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Court Limits the Scope of a Non-Compete in Connection with the Sale of a Business

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Attorney Harrison Oldham

 

 

Many people assume that restrictive covenants entered in connection with the sale of a business will be enforceable, even if they are broader in the scope of time, geography, and restricted activity than would otherwise be acceptable to a court.  For example, courts in Delaware (and most) courts routinely uphold even aggressive non-compete agreements related to the sale of a business. However, in Kodiak Building Partners, LLC v. Adams, the Delaware Court of Chancery reminded us that this is not always the case. In Kodiak, the court found the restrictive covenants imposed on a stockholder in a business acquisition were overbroad and therefore unenforceable.

 

Background

 

In Kodiak, Kodiak, as the Buyer, entered a stock purchase agreement to acquire a roof truss company, Northwest Building Components, Inc. The Defendant, Philip Adams, was both an employee and stockholder of the acquired company.

 

As part of the acquisition, Adams entered into a restrictive covenant agreement with Kodiak that included non-competition, non-solicitation, and confidentiality provisions. The restriction applied for 30 months after the closing and included boilerplate language where Adams agreed the restrictions were reasonable and waived any issue of reasonableness as a defense.

 

About four months after the closing, Adams joined a competing building materials and roof truss company within the restricted geographic territory violating the restrictive agreement. Not surprisingly, Kodiak sued Adams for breach of the restrictive covenant agreement and sought a preliminary injunction.

 

The Court’s Ruling

 

During its review, the Delaware Court of Chancery denied Kodiak’s motion for an injunction for two main reasons:

 

First, the Court found that the restrictive covenant agreement’s waiver provision did not preclude it from reviewing the restrictive covenant for reasonableness.  In response, Kodiak argued that the language prevented Adams from contesting the reasonableness of the restrictive covenants.  On the other hand, Adams argued that the waiver of the right to contest the restrictive covenant violated public policy because it sought to avoid the court’s public policy-based review.

 

Ultimately, the court agreed with Adams.  In doing so, the court noted, “[p]ublic policy requires Delaware courts to evaluate noncompetition and nonsolicitation contracts holistically, carefully, and nonmechanically, with an eye towards reasonableness, equity, and the advancement of legitimate business interests.”

 

Second, the court found the non-compete overbroad unenforceable because it restricted Adams from competing with the acquired business and all companies under Kodiak’s broader corporate organization, including other unrelated construction businesses. The court noted that while Delaware law recognizes Kodiak’s legitimate interest in protecting what it purchased, it has not affirmatively recognized a legitimate interest in protecting the acquirer’s preexisting goodwill. “The acquiring company’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.”

 

It is also noteworthy that the court declined to “blue pencil” the agreement or rewrite the restrictions to make them narrower and therefore enforceable, despite language in the agreement explicitly permitting it to do so. In declining to revise the restrictions, the court noted that it would be inequitable and against public policy to allow an employer who entered into such an overbroad agreement to rely on blue-penciling to place it in a “no-lose” situation.

 

Takeaway

 

Although generally restrictive covenants given in connection with the sale of a business are usually subject to less scrutiny than those in employment relationships, the Kodiak decision demonstrates that restrictive covenants in connection with the sale of a business may be unenforceable if their scope is deemed overbroad. As a result, it is even more critical for employers and potential acquiring companies to review and consult with legal counsel when drafting restrictive covenants.

 


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About Harrison Oldham

Harrison grew up in Mansfield, Texas. He attended Texas A&M University for his bachelor’s degree, where he met his wonderful wife, Kelsey. After graduating magna cum laude from Texas A&M, he attended SMU Dedman School of Law, graduating with honors in 2012. Today, Harrison and his wife live in Dallas, Texas with their son, Teddy.

Since graduating from SMU Law, Harrison has worked exclusively in the field of business law. He has spent time in private practice and in-house, working with clients of every size; from single person startups to Fortune 250 companies. Today his practice focuses on serving the diverse needs of businesses and individuals throughout Texas. You can learn more about Harrison by visiting his website, at: http://lonestarbusinesslaw.com/.

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