Much Overdue Case Law Update, Part I

It has been a while since I surveyed new reported decisions. So over the next few weeks, I'm going to summarize very briefly some of the cases I've seen that piqued my interest. The topics are varied, which is kind of the point.

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Non-Recruitment Clauses in Georgia

Georgia courts have proved to be tough venues when it comes to enforcing restrictive covenants. The prevailing rule of non-severability (for older agreements) generally means that an unenforceable restrictive covenant will void other similar covenants, even if they (standing alone) might be considered reasonable.

But as the Court of Appeals in Georgia recently noted, this non-severability rule does not apply to non-recruitment/no-hire provisions that bar employees from soliciting co-workers. Simply put, those types of restraints to do not rise to the upper tier of restrictive covenants. And so a void non-compete will not invalidate a reasonable no-hire clause. Other courts in other States seen to equate no-hire clauses with more restrictive covenants.

The case is CMGRP, Inc. v. Gallant, and it's written by Twitter star Chief Judge Stephen Dillard. A link to the opinion can be found here.

Seventh Circuit Discusses Sale of Business Non-Compete Dispute

The Seventh Circuit hears about one or two non-compete cases per year. They generally involve questions of Indiana, Illinois, or Wisconsin law. And those States have non-compete laws that are interesting and nuanced.

But E.T. Products, LLC v. D.E. Miller Holdings, Inc. did not require the court to delve much into substantive State law (here, Indiana) because the case hinged on whether certain activity amounted to a breach of the non-competition clause. The case involved a business acquirer's attempt to enforce a sale-of-business non-compete against the seller, after the seller rendered post-closing assistance to the acquirer's distributor. The court found that the seller's conduct did not amount to prohibited competition, saying that "a firm whose sole conduct in the relevant market consists of distributing one manufacturer's product plainly isn't that manufacturer's competitor." The court also noted the seller terminated its relationship with the distributor and rendered no assistance at all once the distributor began competing on some product lines. The facts, as the court recited them, amply demonstrated the defendant's good faith and intent to adhere to the non-compete. The pursuit of the case appeared to be vast overreach.

The opinion, written by Judge Diane Sykes, is available here.

The Protocol for Broker Recruiting and "Good Faith"

Those of us who represent advisory firms and financial advisors have a good deal of familiarity with the Protocol for Broker Recruiting. But many don't. The Protocol's design is to foster client choice, a recognition of the intensely personal nature of the advisory relationship. More broadly, the Protocol represents an industry solution to expensive, uncertain non-compete litigation - in effect, a contractual way around flexible legal standards being applied by judges who generally lack deep knowledge of particular industries.

The Protocol's basic tenets allow an advisor to avoid liability if she takes client information to her departing firm (generally, it must be related to those clients she serviced and the information must be provided to her firm on departure). If followed in good faith, the employee will not be bound by any contractual restrictive covenant or held liable under trade secrets law pertaining to the taken (and disclosed) client information and subsequent solicitation efforts of those clients.

The term "good faith" is a bit nebulous and fact-specific. If an employee engages in bad faith, the she cannot avail herself of the Protocol and courts default back to any signed agreement the employee has. The district court decision in UBS Financial Svcs., Inc. v. Fiore, No. 17-cv-993, 2017 WL 3167321 (D. Conn. July 24, 2017), contains a lengthy discussion of good faith in the context of advisor departures. Ultimately, it found that despite some wrongful behavior, the defendants did not forfeit the Protocol's protections since their notice was proper and they took only information pertaining to their client lists. The court focused on the fact that UBS still had all the information it needed to contact the same clients.

In the past, courts have found that the Protocol did not apply when employees took information beyond what was allowed, altered information in a client database, or deleted contact information in a work e-mail account. Like most good-faith inquiries, each case turns on its facts. The Fiore decision is interesting and well worth a read because it is not particularly clear cut factually. The departing defendants complied with the Protocol in the most crucial ways but still did some things that appeared designed to hinder UBS' ability to retain its wealth-management clients.

John Kanas, What's In Your Wallet ($24M in Restricted Stock...)

Last year, I wrote about the non-compete case involving high-profile New York banker, John Kanas. Along with his associate, John Bohlsen, Kanas sold North Fork Bancorporation to Capital One Financial in 2006 for $13.2 billion. Along the way, Kanas pocketed $24 million in restricted stock (Bohlsen received $18 million).

Not long after the business deal closed, Kanas and Bohlsen - who had agreed to remain employed by Capital One for three years - split under a Separation Agreement. That agreement narrowed the non-competes in the restricted stock agreement to prohibit work in a competitive business only in New York, New Jersey, and Connecticut.

