A Non-Compete Damages Overview

Companies that enforce restrictive covenants against ex-employees often face an uphill battle in proving damages resulting from a breach. It is for this reason that in the vast majority of cases a plaintiff focuses primarily on securing an injunction right away. It also is fairly clear that unless a new employer has aided the breach in some respect (for which it could be liable to an equal extent as the breaching employee) that an individual likely does not have the ability to pay a monetary judgment.

Still, it is important for plaintiff's counsel to understand the damages landscape and how to value a case. In this regard, the following damages theories might be available in a non-compete dispute:

1. Lost profits - The conventional method of proving contract damages is through a showing of lost profits. By definition, lost profits are speculative to a degree because they seek to project a model of economic activity in a counter-factual world. Put another way, but for the breach of the restrictive covenant, what profits would the employer have earned? Lost profits claims are delimited by the "reasonable certainty" rule, which means that a plaintiff must establish loss to a reasonable degree of certainty. Many courts confuse this rule's application. Generally speaking, it applies to the fact of damage. And once a plaintiff shows some damage, it is entitled to greater latitude in quantifying the harm - particularly where the employee's conduct has impeded quantification. In non-compete cases, a party may attempt to prove lost profits by projecting a picture of future sales from diverted or impaired customers.
2. Restitution - Although lost profits is likely the preferred route to establish damages, the concept of restitution also may apply in non-compete suits. Many courts hold that if a plaintiff's lost profits (or reliance) damages are unavailable due to the uncertainty in measuring the loss, a plaintiff can recover in restitution. The term simply refers to the plaintiff's interest in having restored to it any benefit the defendant achieves. Non-compete cases present an obvious case for restitution damages when a new employer has benefited from an employee's breach. The damages simply may be the new employer's own profits that are tied to the employee's breach, not those the ex-employer would have earned absent the breach.
3. Liquidated Damages - I have written extensively, both in this blog and in published journals, regarding the benefits of using liquidated damages clauses in non-compete agreements. The idea is that an employer can predetermine its damages by setting forth a formula in a contract. That formula then would apply if (a) it's a reasonable measure of damages, (b) the potential loss is difficult to quantify, and (c) it is not intended as a penalty to coerce contractual performance. Many cases find that non-compete contracts are well-suited to liquidated damages clauses. The reason is that the interest a non-compete protects is largely intangible. Therefore, proving specific, monetary loss always will be difficult. Drafting is essential, with the employer bearing a significant burden to show that its damages formula is reasonable. Employers would be well-advised to create a working damages model based on objective criteria that will stand up in court to the inevitable defense challenge.
4. Goodwill Impairment - The concept of "goodwill" is intrinsically tied to non-compete cases because many times the contract protects this intangible business interest. Goodwill is nothing more than a company's expectation that its customers will remain with the firm. Since a non-compete violation can result in a permanent loss of customers beyond the covenant's duration, a damages analysis relying on goodwill impairment is another possible means of recovery. In some respect, it overlaps with a projection of future profits so the two analyses shouldn't result in a duplicate damages claim. Although expert testimony is not needed to prove lost profits, it likely would be required if a plaintiff sought to prove goodwill impairment. The reason is that any goodwill impairment analysis should incorporate some sort of regression analysis to explore the relationships among variables that may affect a business's going-concern value.

Assessing damage in a non-compete case frequently is an afterthought. Counsel for both plaintiff and defendant should examine exposure as quickly as possible, even if the facts concerning liability will be the initial focus in the case.

In Alabama, No Implied Covenant Not to Compete In Business Sale (Pinzone v. Papa's Wings, Inc.)

A few months ago I discussed New York's common law rule that in a sale of business, when goodwill is part of transferred assets, the law implies a covenant on the part of the seller not to solicit the patronage of his or her former clients. Under New York law, this is inextricably bound up with goodwill itself, such that even in the absence of an express non-compete in the business sale documents, courts will grant the purchaser one to protect the integrity of the deal.

In Alabama, the opposite is true. The Court of Civil Appeals held that the existence of a covenant not to compete cannot be implied even when the sale agreement includes the transfer of intangible goodwill.

