Noncompete and Nonsolicitation Clauses in Insurer and Insurance Brokerage M&A

Episode Summary

In insurer and insurance brokerage M&A, the value of a business often lies in its people, client relationships and origination capabilities, making noncompete, nonsolicitation, nondealing and nonpoaching restrictions a critical part of deal protection. On this episode of “The Practice Manual,” host Rob Chaplin is joined by colleagues Caroline Jaffer, Helena Derbyshire and Damian Babic to examine how these restrictive covenants operate in practice, the differences between vendor and employment covenants and the U.K. enforceability principles that require restrictions to be carefully tailored to a legitimate business interest. The panel also explores practical risks that can arise in transactions, including TUPE-related issues in asset deals, team moves and post-acquisition hiring, as well as potential U.K. reforms to employment noncompetes.

Key Points

• Restrictive covenants are contractual provisions that restrict what a seller can do after a sale. To protect the goodwill in a business being sold and stop the seller from competing with the target for a defined period, companies utilize noncompetes, nonsolicitation, nondealing and nonpoaching clauses.
• In the employment context, stricter rules apply, including with regard to what legitimate business interests justify the clauses. The panel also examine why a one-size-fits-all approach is a recipe for unenforceability, as well as some of the less obvious risks in insurance M&A, including Transfer of Undertakings (Protection of Employment) (TUPE) transfers, and the litigation risk arising from team moves and hiring individuals subject to known restrictions.
• The U.K. government has issued a consultation paper on reforming noncompete clauses, including proposals for a statutory three-month cap, a complete ban and salary threshold restrictions. The panel assesses what the changes would mean in practice for insurance M&A and the creative retention strategies — such as deferred consideration, earn-outs and enhanced garden leave — that may become increasingly important to consider.

Rob Chaplin (RC):
Welcome to the Practice Manual. I'm Rob Chaplin, head of the Financial Institutions Group here in Skadden in London. Today, I'm joined by my colleagues Caroline Jaffer, also from our Financial Institutions team, and two of my colleagues from our Employment team, Helena Derbyshire and Damian Babic. So delighted to have you with us here today.

So, what are we talking about today? Well, today we're going to be talking about noncompete and nonsolicitation clauses in insurer and insurance brokerage M&A. Why is this so important? So, the answer is that in many insurance organizations, they're all about people, they're all about origination. They're all about finding business.

So, it becomes incredibly important that if you're buying one of these businesses, you ensure that the business is going to be there when you close, the business is going to continue to be able to win new customers in the future, and ultimately, you get what you pay for, and it grows on from there. And these clauses, these noncompete clauses, these nonsolicitation clauses, are crucial in achieving that objective.

So, let's start with the vendor side. Caroline, can you give us an overview of the underlying principle for, and some of the key forms of, vendor considerations, please?

Caroline Jaffer (CJ):
Sure, Rob. As you've mentioned, people are key drivers of value in such transactions, and this is one of the reasons why sellers will give buyers restrictive covenants in the transaction documents.

Restrictive covenants, they are contractual provisions that restrict what a seller can do after a sale. So, as you've also mentioned, one of the reasons is to protect the goodwill in the business being sold and stop the seller from competing with the target for a defined period. In terms of the categories of restriction, there are four that we can talk about.

There's noncompete, which means that the seller basically can't engage in activities competing with the sold business. There's nonsolicitation; a seller can't go after specific or existing or prospective clients after the sale. Non-dealing, which is an interesting one; he seller can't deal with existing or prospective clients at all, regardless of who initiates contact. And non-poaching; so a seller can't hire or engage certain colleagues to set up a competing business. So why do these matter?

They matter for both sides, both the buyer's and the seller's side.

From a buyer's perspective, as you rightly just said, the last thing you would want is for the seller to set up a competing business, taking all their know-how and contacts after the sale. And without such restrictions, there's a very real risk that could happen and erode the value of what you paid for the business during the deal. And from a seller's perspective, agreeing to reasonable restrictive covenants is actually helpful in achieving a higher purchase price.

If you're a buyer, you're not going to be interested in a business where there are no protections and you have no comfort that the price you're paying includes the goodwill of the business. So, yes, those are the main matters.