When Kanas and Bohlsen formed BankUnited in 2011, Capital One claimed a breach of the covenants. I described in a previous post the facts underlying Capital One's claim. Kanas and Bohlsen moved for summary judgment, requesting a federal court in Virginia to void the non-competes.

The court, in a very well-written opinion by Judge Liam O'Grady, found the agreements reasonable. He found the case highly unique, given the extraordinary amount of consideration the defendants received out of the North Fork acquisition and because they were highly sophisticated businessmen.

The interesting aspect of the case involved Capital One's claim that the covenants should be examined under the more lax sale-of-business standard. They weren't, as the court found two factors dispositive of that claim: (1) the covenants were triggered by the end of employment, not the closing date of the transaction; and (2) the covenants were not a condition to the North Fork acquisition. The points are debatable given that the covenants were, in effect, replacements for those that did get signed at the deal's closing. But the court was correct in that the terms of the contract were tied more towards the employment of Bohlsen and Kanas.

The court was tempted to apply the sale-of-business standard, but stated that "policy considerations, such as the bargaining power of the parties, are more properly considered as part of the Court's analysis of enforceability." For a long time, I have been saying that the sale-of-business/employment framework simply does not account for a lot of cases that fall within the two extremes. Cases that are more difficult to assess include covenants between:

(1) franchisor and franchisee;

(2) commercial transactions short of a sale of business (for instance, a staffing agreement); and

(3) executive employment contracts.

Often times you see courts apply a sale-of-business standard to situations where sale-of-business precedents don't fit. It would be far preferable if courts considered such factors as negotiations, bargaining power, commercial realities, and monetary benefits conferred on the promisor when examining restrictions under the traditional reasonableness test. Judge O'Grady's opinion did that, discounting the framework used and focusing more on the public policy aspects of what he was deciding.

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Court: United States District Court for the Eastern District of Virginia
Opinion Date: 5/17/12
Cite: Capital One Fin. Corp. v. Kanas, 2012 U.S. Dist. LEXIS 69385 (E.D. Va. May 17, 2012)
Favors: Employer
Law: Virginia

Recent Decisions of Interest (No. 6)

This week's Recent Decisions highlights a jury verdict in Arkansas arising out of the sale of an accounting practice. In Creed Spann v. Lovett & Co., 2012 Ark. App. LEXIS 192 (Ct. App. Feb. 1, 2012), the Court of Appeals of Arkansas affirmed a verdict where the purchaser of an accounting firm's client list received $434,777 in lost profits after the seller worked with certain restricted clients following the sale.

The decision does not necessarily break any new ground, but it does highlight a couple of important realities clients need to consider when pursuing or defending non-compete suits.

First, the plaintiff - the acquiring firm - retained a lost profits expert to show the amount of damages which would have been realized had the defendant - the selling firm - not worked with restricted clients. The jury accepted the expert's estimation of damages down to the dollar. It did not appear that the defendants put forth a rebuttal expert, suggesting that the expert witness was highly persuasive to the jury. Because damages are so difficult to prove when they are non-liquidated - such as a projection of lost income - experts are essential to a plaintiff's case. Without one, it is highly likely that a court will be left without a basis to award recoverable damages even in the event of breach.

Second, the plaintiff's legal fees in the case totaled over $250,000, an amount it recovered under Arkansas' prevailing party statute. Compared with the verdict award, the amount of fees incurred is relatively high. However, it was far from unreasonable. Competition disputes cost a lot of money, particularly when discovery focuses on triaging the issue of breach, identifying lost clients, and examining what the defendants did with those clients. Preparing for and presenting experts is costly, as well. The opportunity to resolve a case usually is lost once counsel incurs a substantial amount of these fees. Therefore, the best time to explore a business resolution outside of court is right after the issues have been framed in the suit and before discovery begins.

Iowa Appellate Court Addresses First Sale of Business Non-Compete Case In Over 70 Years (Sutton v. Iowa Trenchless)

Sale of business non-compete cases do not often end up in the appellate courts because they are so frequently enforced. While the contract still technically amount to restraints of trade, the level of scrutiny applied by courts is far more lenient than in employment cases.

The Court of Appeals of Iowa took its first sale of business case in more than 70 years and reaffirmed the long-held principle that courts grant a greater "scope of restraint" in sale of business non-competes than in other adhesive contracts. Interestingly, the court stated the "reasonableness" test is the same, "it is only the application of the test that is different." The court even noted that as long as the area covered by the non-compete was coextensive with the company's line of business, an unlimited duration still could be acceptable.

The Iowa court's formulation of the reasonableness test is similar to that in other states. Some courts will, for instance, presume that a protectable interest exists. Many states shift the burden of proof to the party challenging the covenant, in essence requiring him or her to demonstrate unreasonableness. In a normal employer-employee context, the burden often is on the employer to show why the protections are needed.