As I have previously noted, even in more protectionist states like New York, it is far preferable to draft clear covenants and include them in the transaction documents. What these cases discuss are gap-filler rules at common law, which should be invoked sparingly. Parties always are free to contract for a wide array of covenants in connection with an arms' length transaction, and courts generally enforce them as long as they are not patently unreasonable.

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Court: Court of Civil Appeals of Alabama

Opinion Date: 7/9/10

Cite: Pinzone v. Papa's Wings, Inc., 2010 Ala. Civ. App. LEXIS 189 (Ala. Ct. Civ. App. July 9, 2010)

Favors: N/A

Law: Alabama

Franchise Non-Compete Agreement Enforceable By Sylvan Learning Center (Sylvan Learning v. Gulf Coast Ed.)

It has been a while since I've written on non-compete covenants in the context of franchise agreements. The overriding protectable interest that franchisors assert to justify such covenants is "goodwill" - which is the notion that a business's value as a whole is greater than the sum of its parts.

Other common protectable interests - confidential information, long-term clients - may not directly apply to franchise operations. What a franchisor seeks to protect against is the ability of a franchisee to learn its system and simply replicate a business model under a different name.

I've been an advocate of employing non-solicitation clauses, rather than non-compete agreements, for sales employees. The opposite is true with many retail franchise operators. Non-solicitation covenants probably don't protect the franchisor enough. Given the nature of consumer-driven retail businesses, location, advertising and a unified system of operations often bring in business more than direct solicitation of customers. In this sense, it is very common to see non-compete agreements against terminated franchisees enforced regularly.

A good example of this concerned a recent dispute over the operation of a Sylvan Learning Center. Joe Jezewski's franchise and license agreement with Sylvan Learning was terminated, and he immediately began operating a competing educational center in the same store location with the same phone number and same method of conducting business. A district court in Alabama, applying Maryland law, had little trouble issuing a preliminary injunction against Jezewski and enforcing a 20-mile non-compete agreement.

Of interest was the way Sylvan presented the non-compete. It was very careful to point out what Jezewski could do and it emphasized how limited in scope the restriction actually was. Because courts always will consider the potential hardship to one bound by a covenant, plaintiffs - whether employers or franchisors - should always make as part of their case an affirmative showing that they are not seeking to restrict too much.

Also, the court was careful to note that failing to enforce a non-compete against Jezewski would undermine the franchise system, which is built on permitting franchisees to exploit someone else's investment in branding, advertising, and development of goodwill. In this respect, it is much more difficult for franchisees to claim that restrictions are overbroad on hypertechnical grounds or to assert that the covenants do not protect a legitimate interest.

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Court: United States District Court for the Middle District of Alabama
Opinion Date: 10/6/10
Cite: Sylvan Learning, Inc. v. Gulf Coast Education, Inc., 2010 U.S. Dist. LEXIS 107160 (M.D. Ala. Oct. 6, 2010)
Favors: Franchisor
Law: Maryland

Supreme Court of Alaska Addresses First Sale of Business Non-Compete Case (Wenzell v. Ingrim)

Sale of business non-compete disputes are far less frequent than those in the employment context. For good reason; most such cases present very few novel questions regarding enforceability.

However, that is not always the case. In a dispute involving the sale of a dentist's practice, the Supreme Court of Alaska addressed its first sale of busines non-compete case, one with a fascinating set of facts and legal issues.

In 2006, Dr. Guy Ingrim sold his dentistry practice to Dominic Wenzell for the sum of $500,000. The price was allocated between goodwill, supplies and a non-compete. The terms of the non-compete were not that different than what one typically sees in a medical practice sale: 5-year term, with a radius of 15 miles for the first two years of the covenant, and 10 miles for the last three years. The activity restriction in the agreement barred Ingrim from engaging in the "practice of dentistry" within the proscribed territory. The agreement contained a fixed liquidated damages clause setting the price of breach at $250,000.

Ingrim moved to Mexico, but after his marriage fell apart, he came back to Alaska. Around 2007, he took a job with the Alaska Native Medical Center, a federally funded clinic that provides free dental services to Native Americans. Ingrim contended that this did not constitute the practice of dentistry, as that term was defined in the purchase agreement.

