On this cross-over episode of Deal by Deal and The Corner Series, McGuireWoods’ partners Greg Hawver and Geoff Cockrell welcome labor and employment partner Meghaan Madriz to discuss recent headlines regarding the FTC’s proposed ban and the broader legal landscape for non-competes.

Tune in as Meghaan breaks down the evolving enforceability of restrictive covenants, including non-competes tied to employment agreements, sales of businesses, and equity ownership. She also highlights trends in state-specific legislation and shares insights from her experience litigating these issues. The conversation covers how businesses can use alternative tools, such as deferred compensation or retention bonuses, to retain employees amidst increasing scrutiny of non-competes.

You are listening to Deal by Deal, a McGuire Woods podcast. Deal by Deal invites you to conversations with experienced independent sponsors and other private equity professionals. Join McGuire Woods Partners, Greg Hawver and Jeff Brooker as they explore middle market private equity M&A to provide you with timely insights and relevant takeaways.

Hi, this is Greg Hawver, and welcome to a special joint episode of Deal by Deal, which is a podcast for independent sponsors and other investors and middle market private equity and also the Corner Series, which is hosted by my partner in the private equity group, Geoff Cockrell. Geoff, want to say hello real quick?

Yeah, this is Geoff Cockrell. I'm the host of the Corner Series and also Greg and Meghaan's partner. The Corner Series, we focus a little bit more on healthcare topics, but today's topic, exploring recent developments with respect to employee and owner non-competes that have been very much in the news. We're joined by Meghaan Madriz, our labor and employment partner. Meghaan, can you give a little bit of an introduction of yourself and then I'll lead this off with some questions?

Sure. Hi everyone. My name is Meghaan Madrid. I'm a labor and employment partner at McGuire Woods. I would say I probably spend about 80% of my practice working on private equity transactions at the Labor and Employment Specialist, handling not only diligence matters, but drafting, reviewing, culminate on employment agreements, other agreements that are ancillary to the transactions and the restrictive covenants that are going to be executed by the sellers, as well as employees.

So Meghaan, recent events have posed a epic battle between more progressive FTC and Lina Khan leading the charge against the US Chamber of Commerce in this epic legal battle where the FTC has promulgated rules that have abolished a lot of different forms of non-competes, the US Chamber of Commerce brought suit in Texas, and that has ultimately now resulted in the rulemaking being suspended. But before we get into the current developments, maybe we can go backwards a little bit. It feels like the tide has been running in one direction with respect to restrictive covenants and that direction has been away from enforceability. What's your view of the evolution of that tidal shift that you've seen over the last several years?

Yeah, I mentioned that about 80% of my practice is working in private equity transactions, and I would say the other 20 to 30% of my practice is actually litigating these types of claims. I spend a lot of time in court litigating non-compete claims and trade secret claims both on the plaintiff's side and the defendant's side. And certainly over the last couple of years we have seen resistance by courts in various different jurisdictions across the country to enforcing non-compete covenants. And when I say non-compete covenants, I mean our traditional non-compete covenant that prohibits an employee from going to work for a competitor for a certain period of time, not necessarily non-solicitation of customer covenants or non-solicitation of employee covenants, sometimes broadly be referred to as non-compete, but are distinguishable in their own right.

The reason as to why courts have been reluctant to enforce them, I certainly think during COVID there was a reluctance just to put people out of work because of where we were economically in the country. I also think that a lot of it is political. Unfortunately, you have judges that just have, and certainly depending on what state you're in, whether your judges are elected officials or not, if some on certain parries are more opposed to the concept of non-competes and putting some people out of work. And in states where you have had more of a blue wave come in the judiciary that there has been some resistance to those democratic judges to enforcing non-competes just somewhat against the platform that they're elected on.

So yeah, certainly we've seen that and we've seen jurisdictions and states across the country have slowly been passing non-compete laws to rein in what type of employees can be subject to them. Probably the most common type of legislation that we're seeing get passed is putting some type of ban on non-competes based on the income level of the employee, which is really meant to protect more low wage earners from being prohibited by a non-compete.