Interestingly, in the trial court, the employee - Sutton - sought a declaratory judgment that the non-compete was unenforceable. The employer counterclaimed for breach of contract. Both the trial court and appellate court found that the employer failed to establish an actual breach because it could not prove damages.

In reversing the trial court's grant of declaratory relief, however, the court found that Sutton actually had to reimburse the employer's attorneys' fees under a prevailing party provision of the contract, even though the employer never established breach. Sutton, therefore, may have been better off waiting to see if his ex-employer sued him, rather than filing a preemptive suit for declaratory judgment.

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Court: Court of Appeals of Iowa

Opinion Date: 11/23/11

Cite: Sutton v. Iowa Trenchless, LLC, 2011 Iowa App. LEXIS 1359 (Iowa Ct. App. Nov. 23, 2011)

Favors: Employer

Law: Iowa

Non-Compete Clauses in Franchise Agreements

Generally, non-competition clauses are governed by one of two standards: the strict scrutiny test applied most commonly to employment agreements, and the reasonableness test applied in the context of a sale of business.

The tests are different in degree, not kind. Both tests require a showing of reasonableness, but in the employment context, the employer must articulate a legitimate interest worthy of protection. Courts often scrutinize the asserted interest carefully and find that the covenant does not support something the law protects. In the sale of business context, the courts employ are more straightforward time, territory and scope analysis, and generally presume a protectable interest exists - usually goodwill.

In many states, the tests are colloquially known as the employment test and the sale of business test. But many covenants do not fall neatly within these two buckets. A common example is the covenant incidental to a franchise agreement.

I have had many clients come to me with these issues, and there is not a ton of case law assessing whether a franchisor/franchisee non-compete should be judged according to the strict scrutiny standard or the more traditional reasonableness standard. Courts in Pennsylvania, Kansas, and Washington have looked at franchise agreements as akin to employment agreements and applied strict scrutiny to the reasonableness analysis. Courts in New Jersey, Wisconsin, Virginia, and Montana have taken the opposite approach. There appears to be no majority rule.

What are the main differences between a franchisee and employee which might lead one to conclude that the sale of business standard should apply? Here are four:

(1) The franchisee usually has a close association with the franchised system's goodwill;

(2) Tradesmarks and trade secrets are more likely to be closely aligned with, and entrusted to, the franchisee;

(3) Franchisees lose their capital investment upon termination, where an employee's job simply ends;

(4) Competition by ex-franchisees impacts the economic interests of other franchisees.

Additionally, some courts have concluded that failing to enforce covenants in franchise agreements undermines the franchise systems entirely, where that is not at all the case in the employment arena.

There also are, however, some differences between franchisees and sellers of a business. Here are two big ones:

(1) The franchisor retains a significant amount of control over a franchisee;

(2) Franchisees typically are not compensated for the value of the business upon termination.

In my mind, this is a close call. From my review of cases, it seems as though franchise covenants are drafted better than those found in employment agreements and have more reasonable time and territory restrictions. I don't know why this is, but I think there is less adhesion up front. Potential franchisees always have more choices than potential employees.

I also disagree with the idea that covenants automatically should be characterized as employment or sale of business. I think courts should recast them as either arms-length transactions or contracts of adhesion. For instance, executive employees may be in a far superior bargaining position to change or narrow up their non-competes than even a seller of a business or a franchisee.

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

Bank Executive's Non-Compete Dispute Promises To Be Year's Most Interesting Case

John Kanas is a legendary figure within the New York banking community. Five years ago, he sold his highly successful North Fork to Capital One Financial. In the course of doing so, Kanas received a $200 million payout. Kanas stayed on with Capital One, but clearly the match was not working out. Capital One agreed to let Kanas resign earlier than his original contract called for.

Once he resigned, Kanas decided not to hit the country club circuit. Instead, he orchestrated an acquisition of BankUnited, a failed Florida bank that had been seized by the FDIC. Kanas did so with a private equity group featuring such prominent names as Wilbur Ross, who is known for restructuring failed companies in the steel and coal industries. In recent interviews, Kanas has made it clear he wants back into the New York market.

Problem: his Capital One non-compete has not yet expired. Under Kanas' reworked non-compete arrangement, he is prohibited from competing in consumer or commercial banking within New York, New Jersey, and Connecticut. The restrictions are set to expire August 7, 2012.

Capital One claims certain activity by Kanas through BankUnited rises to the level of unfair competition and has enlisted heavy-hitter Orin Snyder of Gibson Dunn & Crutcher to litigate the the non-compete case. Kanas, and co-defendant John Bohlsen, responded with perhaps the nation's best attorney, David Boies.

The suit is interesting on several levels. Capital One's claim really centers on four key facts which it claims constitutes a non-compete violation:

(1) BankUnited already had a banking portfolio which contained mortgages on New York and New Jersey properties at the time Kanas and Bohlsen acquired BankUnited.