The Court disagreed and wisely held that it did meet the standard American Dental Association definition for "practice of dentistry." However, further proving that he who wears the white-hat stands to prevail, the Court had much more to say on the matter.

First, it held that its expansive definition of the restrictive covenant did not answer the question of whether Ingrim breached it. Instead, the Court held that it was a question of fact for the trial court to decide. Though the Court noted that in most sale of business cases, a court need not inquire into the degree of competition between buyer and seller, this case "presents a rare instance where a party is attempting to enforce a covenant not to compete against a person employed by a federally-funded non-profit organization that provides free or low-cost health services."

Second, the Court adopted other states' formulation for deciding how sale-of-business covenants were to be analyzed. It held that the court must consider whether the covenant was greater than necessary to protect the buyer's investment in goodwill and whether the buyer's need to protect its goodwill outweighed both the hardship to the seller and the public interest.

This case presented the rare opportunity for a court to actually give the "public interest" factor much consideration at all. Normally, it's not an issue. But given the unique nature of what Ingrim was doing following his move back to Alaska, it wasn't much of a stretch for the Court to go out of its way and emphasize that the interest of the public had to be considered in determining whether the non-compete was enforceable against Ingrim under the facts.

Finally, the Court was decidedly unimpressed with the liquidated damages clause, reasoning that it made no attempt to forecast actual damages. The real problem with the clause was that it was static; it applied uniformly to any breach and did not decrease over time. Presumably, to have any relation to the buyer's investment in goodwill, the clause should have been drafted to calculate damages in a declining amount over time. A breach on the first day, however, was equal to that on the last. That formulation is suggestive of a penalty, rather than an attempt to pre-determine actual damages.

On remand, Wenzell faces a herculean task. The Court's opinion, though extremely well-reasoned, left little doubt that the trial court ought to be skeptical of Wenzell's claim in light of the fact that Ingrim really wasn't competing for private patients or soliciting anyone.

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Court: Supreme Court of Alaska
Opinion Date: 4/9/10
Cite: Wenzell v. Ingrim, 2010 Alas. LEXIS 39 (Alas. Apr. 9, 2010)
Favors: N/A
Law: Alaska

Allocation of Goodwill In Sale of Business Non-Compete Not Reflective of Protectable Interest's Value (RSG v. Sidump'r Trailer)

Virtually every jurisdiction is in accord with the notion that non-compete agreements in the sale-of-business context are more readily enforced than those incidental to an employment relationship. Courts legitimately recognize that covenants are part of a bargained-for exchange and that compliance with them by the seller allows the buyer to realize the benefit of its bargain.

Though challenges to enforceability of a sale-of-business non-compete are far less common, they do occur and the arguments raised in trying to invalidate a freely negotiated covenant often strain common sense. One contention often argued by a seller trying to wiggle out of a non-compete involves the allocation of purchase price.

When parties enter into an asset purchase agreement, they need to determine the adjusted basis for the assets included in the sale. Sometimes this can be a point of contention, as the buyer and seller need to agree what portion of the purchase price must be allocated to equipment, fixtures, and intangibles - like goodwill.

Goodwill is the most often cited interest that justifies a non-compete in a sale-of-business. It is strictly intangible, representing the reputational value a going concern has built up over time. That value is expressed through repeat business or a particularly strong brand for key products. The buyer, who benefits from a seller's non-compete, faces somewhat of a paradox: It wants to allocate as little of the purchase price to "goodwill" as possible. It would rather allocate the purchase price to hard assets that can be expensed. (Goodwill can no longer be amortized.) If buyer and seller shove very little of the purchase price into goodwill, a seller could raise the argument - as it did (unsuccessfully) in RSG v. Sidump'r Trailers - that a sale-of-business non-compete's protectable interest was worth very little and disproportional to the impact of the restraint of trade.

Courts seem to see right through this argument, perhaps recognizing that an accounting methodology should not mask the realities of a business transaction. An allocation of purchase price has no bearing whatsoever on the protections offered by a seller's non-compete. During this phase of an acquisition, the non-compete likely has already been agreed upon, and the accountants (not the lawyers) have been left with the task of agreeing on a Form 8594 for the purchase price allocation.

