In Fillpoint, LLC v. Maas (2012), a court struck down a covenant not to compete that would take effect only upon termination of employment where the covenant was in addition to a covenant not to compete that was given in connection with a sale of a business.
Michael Maas sold his stock in Crave Entertainment Group, Inc. (Crave), to Handleman Company (Purchaser). As part of the transaction, Mass signed a stock purchase agreement, which contained a three-year covenant not to compete. Also as part of the transaction, Maas signed an employment agreement containing a one-year covenant not to compete, which would become operative when Maas’s employment with Crave was terminated.
Maas resigned from Crave three years after its acquisition. About six months later, he began working for a competitor of Crave. Fillpoint, LLC, which had acquired Crave from Purchaser, sued Maas for breaching his employment agreement (and also sued the competitor and the competitor’s owner for interference with contract). The trial court granted the defendants’ nonsuit motion, and the court of appeal affirmed.
The court noted that under California law covenants not to compete are generally unenforceable, citing Business & Professions Code § 16600. The court also noted an exception to the rule, contained in Business and Professions Code § 16601, which permits the enforcement of covenants not to compete in connection with the sale of a business.
At first glance, it might be thought that putting a covenant not to compete in an employment agreement would be fatal, but not so. The court said that when a purchase agreement and an employment agreement are entered into at the same time or roughly the same time, as part of a single transaction, the agreements must be read together.
Citing Hilb, Rogal & Hamilton Ins. Services v. Robb (1995) 33 Cal.App.4th 1812, 1816–1817, which held that the validity of a covenant not to compete is not affected by its location in an employment contract rather than a merger agreement, the court held that the fact that the covenant not to compete was in an employment agreement was not fatal.
In the instant case, both the purchase agreement and the employment agreement contained covenants not to compete, but those covenants were not identical. The court noted that the covenant not to compete in the purchase agreement protected the goodwill of Crave for three full years, which served the purpose of Business and Professions Code §16601, and was fully performed.
On the other hand, the employment agreement’s covenant not to compete prevented Maas, for one year after the termination of his employment, from (1) making sales contacts or making actual sales to anyone who was Crave’s customer or potential customer during the two years preceding the termination of Maas’s employment, or assisting others in doing so; (2) working for or owning an interest in any business that was in the same business as, or would compete with, Crave; or (3) employing or soliciting for employment any of Crave’s employees or consultants.
Fillpoint conceded that the two covenants not to compete were intended “to deal with the different damage Maas might do wearing the separate hats of major shareholder and key employee.” Thus, the restrictions in the covenants not to compete in the purchase agreement and the employment agreement were different. The purchase agreement’s covenant was focused on protecting the acquired goodwill for a limited period of time. The court said that employment agreement’s covenant “targeted an employee’s fundamental right to pursue his or her profession.”
But referring to “targeting” sounds more like a conclusion than an analysis. One could say the same thing about a valid covenant not to compete. A better way of analyzing the problem with the covenant in the employment, in my opinion, is to say that covenant in the employment agreement protected the goodwill of the business as it existed at the time of the employee’s departure, rather than the goodwill of the business that was actually purchased, and the statute only allows protecting the goodwill that was purchased. This idea does get picked up when the court criticizes the breadth of the covenant.
In Strategix, Ltd. v. Infocrossing West, Inc. (2006) 142 Cal.App.4th 1068, the court held that nonsolicitation covenants barring the seller from soliciting all employees and customers of the buyer, even those who were not employees or customers of the business at the time it was sold, extended the anticompetitive of the covenant reach beyond “the business so sold” and thus was not protected by Business and Professions Code §16601. In the instant case, the employment agreement barred sales to or solicitation of potential customers. Relying on Stategix, the court held the covenant went too far to be enforceable.
Thus, for the reasons stated, the employment agreement’s covenant not to compete was not enforceable.
This case suggests that springing covenants not to compete may not be enforceable. As used in this context, a “springing covenant” is one that does not take effect effect until some event triggers it (say, termination of employment). Because a covenant not to compete that first takes effect years after the purchase of a business could be seen as solely protecting against competition and not protecting the goodwill of a business that has been purchased, such a covenant is legally suspect under California law.