What Is a Restrictive Covenant in Business Law?

Non-disclosure, Non-compete, and Non-solicitation Agreements

Restrictive Covenant
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By definition, a covenant is a promise included in a contract or agreement, and the definition of a restrictive covenant agreement legally implies a party's consent to be restricted by that contract. The term "covenant" means "come together" in Latin and it conveys a willingness to do just that. A restrictive covenant is an agreement that restricts or prevents one of the parties from doing something or holding some type of property.

In this article, restrictive covenants will be discussed in the context of both property law and business agreements. The emphasis will be on restrictive covenants like non-compete agreements, non-solicitation agreements, and non-disclosure agreements.

Restrictive Covenants in Real Estate

A restrictive covenant (sometimes called a deed restriction) in real estate is a deed that includes restrictions on the use of the property and that prohibits certain uses. Restrictive covenants are common in condominium and limited-access community situations, where all properties are similar, and the condo association wants to keep the property values up.

Restrictions might include limiting use (no home-based business, for example), architectural guidelines, square footage, vehicles in the driveway, no pets, and on and on.

Anyone who buys property in a deed-restricted area must agree to the restrictions. Violations usually result in lawsuits, because the association doesn't want to let other property owners think that they can ignore the restrictions. The restrictions are said to "run with the land."

Violations of deed restrictions can be started by an individual or an association. Association documents usually impose fines or put a lien on the property. Another way to fight a violation is in court.

Restrictive Covenants in Business Situations

Restrictive covenants are not considered illegal, but restrictions that are particularly exacting have been found to limit the ability of an individual to do business. In these cases, some courts have found a specific restrictive covenant agreement not to be valid. That is, the court in question would not hear the case. 

In a non-compete agreement, in particular, the value of what is given up (called consideration) should be relatively equal to benefits received (consideration, in the legal term). For example, a business owner signing a non-compete may receive some specific compensation as part of the sales contract.

Types of Business Restrictive Covenants

Three basic types of restrictive covenants exist. 

  • non-compete agreement restricts the activities of one party who agrees not to compete with another, often his employer, for a specific period of time and within a specific geographical area. 
  • A non-solicitation agreement restricts marketing and hiring activities by one individual in a business agreement. One party agrees not to solicit employees or customers from the other. 
  • A non-disclosure agreement restricts communications. One party agrees not to disclose business secrets, trade secrets, proprietary processes or other specific activities or information related to the business. 

Restrictive Covenants in Employment Contracts

The most common restrictive covenants are found in employment contracts, prohibiting employees from taking specific actions either during the term of employment term or after employment ends. 

Non-compete and non-disclosure agreements are most commonly found in employment situations, particularly when a business has invested heavily in an employee through signing bonuses, other incentives, and extensive training. The employee may be entrusted with confidential information, which the business certainly doesn't want to spread about and provided to a competitor if and when employment ends.

Other Examples of Restrictive Covenant Situations 

Restrictive covenant agreements may also be integral to other business relationships, however. Partnership agreements often include non-compete clauses and non-solicitation terms as well as non-disclosure provisions. This is especially common with new owners or partners coming into an existing business. 

A new owner may want the former owner/seller to sign a non-compete agreement restricting him from competing as part of the sale of a business. The new owner might also want to restrict the former owner's ability to hire away employees or solicit existing clients or customers or restrict disclosure. In this situation, the former owner is restricted from competing with the new business owner (a) in specific types of business (b) for a specific time (c) and in a specific area. 

Issues With Restrictive Covenant Agreements 

State laws govern restrictive covenant agreements, and these laws can vary from jurisdiction to jurisdiction in what they allow and what terms will not be upheld. California, for example, has a ban on non-compete agreements, and it disallows every attempt to circumvent this ban. Even when an employee signs a non-compete contract "voluntarily" or "for consideration received," the covenant is not upheld. 

Courts typically come down on the side of employees in disputes over non-compete agreements, particularly if the agreement is not found to be reasonable -- it subjects the employee to undue hardship or it exceeds the nature of protection an employer would justifiably be entitled to. Covenants of less than a year are more likely to be upheld than those longer than two years. 

Non-disclosure agreements are more commonly upheld with regard to trade or business secrets and confidential client information. 

Speak with an attorney in your state if you're contemplating drafting or entering into a restrictive covenant agreement. Its ultimate enforceability will depend not only on your state's laws but prevailing trends in your area, so this is one area in which you might do well to seek professional help before committing. 

Restrictive Covenants and Taxes

A covenant not to compete is considered a section 197 intangible. The cost of a non-compete agreement as part of buying a business must be amortized over 15 years. The amortization period begins with the month the agreement was signed or the month the business began producing income, whichever is later. 

Article Sources

  1. IRS. "Instructions for form 4562 Depreciation and Amortization." Certain section 197 intangibles. Page 15. Accessed Mar. 30, 2020.