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Court: United States District Court for the District of Nebraska
Opinion Date: 1/29/10
Cite: RSG, Inc. v. Sidump'r Trailer Co., Inc., 2010 U.S. Dist. LEXIS 8206 (D. Neb. Jan. 29, 2010)
Favors: N/A
Law: Nebraska

Bad Ass Injunction Shuts Down Coffee House (Bad Ass Coffee Co. v. JH Nterprises)

Non-compete agreements within the context of a franchise relationship pose a unique problem. On the one hand, the covenants are still a restraint of trade and therefore must be analyzed under the rule of reason. On the other, the nature of the protectable interest at stake is far more malleable than rules associated with employment non-compete agreements. It is, in fact, almost identical to the protectable interest associated with a sale-of-business non-compete. But unlike sellers of a business, franchisees often have little bargaining power.

The recent case of Bad Ass Coffee Co. of Hawaii, Inc. v. JH Nterprises, LLC demonstrates why the traditional employee non-compete test does not, or should not, apply to covenants in franchise agreements, and why - effectively - courts seem to apply a sale-of-business analysis instead.

The franchisor, Bad Ass Coffee Company, is a purveyor of gourmet coffee through various franchise locations in the United States. Each franchisee enters into an agreement with a personal and corporate restrictive covenant, preventing it from opening a similar business within a certain geographic area of the assigned franchise store. In this case, the restricted territory was construed under the governing agreement as the City of Jacksonville, Florida.

When the franchisee's agreement with Bad Ass Coffee expired in February, the franchisor gave it the opportunity to renew the contract without paying an additional fee. However, almost immediately after the franchise term expired, the franchisee converted the store to "Java Cove", selling the same products from the same suppliers. The drinks were even sold under the same names.

Bad Ass Coffee filed suit seeking injunctive relief and prevailed with relative ease. The court applied the four-part test in Utah to assess the validity of the restrictive covenant. It did not distinguish the case from a traditional employment case, but this oversight had no impact on the outcome. The only issue concerning the validity of the covenant was the nature of the interest Bad Ass Coffee sought to protect by way of the non-compete. And it was clear the court effectively looked at the same factors that would be discussed in a sale-of-business case.

The court described the goodwill of the franchisor that was at risk from being impaired through the franchisee's conduct. Specifically, the court found that "Defendants' actions in opening Java Cove are likely to send negative messages about [Bad Ass Coffee] to the market and to other ... franchisees....Defendants' overnight switch to Java Cove may signal to potential customers that the Defendants lost faith in the [Bad Ass Coffee] brand. To other franchisees, Defendants' conduct might set an example that they can leave the ... franchise and immediately start competing if they are unhappy with [Bad Ass Coffee]." These factors are nearly identical to what courts would deem important when analyzing a sale-of-business covenant.

Courts, though, often are not clear about which test to apply. In Utah, there are so few non-compete cases in the reported decisions, the court in Bad Ass Coffee may not have had much to work with. But it still should have distinguished the type of interest at issue from those raised in employment cases.

In fact, courts ought to begin with a rebuttable presumption that the covenant protects a franchisor's goodwill and demand a franchisee introduce evidence to the contrary. The focus of such covenants should be on the element of reasonableness. In this case, the court found a citywide limitation was reasonable, and that the covenant was not intended to prevent the defendants from opening, for instance, a gas station which also happened to sell coffee as an incidental product.

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Court: United States District Court for the District of Utah
Opinion Date: 7/2/09
Cite: Bad Ass Coffee Co. of Hawaii, Inc. v. JH Nterprises, LLC, 636 F. Supp. 2d 1237 (D. Utah 2009)
Favors: N/A
Law: Utah

Non-Compete Payments for Sale of Business Will Be Taxed As Ordinary Income (Muskat v. United States)

If a seller of a business receives a substantial payment for a non-compete agreement, can that be characterized as income subject to capital gains tax?

