Beware “Subsidiaries and Affiliates” in Restrictive Covenant Agreements

Common Terms

Many businesses are part of an interconnected web comprising parents, subsidiaries, and affiliated entities. It’s natural to think of these separate entities as part of the larger “company.” 

We often see introductory language in an employment agreement that might read: “The ‘Company’ includes ACME and all of ACME’s parents, subsidiaries, and affiliates.” Further down, in the non-compete provision, the employee agrees not to compete with the “Company” or solicit the “Company’s” customers or employees. 

But what if ACME has 18 subsidiaries in distinct verticals around the world that have no real connection to the employee’s work for ACME? 

Protecting the employer’s legitimate business interests is the foundation of restrictive covenant law. Stretching restrictive covenants to protect not only the employer, but all of the employer’s subsidiaries and affiliates, can strain reasonableness.

Two recent cases demonstrate this issue. 

Cautionary Tales

In Microban International, Ltd. v. Kennedy, the agreement prevented the defendant from competing with the “Company,” defined to include not just the employer, but all of the employer’s “subsidiaries and affiliates.”

These subsidiaries and affiliates apparently spanned North Carolina, Tennessee, Canada, Taiwan, and the United Kingdom. The parties disputed whether the defendant supervised any employees of these subsidiaries or affiliates, but it appeared undisputed that he himself did not directly work for any of them. Thus, the agreement prohibited “competing with companies on different continents that [the defendant] has never worked for and with which he has, at most, only a tangential connection.”

The court denied the plaintiff’s motion for a preliminary injunction due, in part, to the scope of the restrictive covenants. 

In Kodiak Building Partners, LLC v. Adams, similar issues led the court to declare restrictive covenants entered in the sale of a business unenforceable.

The plaintiff’s business model was purchasing and then operating smaller companies in the construction industry, including companies that produce roof trusses, lumber, drywall, steel construction supplies, and kitchen interiors.

The restrictive covenants at issue protected all of the plaintiff’s subsidiaries and affiliates within its entire “Company Group,” including other companies it acquired in industry segments unrelated to the defendant’s roof truss business. The geographic scope reached a 100-mile radius around any location where any business in the “Company Group” sold products or provided services within a year of closing.

The court held the restrictive covenants overbroad and unenforceable.

“Restrictive covenants in connection with the sale of a business legitimately protect only the purchased asset’s goodwill and competitive space that its employees developed or maintained. The acquirer’s valid concerns about monetizing its purchase do not support restricting the target’s employees from competing in other industries in which the acquirer also happened to invest.”

Conclusion

Seeking to protect all subsidiaries and affiliates through a single entity’s restrictive covenants has clear risks, especially when the employer is connected to a large network of companies in distinct industries. Counsel should consider alternatives to find the right balance between business protection and enforceability.