The FTC’s Notice of Proposed Rulemaking of its Non-Compete Clause Rule, which would ban non-competes altogether if promulgated, opened 2023 with a bang. Whether it goes into effect, in what form, and whether the Rule will survive the legal challenges it will encounter, all remain to be seen and likely will not be resolved for many months, if in 2023 at all.[1] In the meantime, employers still need to contend with the ever-evolving world of non-compete law in the United States. The year 2022 saw an ongoing trend of legislatures passing laws intended to narrow the scope of non-competition agreements but courts—including in California, which may be a surprise for some to hear—continuing to enforce them. Meanwhile, other courts continued grappling with important issues—such as sale of business criteria and under what circumstances may a sale-of-business non-compete be unenforceable—that are already important now and will become even more so if the FTC’s proposed ban goes into effect. Other decisions dealt with evergreen issues such as contract interpretation and blue penciling. And still others considered the ever-increasing importance of California’s choice-of-law and choice-of-forum exception codified in California Labor Code Section 925(e). Below is a summary of some key non-compete highlights from 2022.
- Lawmakers Narrow Non-Competes. Colorado, the District of Columbia (D.C.), and Illinois are among the jurisdictions where new laws narrowing the reach of non‑competition agreements for employees went into effect in 2022. Among other limitations, Colorado law was amended to bar non-competes for employees earning less than $101,250 and to require a non-compete agreement be given to an employee before starting employment or at least 14 days before going into effect for current employees. The D.C. law bars non-competes for employees earning less than $150,000 annually and requires employees be given at least 14 days’ notice to review a non-compete before it goes into effect. The Illinois statute bars non-competes for employees earning less than $75,000 per year, imposes a 14-day notice requirement, and requires adequate consideration of at least two years of employment or financial benefits (which are not defined but presumably include raises, bonuses, stock grants, promotions). Notwithstanding any choice of law provision to the contrary, each of these jurisdictions will apply its law to a non-compete entered into by an employee who lives or works in the jurisdiction. Non-competes entered into in exchange for the sale of a business continue to be enforceable in each of the jurisdictions despite these new laws.[2]
Delaware Chancery Court Refuses to Enforce or Blue-Pencil Overbroad Deal Non‑Compete. Sale of business non-competes are generally afforded greater deference and are often exempted from statutory restrictions. But in Kodiak Building Partners, LLC v. Adams, 2022 WL 5240507 (Del.Ch. Oct. 6, 2022), a recent Delaware Chancery Court case served as a reminder that greater deference does not always mean enforceability, even in a contractarian jurisdiction such as Delaware. Surprising many, the Delaware Chancery Court in early October 2022 both (a) struck down a sale of business non‑compete the court found to have been overbroad because the non-compete barred the seller from competing not only with the business it sold, but also the buyer’s other businesses, and (b) declined to exercise the court’s discretion to blue-pencil and enforce a trimmed-down version of the non-compete that may have been found more reasonable.[3] Although the court recognized that buyers have legitimate interests under Delaware law to prohibit sellers from competing “in the relevant industry” and conceded that the seller was violating the non-compete, the court drew a line between the goodwill of the seller’s business (a legitimate interest) and the existing goodwill of the buyer’s (not a legitimate interest), at least insofar as the buyer’s goodwill concerned industry “segments” different from what it was getting from the seller through the transaction. Even though the court had the option to blue-pencil it, the court declined to do so, suggesting that the employee who sold his share of the business for around $1 million had unequal bargaining power and it would not be equitable to blue-pencil under those circumstances.[4]
California Courts Enforce Sale of Business Non-Compete Against Seller Tied to Termination of Employment (Not Closing Date). Ten years ago in Fillpoint, a California appellate court refused to enforce a sale of business non-compete that defined the duration as the longer of X years from closing or Y years from the seller’s termination of employment. Fillpoint, LLC v. Maas, 208 Cal. App. 4th 1170, 1182-83 (2012). Since then, there has been a trend in California deals where the duration of the seller’s non‑compete is only defined as X years from closing. In 2022, however, two California state and federal court judges enforced sale of business non-competes where the seller was barred from competing with the buyer for Y years from the seller’s termination of employment. In the first case, Blue Mountain, the court enforced a three-year nonsolicit tied to termination of seller’s employment that was entered into in connection with transfer of ownership interest. Blue Mountain Enterprises, LLC. v. Owen, 74 Cal. App. 5th 537 (2022). “The validity of that covenant,” the court held, “is not affected by its location in the employment contract rather than the merger agreement.” “The purpose of the statute is served as long as the covenant is executed in connection with the sale or disposition of all of the shareholder's stock in the acquired corporation.” at 553.
