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Restrictive Covenants and Key Employees
By Ray Chodos, March 2003

Balancing the employer need for restrictive employment contracts with employee rights and enforceability.

Oftentimes family owned businesses will rely heavily on employees and managers to deliver client services in such a way as to develop loyalty and continued patronage. Inherent in development of good customer retention lies personal service and evolvement of a relationship between client and service provider. Private businesses may recruit and invest years in training the employee or manager to learn the nature of their particular service and pricing practices in order to enable the employee to operate the department or practice area. It is not unusual for a well established employee in such a position to realize that there is a substantial earning potential for them to deliver the same services to the same customers without their employer involvement. Most professional firms (law and CPA) were formed by departing employees venturing forth on their own. The employer has in effect recruited, trained and enabled his employee to become his most effective competitor for his own client’s business. The dilemma the employer faces is providing the customer with the best service providers possible; “but only while they work for me”.

After the employer’s rage abates he may engage an attorney to draft an employment contract containing strong restrictions on future such unintended results with key employees/ managers. While an eager new employee may agree to sign such a covenant, they do not yet generally realize the opportunity for personal gain they will encounter if and when they are seasoned providers to many large and important clients.

Common sense would dictate that if an employee signed a contractual employment restriction containing specific “don’t do” items, they would be enforceable in the event of a breach. The legal system under which we operate is not always intuitive or logical.

Courts have an obligation to promote free enterprise and encourage competition. Restraining an employee from employment and preventing and employer from hiring is very difficult for a judge to support. Restraint of trade or tending to lessen competition is against public policy. What sort of agreements are courts likely to uphold? The guidelines are : (1) as to time; (2) as to territorial effect, and; (3) are otherwise reasonable, considering the scope of the employer's business interest sought to be protected and the effect on the employee. The word reasonable is obviously subjective and renders predictability of outcome to chance.

What can an employer do to protect his very business?
If you are going to utilize an employment contract containing restrictive covenants, there should be evidence of “employer investment”, managerial responsibilities, and trade secret value. The restriction must be in exchange for valuable consideration rather than as a punishment or trade restraint. Consideration may be in the form of a supplemental perk package, or compensation reflective of value placed on the responsibility to protect employers business. The document may be crafted to evidence unique characteristics of the owner/provider’s service that attracts and retains clientele and is therefore essential to the continuation of the employer’s business. Contracts may contain “liquidated damages” to reimburse the employer for losses and costs incurred in training and developing the employee. Losses are often difficult to accurately ascertain since future client earnings are often merely speculative. Employment restriction violations are also difficult to identify. If ordering volume falls from a particular customer; can we comfortably inquire as to where it went and why? The same is true for other departing employees possibly proselytized by a key man departure. We would have difficulty tracking every possible infraction and the customer may preferred to do business with the new entity due to familiarity or lower cost considerations.

An ounce of prevention…
The best of employees will at least consider going into business for themselves at some point. The motivation is generally financial as well as recognition and challenge. A mature successful business faces these employee challenges perpetually. There is a practical limitation on key employee compensation lest the “tail wag the dog”. Creative structured employment arrangements enable a talented and dedicated employee to feel like they are self employed and have unlimited earning capability.

A branch manager could be compensated as a “partner” based on the decrease in operating expenses and increases in revenue generated by his unit. Compensation could be immediate or deferred to create a more tax favorable menu. A key sales person could be compensated greater for bringing in new clientele with a trailing residual commission for repeat sales. This process builds customers while still compensating the sales person for servicing existing clients (albeit on a lower level). Another tool is a SERP (Supplemental Employee Retirement Plan) intended to reward tenure with cash at retirement or premature death. These programs are selective and need not cover other than key employees.

Keep an ear to the ground
Sometimes listening well can allow grievances to be aired and avoid the “I’ve got to do something” feeling a frustrated employee may experience. Monthly manager’s meetings encouraging written suggestions for improvements and changes are often enlightening and allow managers to discuss concerns among themselves before they become grievances.

Consider a creative employment contract
If you have a valuable employee dealing with your clients and the employee chooses to leave and clients elect to follow, there is little you can do to stop either one. You can however deal with this event as a sale of a part of your business. A contractual agreement can be presented to a prospective new employee in a buy and sell fashion. If a client relationship is worth some reasonable multiple of recent billing activities, a sale of any such accounts can be prearranged on an installment basis. While we are not encouraging the employee to leave, this “sale” prearrangement deals with what may be inevitable in an equitable fashion. The employer gets compensation for the asset and the contract does not appear to restrain trade or be punitive. Similar arrangements can be crafted for luring and engaging existing employees to leave. An employment agency would likely charge a portion of a years pay to provide screened and trained employees. The customary fee can become the employers guide to “reasonableness” of the contract for staffing someone else’s business. Certainly no employer wants to be cherry picked of their best people and customers. The approaches discussed allow for fair compensation, discourage stealing and generally avoid acrimonious expensive litigation.
Our justice system is often more sympathetic to the plight of an employee than to a successful business that can sustain a loss with less hardship. The experience and skill of the contract draftsman has considerable impact on the signal sent to employees and ultimately in the enforceability of the agreed upon actions. Lawyers accustomed to drawing employment contracts may not be involved when they go sour and cost the employer dearly. All parties can benefit from reading the agreement from a prospective adversarial point of view. Employees rarely plan to take the employer’s secrets, customers and best employees when they are first recruited.

As their skills are honed and they realize their value, there is a feeling of entitlement to get what they are “truly” worth. The seasoned employer anticipates this phenomenon and prepares strategies to avoid problems before they ripen and impact the family business.

Ray Chodos is a member of the Wealth Preservation Group, LLC of Greenwich Connecticut. An alliance of professionals specialized in serving the concerns of business owners and their advisors for tax minimization, wealth preservation, and business succession. WPG also consults for financial and professional institutions in areas of marketing and practice development. Learn more at www.WealthPreserve.com.
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