(2) BankUnited has planned to construct and open branches in New York and has advertised for open positions at these locations.

(3) Kanas placed a bid for the Bank of Ireland's New York commercial banking portfolio on behalf of BankUnited. (Bank of Ireland has been forced by that country's financial regulators to sell off a significant percentage of its foreign loan portfolio, and many of the real estate properties are located in New York).

(4) BankUnited has entered into an agreement to acquire Herald National Bank, a commercial bank located in Manhattan specializing in small to mid-size commercial lending.

The defendants have answered the complaint and from their statements, it is clear they do not believe that alleged activity constitutes a non-compete violation. They are contesting the reasonableness of the agreements they signed and believe that they constitute unenforceable restraints of trade if they were interpreted as Capital One proposes.

Interestingly, there is no motion for preliminary injunction on file. The complaint does seek an extension of the non-compete period commensurate with the period of breach, which could be ongoing until next August - depending on what the Court views as a breach. Capital One also is seeking a disgorgement of consideration paid to Kanas and Bohlsen for signing the non-competes, but it's not clear if this would need to be some sort of prorated amount based on the time period each sat out. However, given the dollars paid to both Kanas and Bohlsen (who pocketed $100 million), the claim for disgorgement at least would be well into the 7 figures.

This is one of those cases where you can anticipate a discovery fight. The interpretation of the defendants' conduct, and how it fits into the non-compete contracts, will be front and center. That should mean high-stakes depositions and costly document production. It is unlikely that the court would view the non-competes signed in exchange for millions of dollars to be unenforceable restraints. More likely, if the defendants prevail, the court will have to find that Capital One's interpretation is incorrect. Other high-profile executive disputes, such as that involving involving Mark Hurd, have settled quickly, so perhaps all sides will determine that a confidential settlement is the best option.

Virginia law governs the non-compete contracts, so that state's blue-pencil rule could pose a problem for Capital One if the court finds that the contracts contain some overbroad terms. Virginia's Supreme Court has not approved of a blue-pencil rule, though the case law there is employee-friendly in many respects and courts "discourage" modification of overbroad covenants.

Covenant Not to Solicit Clients Implied When Goodwill Sold With Business (Bessemer Trust Co. v. Branin)

Last year, a client called me and described a familiar problem. He had purchased an insurance business from another agent in town, who had worked for a while during the transition but quickly became dissatisfied. When the relationship finally soured, the agent left and started a competing agency, soliciting away his former clients.

The buyer clearly purchased the agency's goodwill and client list, but the covenants in the closing documents were a mess. Still, the buyer believed that the integrity of the transaction depended on the agent not soliciting his former customers away. He's correct, at least under most states' laws.

The Court of Appeals of New York clarified the "implied covenant" rule in Bessemer Trust Co. v. Branin, which dealt basically with the above scenario in the financial services world. The Court clarified that a seller may not actively solicit the patronage of his former clients when the goodwill of an established business is sold.

The Court addressed a related question: what assistance can the seller provide the new employer with respect to those clients? Several factors were addressed.

First, the custom of the industry is always relevant.

Second, a court must assess whether the seller initiated contacted with his old customers, or whether the customers reached out to the seller's new firm.

Third, a seller may advertise generally to the public, but cannot send targeted mailings or make individualized telephone calls to former clients.

Fourth, when a client seeks "factual information" about the seller's new firm, the seller cannot explain why he believes his products or services are superior to that offered by his former firm.

Fifth, a seller cannot convey proprietary information about his former customers to his new employer.

Sixth, a seller can assist his new employer in making a sales pitch to a former client and may be present during such a meeting, but must limit his responses to "factual matters."

Keep in mind that these factors are to be considered when there is no restrictive covenant contained in the business sale documents. When a business purchases a competitor's goodwill, carefully drafted covenants must be included both in the sale documents and in any transition or stay-on employment agreements. Those covenants can, and should, prohibit much broader restrictions that would prohibit the type of activity the Court of Appeals described above. They also should provide a panoply of self-executing remedies for breach, such as extension of the restriction and, when appropriate, liquidated damages.

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Court: Court of Appeals of New York

Opinion Date: 4/28/11

Cite: Bessemer Trust Co. v. Branin, 16 N.Y.3d 549 (Ct. App. 2011)

Favors: N/A

Law: New York

There Is No End to Creative "Non-Compete" Arguments (Lindskov v. Lindskov)

As a disclaimer, I am not commenting on this case because it breaks any new ground legally. However, it does demonstrate the ends to which litigants will go to try and stop what they claim is a competitive injury.