Do you think part of this trend as well as we look back at the evolution, have you observed Meghaan, over the years and decades that maybe employers were getting too aggressive with the scope of who among the rank and file employees are subject to these? The example when this was all over the press for the last six months or so, was hairdressers as an example of a group of employees that were often asked to sign these non-competes that would keep them from earning a living. Have these grown from being a limited subset of signatories to non-competes to now everyone is seeking to impose them and that's why courts are fighting back? I'm not too familiar with the history.

Yeah, I certainly think that's part of it and that certainly comes into play with the idea that a non-compete is not a one size fits all type of restriction. And I think that's where some companies have flip-faulted because they're using the same non-compete regardless of what the employee does for the company, what their role is, how senior they are or not senior they are. In your example with a hairdresser, I'm sure there are still courts that would enforce depending on the jurisdiction and non-compete against a hairdresser if it prohibits them from opening up a salon right next door to where they were working before. But if you're going to try to stop that hairdresser from opening up a salon in the entire state in which they're working, you're going to have a lot of courts say, "Well, this is just ridiculous because most people are not going to drive interstate hundreds of miles just to see one hairdresser, no matter how great they are with coloring someone's hair."

And Greg, I also think it's been an evolution. So I do a lot of healthcare transactions and that often involves healthcare providers and non-competes are a feature in those. And while it's true that direct competition is one of the things they're trying to prohibit by the restrictive covenant, I think it's also an undertow of those provisions that what in particular a buyer wants is less to avoid competition and more to just make it difficult for someone to leave. Because in a provider business, you're buying future things that are going to be happening and that the future stuff that you're actually buying is the work of those providers. And so it's less their competitive dynamics and more you need them not to leave, which is a little different idea.

Maybe that's a good segue before we continue down the evolution to where we are now. Maybe just going over the types of non-competes that are in the toolkit of an acquirer of a business or an owner of a business. Meghaan you alluded to a non-compete type to an employment agreement, which I think those are primarily the ones in the crosshairs of the FTC currently. But we also, when acquiring businesses or selling businesses need to think about a sale of business non-compete, which is generally more enforceable, but we like your thoughts on that together with there's non-competes tied to ownership of equity interest in a go-forward entity separate from the sale transaction. And then the other tools in the toolkit can be confidentiality, provisions, non-solicit of the employees of the business, non-disparagement and things of that nature. So Meghaan, probably see all of those tools in the toolkit and you spend a lot of time or most of your time on the employee non-competes.

Yeah, so I would say I spend most of my time on the employee non-competes and then on the non-competes or the restrictive covenants that are going to be signed by an employee in some fashion, whether that be in the equity grant agreement that they're signing, whether it be a standalone restrictive covenant agreement that the employee is going to sign. So certainly mostly in the employment context, but also we will look at them in the context of a sale of the business, particularly flagging when we're dealing with states that have nuanced laws on even in the sale of a business. Come to mind, Louisiana for example, which is one that in their statute it does delineate what's required for a sale of a business non-compete in terms of how long it can be. For example, which differs from Delaware, which is oftentimes the go to choice of law for the sale of business non-competes.

So definitely see them all and all different kinds of considerations are necessary when you're drafting those restrictive covenants based on who's going to be signing them and then what state law is most likely going to apply when going to enforce that agreement.

And if those three contexts of restrictive covenants being the employment one, the sale of business and something tied to equity ownership, if the employment context is under siege both by current contemplated federal rulemaking, but also evolution in state enforcement and state legislation, how would you handicap the health of restrictive covenants tied to sale of business and the health of covenants that might be tied to equity ownership?

I certainly think, as we alluded to the sale of the business, restrictive covenants are the ones that are most likely to be enforced as long as the buyer is not trying to overreach in terms of the covenants that they're getting from the sellers. And we've actually seen some recent cases, or at least one recent case from a Delaware Chancery court where it didn't enforce a sale of business non-compete because it was overreaching in the scope. And what's always important for buyers to keep in mind in the sale of the business context is that when I say overreaching, what I mean is that you want to keep the restrictive covenants tied to the business that's being acquired. That's the interest that the buyer is trying to protect, right? It's paying money to a seller to acquire either the assets or the equity of this existing business.

