New Case Is Reminder of Need to Carefully Draft Non-Competes Connected to Sale of Business

August 29, 2012 - 7:36 AM
Topics: Court Decisions, Non-Compete and Trade Secrets

This week a California court reinforced the general validity of non-compete agreements in the context of the sale of a business, but nonetheless struck the agreement at issue in the case on the ground that it was overbroad and not limited to protecting the buyer's good will interest in the business.  The case is Fillpoint v. Maas and the decision is here.  Most California employers are aware that California law generally prohibits non-compete agreements in the employment context based on the public policy favoring employee mobility and the right to pursue a livelihood.  However, one notable exception to this general rule is California's statutory allowance of non-compete agreements connected to the sale of a business.  This exception is codified at California Business and Professions Code section 16601.  The purpose behind the exception, generally, is that the buyer of a business has a justifiable interest in preventing the seller from obliterating the value of the sold business by running out and competing against the buyer.  As such, reasonable restrictions on competition are upheld when based on agreement of the parties in connection with the sale of a business.

In Fillpoint, the employer, Crave, was in the business of distributing and publishing video games and Maas was an employee and stockholder in Crave.  Crave was acquired by Handleman. As part of the acquisition, Maas sold his stock to Handleman and signed a stock purchase agreement containing a non-compete agreement.  He also signed an employment agreement with Handleman containing an additional non-compete provision.  The two agreements cross-referenced eachother and were “integrated” but the non-compete provisions were not identical.  The non-compete provision in the stock purchase agreement essentially prohibited Maas from competing for a three year period following Handleman’s acquisition.  In contrast, the employment agreement prohibited Maas from competing for a one year period following Maas’ termination of employment, whenever that might be (it was not tied to the timing of Handleman’s acquisition of Crave).

Maas fulfilled the three year term of the non-compete in the stock purchase agreement (as he continued working for Crave this entire time).  However, after the three year period expired, Maas resigned and went to work for a competitor, in violation of the one-year covenant not to compete in his employment agreement.  By this time, Handleman had been acquired by another company, Fillpoint.  Fillpoint sued Crave for violation of the non-compete.  The issue in the case was whether the non-compete in the employment agreement was enforceable under B&P Code section 16601’s allowance of non-compete agreements connected to the sale of a business.  The trial court held as a matter of law that the non-compete provision in the employment agreement was not enforceable and the court of appeal agreed.

The court held that the two agreements had to be read together in evaluating whether the provisions were enforceable under the sale of business exception.  To this end, the court held that the three year provision in the stock purchase agreement was valid under section 16601.  However, the court held that the additional one-year provision in Maas’ employment agreement could not be enforced under section 16601 because it was not sufficiently tied to the sale of the business.  Unlike the stock purchase agreement’s non-compete, which provided for a non-compete term immediately following the acquisition, the employment agreement’s non-compete term provided for a non-compete term that was tied to Maas’ separation of employment with the company—whenever that might occur in the future.  Thus, it had nothing to do with protecting the buyer’s interest in the value of the sold company.  Instead, it was more geared toward limiting Maas’ mobility and freedom to compete generally.  The court noted that the provision was so broad in scope that it aimed to prohibit Maas not just from soliciting known Crave customers or employees, but also from doing business with Crave actual or potential customers or employing Crave employees.  Based on the breadth of the non-compete and insufficient connection to the actual sale of the business, the court held that it was void and unenforceable.

The Fillpoint case is a good reminder that even where a statutory exception exists permitting non-competes in limited circumstances, these provisions are still carefully scrutinized by California courts and must be carefully drafted to best ensure enforceability.

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Cal Labor Law

Robin E. Largent is a Partner in CDF’s Sacramento office and may be reached at 916.361.0991 or BIO »

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