From the State of South Dakota (home to the Badlands, Custer State Park and - of course - Wall Drug) comes a family dispute in the business of selling farm implement equipment. Two cousins, Dennis and Les Lindskov, were apparently very successful sellers of New Holland farm equipment and obtained dealerships in Isabel and Mobridge. After an apparent falling out (and after New Holland refused to allow them to "split" the dealerships), Dennis bought out Les.

Problem. Dennis did not secure a non-compete at the time of closing. The closest the sale documents came to a restrictive covenant was a mutual non-disparagement clause, which generally makes a contractual obligation out of the common law of defamation or commercial disparagement.

After Dennis bought out Les, Les started a new business with his son selling the same New Holland equipment in the same areas of Isabel and Mobridge. Dennis filed suit, claiming that the non-disparagement clause prohibited such competition. Not surprisingly, the courts disagreed and refused to interpret the covenant against disparagement as a broad non-compete.

Suits like this tend to arise during a bitter divorce or (as here) an acrimonious family business break-up. Their intent is often not to prevail, but to cause the defendant to become distracted or have his or her reputation harmed with suppliers and customers. Courts need to ferret out strike suits that facially lack merit, particularly when sophisticated parties engage counsel and come to a negotiated resolution. Unfortunately, the court system is not quick or efficient in most cases, and a party can prolong a meritless suit for quite a while. That may have the intended effect of litigation. Not to win necessarily, but to inflict some competitive pain through the lawsuit's mere filing.

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Court: Supreme Court of South Dakota

Opinion Date: 7/6/11

Cite: Lindskov v. Lindskov, 800 N.W.2d 715 (S.D. 2011)

Favors: Not applicable

Law: South Dakota

Defendant's Gains From Breach of Non-Compete Not A Proper Measure of Damages (Phelps v. Wystrach)

The Court of Appeals of Arizona found recently that in the sale of business context, the purchaser could not rely upon the seller's gains from the breach of a non-compete agreement to establish damages.

The factual matrix in Phelps v. Wystrach is a common one. Wystrach sold her veterinary practice to Phelps and in turn gave Phelps a 5-year, 40-mile non-compete. That covenant, apparently, also included a separate covenant that Wystrach would not solicit the practice's former clients. It is not clear if this covenant contained any time or territory limit.

Following the closing of the practice's sale, Wystrach serviced the veterinary business of her former largest client, a breeder and trainer of show horses in Tucson. The owner of the horse farm testified she would not have worked with Phelps even if Wystrach had been unavailable. This is a classic third-party refusal to deal defense, which the court noted was irrelevant to the issue of whether Wystrach breached the non-compete agreement.

The issue of damages was a different matter, however.

The court found that evidence of Wystrach monetary gains from working with the horse farm was not a proper basis upon which to award Phelps damages arising out of the non-compete agreement. The holding is similar to TruGreen Cos., LLC v. Mower Bros, Inc., which I discussed a few years back that held under Utah law unjust enrichment is not a basis for awarding damages for a non-compete claim.

The concept of unjust enrichment damages in a sale of business context seems materially different than in a normal employee case. In a business sale, a purchaser is specifically paying the seller to avoid soliciting or working with customers of her former firm. Any breach would logically compromise the value of what was paid for the business. Employment cases, obviously, lack this key damages metric.

This highlights the need for sellers to include liquidated damages clauses in the purchase agreement. A predetermined damage formula can avoid the problems of proving lost profits and obtaining only chimerical relief at trial, like the buyer did in Phelps.

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Court: Court of Appeals of Arizona, Division Two
Opinion Date: 10/29/10
Cite: J.A. Phelps v. Wystrach, 2010 Ariz. App. LEXIS 201 (Ariz. Ct. App. Oct. 29, 2010)
Favors: N/A
Law: Arizona

Asset Purchase Agreement Did Not Transfer Right to Enforce Non-Compete (JSC Terminal v. Farris)

The transfer of a business, either by way of stock sale, asset sale or merger, always yields interesting issues concerning existing non-compete arrangements.

In many cases, employees who suddenly find themselves with new ownership may be saddled with unforeseen circumstances, such as reporting to a new manager and facing a cut in incentive pay. Usually, these changes do not allow an employee to break a valid covenant.

However, the issue of whether a covenant has been (or can be) assigned to a new business owner is a much more nuanced question of law. In some states, assignments are prohibited. In others, the employment contract must speak directly to the question and permit assignments. Finally, some states allow implied assignments.

But, as with anything else, contract language still governs. And that includes the underlying sale documents themselves. A perfect illustration arose when JSC Terminal bought the assets of MidWest Terminal. MidWest transferred to JSC all fixed assets and "all other assets, whether tangible or intangible, which are required and necessary to operate the business." Employee Paul Farris was fired by JSC, hired by a competitor, and sought to solicit JSC's accounts.

