Competition and Contract Breaches: How Business Sales Affect Noncompete Covenants
by Stephan Mihalovits
One latest political football seems to be the role government plays in either stimulating or stymying free enterprise. We usually associate government with burdensome regulation that handcuffs business.
But contrary to our predetermined bias, in a recent case, the California Court of Appeal reaffirmed free movement of labor in the state by nullifying noncompete covenants in employment contracts, even where the covenant is part of the sale of a business.
It is bedrock law in California that noncompete covenants are generally not enforceable. Business & Professions Code Sec. 16600 states “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.”
This means a company cannot generally prevent an employee through contract from working in the same profession or industry after she or he is no longer employed by the company. But many companies would argue such covenants are entirely justifiable.
Businesses have legitimate reasons for seeking to bind their future former employees. They hire employees and invest in their skills. Investments take many forms, including the time and money involved in paying for training and continuing education. Investing always takes varying amounts of time and money, and companies are often happy to invest, as long as the investment is a good bet.
A business may justifiably seek to prevent an employee from using training the company paid for in order to gain employment with a rival competitor.
The employee may have learned confidential trade secrets that may be divulged if the employee worked for a competitor, no matter if the company secured a nondisclosure agreement. Accordingly, businesses use noncompete covenants to prevent employees from divulging and using trade secrets.
Lawful Noncompete Covenants
Despite these legitimate interests in favor of covenants not to compete, such provisions are generally not enforceable. But California established two limited exceptions. Noncompete covenants can be lawful if either the covenant occurs in connection with the sale of a business, or in connection with dissolution of a partnership. (B&P 16600-16602).
The rationale behind the business sale exception goes to the value of the business during and after a sale.
Suppose a dentist pays a lot of money to buy a popular, retiring dentist’s business. The value of the business depends on the selling dentist retiring and not offering more services to his customers.
Now suppose after the sale the seller spontaneously comes out of retirement and establishes a new practice in the same geography. The business the buyer bought is now worth far less, because the seller’s customers will likely return to their former dentist. To protect the value of the asset, the buyer dentist is allowed to contract that the seller not be able to compete for a certain number of years.
In the recent case of Fillpoint, LLC v. Maas, et al., (August 24, 2012), the Court of Appeal concluded a noncompete covenant was unenforceable, even when arguably in connection with the sale of a business.
In Fillpoint, Michael Maas sold all his shares of Crave Entertainment Group to buyer Handleman Company. As part of the sale, Maas agreed not to compete with Handleman for three years. At the same time, the two sides entered into a written employment agreement where Maas:
(1) agreed to work for Handleman for three years, and
(2) agreed not to compete for one year after he eventually left. Maas left after completing the three-year agreement and went to work for a competitor. Handleman then sued to enforce the one-year noncompete covenant.
But the Court struck the covenant as unenforceable while upholding the three-year covenant, which was already completed. The three-year covenant was enforceable as directly related to the sale. The buyer paid Maas for his share of the Crave business based partly on the premise that Maas would not compete with Crave for three years.
But the one-year covenant dealt only with the employment agreement. There was no legal justification for prohibiting Maas from working for whomever he chose once he satisfied the three-year covenant. Since there was no connection to the sale, given the general rule of prohibition, the Court struck the one-year noncompete covenant as unenforceable.
The message of Fillpoint is that free movement of labor is alive and well in California, and even may trump California’s equal fondness for freedom of contract. Parties are generally permitted to contract to whatever they wish, within reason. But even with employment agreements entered into as part of a business sale, contracts will not prevent workers from engaging in future competition.