And so what the seller should be prohibited from competing against is what that business looks like as it's being acquired and what are the customers and the employee base of that business as it's being acquired, and where does that business do business as it's being acquired. Where courts are more likely to not enforce the sale of a business non-compete or non-solicitation covenant is when those covenants in the purchase agreement are meant to grow with the business post-closing. Courts don't like that because the idea is that's not what the buyer purchased. That concept of having covenants that are going to grow with the business post-closing, that's where the employment agreement restrictive covenants come in or where the equity grant, restrictive covenant agreements come in.

I've been interested in another gray area as relates to sale of business, and I believe this was mentioned in the FTC rulemaking, but I think the prototypical example of the sale of business non-compete is a founder of a business who owns 80% sells the business, so then he or she can't turn around and compete a week after. And that makes total sense. But as you start looking at rank and file who have been granted some profits interest in this company and maybe they're getting about one year salary worth in an exit transaction and they're assistant to the CFO, are they really selling the business? Are they really negotiating the terms of that sale? Is that an area that courts have been focused on outside that some vague language, I think in the FTC rulemaking?

Generally speaking, when that profit interest is granted, the employee is going to be bound by a restrictive covenant agreement either in the profit interest grant agreement itself or you're having them sign a jointer to the operating agreement and the operating agreement has restrictive covenants in it that they're bound to. And so typically those are the restrictive covenants that are going to be relied on to restrain that employee going forward to include someone whose ownership is really diluted and make them a "seller" into the purchase agreement just because they were, like you said in that scenario, Greg, I think courts are going to be resistant to that. Courts have even the issues come up, for example, not in the profit interest context, but just someone being pretty much like an extreme minority owner of a business in a California case many years ago dealing with whether or not that person could be bound to the restrictive covenants under California's exception for sale of businesses. And basically, in that case, the court was looking at what was the extent of their ownership.

And so I certainly think if it's more of a token ownership or some of these practices where the person is considered a member of the LLC by nature of their profit interest. I don't know that courts would really consider them to be a seller for purposes of the sale of the business non-compete. But really that hasn't been litigated.

And what do you think of the non-compete that may be hardwired into the LLC operating agreement? That context also has some other weird edges in the sense that it's usually going to be designed to run for as long as they own equity in the LLC, but the individual doesn't have any clean ability to make that end. They don't have the right to put the equity to anyone. There may be a sale, but it may only be a partial sale, so they own this equity, you can't cleanly get out of it. So it may be perpetual structurally. How do you think about restrictive covenants that are hardwired into an LLC agreement?

That's another one where we just haven't seen a ton of litigation interpreting how courts would enforce them because typically the way that, of course it's going to depend on the operating agreement, it's going to depend on the equity agreement in terms of what's the trigger for when the restrictive covenants begin to run, and then also how long is that employee going to potentially hold the equity. And if there's a scenario and based on the way the agreement is drafted that it's very open-ended as to when the restrictive covenants, the tail of them would actually begin to run, it's likely that you're going to face enforceability concerns because at that point, it's almost like you're binding an employee to just an open-ended restrictive covenant. I would say the scenario is clearer where you have it's set up that the employee is only going to hold the equity while they're an employee, and then when their employment terminates, they're going to forfeit the equity or it's going to automatically be bought back if it's vested, for example.

And then the non-compete is running from that period of termination, that at least there's a clear definitive point as to when restrictive covenants begin to run. And at that point, more likely to at least for the temporal period of the restrictive covenants to be found reasonable, but you still have to consider the scope of the covenants and the geographic restrictions not being overreaching. Where I think under the equity document and under the operating agreements where another remedy that the companies have for breach is clawback. And clawback of the vested equity, clawback of any options that have been exercised, any type of vested units. And that's one where you need to make sure that all of the clawback provisions in these agreements are very clear as an alternative remedy. So if a court were to find that it's not going to enforce the restrictive covenants because they're unreasonable when evaluating restrictive covenants under the applicable law, but as a matter of contract, it might still enforce the clawback provisions.

Just to drill down on that, that's a really good point. So what you're saying is that it will generally be a higher bar for a court to enjoin someone and say, "You can't work, that violates your non-compete," or issue some injunction, but a court will be more likely to enforce a monetary penalty like forfeiture of units?

