Lessons from the Conrad Black Trial on Non-Compete Agreements
Christopher Neufeld and Trevor Hood*
The Conrad Black trial provided significant newspaper fodder, with its focus on the convergence of wealth and arrogance; yet for business executives, the essential lessons for protecting their own professional integrity have been largely left untold. For as Conrad Black and his cohorts have discovered, the pursuit of ill-conceived noncompete agreements that facilitate one’s greed can be a perilous venture. And with the legal precedent established by the verdict in the Conrad Black trial, no business executive should expose themselves to a legal assault on the basis of their receipt of non-compete payments. Lesson #1 – Ascribe the Non-Compete to the Appropriate Parties Non-compete agreements are not freely assignable financial paper, which can be attributed to any business entity or individual within a corporation’s network of companies and executives. The business entity or individual receiving the benefit of the non-compete arrangement must actually be entitled to its receipt. HLG, Conrad Black’s financial and accounting entity that lacked any operational capacity, was incapable of competing with the purchaser newspaper companies, nevertheless it was HLG, as opposed to Hollinger International (the operational company), which received over $42 million in non-compete payments. The judicial system has taken the view that the vendor company should be looking to optimize the purchase price’s retention by the company (and in turn its shareholders). This creates a vicious conflict when business executives look to maximize their personal return on the transaction, through the improper use of personal holding companies and/or the re-allocation of non-compete payments. Companies should not be treated as any individual’s personal fiefdom through which all manner of profits can be extracted. Furthermore, each individual and corporate entity should retain independent legal counsel to confirm the appropriateness of their decisions. With the ever common confluence of multiple corporate entities (combined with business executives seeking a direct stake in the transaction), the attainment of independent legal counsel is all too frequently shunned, when it should be a priority. Lesson #2 – Determine if the Designated Party is Already Legally Obligated Not to Compete With the enormous amount of corporate documentation and legal obligations surrounding every transaction, both past and present, there always exists the potential that there are pre-existing legal obligations not to compete. When such antecedent obligations exist, they have a direct impact on the negotiation of any non-compete agreement and cannot be disregarded. As Conrad Black learned, seizing additional profit under suspect terms exposes oneself to serious and more costly ramifications.
Extreme care must be taken when ascribing non-compete payments to individuals, as this invariably results in a loss of profit / gain to the company and its shareholders. It is therefore important to assess the individual’s employment agreement to ascertain any pre-existing non-compete provisions, especially when combined with a personal disposition to stay on, may result in a personal non-compete having very little value. Be wary of too many individuals and corporate entities receiving non-compete payments, especially when they are inter-related (individuals and corporate entities that are also in control of that other company) as it may result in double-dipping. From the company’s standpoint, there are alternatives to providing an individual a personal non-compete agreement. Providing individuals in the company with reasonable severance commitments, can have a comparable effect to a non-compete, while retaining greater shareholder value since the cost only accrues upon their early termination. Another viable alternative to a non-compete agreement would be to indemnify the purchaser company up to a set limit for any damages that the purchaser company might suffer as a result of competition if the individual in question left the vendor company during the period that the non-compete would have been in effect. This scenario results in zero direct cost to the vendor company and equal protection to the purchaser company. Lesson #3 – Undertake an Independent Valuation of the Non-Compete Agreement’s Value An independent valuation not only provides verification to a corporation that shareholder value is being maintained but it also provides supporting documentation for both the purchaser and the vendor. From the vendor’s perspective, given the changes made to the Income Tax Act (Canada) subsequent to the Fortino case 1 , the independent valuation can be utilized to support the tax election that is now required under Section 56.4 of the Income Tax Act. Even where the Parties to the transaction are unrelated, any allocation in price to the non-compete agreement will be subject to the scrutiny of the Canada Revenue Agency and may need to be supported in order to minimize the risk of reassessment and potential unplanned tax consequences. On the purchaser’s side, the independent valuation will also provide support for the allocation of purchase price in accordance with accounting standards now in effect. In either case, a recognized expert who is also a “disinterested party” should be engaged to complete the valuation in order to minimize the exposure to all parties involved in the transaction. Lesson #4 – Overcome the Impetus to Secure the Maximum Tax Benefit All too frequently tax benefits become the driving factor behind the structuring of corporate transactions (Hollinger International initially entered these transactions with the stated corporate purpose of refocusing on larger publications and reducing Hollinger
1
Her Majesty the Queen v. Fortino, 2000 D.T.C. 6060 (Tax Court of Canada).
