There is often an assumption that restrictive covenants entered into in connection with a sale of business will be enforceable, even if they are broader in scope of time, geography, and restricted activity than would otherwise be acceptable to a court. 

A recent opinion out of the Delaware Court of Chancery in Kodiak Building Partners, LLC v. Adams challenges this assumption.

The case arose out of a business transaction by which Kodiak Building Partners, LLC, whose business model is to purchase and operate smaller businesses in various sectors of the construction industry, purchased a roof truss company, Northwest Building Components, Inc. Defendant Philip Adams was a former employee and stockholder of Northwest.

In connection with the acquisition, Adams was paid nearly $1 million, became an employee of Kodiak, and entered into a restrictive covenant agreement (RCA), which included noncompetition, nonsolicitation, and confidentiality provisions. The RCA applied for a period of 30 months from the closing and included boilerplate language that Adams acknowledged the reasonableness of the restrictions and waived any issue of reasonableness as a defense. About four months after the closing, Adams resigned and joined a competing building materials and roof truss company within the restricted geographic territory.

Kodiak filed a lawsuit against Adams in the Delaware Court of Chancery arguing that he was in breach of the RCA and seeking injunctive relief. Despite recognizing that covenants not to compete in the context of a business sale are subject to a “less searching inquiry,” the Delaware Court of Chancery denied Kodiak’s Motion for Preliminary Injunction for two main reasons:

1. The Boilerplate “Reasonableness” Language in the RCA was Against Public Policy.

The RCA contained standard boilerplate language stating that the restrictions were reasonable in scope and that Adams waived any argument to the contrary. Kodiak asserted that this language precluded Adams from contesting the reasonableness of the RCA. Adams, on the other hand, argued that the waiver of right to contest the restrictive covenant was a violation of public policy because it sought to avoid the court’s public policy-based review.

In agreeing with Adams, the court noted “[p]ublic policy requires Delaware courts to evaluate noncompetition and nonsolicitation contracts holistically, carefully, and nonmechanically, with an eye towards reasonableness, equity, and the advancement of legitimate business interests.” The court would not agree to skip over this evaluation simply because one party stipulates the test is not necessary.

2. The Scope of the Noncompete Provision was Not Tailored to Protect a Legitimate Business Interest.

Next, and perhaps more critically, the court determined that the noncompete was overbroad in relation to the legitimate business interests it was intended to protect. The court found that in the context of the sale of business, those legitimate business interests are limited to “the assets and information [the buyer] acquired in the sale.”

The RCA at issue restricted competition with any business in Kodiak’s portfolio of companies, not just the business of Northwest. Likewise, it restricted solicitation of any client or customer of any member of the company group and defined Confidential Information to include information relating to the other business lines under the Kodiak umbrella.

The court noted that while Delaware law recognizes Kodiak’s legitimate interest in protecting what it purchased from Northwest, it has not affirmatively recognized a legitimate interest in protecting the acquirer’s preexisting goodwill. “The acquiring company’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.”

It is important to note that the opinion does have its own fact-specific limitations. Kodiak did not offer any evidence that Adams had access to confidential information or goodwill of the other portfolio companies post-acquisition, nor did it show that he had any post-closing relationship with any member of the company group other than Northwest. Had Kodiak acquired Northwest’s business, integrated it with the other business lines, and shared confidential information and goodwill relating to those other business lines with Adams, the enforceability analysis would likely be impacted.

It is also noteworthy that the court declined to “blue pencil” the agreement, or rewrite the restrictions to make them narrower and therefore enforceable, despite language in the agreement explicitly permitting it to do so. In declining to blue pencil the restrictions, the court noted that it would be inequitable and against public policy to allow an employer who entered into such an overbroad agreement to rely on blue penciling to place it in a “no-lose” situation.

Takeaway

While it may be true that courts will allow for a broader scope of reasonableness in connection with a sale of business, reasonableness will still be analyzed in relation to the scope needed to protect the acquiring company’s economic interests. The Court of Chancery has now affirmatively limited this economic interest to the goodwill and information obtained through the acquisition, carving out any preexisting interests of the acquiring company. Moving forward, drafters may consider including more detailed recitals establishing agreed-upon facts that support why the scope and geography of the restriction are reasonable to protect the interests of the acquiring company, especially if the scope of the restriction goes beyond the business of the target company.

The court has also chipped away at many of the shields employers have historically relied upon to increase the likelihood of enforcing restrictive covenants – reasonableness provisions and blue penciling. Without these safeguards, it is critical that when drafting restrictive covenant agreements, regardless of the context, employers carefully consider which legitimate business interests require protection and avoid boilerplate provisions. While a narrowly tailored agreement may limit market protection to some degree, an overbroad or overreaching agreement could leave the employer with no protections at all.