The second case, Arthur Gallagher, involved two non-competes—one in a sale purchase agreement and one in an employment agreement, both of which were entered into at time of sale—just like Fillpoint. Arthur J. Gallagher & Co. v. Petree, 2022 WL 1241232 (E.D. Cal. Apr. 27, 2022). Relying on Fillpoint, the employee argued that the non‑competes were unenforceable because the term did not run from the time of sale but instead prohibited him from soliciting his former employer’s customer two years after his employment ended. The court disagreed. Fillpoint was distinguishable, the court found, because in Fillpoint the two non-competes were distinct, whereas here they were identical. “The distinction [between the two non-competes in Fillpoint] mattered because the latter targeted the defendant's right to pursue his profession, whereas the purchase agreement was focused on the acquired goodwill.” The court also relied on the fact that “the parties specifically agreed the express purpose of those restrictive covenants was to ‘protect the Personal Goodwill Assets, business and other Property’ that AJG was purchasing from Petree, and that they were ‘reasonably necessary and tailored to protect [Gallagher's] legitimate business interests.’” Arthur J. Gallagher, 2022 WL 1241232, at *3 (E.D. Cal. Apr. 27, 2022). The defendant apparently tried to argue that the scope of the non-compete was broader than needed to protect the purchased goodwill, but that, too, the Gallagher court found unpersuasive.
- Massachusetts Court Clarifies Sale of Business Exception. Even before the FTC’s proposed rule, the scope of the sale-of-business exception has long been an important and at times slippery issue, as a sale of business can take various forms. What if an employer effectively purchases a “book of business” from one of its employees? Can a non‑compete entered into in connection with that sort of transaction qualify as a sale of business? According to one Massachusetts court in July 2022, the answer would be no, at least not when it involves converting an employee’s right to receive a commission to a fixed salary. Lighthouse Insurance Agency, Ltd v. Lambert, involved a licensed insurance producer who sold insurance on commission—40% for new business and 40% for any renewals by those accounts. In 2020, his employer asked him to enter in a new employment agreement with a new compensation structure, with an $80k salary plus 40% commission for new accounts originated by him. The employer characterized this new compensation arrangement as involving the purchase and sale of the employee’s “book of business.” The court disagreed. “The right to commission payments from the insurers on those accounts belonged to [the employer],” the court observed. And “[the employee] could not sell or assign any interest in those accounts to [the employer] or to anyone else.” All the employer was really doing, as the court saw it, “was converting [the employee’s] continuing right to receive a share of [the employer’s] commissions on the accounts [the employee] had brought to the agency into a new right to receive a fixed salary plus a small portion of the commissions to which [the employee] had previously been entitled.” Even assuming this would have qualified as a “book of business,” the court suggested that it still would have fallen short. The Massachusetts statute defines non-compete to exclude agreements “made in connection with the sale of a business entity or substantially all of the operating assets of a business entity or partnership, or otherwise disposing of the ownership interest of a business entity or partnership, or division or subsidiary thereof, when the party restricted by the noncompetition agreement is a significant owner of, or member or partner in, the business entity who will receive significant consideration or benefit from the sale or disposal.” See G.L. c. 149, § 24L(a). And the employer had not argued that a “book of business” was a “business entity” or assets of a “business entity or partnership.” https://faircompetitionlaw.com/wp-content/uploads/2022/06/09-066-22.pdf