Yeah, it certainly can depend on the jurisdiction, right? In different courts, for example, we take California for example. California is not going to view the ability to clawback equity any different in terms of enforcing the actual non-compete. If it's considered a non-compete that's void under the statute, it's not going to enforce the clawback remedy either. But there are other jurisdictions, say like Delaware or New York that have more these employee choice doctrines in terms of honoring the contracts that are entered into between parties. And in that situation, more likely to enforce the clawback provisions as a matter of contract principles not analyzed under the reasonableness analysis that typically required for enforcing a non-compete in terms of actually enjoining someone from going to work for a competitor.

Another strategic benefit of that provision, meaning forfeiture of equity, is that it shifts the mover burden. Because if it's the employer company that's having to walk into court and seek to have the court enjoin the person from doing something that they don't want them to do, then the company, the employer, is bearing the mover burden in that scenario. Whereas if the documents are set up so that if this person competes or does something that's violative of that covenant, the employer can send them a notice saying, "Look, this is what you did, and pursuant to the agreement, you've forfeited your equity." And in that scenario, you've shifted the mover burden to the individual which can have some strategic benefits.

Yeah, absolutely.

Meghaan, in light of some of the uphill battles of covenants, do you see folks moving towards other tools? And maybe starting with one that I think can be effective, going back to what I said earlier, that in many ways the restrictive covenant is sometimes less about not having someone compete against you and more wanting to keep them around because that's part of maybe what you paid for. In that context, might it be easier and more direct to utilize tools that are not tied to competition at all, whether that is vesting of equity, meaning if somebody leaves, they're going to lose equity just outright. It doesn't matter whether they compete or not, they just didn't run out the clock on time-based vesting. Or the use of other maybe deferred comp arrangements, which are popular in other settings like investment banks where the idea is, okay, individual, here's $300,000 worth of deferred compensation and you're going to get one third of it each year over the next three years with the idea being there's no restriction on you leaving and competing, but if you leave, you're going to always be walking away from something.

So leaning into tools that are designed more to keep someone around than prohibit their competition, are you seeing more emphasis on that?

Honestly, I'm not seeing more emphasis on that. And maybe that might just be because of a desire to not put more cash out upfront if you don't have to. I think it's certainly those tools are something that employers should consider for individuals who are, that they perceive to be very valuable to the operation of the business, and there's a necessity to try to keep them on as long as possible. I certainly think deferred comp arrangements, retention bonuses where milestones have to be met into the future for them to get that type of money are very good tools for companies to use to help retain talent if that is more what their goal is. Because I certainly agree that giving them an agreement with restricted covenants in them is not necessarily going to always be the deterrent that employers may think they're going to be.

So often individuals sign these agreements on the front end because at the time they're not thinking of leaving the company. That's not what their present intentions are. They sign these agreements, don't really think much of them until the time comes when they have an opportunity to go somewhere else. And at that point, the new employer might be willing to take the risk and identify the employee because they really want them, and so they're willing to take on the legal battle or the employees going to take the gamble that their employer doesn't typically go after employees who leave in violation of the non-compete. So they're going to take that risk and deal with it if it comes up. And so I just think that deterrent effect is not necessarily going to keep someone if that's really the ultimate goal, and that really shouldn't be. If that's your goal with respect to a restrictive covenants. I think as you're mentioning, there are other tools that are more likely to accomplish the goal than this idea of some deterrent effect into the future.

I think that as you, to the theme of Geoff's point is crafting your package of carrots and sticks for your sellers and owners and employees and things of that nature. And I think part of that question hinges on what you think the next 2, 3, 4, 5 years are going to look like with respect to the enforceability of non-competes and employees and otherwise. And maybe that brings us back to the litigation in the district court of Texas and just maybe honing back again on what is the current state of play then maybe getting your thoughts on what the future might look like. Meghaan, I know that it's impossible to tell where all this is going to land, but wanted to get your thoughts on current state of play and with this case and going forward.