Not according to the First Circuit Court of Appeals which strongly denounced the efforts of one Irwin Muskat.

The case arose out of the sale of Muskat's business, Jac Pac Foods (based in Manchester, New Hampshire). It seems beyond dispute Muskat was highly successful at growing the family business, whose signature line was the distribution of meat products to restaurant chains. In 1998, Corporate Brand Foods America bought Jac Pac's assets for $34,000,000. Above the purchase price, CBFA paid Muskat nearly $4,000,000 for a covenant not to compete. About one-quarter of that was paid up front.

Muskat filed his 1998 tax return and listed the payment as ordinary income, paying income and self-employment taxes accordingly. However, he had a change of heart and filed an amended return for 1998, seeking to recharacterize the income as a capital gain. Because of the lower rate for capital gains income, he sought a tax refund of $203,434.

After the Internal Revenue Service denied the request, Muskat filed suit.

The First Circuit affirmed the trial court's judgment in favor of the United States. In its holding, the court made a number of important findings that business sellers will want to keep in mind:

(1) payments received in exchange for a non-compete are usually taxed as ordinary income;

(2) payments received for the sale of goodwill are usually taxed as capital gains;

(3) when a party seeks to vary a written allocation of income, that party bears the burden of submitting "strong proof" that the contracting parties actually intended the payments to compensate for something different; and

(4) the "strong proof" rule is analogous to the clear and convincing evidence standard familiar to litigants.

Applying these precepts to the IRS' ruling, Muskat was doomed. Muskat negotiated the sale of business documents - including his own employment and non-compete agreements - and those agreements clearly said the money paid to Muskat was to protect Jac Pac's (not Muskat's goodwill) and to prevent Muskat from competing with CBFA after the closing.

Muskat could not muster up any evidence that the payments were intended for something different, i.e., his personal goodwill. Exactly what Muskat argued in support of this proposition is not at all clear. In fact, the sale documents showed CBFA paid $16,000,000 for Jac Pac's goodwill, making any separate goodwill payment to Muskat "implausible."

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Court: United States Court of Appeals for the First Circuit
Opinion Date: 1/29/09
Cite: Muskat v. United States, 554 F.3d 183 (1st Cir. 2009)
Favors: N/A
Law: Federal

Confusion Reigns In Alabama Sale-of-Business Non-Compete Dispute (Martin v. Battistella)

For some reason, doctors and veterinarians seem to be aggressive litigants in the context of non-compete agreements. The disputes permeate not only the employment context, but also when one of these professionals sells his or her business.

In a "sale-of-business" scenario, non-compete agreements are not cloaked with unequal bargaining positions. When a buyer purchases intangibles or goodwill, a non-compete with respect to certain business or clients can sometimes be implied. More often, however, the non-compete is set forth in the purchase agreement. In addition, longer restrictive periods and more flexibility in terms of scope (both for geography and type of activity) are permitted as necessary to effecutate the integrity of the deal.

The rules in Alabama, however, are a little different. Alabama is one of those states which has a statute governing non-compete agreements. Section 8-1-1(a) of the Alabama Code purports to bar contracts by which anyone is "restrained from exercising a lawful profession, trade or business." The statute creates an exception for employment and sale-of-business non-compete agreements, but does not mention the term "professionals." Alabama courts have, therefore, read the two provisions together as barring non-competes for professionals in the sale-of-business context.

In a recent case involving veterinarians, the court proceeded to hold that a declaratory judgment action against the seller was premature and not ripe because no damage had yet occurred as a result of the veterinary practice she commenced within the non-compete period. The court's decision is curious, because it would have been far easier to hold simply that a veterinarian cannot be subject to a non-compete - as prior case law clearly said. Instead, the court analyzed whether the buyer's payment for goodwill had been impacted, and it concluded there was no evidence yet of any damages.

Apparently, the buyer did not pursue an injunction. That remedy was not discussed in the appeal.

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Court: Supreme Court of Alabama
Opinion Date: 11/26/08
Cite: Martin v. Batistella, 2008 Ala. LEXIS 248 (Ala. Nov. 26, 2008)
Favors: Employee/Seller of Business
Law: Alabama