A federal court in Kentucky held that the language in the Asset Purchase Agreement between MidWest and JSC did not transfer employment agreement obligations. In particular, the court noted that non-compete arrangements, which are certainly valuable and favored in Kentucky, were not necessary to operate a firm's business.

The court may have been helped by two additional facts: Farris' contract permitted assignment only if MidWest's successors were related to the then-owners of the company and the APA indicated JSC had no obligations to MidWest's employees following closing. While the latter fact was certainly not dispositive of the assignment issue, it was suggestive of the clean break in employment relationships envisioned by the parties as of the closing date.

The key factor in the case, though, was the limited language in the APA concerning transfer of assets. What is interesting is how an employee like Farris would learn of the APA's terms before deciding on whether post-employment competition was permitted or prohibited.

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Court: United States District Court for the Western District of Kentucky
Opinion Date: 5/27/10
Cite: JSC Terminal, LLC v. Farris, 2010 U.S. Dist. LEXIS 52481 (W.D. Ky. May 27, 2010)
Favors: Employee
Law: Kentucky

Supreme Court of South Carolina Holds Trial Court Cannot Rewrite Territorial Restriction (Poynter Investments v. Century Builders of Piedmont)

South Carolina is a state with a fairly strict blue-pencil rule, meaning that drafting is at a premium. Because judges cannot rewrite parties' agreements for them, a non-compete will stand or fall on its own, with courts able to strike only certain terms to avoid overbreadth problems.

The Supreme Court of South Carolina issued another ruling illustrating the narrow scope of its blue-pencil rule in a sale-of-business non-compete. The trial court determined that the seller of a business should be enjoined from violating the covenant, but issued a ruling which modified the geographical scope of the contract beyond what South Carolina courts permit.

The non-compete at issue contained a step-down clause (a topic on which I recently wrote), first providing that it would extend to an area of 75 miles from the principal place of business. If that were unenforceable, the covenant would be limited to Greenville County and any county that borders it. If that were unenforceable, the covenant then would be limited to just Greenville County.

The court went with the last step-down clause and enforced the covenant only in Greenville County. Its error was apparently trying to craft some compromise among the various step-down provisions. The court held the seller was enjoined from competing within Greenville County and an area within 15 miles from the principal place of business.

The latter part of the order, the 15-mile restraint, was an addition to the non-compete's geographic term. While it may not seem unfair or unreasonable, the court's modification of the covenant went beyond what South Carolina courts permit. In a state that employs the equitable modification rule, the result likely would have survived appellate scrutiny.

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Court: Supreme Court of South Carolina
Opinion Date: 5/24/10
Cite: Poynter Investments, Inc. v. Century Builders of Piedmont, Inc., 694 S.E.2d 15 (S.C. 2010)
Favors: Employee
Law: South Carolina

Georgia Appellate Court Finds Non-Compete Incident to Stock Purchase Agreement Is Subject to Lower Degree of Scrutiny (American Control Sys. v. Boyce)

Not all non-compete agreements are subject to strict scrutiny. Most covenants contained in employment contracts are, but that is not always the case.

A recent case out of Georgia illustrates an interesting exception to this rule.

Four shareholders, including Boyce, owned a computer services company from 1995 to 2001. In 2001, Boyce and one other shareholder sold certain shares to an LLC, which gained control of the company following the sale. In connection with the stock purchase agreement that Boyce signed, he entered into a new employment contract with the company, American Control Systems. His employment agreement contained an industry non-compete covenant, as well as a non-solicitation and non-disclosure agreement.

Several years later, Boyce resigned to work with his wife's information technology company. ACS filed suit, claiming his employment violated the non-competition covenant. Boyce argued for strict scrutiny of the covenants, claiming they were overbroad under Georgia's highly favorable law governing employee non-competes.

ACS disagreed and argued that strict scrutiny did not apply, contending the covenants were executed in connection with a stock purchase and should be subject to the sale-of-business analysis of low scrutiny. In Georgia, a sale-of-business covenant can be blue-penciled or reformed to make it reasonable. That is not the case with employment covenants. Classification of a covenant, therefore, can be outcome-determinative in a state like Georgia.

The Court of Appeals agreed with ACS, finding that although the covenant was contained in an employment agreement, it was a condition precedent to the stock purchase agreement between Boyce and the majority shareholder. Also relevant to the court's finding was Boyce's status as an existing shareholder and the fact he was in a relatively similar bargaining position as the covenantee.

Attorneys analyzing the enforceability of non-competes always must examine context. If the covenants were typical at-will employee covenants, strict scrutiny usually applies. If they were executed in connection with a business transaction, then it is far more likely a different reasonableness standard will apply.

