In Samuelian v. Life Generations Healthcare, LLC, — Cal. App. 5th —, 2024 WL 3878448 (Cal. App. Aug. 20, 2024), the California Court of Appeal answered two long outstanding questions of California law concerning the enforceability of noncompetition agreements in the context of the sale of a business:

1. Yes, a partial sale of an ownership interest in a business may support a noncompete under the rule of reason (even though the sale of business exception under Business & Professions Code Section 16601 permitting non-competes requires the sale of an entire ownership interest and associated goodwill, otherwise it is “void per se”); and
2. Yes, status as a member of an limited liability company (“LLC”) can potentially support a noncompete during the period of membership if there is contract language imposing fiduciary obligations on the member.

In Samuelian, two members of the defendant LLC sold part of their interest in the company, but retained a minority membership interest with voting and information rights. The operating agreement imposed fiduciary duties on all of the company’s members, including specifying that they could not to compete with the company during their membership. The company alleged that the two partially-selling members breached the noncompetition provision, which triggered the company’s right to purchase their remaining ownership interest. The members argued that the noncompetition provision was per se void under California law while the company argued that the noncompetition provision had to be evaluated under a “rule of reason.” Until Sameulian, no case had addressed the issues raised by this case.

In Ixchel Pharma, LLC v. Biogen, Inc., 9 Cal. 5th 1130 (2020), the California Supreme Court clarified that the “void per se” standard applies in the context of employment agreements and the sale of a business, while a “reasonableness standard” applies to business to business agreements, i.e., “agreements limiting commercial dealings and business operations.” Previously, in Edwards v. Arthur Andersen LLP, 44 Cal. 4th 937 (2008), the California Supreme Court had rejected the common law “rule of reasonableness” for employment noncompete agreements, and instead held that Business & Professions Code Section 16600 rendered noncompete agreements per se void unless the agreement fell within one of the statutory exceptions (generally, the sale of an entire business interest and associated goodwill). 

It was unclear following Ixchel how courts would apply the new rule of reason standard for business to business transactions outside the joint venture context of that case and whether courts would broaden the scope of the business to business exceptions beyond the three statutory exceptions set forth in Sections 16601, 16602 and 16602.5. In Samuelian, the California Court of Appeal held that the reasonableness standard also applies to partial sales of a business under certain circumstances. In reaching this holding, the Court began by looking to the purpose behind Section 16600: “a settled legislative policy in favor of open competition and employee mobility.” The Court reasoned that in the partial sale of a business, “the seller remains an owner of a business . . . and may hold some degree of control over its operations” and that “[d]ue to that ongoing connection, noncompetition agreements arising from a partial sale must be evaluated under the reasonableness standard to determine whether they have procompetitive benefits.” Under Samuelian, whether a noncompetition restriction will be upheld in connection with a partial sale of a business requires an evaluation of whether the restriction is more harmful or helpful to competition and is “reasonable in light of the seller’s ongoing connection with the company” when considering “the facts peculiar to the business in which the restraint is applied, the nature of the restraint and its effects, and the history of the restraint and the reasons for its adoption.”

The Court explained that after a partial sale, selling owners may owe the company a duty of loyalty that prohibits them from competing with it, and that adopting a “void per se” rule would “unnecessarily interfere with these fiduciary duties.” The Court also held that while the California Revised Uniform Limited Liability Act does not include a de facto imposition of fiduciary duties on members in a manager-managed company, those duties can be imposed contractually in the company’s operating agreement. In reaching this holding, the court confirmed the continuing validity of in-term restrictive covenants in the employment context. 

The Samuelian decision fills an important gap in California law pertaining to the partial sale of a business interest and a reminder that companies should consult with counsel to carefully consider whether to impose contractual fiduciary duties on members in operating agreements, as well as how to structure any noncompetition provisions and other restrictive covenants so that they are reasonable or otherwise fall within one of the statutory exceptions under Section 16600 et seq.