The California Court of Appeal (Fourth Appellate District) recently addressed the enforceability of non-compete covenants in the context of purchase and employment agreements in Fillpoint, LLC v. Michael Maas et al., __ Cal. Rptr. 3d __, 2012 WL 3631266 (Cal. Ct. App. Aug. 24, 2012). Fillpoint involved an executive-level employee and shareholder who, in connection with the sale of his former employer, entered into both a stock purchase agreement and an employment agreement with the purchaser. Each agreement signed by the employee contained a non-compete covenant, but the two covenants were not identical.

Among other things, the covenant in the purchase agreement prohibited the employee from competing with the purchaser in the three-year period following the close of the transaction, while the covenant in the employment agreement prohibited competition in the year following termination of his employment with the purchaser. The former employee-shareholder satisfied the purchase agreement covenant. In fact, he worked for the purchaser for a full three years after the closing, but then accepted employment as the CEO of a competitor six months later. At that point, the purchaser sued for breach of the non-compete covenant contained in the employment agreement. The facts of the Fillpoint case presented the court with a unique opportunity to compare and contrast the two non-compete covenants at issue under California law.

The court held that while the non-compete covenant in the purchase agreement was sufficiently narrow, met statutory requirements, and thus was enforceable, the non-compete covenant in the employment agreement was overly broad, not statutorily justified, and unenforceable. In reaching its opinion, the court reviewed existing California case law regarding the enforceability of non-compete covenants in both the employment and sale of business settings, thereby providing important reminders for practitioners looking to protect the goodwill of a purchased business as well as serving as a cautionary tale against the use of inconsistent and overly broad non-compete covenants.

Factual background

In October 2005, Handleman Company acquired Crave Entertainment Group, Inc. by means of a stock purchase. Maas was an executive-level employee and shareholder of Crave. Maas and other Crave shareholders entered into a stock purchase agreement with Handleman, pursuant to which Handleman acquired all of Crave’s capital stock. The purchase agreement included a non-compete covenant, which restricted all major shareholders, including Maas, from competing in Crave’s business of distributing and publishing video games for three years following the closing of the transaction. In conjunction with Handleman’s acquisition of Crave, Maas also entered into an employment agreement with Crave under which he agreed to work for Crave for three years. The employment agreement contained a one year non-compete covenant, triggered upon Maas’s cessation of employment with Crave.

Maas resigned from Crave in November 2008, having fully satisfied the three year non-compete covenant contained in the purchase agreement. Six months later, Maas became the president and Chief Executive Officer and a shareholder of Solutions 2 Go, a competitor of Crave. Fillpoint, Crave’s successor-in-interest, sued Maas for breach of the non-compete covenant contained in his employment agreement.

Legal background

Non-compete covenants are generally unenforceable under California law unless they fall into one of California’s limited statutory exceptions. The most commonly employed statutory exception permits the enforcement of a non-compete covenant made in connection with the sale of a business. Bus. & Prof. Code, §16601.

This exception provides that any person who sells the goodwill of a business or any owner of a business entity selling all of his or her ownership interest in the business entity may agree with the buyer to refrain from carrying on a similar business within a specific geographic area in which the business sold its goods and/or services as long as the buyer carries on a like business. The exception serves to protect the value of the business acquired by the buyer and to ensure fairness by preventing a seller from engaging in competition that diminishes the value of the asset he or she just sold.

The Court of Appeal opinion

Because Maas had already fully satisfied the non-compete covenant in the purchase agreement, Fillpoint’s suit against Maas turned on the enforceability of the longer non-compete covenant in Maas’s employment agreement. Before addressing that issue, the Fillpoint court first confirmed the general proposition that an otherwise enforceable non-compete covenant will not be deemed invalid simply because it is contained in an employment agreement as opposed to a purchase agreement. The court confirmed that nothing in Business & Professions Code section 16601 requires a non-compete covenant to be contained in a particular type of document, and held that a valid covenant could be placed in an employment agreement, a purchase agreement or even a stand-alone agreement, as long as the covenant otherwise met applicable statutory requirements (i.e., the covenant was given in connection with the sale of the goodwill of a business). The Fillpoint court also held that where a series of documents are entered into in conjunction with an acquisition transaction, all of the transaction documents, including employment agreements, would be read together in applying the agreements.

