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Covenants Not To Compete: Restraining a Seller/Employee Against Competition – Not As Easy As it Looks

Posted in Trade Secrets and Competition

Section 16601 of the California Business and Professions Code provides a well-known exception to California’s statutory refusal to enforce contractual commitments not to compete.  Under that section, Courts will enforce “reasonable” restrictions on the seller of a business to engage in competition against the buyer of that business.  This is a commonsense approach: a buyer of goodwill should be able to protect the value of what it has purchased from future competition from the seller  – even when the seller of the business goes to work for the buyer as an employee.

Here, a routine situation is:  A company buys a business and employs the seller to assist in a smooth transition of customers and operations.  Sometimes the employment will last months and sometimes it lasts for decades.  That variability can confuse buyer/employers:  they know that, once they employ the seller, they have effectively prevented the seller from competing while the buyer employs him/her (both self-interest and the duty of loyalty that employees owe their employer usually prevent that).

But the seller wants something to protect it after the employment ends.  For that reason it is common for buyers to place covenants not to compete in both the purchase agreement and the documents reflecting the employment.  The covenant not to compete in the purchase agreement runs from the closing of the sale, and the covenant not to compete in the employment agreement runs from the termination of employment.

But buyers who employ a seller should be aware of the limits on their ability to restrict the seller employee’s future competition. Some years ago, the Court in Strategix, Ltd. v. Infocrossing West, Inc.  (2006) 142 Cal.App.4th 1068, made clear that the 16601 exception will only permit restriction of the seller’s ability to solicit his/her former customers. If the seller goes to work for the buyer and then leaves, the Court will not enforce a restriction against solicitation of customers that were not part of the business sold by the seller employee.  The buyer cannot bootstrap its existing or later acquired customers into the exception.

More recently, the Court in Fillpoint, LLC v. Maas (2012) 208 Cal. App.4th 1170 found that a second, separate covenant not to compete contained in an employment agreement was unenforceable. The first covenant had been contained in the sale document but it had expired by the time the seller terminated his employment.

Attorneys drafting such agreements (and the parties they represent) should pay attention to the rules articulated in these and other cases.  Properly drafted to fit within these limits (to only limit competition that would diminish the value of the business sold), a covenant not to compete can last for a substantial period of time after the seller leaves the employment of the buyer.

Strategix and Fillpoint teach us, however, that the difference between an enforceable and unenforceable restrictive covenant often lies in the drafting.