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Restrictive Covenant

A provision in an agreement that prevents one party from taking a taking a specific action

What is a Restrictive Covenant?

A restrictive covenant is a promise included in a legal agreement that prevents one party to the contract from taking a specific action. When a party enters into a restrictive covenant, he/she agrees to refrain from doing something or from using a property in a certain way that is restricted by the contract.

 

Restrictive Covenant

 

For example, when purchasing real estate, the buyer may agree to use the property for the designated purpose only and not for other purposes. If the agreement specifies that the property can only be used for residential purposes, the buyer cannot then convert the property to business use.

 

Types of Restrictive Covenants

The following are common types of restrictive covenants between companies and their employees:

 

1. Non-compete agreement

A non-compete agreement restricts one party from competing directly with the other party for a specific period of time or within a defined geographical location. The party that agrees not to compete must be compensated in some way by the other party.

For example, an employer may require employees to sign a non-compete agreement that prevents them from competing with their employer when they leave the company. Another example of a non-compete agreement is when a business owner sells their business and they agree not to set up any new company that would compete with the new owner. Such restrictions usually expire after a specified period of time (e.g., two years, five years, etc.).

 

2. Non-solicitation agreement

A non-solicitation agreement restricts a former employee from soliciting employees and/or customers from their former employer after leaving the company. Many businesses require senior executives such as managers, accountants, and CEOs to sign a non-solicitation agreement.

To be enforceable, the restrictive covenant must define reasonable limits, either according to a period of time, geographical area, or type of work. In some states, such as California, there are specific laws that make non-solicitation agreements unenforceable unless they are introduced to protect trade secrets.

 

3. Non-disclosure agreement

A non-disclosure agreement is a legal contract between an employer and employee, which prevents the latter from disclosing proprietary or confidential company information and processes. In return, the employee must be properly compensated for signing the non-disclosure agreement.

The agreement is active during the employee’s tenure and for a specific period after exiting the company. For the contract to be enforceable, the agreement must be protecting valuable information such as a trade secret or confidential information about the business.

Non-disclosure agreements are commonly used when a company contracts for the services of a freelancer or other independent contractor. The freelancer has no inherent loyalty to the company but may acquire valuable information about it in the course of working with company employees.

Since business owners have invested a lot of money into developing the company, its employees, and customers, restrictive covenants are designed to protect such investments.

 

Restrictive Covenants in Real Estate

Restrictive covenants in real estate exist to prohibit the use of a property in a certain way by tenants, homeowners, or other occupants. Such restrictions often exist in gated communities and condominium developments. Many of the restrictions are often focused on preserving a certain style, appearance, or functionality of the community.

Some of the restrictions that may be introduced include prohibiting owners from carrying out business activities on the residential property, running a home-based business, or installing a home office on the premises.

The restrictions on real estate may also be in the form of architectural guidelines. The developer or seller of the property may limit renovation plans that would substantially alter the original appearance of the property. For example, homeowners may be restricted from expanding a garage or from increasing the total square footage of their home beyond a set maximum limit. The intention is to maintain some uniformity in regard to things such as the basic color scheme and appearance of properties in the neighborhood. Radical alterations might have a negative effect on property values, thereby harming other homeowners in the community.

When one of the original homeowners sells their property, the restrictions are passed on to the subsequent owners. Any violations of the property guidelines can result in lawsuits and fines. Therefore, it’s important when you’re purchasing property in a development to make sure that you are aware of whatever homeowner’s association or other restrictions exist.

 

Limiting Restrictive Covenant Agreements

Whether restrictive covenants are enforceable or not, and to what extent, depends largely on state laws (and therefore can vary widely from one state to another). Most states impose varying rules on what specific types of clauses are allowed in restrictive covenant agreements.

For example, non-compete agreements are unenforceable in California, even if the employee signed the contract voluntarily and was compensated for entering into the agreement. Courts tend to favor placing the least possible restrictions on employees.

 

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:

  • Golden Parachute
  • How to Quit a Job?
  • Reasons for Leaving
  • Severance Pay

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