property's value and, thereby, the money they have invested into the real estate.
Negative Covenants in Employment Contracts
As mentioned above, non-compete and non-disclosure agreements are the two most common restrictive covenants used in employment contracts.
The main objective of these two agreements in the employment context is to protect an employer's goodwill, including its intellectual property (IP), brand reputation, proprietary technology, and trade secrets.
The covenants usually restrict employees from doing certain things during or after their employment that can damage the employer's reputation and shrink its profits.
In addition, restrictive covenants are also utilized by employers to ensure that the money they have invested in their employees through signing bonuses, professional training, and other forms of incentives won't go to complete waste, as human capital management can be costly.
If an employee violates the restrictive agreement, the employer has the right to seek a court injunction to stop the breach and file a financial claim for damages.
To maintain these covenants' enforceability, employers should periodically review and update the contract clauses.
This is because the ultimate enforceability of restrictive covenants is subjected to state law and prevailing trends and standard practice in the local area. Hence, it is in the employer’s best interest to seek professional consultation when drafting negative covenants.
Negative Covenants in Bond Issues
A trust indenture is included in the bond contract in most corporate bonds issues over $5 million. A trust indenture is simply an agreement between a bond issuer and investors highlighting the responsibilities the bond issuer needs to fulfill.
These responsibilities are written as negative covenants to safeguard bond investor interests by ensuring that the issuer is not engaging in activities that could lead to a decline in their credit standing or inability to pay back the accruing debt.
Normally, they prohibit the issuer from issuing more debts until the existing ones have matured or taking any risky bets that may negatively impact the investors.
Moreover, some covenants may also require the issuer to keep the debt-to-equity ratio less than one, ensuring the issuer's assets are financed mainly through its equity rather than debt.
Yet other covenants may limit how much dividends the issuer can pay its stockholders. For example, beyond a certain threshold, the issuer may be restricted from paying the dividends completely.
This provision helps reduce the issuer's default risk and ensures they pay principal and interest on time.
However, there is an inverse relationship between the number of vital covenants and bond yields. If many negative covenants are associated with a bond, the bond's yield is likely low.
Negative Covenants in Mergers and Acquisitions
In an M&A transaction, a restrictive covenant normally contains multiple (non-compete vs. non-solicitation vs. non-disclosure) obligations rather than one.
Among the three types of obligations, the non-compete and non-solicitation agreements are the most common covenants in M&A contracts. Such covenants are normally in place to protect the buyer of the business sold.
Typically, these restrictive covenants limit the seller of the business from engaging in any activities that compete with the company sold, which includes starting another business in the same field or stealing key employees, suppliers, or customers from the company sold.
These covenants are normally included in the transaction document and always have specified time and geographical scopes attached, making them more realistically enforceable.
For M&A transactions involving startups, the founders or key employees are the greatest assets to the buyer of the business. Hence, ensuring these strategic plays are not on the competing market is crucial for the buyer to develop the company further.
In that circumstance, the buyer would normally introduce a restrictive covenant to protect his or her interests by preventing the seller or the key staff from starting a parallel business and/or soliciting other employees from the acquired company.
Negative Covenants in Real Estate
In real estate, restrictive covenants are usually used by developers, landlords, or homeowners' associations to safeguard their interests by limiting the use of a property. (These restrictive covenants are also called deed restrictions in the context of real estate.)
The objective of such covenants is mainly to preserve the existing style, appearance, or functionality of the community or neighborhood. They are common among condominiums and limited-access communities.
Some of these covenants may limit property owners from using residential properties for business purposes, which means that the owners cannot install a home office or run a home-based business at the property.
In addition, restrictive covenants can also include architectural guidelines. For example, the real estate developer may use such covenants to prevent the buyers from modifying the property's original appearance to maintain the aesthetic uniformity of the neighborhood.
This is because property values can drop, harming the developer and other homeowners/buyers in the community if some owners make radical changes to their properties, like enlarging a garage or renovating a garden.
Breaches of the contracts will lead to lawsuits, as sellers and/or homeowner associations are generally very strict with the restriction enforcement and don't allow anyone to bypass the rules.
Issues with Negative Covenants
The main issue with restrictive covenants is that they are hard to enforce. As mentioned above, the primary purpose of these covenants is to protect a business, employer, investor, or landlord's financial interest.
However, the enforcement process can take a long time and be very complicated if one party breaches the contract. Lawyers would have to work on collecting evidence to go through litigation, which is a lengthy and expensive process.
All the while, what the damage caused cannot easily be undone.
Furthermore, in the United States, different states have different requirements on what clauses can be included in negative covenants.
As mentioned above, in California, non-compete agreements are illegal, while non-solicitation agreements are hard to enforce due to state law limitations.
This means that even if a non-compete agreement is signed by an employee at will, and the employee somehow breaches the contract, the Californian court will not uphold the covenant against the employee.
As for the tax treatment of restrictive covenants, a non-compete is considered an intangible asset, which means the cost of a non-compete agreement as part of a business purchase needs to be amortized over a 15-year span.
The amortization period started in the month when the covenant was signed or when the business began generating income.
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