Turning to the specific non-compete covenant in Maas’s employment agreement, the Fillpoint court noted that the covenant was significantly broader than the non-compete covenant in the purchase agreement, and prevented Maas from:

  • making sales contacts (or assisting others in doing so) with anyone who was Crave’s customer or potential customer during the two years preceding the cessation of Maas’s employment (as opposed to those who were customers at the time of the sale of Crave);
  • working for or owning an interest in any business that would compete with Crave; and
  • employing or soliciting for employment any of Crave’s employees or consultants.  

The court noted that while the non-compete covenant in the purchase agreement was narrowly tailored to protect Crave’s business as it existed as of the closing of the acquisition, the non-compete covenant in Maas’s employment agreement professed to protect the Crave business as it existed as of the cessation of Maas’s employment – which had likely changed in the three years since the closing of the transaction. Because the employment covenant attempted to extend the non-competition restriction beyond “the business so sold,” it was overly broad and unenforceable.

This important distinction is often overlooked in transaction documents: to be enforceable under California law, a non-compete covenant given in connection with the sale of a business must only restrict competition with the sold business as it existed at the time of the sale, and not as it may exist in the future. Because the employment agreement non-compete covenant in Fillpoint was not narrowly tailored to protect only the interest of the sold business as it existed at the closing of the transaction, the court found that it was not narrowly tailored to protect the good will of an acquired business, as intended by section 16601. In reaching this conclusion, the court noted that the employment agreement non-compete covenant contained impermissibly broad non-solicitation terms that unlawfully affected Maas’s right to be employed in the future.

Interestingly, the Fillpoint court did not take the opportunity to address a much more important, but unsettled, issue regarding restrictive covenants: whether such covenants may properly run from the unknown and uncertain date of termination/cessation of employment, as opposed to the fixed and certain date of the closing of the transaction itself. The Fillpoint court could easily have seized upon this key difference between the two covenants at issue to hold that the employment agreement covenant Maas signed was unreasonably long in duration because it theoretically could run for many years after the closing—for one year longer than the length of his employment, which in turn could last a lifetime. While it had the opportunity to resolve this unsettled area of the law, the court declined to bring much-needed resolution to this issue. Thus, it remains unclear whether, under California law, a post-employment non-compete term is enforceable where the term of the employment agreement (and thus the duration of employment) is potentially indefinite (e.g. where the covenant runs from cessation of employment or where it runs from termination or expiration of an employment agreement that contains an “evergreen” renewal provision).

Practice points

If a buyer of a business desires to include non-compete covenants in both the purchase agreement and a selling shareholder’s employment agreement, care must be taken to carefully draft each covenant to fit within California’s narrow statutory exceptions. In particular, the following points should be noted:

  • Non-compete covenants must fit strictly within the limited statutory exceptions for the sale of a business or its assets, the disposition of shares or other interests in a business, or the withdrawal from or dissolution of a partnership or limited liability company.
  • A non-compete covenant otherwise meeting the statutory exceptions may be placed in the purchase agreement, employment agreement, or some other document, including a stand-alone agreement.
  • A non-compete covenant must be designed to protect the value of the goodwill of the business being sold, and limited in scope so it does not exceed that purpose.
  • A non-compete covenant can only be provided for the business being sold and cannot be tied to the broader business of the acquiring company, both in terms of geography and customer base.
  • Consistency matters; employment and other agreements executed in connection with a purchase agreement should contain terms consistent with the purchase agreement.
  • Customer non-solicitation covenants are generally subject to the same rules as non-competition covenants.
  • Caution should be exercised in setting the “trigger point” for a non-compete covenant, in order to avoid a later finding that the covenant was unreasonably long.