RC:
So, thanks, Caroline. That's a great overview. Noncompetes, nonsolicitations, nondealing restrictions, nonpoaching restrictions. So, this all sounds absolutely fantastic, but Helena, how enforceable is all of this?

Helena Derbyshire (HD):
Good question, Rob, because, of course, the seller's entitled to protect the value in the business they've just paid for. But there are quite a few parameters around enforceability of restrictive covenants, and that's not guaranteed.

The main reason for that is that the starting points that the courts in the U.K. have is that a covenant of this nature is in restraint of trade, and that's against public policy.

So, in order to be able to enforce a restriction, the party that wants the protection really needs to be able to demonstrate that it goes no further than is absolutely necessary to protect a legitimate business interest.

In the context of a business sale, that would be protecting the goodwill in the business.

When you're looking at the enforceability of covenants, there are a number of things that the courts will take into account, but I guess the key things are the context -- What are the circumstances? Why have we entered into these restrictions? What is it that we're trying to protect?

And then also, the construction of the covenant. And it's really important because a court would be balancing the interests of both of the parties of the transaction, as Caroline has said.

Some of these restrictions are in the interest of both the seller and the buyer, so there's certainty around the transaction. In a commercial context where you're selling a business, you might be able to enforce covenants that are longer or broader in scope than you might expect to see in an employment context, which we'll talk about later, because you're balancing different interests.

In a commercial context on a business sale, you've got two parties that have entered into commercial transaction. Money has been paid, they know what they're entering into. It might be slightly different with an employee, just because there's an assumption that there's an inequality of bargaining power between an employee and their employer. So, the context of the covenants, that's important. And, so, the parties have different interests to protect.

And quite often, we see people wanting to protect their whole business rather than just the business that has been sold, which is what there's a legitimate interest in the buyer protecting rather than their whole business. So, it needs to be tailored very narrowly to what you've just bought.

And, also, you need to think about the scope of those restrictions, and key factors include, for example, the geographical scope. You might not have a worldwide business. You need to protect the business in the areas where you are already trading at the point of completion and not try to enforce it more widely, which we quite often see buyers wanting to do. And that can go to the enforceability of the restriction. A key point in the U.K. to bear in mind is that those restrictions are all or nothing.

So, the courts will not rewrite a restriction. If it's not enforceable, it falls away altogether. They might, with blue pencil, add a couple of words in the restrictions, but if it doesn't work with those words taken away, it falls.

RC:
So, there's a very strong moral there, which is don't be greedy, otherwise you may end up with nothing.

HD:
That's quite right.

RC:
That's quite a powerful message.

HD:
It is.

RC:
So, that's vendor restrictions. Damian, take us to the employment side.

Damian Babic (DB):
Sure, Rob. So we're in a different world in the employment context, and the first thing to note is, unlike restrictive covenants in the vendor context, there are stricter rules that apply in the employment relationship, and that's really because there's an assumption that there's an inequality of bargaining power between an employer and an employee.

So, courts are much more willing to take a stricter look at restrictions that are entered into in the employment context, and they're only going to enforce a restriction that goes no further than is reasonably necessary to protect an employer's legitimate business interests.

So, what does that look like in an employment context? Well, a legitimate business interest of an employer might be its confidential information and its trade secrets, as well as its relationships with key customers, suppliers or staff.

So, the types of employment restrictions generally overlap with those that, Caroline, you were setting out earlier in a vendor context, and those include noncompetes, nonsolicitation restrictions, and nondealing and nonpoaching.

But of course, in an employment setting, we're looking at those restrictions in the context of the employer's business rather than a business that's being sold. There's just one more type of restriction that's worth mentioning in this context, which is noninterference with suppliers, and that's basically where a former employer is restricted from interfering with key supplier relationships, and that's also an important one to remember.

RC:
So, that's really helpful, Damian. So, in other words, the courts take a much more conservative approach with employment covenants. They're less enforceable than the vendor covenants that Helena was talking about. I guess let's unpack that a little bit more. Helena, bring that to life for us. What kind of duration, what sort of scope can we get when we're acting on the buy-side?

HD:
Sure. So, I think one of the key things that we mentioned earlier is that balance of interest between the employer and the employee, and you've got that burden with an employee of demonstrating ... the employee's going to say, "If I can't work in this industry, I've been in insurance all my life, I'm not going to be able to earn a living." So, there is a real balance of interest there.

