Courts and state legislatures continue to take aim at post-employment non-competes. In a companion blog, we recently detailed the Federal Trade Commission’s proposed rule banning post-employment non-competes. However, for years (and even under the FTC’s overreaching proposed rule), non-competes in the sale of business context have generally received less scrutiny.
The Delaware Chancery Court threw the deal world a curveball when it recently declined to enforce a sale of business non-compete. In Kodiak Building Partners, LLC v Adams, the Delaware Chancery Court ruled that a non-compete contained in the parties’ sale of business agreement was overbroad. Rather than blue-penciling or otherwise modifying the covenant to modify or strike the overbroad restriction, the court struck the non-compete unenforceable in its entirety.
As background, Kodiak operated four business lines in 81 locations and 16 states: (i) lumber and building materials which, depending on the location, may include roof trusses; (ii) gypsum, including drywall and related supplies; (iii) construction supplies, primarily steel, rebar and structural steel, and (iv) kitchen interiors, such as kitchen appliances, flooring, cabinets and countertops.
Kodiak entered into a stock purchase agreement to acquire Northwest and Mandere Construction, Inc., an Idaho corporation selling, manufacturing and delivering roof trusses. In connection with the acquisition, Kodiak entered into a restrictive covenant agreement with certain of Northwest’s stockholders, including Philip Adams.
The restrictive covenant agreement with Adams was detailed and included limitations on geography and time. It prohibited him for a period of thirty (30) months post-closing, from owning, managing, operating, controlling, or participating in the ownership, management, operation or control, in any endeavor or activity or “Business” which was similar to or in competition with the “Business” or any part of it, anywhere in Idaho or Washington and within a 100 mile radius of any location outside of Idaho and Washington where Kodiak had sold products or provided services within the 12-months prior to closing. Business was defined as “manufacturing, marketing, selling, distributing, installing and/or delivering of trusses; roof, floor and stair components; framing; siding and other building materials and supplies, and providing services with respect thereto, including design, engineering, turn-key solutions, project management and trade coordination services.”
Adams joined a competing truss business within three months of closing. Kodiak then filed a lawsuit against Adams seeking to enforce the non-compete. The Delaware Chancery Court ruled the non-compete unenforceable. As is customary under Delaware’s quasi “rule of reason” analysis, the Court first observed that restrictive covenants must advance a legitimate business interest of Kodiak, the party seeking enforcement. The Court further acknowledged that in the context of a sale of a business, Kodiak had a legitimate business interest to protect the assets and goodwill it acquired in the sale. However, the Court opined that the prohibition against Adams went beyond trying to protect the roof truss business Kodiak acquired from Northwest. Instead, the restriction on Adams extended to all four of Kodiak’s business lines, which exceeded the scope of the transaction.
Specifically, Vice Chancellor Zurn found the non-compete overbroad because it restricted Adams from competing within 100 miles of all of Kodiak’s locations rather than the one Northwest location Kodiak acquired and because the expansive definition of “Business” encompassed all of Kodiak’s four business lines rather than just the truss business in which Adams worked. The Court noted “the buyer’s valid concerns about monetizing its purchase do not support restricting the seller from competing in other industries in which the buyer also happened to invest in prior to the acquisition.” This language suggests the Court would have placed less scrutiny on restrictions tied solely to (i) Northwest’s geographic location; and (ii) Northwest’s truss business.
Just as notable, the Court refused to blue-pencil or otherwise modify the covenant and strike the overbroad provision. Instead, the Court deemed the entire non-compete unenforceable because of the overbroad provision, and opined that in blue penciling overbroad restrictive covenants, courts create a “no-lose” incentive.
It remains to be seen whether other Delaware courts adopt the Kodiak rationale and holding, but buyers would be wise to ensure non-competes, even in the sale of business context, are tailored to protect the legitimate business interests acquired in the transaction.