- Federal Court Applies Janitor Rule In Georgia. Georgia, like some other jurisdictions, recognizes what is known as the janitor rule, e., that a non-compete may be unreasonable and thus unenforceable if it prohibits an employee from working in any capacity for a competitor, even in a non-competitive capacity, such as a janitor. The non‑compete in this case defined “prohibited activity” as “activity to which I contribute my knowledge, directly or indirectly, in whole or in part, as an employee, employer, owner, operator, manager, advisor, consultant, agent, partner, director, stockholder, officer, volunteer, intern or any other similar capacity to an entity engaged in the same or similar business as AmSpec.” Did “knowledge” necessarily cabin the clause, such that the employee was prohibited from working only in a capacity in which he used the knowledge he gained from his prior employer? No, the court held. Relying on the dictionary definition of “knowledge,” the court found that “knowledge” was all‑encompassing and that meant “Defendant cannot directly or indirectly give or supply to any competitor of AmSpec any of the facts and other things that the Defendant is aware of, regardless of when or how he became aware of them.” Because that effectively prohibited the former employee from working in any capacity, it was unreasonable and thus unenforceable. Georgia is a blue-pencil jurisdiction like Delaware, but as was the case in Kodiak, that did not save the non-compete. In the court’s view, its blue-penciling powers were limited to striking unreasonable restrictions or narrowing over-broad territorial designations. But adding the language “learned while employed by Plaintiff” to the Agreements would create a limitation from “whole cloth” and the court would be rewriting the agreements to save an otherwise unenforceable clause. AmSpec, LLC v. Calhoun, 2022 WL 17740307, at *7 (S.D. Ga. Dec. 16, 2022).
- Courts Provide More Clarity on California Labor Code Section 925(e)’s Potential Application to Silicon Valley and Other California Non-Competes.
- Effective January 1, 2017, California Labor Code Section 925 required any agreements signed as a condition of employment in California to be governed by California law and allowed any such agreements not designating California law to be voided at the option of the employee. The new law included an exception, subsection (e), which on its face allowed an employee who was represented by counsel in the negotiation of such an employment-related agreement to select another state’s law to govern the agreement.
- In 2018, the Delaware Chancery Court invoked Labor Code Section 925(e) to enforce a non-compete against a California executive on the basis of a Delaware choice of law provision in the non-compete.[5]
- More recently, in 2021, the federal court for the Southern District New York applied a Delaware choice of law provision in a non-compete over the objection of an executive who argued that Section 925 required the application of California law, where the Court was convinced the executive in fact had been represented by legal counsel in the negotiation of the non-compete.
- While they did not actually apply a non-California state’s law to enforce the non‑compete under Section 925(e), at least two California courts in 2022 issued rulings indicating they may have done so if the evidence that the California executive was represented by counsel in negotiating the non-compete had been more persuasive. In fact, one of those courts, the Ninth Circuit Court of Appeals, went so far as to find that, with respect to a California employee who is represented by legal counsel, “Such an employee is free to negotiate whatever forum-selection clause they want.”[6]
We can only expect further non-compete developments in 2023 and beyond, and the MoFo team will report on them as they arise. Stay tuned!
[1] See https://www.hr.com/en/magazines/legal_compliance_excellence_essentials/
[2] See, e.g., https://www.mofo.com/resources/insights/220721-dc-council-waters-down-non-compete-ban and https://www.mofo.com/resources/insights/210630-illinois-ushers-new-restrictions.
[3] See https://elc.mofo.com/topics/delaware-court-refuses-to-enforce-or-blue-pencil-sale-of-business-non-compete.
[4] Those wondering whether Kodiak could be an outlier or a start of a broader trend in Delaware should note the recent case of Ainslie v. Cantor Fitzgerald, L.P., 2023 WL 106924, at *8 (Del. Ch. Jan. 4, 2023), in which the court found a non-compete in a limited-partnership agreement to be unenforceable, along with a “conditioned payment device,” which the court found to be an unenforceable forfeiture for competition. See https://elc.mofo.com/topics/delaware-court-refuses-to-enforce-or-blue-pencil-sale-of-business-non-compete for more information.
[5] Several months later, that executive presented evidence clarifying that he in fact was not represented by legal counsel, and the Chancery Court reversed its decision and declined to enforce the non-compete against the California executive. See Nuvasive, Inc. v. Miles, 2019 Del. Ch. LEXIS 325, 2019 WL 4010814.
[6] Depuy Synthes Sales, Inc. v. Howmedica Osteonics Corp., 28 F.4th 956, 964 (9th Cir. 2022).