By: James Kachmar
Readers of this blog will note that we frequently remind them that California law generally prohibits non-compete agreements. There are very limited exceptions to this general rule, one being that the seller of goodwill in a business can be bound by a valid non-compete agreement to protect the goodwill that is being purchased. Sometimes, the buyer of a company will want to continue to employ certain key employees, who can also be the sellers of the goodwill of the former company. We have seen instances where the purchasing company gets creative and subjects the seller/key employee to two covenants not to compete, one in the purchase agreement and the other in an employment agreement. Last week, a California appellate court shut the door on this approach in the case Fillpoint, LLC v. Maas.
Maas was an employee and stockholder in a video game company. In 2005, Handleman (which was later acquired by Fillpoint) purchased the video company pursuant to a purchase agreement. Under the terms of that purchase agreement, Maas agreed to a covenant not to compete for three years after the closing date of the transaction. At about the same time, Maas signed an employment agreement by which he agreed to work for the acquiring company for three years. That employment agreement had a separate covenant not to compete which prohibited Maas from working in the video game industry for one year after the termination of his employment.
After working for the new company for three years, Maas resigned and six months later joined a competitor. Fillpoint sued Maas for breach of contract for violating the one year non-compete in his employment agreement (and also sued his new employer for interference with contractual relations). At the time of trial, Maas filed a motion for non-suit stating that the one year non-compete set forth in his employment agreement was unenforceable under California law. The trial court agreed and dismissed the lawsuit.
In affirming the court’s dismissal, the appellate court began by recognizing that Business and Professions Code section 16600 prohibits any contract “by which anyone is restrained from engaging in a lawful, profession, trade or business,” except as otherwise provided under California law. Section 16601 makes an exception in the case where the non-compete is necessary to protect a buyer’s purchase of a company’s goodwill. The court noted, “section 16601’s exception serves an important commercial purpose by protecting the value of the business acquired by the buyer. ‘In the case of the sale of the goodwill of the business, it is ‘unfair’ for the seller to engage in competition which diminishes the value of the asset he sold.’” Thus, the Court had no problem recognizing the validity of the three year non-compete provision that was contained in the purchase agreement.
However, the Court noted that the non-compete provision in the employment agreement was a bit different than the one contained in the purchase agreement. Although the Court held that both agreements had to be read together since they were part of the same transaction, the non-compete in the employment agreement would only be enforceable if it satisfied the “goodwill” exception under section 16601. The Court held that it did not.
The Court reasoned that the non-compete in the purchase agreement was reasonably necessary to protect the value of the goodwill that was being purchased. This complied with section 16601. However, the one year non-compete in the employment agreement was clearly intended to affect Maas’s rights to be employed in the future after the expiration of the three year non-compete period in the purchase agreement. The Court concluded: “The purchase agreement’s covenant was focused on protecting the acquired goodwill for a limited period of time. The employment agreement’s covenant targeted an employee’s fundamental right to pursue his or her profession.” Thus, the Court held that the additional one year non-compete provision in the employment agreement was unenforceable.
The Fillpoint decision continues the trend in California for courts to heavily scrutinize restrictive covenants to ensure that they meet the spirit of section 16600 and its prohibitions against restraining an employee’s mobility. Businesses that are acquiring other companies and want to employ key employees who happen to be selling shareholders need to consult with legal counsel to ensure that the structure of the deal, including any non-compete provisions, is enforceable under California law.