Practical Answers to Employment Law Issues
December 07, 2022 - Non-Compete

Delaware Court Refuses to Enforce or Blue Pencil Sale of Business Non-compete

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20 second read: While courts generally appear to give greater deference to enforcement of sale of business non-competes, at least one Delaware court confirmed that if a court thinks the restrictions go beyond the scope of the business being sold, it may refuse to enforce the non-compete and strike it in its entirety without blue-penciling. A consideration for parties when drafting sale of business non-competes.

From the pending Freedom to Compete Act and potential upcoming initiatives at the Federal Trade Commission, to laws recently passed from Washington, to Colorado to Massachusetts to the District of Columbia and in multiple states in between, there has been an increasing trend across the country in restrictions being placed on non-competes in the employment context. Non-competes in the sale of business context, however, have continued to withstand this trend.  Even jurisdictions such as California that ban or drastically limit non-competes in the employment context allow non-competes in the sale of the business context (with some limitations). Otherwise, courts in general tend to apply a less searching standard for determining the reasonableness of sale of business non-competes, which favors enforcement, since the restricted individuals are selling their business, including their businesses’ confidential information, trade secrets, and goodwill, usually in exchange for significant monetary and other consideration.  As a practical matter, many non-competes in the sale of business context are also governed by Delaware law because, among other reasons, Delaware is a popular state for incorporating companies and generally viewed as being favorable to businesses.

In the recent decision of Kodiak Building Partners, LLC v. Adams, 2022 WL 5240507 (Del. Ch. Oct. 6, 2022), however, the Delaware Court of Chancery struck down a sale of business non-compete and refused to blue pencil it because the non-compete sought to prohibit the seller from competing against both the buyer’s existing businesses and what the buyer acquired in the sale.  Despite there being no dispute that the restricted seller breached the non-compete by joining a competitor operating in the same industry as the sold business, the court reasoned that the buyer could not show a legitimate interest to support barring the seller from competing against all of the buyer’s existing businesses in the company group, even though many of those entities were in the same industry as the business that was sold.  And rather than blue pencil it, the court struck it down altogether.

Background

The case arose out of what appears to have been a relatively small transaction, in which the plaintiff, Kodiak Building Partners, entered into a stock purchase agreement with Northwest Building Components and Mandere Construction, Inc. (“Northwest”).  Kodiak purchased the companies directly from Northwest’s four stockholders.  One of the stockholders, defendant Philip Adams, was a general manager for Northwest.  Adams received around $1 million in the transaction for the 8.33% interest he held in Northwest.

In connection with the deal, Kodiak entered into non-compete agreements with Adams, where Adams agreed to the following non-compete in favor of Kodiak and its subsidiaries and affiliates (together defined as the “Company Group”):

Non-Competition.... Adams ... for a period of 30 months beginning on the date hereof (as applicable, the “Restricted Period”), agrees not to ... anywhere in the states of Idaho and Washington, and within a 100 mile radius of any other location outside of those states in which [Northwest, MCI,] or any member of the Company Group have sold products or provided services within the 12 months prior to Closing (the “Territory”), own, manage, operate, control, or participate in the ownership, management, operation or control of, or carry on, be engaged in, permit his, her or its name to be used in connection with, have any financial or other interest in or be otherwise commercially involved in (including as a lender or a donor), any endeavor, activity or business which is similar to or is in competition with the Business or any part of it, or provide any service to any business or Person engaged in the Business....

As part of the non-compete, Adams acknowledged the agreement was reasonable and that he was waiving as a defense any issue of reasonableness.

It appears that six of the Company Group members provide similar services or products as Northwest: roof trusses.  Id. at *10.  The rest of the Company Group members apparently provide different but related services concerning home improvement, such as “manufacturing, marketing, selling, distributing, installing and/or delivering ... floor and stair components; framing; siding and other building materials and supplies, and providing services with respect thereto, including design, engineering, turn-key solutions, project management and trade coordination services.”  Id. at *12.

A little over a year after closing, Adams left Northwest to become general manager of one of its competitors, Builders First Source, Inc. (BFS), which is also a supplier of roof trusses, at a location about 24 miles from where he worked for Northwest.  Shortly thereafter, Kodiak filed a complaint for breach of contract against Adams and moved for a preliminary injunction.  Id. at *3.

Decision

In its briefing, Kodiak pointed to Adams’s failure to cite a single case from Delaware or elsewhere where a court found a sale of business non-compete to be unenforceable.[1]  The Kodiak court, however, proceeded to do just that, finding the non-compete to be unenforceable because its scope was not supported by a legitimate interest and refusing to blue pencil the restriction to make it enforceable.