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Court: Court of Appeals of Georgia, Third Division
Opinion Date: 3/29/10
Cite: American Control Systems, Inc. v. Boyce, 694 S.E.2d 141 (Ga. Ct. App. 2010)
Favors: Employer
Law: Georgia

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

Employees' Non-Competes Executed In Sale of Business Subject to Lower Scrutiny (Mohr v. Bank of New York Mellon Corp.)

It is common in the sale-of-business context for the seller's principal to stay on as an employee of the buyer for a period of time following closing. Particularly in professional services firms, it is essential to the transition of the business that the seller be affiliated in some way to help migrate accounts and relationships to a new firm.

As one would expect, the buyer in such a deal has a right to have its financial investment in the acquisition protected, and it is common for lengthy non-competes to be issued. When the seller's principal stays on following sale, the most prevalent approach is to have the seller sign a long-term employment contract with a covenant not to compete triggered upon one of two events. Normally, the contracts are written so the covenant runs from the longer of (a) a period from the closing date, or (b) termination of the seller's employment.

Because the non-compete often is issued in the context of an employment contract, sellers sometimes argue that it is subject to the employee rules governing non-competes - which are far more exacting than those involving covenants in the sale of a business. This is exactly what happened in the dust-up between Bank of New York and two employees who had sold their investment management firm to BONY in 2003.

A federal court in Georgia bought the employees' argument and determined that the non-competes were employment covenants subject to strict scrutiny. In Georgia, this is a key issue because the blue-pencil rule does not permit any modification of employee non-competes and (at least for the time being) Georgia law is very employee-friendly on the issue of what types of restraints are reasonable.

That is not quite the same in the sale-of-business context. Even in Georgia, where covenants are highly disfavored, sale-of-business non-competes are subject to a much lower degree of scrutiny and can be blue-penciled.

The Eleventh Circuit in Mohr v. Bank of New York reversed the district court's finding that a non-compete contained in an employment contract executed at the same time as an asset purchase agreement was subject to strict scrutiny. Instead, the court found the multiple cross-references among the contracts, the incorporated terms and definitions, and the overall purpose of the transaction resulted in a "unitary contractual scheme in which [BONY] sought to purchase both the clients lists owned by [the seller] and its goodwill, that is, the client relationships." Accordingly, the covenant was subject to far less scrutiny.

Attorneys who represent buyers in business transactions where the seller is staying on certainly would be well-advised to make reference in the employment contract that it is ancillary to the sale of a business. Also, a signed employment contract or covenant not to compete ought to be a scheduled seller delivery at the time of closing. This should remove any doubt as to whether the covenant is characterized as ancillary to employment or a sale of business.

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Court: United States Court of Appeals for the Eleventh Circuit
Opinion Date: 3/24/10
Cite: Mohr v. Bank of New York Mellon Corp., 2010 U.S. App. LEXIS 6309 (11th Cir. Mar. 24, 2010)
Favors: Employer
Law: Georgia

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

Attorneys' Fees In Complex Non-Compete Case Exceed $500,000 (Western Insulation v. Moore)

Most well-drafted non-compete agreements contain "prevailing party" fee-shifting clauses. In fast-moving emergency litigation, attorneys' fees often become a significant impediment to settling the case and can far exceed damages exposure.

Just because a party does not obtain a large damages verdict for proving breach of a non-compete does not mean attorneys' fees are off the table. When courts examine whether to award fees, it will look to whether the plaintiff obtained significant relief - and the most significant relief a plaintiff can obtain usually is an injunction.

Such was the case in the hotly-contested suit Western Insulation v. Moore, a case arising out of a sale-of-business non-compete violation by Hal and Melanie Moore. The defendants sold their business for $41 million and agreed to a non-competition covenant for a period of seven years. At trial, the plaintiff was largely unsuccessful in proving compensatory damages, but it did obtain injunctive relief. As such, the defendants were liable for attorneys' fees.

The total attorneys' bill from the plaintiff's very competent counsel? $557,555.30. The award ultimately was reduced to $218,705.90, which the Fourth Circuit affirmed on appeal as reasonable considering the success the plaintiff obtained. Though the amount may strike some observers as large, it is not at all out of the realm of reasonableness.

Any non-compete dispute which is defended on the basis that the covenant is simply unenforceable will be expensive to litigate, more so from the plaintiff's side than the defendant's. Extensive third-party discovery involving customers, suppliers, and co-workers will need to be conducted so that the issue of reasonableness and the legitimacy of asserted business interests can be decided. Cases which are defended on the basis of a contract defect, such as consideration or expiration of a term contract, are generally much more streamlined and efficient to defend.