International’s debt, yet these objectives were subverted by ensuing profiteering and tax motivations). While being tax efficient should be a critical component to structuring the transaction, the parties involved need to be cautious about employing overly aggressive tax strategies. In addition, the structuring needs to be supported by business practicalities, especially where related party transactions are involved. The General AntiAvoidance Rule (set out in Section 245 of the Income Tax Act) must never be taken lightly, as its potential to decimate tax-driven transaction is extremely pervasive. Lesson #5 – Structure the Non-Compete Payments Accurately The non-compete payment should constitute separate consideration that is distinguishable from the remainder of the purchase price. As such, the valuing of noncompetes should be done at the outset of the transaction, as it is preferable to avoid the non-compete becoming a carve-out from an earlier price figure. Care should be taken to avoid offering duplicative payments, i.e. both management service fees and non-compete payments (the Special Committee investigating Conrad Black and Hollinger concluded that Hollinger’s auditors, KPMG, and outside legal counsel, Torys LLP, failed to warn the audit committee as to the impropriety of these fees together with their excessive size being in violation of fiduciary standards). Look to insure that the payments are discernable and this is best supported by an independent valuation in establishing the price allocations. Lesson #6 – Have it Reviewed by Your Audit Committee The company’s audit committee (with independent directors), accountants and/or law firm should review and approve the process that resulted in the non-compete payments and the price allocation. For publicly traded company, this is regulated by CSA Multilateral Instrument 51-110 Audit Committees, however the practice should be implemented by all business entities, irrespective of their size or the value of the noncompete allocation. An independent review and fairness review of the non-compete agreements should be an imperative (requiring full disclosure and transparency with your independent reviewers). Lesson #7 – Don’t Oversell the Value of the Non-Compete Conrad Black made the mistake of overselling the value of the non-compete agreements when he sought to induce board approval. Direct benefactors are rarely the appropriate choice for objective analysis (Hollinger International had significant debt issues and Conrad Black’s own loan defaults should have been the priority). Instead, business executives need to do what Conrad Black ‘claimed’ to have done: have “disinterested people” handle these matters. The information put before the independent reviewers must be accurate and complete. Yet what is all too frequently overlooked are alternatives to non-compete payments, especially when it relates to individuals who are seeking personal non-compete
payments. These side deals have little benefit to the principal corporation, as they only serve to enhance the personal wealth of the individual signatory. Summation Non-compete payments can now pose substantial danger to the parties negotiating the sale of their business if they seek to be too aggressive and collect more profit (especially personal profit) than is legally permissible. As such, the structuring of the non-compete payments should be subjected to rigorous scrutiny to insure that the parties remain onside with the Canada Revenue Agency. Conrad Black exposed the dark side of non-compete payments, subjecting future corporate transactions to added scrutiny by the Canada Revenue Agency, but in turn providing invaluable lessons for properly structuring future transactions.
* ABOUT THE AUTHORS: Trevor Hood is Vice President of the Corporate Finance Division with SB Partners LLP and a Chartered Accountant and Chartered Business Valuator. Christopher Neufeld is a corporate commercial lawyer with Feltmate Delibato Heagle LLP, having previously worked as a Wall Street attorney in securities and commercial litigation.
DISCLAIMER: This article has been prepared for general informational and educational purposes, and is not intended as legal advice or legal opinion and is not a substitute for specific legal advice. You should obtain competent legal advice on anything discussed in this article and not rely upon the explanations of the law set out in these materials. While every effort has been made to make these materials as accurate as possible, the matters discussed here are complex and these materials are necessarily simplistic and incomplete. Neither the author nor Feltmate Delibato Heagle LLP will be responsible for any errors or any application of the contents of this article.