In general terms, 12 months, I would say, is the maximum that you would expect to be able to enforce in the employment context. When the courts look at these restrictions, they will weigh up what it is that you're intending to protect, and they'll look at a lot of factors, including the role of the employee in the organization, the access that they've had to confidential information, the shelf life of that confidential information. A lot of the time, employers assume that their confidential information is really valuable and is going to last forever.

But actually, if you've got a 12-month business cycle, it's out of date by the next business cycle. So, you can't expect to enforce restrictions for longer than that.

Whether the employee's had access to business plans, what relationships they have with other people, with brokers, with other people in the industry, how long does it really take to shore up that relationship?

So, all of those things are taken into account in determining whether or not a restriction is enforceable in relation to a particular employee.

Another factor and a common pitfall that we see is that employers, (A) they want to have covenants for longer than they really need, and they always assume they need longer than they want to, but also that they try to apply a one-size-fits-all approach. Now, I appreciate it's really difficult. You have a stretched HR team. You want to prepare rollout contracts in a very straightforward way to your different employees. But if you approach it with a one-size-fits-all approach, you're likely to fall down because everybody has a different role in the organization. Everyone has different things to protect.

And you might have one very senior employee in the organization, for example, someone in, I don't know, maybe the HR team, who doesn't have as much access to confidential information about the trading and the business than a very junior employee who's really in the weeds of what they're doing on the underwriting side.

So, you need to look very carefully and tailor the covenant to the particular employee, to the geographic location in which they're working, the parts of the business that they're touching, and the information and the people that they have access to.

RC:
So, be contextual, be sensitive, get on top of this quickly on the buy-side, because this isn't something which you can do in the last 48 hours of the transaction.

HD:
Absolutely. And think long and hard about what you really need.

RC:
Yes.

HD:
Because quite often you might have a wish list, but when you whittle it down, and going back to the point that we had earlier, the covenants fall altogether if you're too greedy.

RC:
The paradox of this discussion is less is more.

HD:
Absolutely.

RC:
Okay, let's build that out a little bit further and look at some other risks. So Caroline, Damian, what other things should we talk about? What other risks are there to consider, Caroline?

CJ:
So, looking at this from a business protection perspective, one area that deserves particular attention is asset deals involving transfers under the Transfer of Undertakings (Protection of Employment) Regulations, more commonly known as TUPE.

RC:
That's one of those great bits of jargon that gets bandied around, and everybody thinks they know what it means…-

CJ:
Indeed. Yeah, TUPE is quite the red flag. So, TUPE can apply on an asset sale or where services are outsourced or transferred to a new service provider.

And why is this a risk? Well, under TUPE, employees have a right to object to their transfer, and this does have quite stark consequences.

So, the consequences really are that the employee's contract of employment falls away, which also means any restricted covenants and confidentiality provisions are no longer enforceable. And this isn't just a theoretical risk, as well-advised employees could seek to use this loophole, and they do in the TUPE process.

So, how can one mitigate against this? Well, it comes down really to having a clear employee communication strategy and effective retention measures in place from the outset.

RC:
Great. Damian.

DB:
So, sure. So looking at it through a non-compete lens, it's also important to think about team moves following a business acquisition, because that's another key area of litigation risk. So, if a buyer is looking to bring on key individuals or bolt on a team post-acquisition, and those individuals are subject to known restrictive covenants with their existing employer, then there's a real risk there that claims could be brought.

Now, the scope of these claims are pretty broad, and they could cover claims against the individuals themselves to get an injunction to stop them breaching their restrictions, but also against an incoming employer for inducing a breach of those restrictions if they know about them.

So, given the importance of people in the insurance and brokerage space, this type of litigation tends to be really time-consuming, expensive and also can cause real reputational harm, which in this industry is a real issue.

So, to give you a sense of how this kind of practically plays out in context, let's say a buyer completes an acquisition and then it looks on to strengthen the team, an insurance team, by hiring a senior broker from a competitor. Now, that senior broker might be subject to a 12-month noncompete clause in their existing employment agreement, and if the buyer knows about those restrictions and brings them on board regardless, then the former employer could seek an injunction, not only against the employee, but also against the incoming employer. You're then looking at urgent interim applications, battles around disclosure and this plays out all in an insurance market where everyone knows everyone else. And so the commercial reputational damage also can be really significant.