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Court: United States Court of Appeals for the Fourth Circuit
Opinion Date: 1/22/10
Cite: Western Insulation, LP v. Moore, 2010 U.S. App. LEXIS 1445 (4th Cir. Jan. 22, 2010)
Favors: Employer
Law: Virginia

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

Notice Provisions Can Impact Non-Compete Agreement's Enforceability (ZVUE v. Bauman)

Contract provisions detailing notice requirements for how a relationship is to be terminated run the gamut from non-existent to vague to overly detailed. Frequently, notice provisions are found in sale of business contracts and specify precisely how an employment or consulting contract will be terminated and whether a party has an opportunity to cure a claimed breach or performance issue. Notice provisions are less prevalent in run-of-the-mill employment contracts, but they sometimes still govern how an employee must be notified of his discharge and whether he is entitled to severance pay or disclosure of the reasons why he has been fired.

The case of ZVUE v. Bauman addresses the importance of complying with contract notice provisions when trying to enforce, or break, a non-compete clause. Though the case deals with myriad business and intellectual property issues arising out of the sale of entertainment websites, one particular issue dealt with the applicability of a customer non-compete. The clause did not apply if either party terminated the employment agreement "without cause." However, for the employee to avail himself of this right, he had to give notice of his intent to terminate to the company detailing the breach of the underlying asset purchase agreement and granting the company 10 days to cure the breach.

He failed to give the proper written notice and therefore was unable to claim his resignation was a termination "without cause." One can envision a number of circumstances in how a notice provision will impact the rights of either side. For instance, if an employment agreement provides an employee is entitled to written notice of his termination, and that notice is not provided, the employee has an argument the employer failed to abide by the terms of the agreement. The notice provision also may be tied directly to the non-compete. Though this often requires a careful parsing of the agreement and its several provisions, the employee will generally get the benefit of any contract ambiguity or drafting errors.

The Bauman case is just an example of how employers and their attorneys must think through each contract provision. Using standard contract terms may not work particularly well in non-competes, as they can have unintended consequences for employers.
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Court: Supreme Court of New York, New York County
Opinion Date: 4/15/09
Cite: ZVUE Corp. v. Bauman, 2009 N.Y. Misc. LEXIS 861 (N.Y. Sup. Ct. Apr. 15, 2009)
Favors: N/A
Law: New York

Drafting Oversight Voids Employee's Non-Compete Agreement in Sale of Business (Herring Gas v. Pine Belt Gas)

Most non-compete are ancillary either to an employment relationship or a sale-of-business transaction. Regarding the latter, a party seeking to escape any competitive restrictions usually meets with little success if its effort is based on protectable business interests or reasonableness as to the contract's scope. A fair number of sale-of-business cases, therefore, turn on the contract language and whether a restrictive covenant survives an acquisition.

The Supreme Court of Mississippi recently held that an employee's non-compete agreement was not enforceable when the governing asset purchase agreement made no reference to existing non-compete agreements as a "purchased asset." In Herring Gas Co., Inc. v. Pine Belt Gas, Inc., the buyer sought to enforce a non-compete covenant against Jimmy Rutland, an employee of Broome LP Gas, the entity which sold its assets to Herring Gas. The deal closed on April 19, 2006, and Rutland quit to join a competitor five days afterwards. A few weeks later, Broome assigned Rutland's non-compete agreement to Herring Gas.

About a month after the closing, Herring Gas wrote a cease and desist letter to Rutland challenging his decision to work for another purveyor of propane gas within the restricted territory (75 miles from Purvis, Mississippi). Herring Gas chose not to file suit for another six months.

The trial court held that Herring Gas, as the entity acquiring Broome's assets, could not enforce the covenant against Rutland. The Supreme Court affirmed for two reasons: (1) the language of the asset purchase agreement precluded enforcement by Herring Gas; and (2) the assignment failed because Rutland had already quit.

The first issue demonstrates the care with which counsel should approach employee non-compete agreements during the due diligence and closing phases of a transaction. The definition of purchased assets mentioned nothing about employment contracts or non-competes, and there was a specific exclusion of all other assets not identified in the contract of sale. Moreover, the parties failed to effectuate any assignment of the employment agreements at the time of closing. These facts ultimately precluded enforcement by Herring Gas.

In most jurisdictions, when a key employee signs a restrictive covenant concurrent with the sale of assets, that contract - even though styled as an employment agreement - will be examined in accordance with the more lenient enforceability standard where a protectable interest is virtually presumed.

However, this rule will not apply when the non-compete is an existing obligation that arose well before the sale date. The problem with Rutland's contract could have been avoided had the issue been addressed specifically in the closing documents.

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Court: Supreme Court of Mississippi
Opinion Date: 2/12/09
Cite: Herring Gas Co., Inc. v. Pine Belt Gas, Inc., 2009 Miss. LEXIS 65 (Miss. Feb. 12, 2009)
Favors: Employee
Law: Mississippi