November 3, 2022

Del. Chancery Invalidates Sale of Business Non-Compete

In Kodiak Building Partners, LLC v. Philip D. Adams, (Del. Ch.; 10/22), the Chancery Court invalidated a non-compete covenant agreed to by a target’s former employee stockholder in connection with the sale of the target’s business.  Vice Chancellor Zurn first concluded that a purported waiver of the stockholder’s right to contest the reasonableness of the covenant’s restrictions violated public policy.  She then determined that the covenant itself was unenforceable. This excerpt from a Hunton Andrews Kurth memo on the decision explains her reasoning:

The court ultimately found that the restrictive covenants were overbroad in relation to the legitimate business interests they were intended to protect.  The court stated that, in the context of a sale of a business, those legitimate business interests are limited to protecting “the assets and information [the buyer] acquired in the sale.”

Among other things, the restrictive covenants in question (i) restricted competition with Kodiak’s other portfolio companies, beyond merely the business of Northwest, (ii) restricted solicitation of any current or prospective client or customer of Kodiak’s other portfolio companies, beyond merely the clients and customers of Northwest, and (iii) defined Confidential Information to include information relating to Kodiak’s other portfolio companies.

The court noted that, while Delaware law recognizes Kodiak’s legitimate economic interest in protecting what it purchased when it acquired Northwest, it has not affirmatively recognized a legitimate interest in protecting all of the buyer’s preexisting goodwill that predated the buyer’s purchase of the target company.  After a fact specific analysis, the court held that “[t]he acquiring company’s valid concerns about monetizing its purchase do not support restricting the target’s employees from competing in other industries in which the acquirer also happened to invest.”

Vice Chancellor Zurn also declined to “blue pencil” the terms of the non-compete, even though the agreement gave her the authority to do that.  Instead, she cited the Court’s decision in Delaware Elevator v. Williams, (Del. Ch.; 3/11), for the proposition that disparities in bargaining power between an employee and employer make it inappropriate to blue pencil non-compete provisions in these situations. Doing so would provide an incentive to employers to overreach, since they would be in a position to compel agreement with unenforceable terms and, in the event of a challenge, rely on the court to provide them with the maximum level of protection permissible.

The Hunton Andrews Kurth memo says that one of the decision’s key implications for private equity sponsors and other buyers with existing businesses in different industries or geographic locations is that they won’t be able to rely on sale of business non-competes to protect those interests. That’s because, in the Court’s view, when it comes to non-competes, “a buyer’s legitimate business interests are limited to the assets/goodwill and information that the buyer obtained in the acquisition.”

John Jenkins