Delaware Court Raises Eyebrows by Striking Down Noncompete in Sale Transaction

Alerts / December 15, 2022
Key Takeaways
  • The Delaware Court of Chancery has shown, in a surprising decision in a recent case, that it is willing to strike down overly broad seller noncompetition covenants, even when the restrictive covenants have been mutually agreed to by sophisticated parties as part of a sale-of-business transaction.
  • The Court emphasized its duty under public policy to scrutinize the reasonableness of noncompetition covenants, even where a contractual party has waived its right to challenge reasonableness. Since such waivers may not be observed by the Court, they may be of limited utility.
  • The Court indicated it is hesitant to “blue pencil” and enforce narrower versions of seller noncompetes, so drafters should not plan to rely on this safety net.
  • This decision could seriously impact diversified acquiring companies and private equity acquirers seeking to add a business line or a new portfolio company while protecting their existing businesses.
  • It requires acquirers — and their counsel — to think more carefully and specifically about defining the scope of competition in buyer noncompetes to mitigate against the risk that this decision is not an outlier.
  • Noncompetes increasingly face disfavor in legislatures, the FTC, courts and public opinion but are still a necessary requirement for buyers. This means it is now paramount to create surgically precise definitions in acquisition and other agreements. Broad noncompetes that solely rely on rules of reason and blue penciling are no longer an appropriate practice in crafting agreements, even in the context of sales of business.

The Delaware Court of Chancery (the Court) has raised eyebrows with a recent decision, in the case of Kodiak Building Partners, LLC v. Adams, to strike down a noncompetition covenant binding upon a seller in a sale transaction.

Courts may, and sometimes do, decline to enforce noncompetition covenants if the covenants are found to be unreasonable. But in determining whether a noncompetition covenant is reasonable in the context of a sale transaction (as opposed to when the covenant is contained in an employment agreement), courts tend to be deferential to the agreements of the (presumably sophisticated) parties. The Kodiak decision cuts against the grain in this respect and raises the question of whether the case is an outlier or if the Court can be expected to start scrutinizing sale-of-business noncompetes more strictly in the future.

The facts of Kodiak are as follows: Philip Adams was party to a stock purchase agreement, pursuant to which he and the three other owners of roof truss producer Northwest Building Components Inc. sold their shares in Northwest to Kodiak Building Partners LLC. In connection with the sale, Adams entered into a restrictive covenant agreement containing noncompetition, nonsolicitation and confidentiality covenants. It is undisputed that Adams breached his noncompetition covenant within months of the closing of the sale transaction when he took a position with another roof truss producer. Yet, when Kodiak sought to enjoin Adams from continuing on with his new employer, the Court refused to enforce the noncompetition covenant, finding that the scope of the covenant was unreasonable and that enforcement would be inequitable.

The crux of the Court’s reasoning was that the noncompetition covenant was egregiously overbroad. This was because it defined the terms “Business” and “Territory” with respect to the business and geographic operations of not just Northwest but also Kodiak Building Partners itself and each of its 19 subsidiaries. Indeed, over several years preceding the purchase of Northwest, Kodiak Building Partners had expanded its business significantly through the dogged pursuit of strategic acquisitions. It had established four principal lines of business that its subsidiaries operated in 16 states across the country. In contrast, Northwest had only one business line – the production of roof trusses – and only provided services in Idaho, Washington and Montana.

The Court took great issue with the expansive drafting of the noncompetition clause in Adams’ restrictive covenant agreement. It explained that the purpose of noncompetition clauses in sale transactions is clear and circumscribed: It is to protect an acquirer’s legitimate economic interest in a purchased target company from competition by the prior owner. By including its other businesses in the scope of the noncompete, Kodiak Building Partners attempted to subject Adams to employment restrictions not justified by its economic interest arising from the sale transaction. Accordingly, the Court determined that it would be inequitable to enforce the covenant against Adams and struck it down entirely.

Notably, and perhaps surprisingly, the Court also declined to blue-pencil the noncompetition covenant, explaining simply “[W]here noncompete or nonsolicit covenants are unreasonable in part, Delaware courts are hesitant to ‘blue pencil’ such agreements to make them reasonable.” Further, when Kodiak Building Partners pointed out that in the restrictive covenant agreement, Adams had expressly waived his right to challenge the reasonableness of the noncompetition covenant, the Court said that such a waiver did not matter because the Court had a mandate, under public policy, to review noncompetition covenants for reasonableness.

Drafting parties should take careful note of how the noncompete covenant ties to the business being acquired, with emphasis on how “Restricted Business” and “Territory” are defined so as to ensure restrictive covenants are deemed reasonable. An acknowledgment of reasonableness by the parties may not be enough.

Authorship credit: Jennifer Rodriguez and Steven Goldberg

Baker & Hostetler LLP publications are intended to inform our clients and other friends of the firm about current legal developments of general interest. They should not be construed as legal advice, and readers should not act upon the information contained in these publications without professional counsel. The hiring of a lawyer is an important decision that should not be based solely upon advertisements. Before you decide, ask us to send you written information about our qualifications and experience.