So, to tie this all together, it's absolutely essential to review not only the employment contracts of the individuals who are employed by the business that you're buying, but also to ascertain the restrictions that key employees that you're hiring in the market are subject to. Having a robust recruitment process in place is really important to help manage some of those risks.

CJ:
Such an important problem, isn't it?

RC:
It is such an important problem, and when it goes wrong the consequences can be terrible in terms of the damage that happens to the business.

Finally, it's worth looking ahead. Helena, are there any changes on the horizon in this field?

HD:
So, the government is consulting at the moment about proposed changes to the restrictive covenant regime. At the moment, there isn't really any legislation around it. It's based on case law.

But there is a consultation paper available on the gov.uk website where various proposals to amend noncompetes and employment agreements, in particular, are proposed. And there are three key changes that I would pull out from that consultation paper.

The first one is a proposal to limit the duration of restrictive covenants, and the common period suggested is three months, which you might think …

RC:
Incredible, compared to what we're used to in the insurance industry

HD:
It is really short compared to what you're used to. Particularly where you've got a renewal cycle that's on a 12-month cycle, three months isn't going to get you very far.

One of those proposals is that the three months would apply to larger employers with a view to smaller employers having a more vested interest in keeping the business that they are growing secure, and maybe six-month restrictions for smaller businesses.

I think there's been a lot of pushback on that in the consultation, so it'd be interesting to see where that gets to.

The second proposal is banning noncompetes in employment contracts altogether, which is pretty draconian. It would mean that you would be falling back on other types of restrictions, so the nonsolicits that Caroline set out at the beginning, so nonsolicits of employees, nonsolicits of business contacts, nondealing.

But, one of the things that the government is also looking at is not making a workaround. So, for example, in California, noncompetes have never existed. They've never been enforceable, and employers have got very creative in the ways that they deal with that by, for example, putting restrictions on deferred compensation, other ways around it, relying on their nondealing clauses. But, increasingly, that's just not going to wash because it's just seen as a workaround.

The other proposal is a ban on noncompetes for employees below a certain salary threshold, but no one really knows what that salary threshold might be, and I think a lot of these are just ideas that have been thrown out there. That's going to be something that's really important in the insurance industry, and it will be interesting to see how that plays out, whether it's on base pay or whether it includes your variable bonuses, which I know are prevalent in the industry and really increase someone's remuneration, and whether the tipping point might determine on the remuneration structures going forward.

RC:
So, a legal minefield, which is subject to uncertainty.

HD:
Yes.

RC:
It's a bit scary. Caroline, how does this play out in practice in an M&A context?

CJ:
Well, just echoing what Helena was saying, it would be really significant for the insurance and brokerage sector. The ability to impose meaningful noncompetes on key employees is key, and if that were to be removed altogether, buyers in M&A may need to put additional vendor restrictions, as Helena was saying, in the deal documents.

And also be more creative, potentially, about retention mechanisms. So, Helena mentioned deferred consideration, but maybe earn-outs and also enhanced garden leave provisions might also be other things that could be considered. But, all of this would be to protect the value and the business that the buyers are acquiring.

RC:
So, one of these areas of our practice where there's a lot of market practice, there's a lot of very sector-specific market practice in the area. It's a sort of tricky legal area because of this binary, you either win or you lose on the clause.

So, I think what we'd probably say to our viewers is to say that if you have one of these situations, please come to us early if possible, and give us the time to work our magic, whichever side of this that we're on.

HD:
Yeah, I think so. And I think, Rob, it's also really important the forward planning and something that Caroline mentioned with garden leave clauses. So, something you can think about when you're drafting your contracts is how you shore up those relationships, because a long notice period during which you can keep someone out of the market is probably a better way to protect you than relying on a traditional noncompete these days.

RC:
We often do transactions with the spirit of optimism, but sometimes you have to look at the worst-case scenario.

HD:
Indeed.

RC:
Okay. Well, look, Damian, Helena, Caroline, thank you so much for taking part in this episode. That brings us to the end of the episode today. Do please join us next time.