  • Agreement Not to Challenge Non-compete Not Sufficient for Injunction: Kodiak argued that it was entitled to an injunction because Adams had stipulated in the non-compete that he would not challenge the reasonableness of the non-compete as a defense.  The court disagreed. Despite acknowledging Delaware’s contractarian nature and acknowledging that there was no authority on point, the court found that “an employee’s promise not to challenge the reasonableness of his restrictive covenants cannot circumvent this Court’s mandate to review those covenants for reasonableness.”
  • No Legitimate Interest to Protect Competition Against the Company Group: Kodiak argued that the non-compete was enforceable because: (1) Kodiak had “a legitimate interest in protecting not only Northwest and MCI’s goodwill, but also that of Kodiak, other members of the Company Group, and the Business” and, in the alternative, (2) the non-compete was needed to protect all confidential information about the entire business from misuse. Despite Kodiak demonstrating that Adams knew and had access to confidential information belonging to Northwest and several members of the Company Group, the court found that Kodiak did not have a legitimate interest in enforcing the non-compete to prevent competition against members of the Company Group, other than Northwest. Although the court recognized that buyers have legitimate interests under Delaware law to prohibit sellers from competing “in the relevant industry” and conceded that Adams was violating the non-compete, the court proceeded to draw a line between the goodwill of the seller’s business and the existing goodwill of the buyer’s, at least insofar as the buyer’s goodwill concerned industry “segments” different from what it was getting from the seller through the transaction. The court reasoned:
    • Restrictive covenants in connection with the sale of a business legitimately protect only the purchased asset’s goodwill and competitive space that its employees developed or maintained. The acquirer’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. Kodiak’s legitimate economic interest supporting a restrictive covenant binding a Northwest employee and stockholder does not extend to goodwill and competitive space acquired in other transactions with other Company Group members in other industry segments.
  • Court Declined to Blue Pencil: Unable to persuade the court to enforce the non-compete in its entirety, Kodiak asked the court to blue pencil and enforce it as modified. Although the court acknowledged that Delaware is a blue-pencil state, where courts have discretion to modify overbroad non-competes, it declined to exercise that discretion, striking down the entire non-compete.  In doing so, the court relied on cases in the employment context (rather than the sale of the business context), appearing to suggest that Adams had unequal bargaining power with Kodiak.
    The court also seemed to suggest that it is not appropriate to blue pencil a non-compete in a preliminary injunction order, quoting the following language from a Delaware Supreme Court opinion: “[t]o blue-pencil a contract ... is not an appropriate exercise of equitable authority in a preliminary injunction order.”  Id. at n. 49 (citing C & J Energy Servs., Inc. v. City of Miami Gen. Employees’, 107 A.3d 1049, 1072 (Del. 2014)).  But the full quote from that case indicates that, instead of adopting a categorical rule, the Delaware Supreme Court was taking issue with the manner in which it had been applied—namely blue penciling “to excise a provision beneficial to a third party.”  C & J Energy Servs., Inc. v. City of Miami Gen. Employees’, 107 A.3d 1049, 1054, 1072 (Del. 2014) (“To blue-pencil an agreement to excise a provision beneficial to a third party like Nabors on the basis of a provisional record and then declare that the third party could not regard the excision as a basis for relieving it of its own contractual duties involves an exercise of judicial power inconsistent with the standards that govern the award of mandatory injunctions under Delaware law.”).

Takeaways

Although it is unclear whether other courts applying Delaware law to sale of business non-competes will follow the Kodiak decision, the case raises certain considerations for companies to keep in mind when drafting or trying to enforce non-competes in the sale of business context in Delaware.

  • Even in the sale of business context, careful consideration should be given to drafting and determining the scope of the non-compete and the legitimate business interests the non-compete is intended to protect.
  • If the non-compete will cover a buyer’s existing businesses, consider whether the existing businesses are in the same industry as what the buyer is acquiring.
  • If buyer wants to subject individual sellers to non-competes that cover the company’s existing businesses, the non-compete could be even more defensible if the buyer employs the individual seller post-closing rather than have the individual seller remain employed by the acquired entity (as seemed to be the case in Kodiak). In that case, the buyer should also consider having the seller enter into separate employment non-competes in addition to having a non-compete related to the sale of business.
  • Care should be paid before blue penciling is relied upon as a guaranteed fail-safe.  Blue pencil often means something different depending on the jurisdiction.  Just because a court is in a jurisdiction where it can blue pencil, does not necessarily mean it will or that it must.

[1] Plaintiff’s Reply Brief in Support of Its Motion for a Preliminary Injunction, KODIAK BUILDING PARTNERS, LLC, Plaintiff, v. Philip D. ADAMS, Defendant, 2022 WL 4758315 (Del.Ch.) (“But Adams has failed to cite a single casefrom Delaware or otherwisewhere the Court found a non-compete entered into in connection with the sale of a business to be unenforceable.  To the contrary, Delaware courts have enforced restrictive covenants much broader than the one at issue here because such restrictions are ‘common-place’ and designed to ‘clear the seller from the competitive space while the buyer strives to make the business he just bought successful.’”).