Yeah, certainly with the case in Texas, we know that the court graded summary judgment. For Ryan, not the FTC. And so the rule has been set aside based on that. Nationwide, there's still the case in Pennsylvania where the court had denied the preliminary injunction that was requested by the plaintiffs. In that case, it's possible that the court in that case could issue a different ruling than the court in Texas. And then we have a circuit split. It certainly perceived that the FTC would prefer to have the appeal heard in the third circuit, which is where the Pennsylvania case is, as opposed to the fifth circuit thinking that it might be slightly more favorable to the FTC. I think obviously don't have a crystal ball, but from what I'm reading, people giving their opinion as to what they think is going to happen is that it's going to go to the Supreme Court.

But of course, while all that is playing out, we are currently in a presidential election year, and the outcome of the presidential election could also certainly impact whether this FTC rule gets revived, moves forward in some fashion. But I think that the basic advice for companies now that are considering non-competes is that don't let the FTC rule, which as we said is now not going into effect or did not go into effect on September 4th. Don't let that be an impediment to putting in place restrictive covenants that the companies may want, whether it be an employment agreement or equity grant agreement, and really at this point just needing to be making sure that you're complying with state law requirements.

And I think that's really important for companies to be mindful of because so often I think there's this desire to reuse forms. "This is the employment agreement we've always used." But even though the employment agreement you've always used. What's enforceable? And Virginia for example, it's not necessarily going to be enforceable in Texas or in Minnesota or in Arkansas. And so it's important to look at the state law nuances when it comes to enforcing restrictive covenants.

And for example, I think one thing that's really important to be mindful of is that not all states will reform an overbroad covenant. So you have some states that followed this reformation approach that basically says, okay, here's a really overbroad restrictive covenant As it's written, it's overbroad, but the employee, the court is willing to reform the covenant and enforce it just based on the circumstances of the case. For example, employee goes to direct competitor working in the same geographic area that he worked in the same role, even though the non-compete prohibited him from working in the entire United States in any capacity. Courts that follow a reformation approach, instead of just saying, "The non-compete is overbroad, I'm not going to enforce it." They'll reform it and enforce it as reformed.

You have other states that take a very strict blue pencil approach to enforcement of non-compete, the non-solicitation covenants. And in that case, unless it can sever out a distinctly severable provision of the agreement to make it reasonable, if it's overbroad as drafted and it can't be severed i.e. blue pencil, it's just not going to be enforced at all. And then you have some courts and some jurisdictions that refuse to even blue pencil. And so I think it's very important for companies to be mindful of what approach is being followed by the courts. Because if you're going to take this approach of, I'm just going to use my very broad, off the shelf non-compete that I typically use regardless of date of the employee or position of the employee. Well, you might be damning yourself from the get-go, because that's not going to be enforced.

One of the critiques of the FTC's action is that doing such a thing through rulemaking is an unstable environment, meaning that a regime change in the presidency could change that policy completely, and the rule could change completely. If this is headed to the Supreme Court, what's the generally viewed timeline for having national resolution if this is a judicial pathway?

Yeah, I don't think it would be until next year, and certainly I'm not an appellate attorney, but the appellate timeline to even file the appeal to the fifth circuit and the Ryan Case has not passed yet. We don't have a decision from the Pennsylvania District Court that would even create the potential circuit split and then the appeal to the third circuit. And so then while they might be expedited appeals, that's still going to put those appeals into 2025, which means it wouldn't get to the Supreme Court until sometime, probably late 2025. So I don't think this is something that we're necessarily going to have a clear answer from the Supreme Court in the very near term, and certainly not before the election.

And to your point earlier, it is probably more important to keep tracking the developments at the state level depending on where you're at and to revisit a theme, you are seeing more and more states being negative towards these non-competes, right?

Definitely. Certainly. Little by little, the ability to have non-competes is being chipped away. Just last year, for example, Minnesota passed a statute prohibiting non-competes in the employment context. I think we're going to continue to see more legislation like that being introduced at the state level, particularly as I think it's unlikely that the FTC rule ever goes into effect, and so I think that's going to increase the activism on the state level.

Well, Meghaan, we could talk about this for quite a while, but maybe we'll end it there. Really appreciate your insights. This is going to be a bumpy ride for a while, so we should all buckle up and stay tuned.

Sounds great. Thanks for having me.

Thanks, Meghaan. Thanks, Geoff.

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