Buyer beware: Delaware refuses to force sale of business without competition | Sheppard Mullin Richter & Hampton LLP

Courts and state legislatures continue to target post-employment non-competes. In a companion blog, we recently detailed the Federal Trade Commission’s proposed rule banning post-employment non-competes. However, over the years (and even under the FTC’s sweeping proposed rule), non-competes in the context of business sales have generally received less attention.

The Delaware Court of Chancery threw the dealmaking world into a tailspin when it recently declined to impose a non-compete on the sale of a business. IN Kodiak Building Partners, LLC v. Adams, a Delaware court of chancery ruled that a non-competition clause contained in the parties’ business purchase agreement was overbroad. Rather than blue-pencil or otherwise amend the contract to modify or strike down an overbroad restriction, the court found the non-compete unenforceable in its entirety.

In background, Kodiak operated four lines of business in 81 locations and 16 states: (i) lumber and building materials which, depending on the location, may include roof trusses; (ii) plaster, including drywall and related supplies; (iii) building materials, primarily steel, rebar and structural steel, and (iv) kitchen interiors, such as kitchen appliances, flooring, cabinets and worktops.

Kodiak has entered into a stock purchase agreement to purchase Northwest and Mandere Construction, Inc., an Idaho corporation that sells, manufactures and supplies roof trusses. In connection with the acquisition, Kodiak entered into a restrictive covenant with certain shareholders of Northwest, including Philip Adams.

The restrictive covenant with Adams was detailed and included geographic and time restrictions. Prohibited for a period of thirty (30) months after closing from owning, operating, managing, controlling or participating in the ownership, management, operation or control of, any undertaking or activity or “Business” that is similar to or in competition with the “Business ” or any part thereof, anywhere in Idaho or Washington and within a 100-mile radius of any location outside Idaho and Washington where Kodiak sold products or provided services within 12 months prior to closing. The business is defined as “the production, marketing, sale, distribution, installation and/or delivery of lattice supports; roof, floor and stair components; framing; siding and other construction materials and supplies and the provision of related services, including design, engineering, turnkey solutions, project management and trade coordination services.”

Adams joined a competing lattice business within three months of closing. Kodiak then filed suit against Adams seeking enforcement of the no-compete. The Delaware Court of Chancery ruled that the non-compete was unenforceable. As is customary under Delaware’s quasi “rule of reason” analysis, the Court first observed that the restrictive covenants must advance the legitimate business interest of Kodiak, the party seeking enforcement. The court further confirmed that in the context of the sale of the company, Kodiak had a legitimate business interest in protecting assets and goodwill he acquired in sales. However, the court concluded that the injunction against Adams went beyond trying to protect the roof rack business that Kodiak acquired from Northwest. Instead, the cap on Adams extended to all four of Kodiak’s business lines, exceeding the scope of the transaction.

Specifically, Vice Chancellor Zurn held that the non-compete was overbroad because it limited Adams to competing within 100 miles of all of Kodiak’s locations instead of the one northwest location that Kodiak had acquired, and because the expansive definition of “business” included all four of Kodiak’s business lines. but only the grating business where Adams worked. The court noted that “the buyer’s valid concern about monetizing its purchase does not support restricting the seller from competing in other industries in which the buyer also invested prior to the acquisition.” This language suggests that the Court would pay less attention to limitations based solely on (i) Northwest’s geographic location; and (ii) Northwest’s grating business.

Equally notable, the Court refused to blue-pencil or otherwise modify the covenant and strike out an overbroad provision. Instead, the Court found the entire non-compete unenforceable because of the overbroad provision and opined that in overbroad blue-penned restrictive covenants, courts create a “no-lose” incentive.

It remains to be seen whether other Delaware courts will follow suit Kodiak reasoning and holding, but buyers would be wise to ensure that they do not compete, even in the business context of the sale, tailored to protect the legitimate business interests gained in the transaction.

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