California Court of Appeal Refuses to Enforce Non-Compete Against Selling Shareholder

by Sheppard Mullin Richter & Hampton LLP
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[authors: Jennifer Redmond and Jonathan Sokolowski]

In Fillpoint, LLC, v. Maas, Case No. G045057, 2012 Cal. App. LEXIS 914 (Cal. App. Aug. 24, 2012), the California Court of Appeal for the Fourth District recently refused to enforce a covenant not to compete against the former employee and selling shareholder of a video game company. The Court determined that half of a two-part noncompete agreement entered into in the context of the sale of a business was unenforceable, despite the exception for such covenants found in California Business and Professions Code Section 16601 (“Section 16601”). This case answers what had previously been an open question under California law: whether an acquiring company can obtain a non-compete that begins to run upon termination of employment (as opposed to or in addition to a non-compete that begins to run upon closing) from a shareholder who becomes an employee of the buyer. See Hilb, Rogal & Hamilton Ins. Servs. v. Robb, 33 Cal. App. 4th 1812 (1995) (enforcing a noncompete agreement against a selling shareholder that commenced at termination of employment, without any discussion or analysis of whether using termination of employment as the trigger for a noncompete violates Section 16601).

In Fillpoint, Michael Maas, an employee of Crave Entertainment Group, Inc. (“Crave”), executed a stock purchase agreement (“SPA”) when he sold all of his stock in Crave to Handleman Company (“Handleman”) as part of Handleman’s acquisition of Crave. The SPA contained a three-year non-compete which was set to begin running at the SPA’s closing date. At the same time and in connection with Handleman’s acquisition of Crave, Maas also entered into an employment agreement with Crave containing one-year non-compete, customer non-solicit, and employee non-solicit covenants, all of which would begin to run upon the termination of his employment. Maas’ employment agreement was contemplated by the SPA, which included an integration clause referencing the form employment agreement. Additionally, Maas’ employment agreement referred back to the SPA and stated that the SPA would prevail in the event of any conflict between the agreements.

Maas eventually resigned his employment three years after the acquisition of Crave and, about six months later, began working for a competitor of Crave. Fillpoint, LLC (“Fillpoint”), which had acquired Crave from Handleman, brought suit against Maas for breach of his employment agreement. At trial, Maas moved for nonsuit after Fillpoint’s opening statement, and the Superior Court concluded, among other things, that (1) the covenants in the SPA and the employment agreement were separate and (2) the covenants not to compete and not to solicit in the employment agreement were unenforceable under California’s general rule against such covenants (Business and Professions Code Section 16600).

On appeal, the Court of Appeal held that the trial court erred in its conclusion that the covenants in the SPA and the employment agreement were separate. The Court of Appeal held that the agreements “must be read together as an integrated agreement” because (1) of the cross references between the SPA and employment agreement and (2) the two agreements were entered into between the same parties and around the same time, and were part of a single transaction.

Despite winning this battle, Fillpoint lost the war. The Court of Appeal held that reading the agreements together does not mean that the covenants contained in the employment agreement are enforceable. Instead, the covenants must fit within Section 16601’s exception to the general rule that non-competes are unenforceable. More specifically, Section 16601 permits the enforcement of covenants not to compete to protect the goodwill of a business in connection with the sale of such business. The purpose behind this exception is to prevent a seller from engaging in competition which would diminish the value of the assets being sold. The Court of Appeal determined that the SPA’s non-compete was intended to protect the goodwill of Crave as it prevented Maas from engaging in a competing business, or from setting up, or helping another to set up, a competing business, during the three-year period immediately following Handleman’s acquisition of Crave. In contrast, the covenants contained in the employment agreement were triggered upon Maas’ termination and, for one year following his termination, would prohibit him from, among other things, selling competitive products to anyone who was a customer or a potential customer of Crave during the two years preceding his termination, working for a competing business, or employing or soliciting for employment any of Crave’s employees. The court determined that such covenants were intended to restrict Maas’ right to pursue his profession in the future and, thus, did not meet Section 16601’s limited exception. For these reasons, the court held that the covenants in the employment agreement could not “be reconciled with California’s strong public policy permitting employees the right to pursue a lawful occupation of their own choice” and were unenforceable.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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