Be Careful What You Ask for: Delaware Court of Chancery Cracks Down on Expansive “Sale of the Business” Noncompetes

A recent opinion from the Delaware Court of Chancery will significantly impact how buyers and their counsel structure and draft restrictive covenants that purport to prohibit sellers from (i) competing against the buyer and (ii) challenging the reasonableness of those covenants in court.

Background

The case, Kodiak Building Partners, LLC v. Philip D. Adams, C.A. No. 2022-0311 (Del. Ch. Oct. 6, 2022), arose from the acquisition of a roof truss company, Northwest Building Components, Inc. (“Northwest”) by Kodiak Building Partners, LLC, a Delaware limited liability company (“Kodiak”).  Kodiak’s business model is purchasing and then operating smaller companies in the construction industry around the country, including companies specializing in lumber and building materials, gypsum and related supplies, construction supplies and kitchen interiors. 

On June 1, 2020, Kodiak entered into a stock purchase agreement to buy Northwest, which operates out of a single location in Rathdrum, Idaho.  One of Northwest’s sellers was defendant Philip Adams (“Adams”), Northwest’s general manager and owner of 8.33% of Northwest’s common stock. 

In connection with the transaction, Adams was paid approximately $900,000 for his Northwest stock and, along with the other shareholders of Northwest, entered into a restrictive covenant agreement, which included noncompetition, nonsolicitation, noninterference and confidentiality covenants.  The agreement applied for a period of 30 months from the closing and included language where Adams acknowledged the reasonableness and necessity of the restrictive covenants and waived any issue of reasonableness as a defense to Kodiak enforcing those covenants.

Adams resigned from Northwest in October 2021 and subsequently took a job with a direct competitor of Northwest that has a national roof truss business supplying building materials and providing design services.  Adams worked in a facility of the competitor located approximately 24 miles away from the Northwest location where he previously worked, well within the restricted geographic territory set forth in the restrictive covenant agreement.  Northwest learned of Adams’ new position when it lost a job to the competitor as a result of Adams’ work.  Northwest sued Adams in Delaware and sought a preliminary injunction to enforce his restrictive covenants.

Court’s Opinion

The court noted that Delaware courts “carefully review” restrictive covenants to ensure they (i) are reasonable in scope with respect to geography and time, (ii) advance a legitimate business interest of the party seeking enforcement and (iii) survive a balance of the equities.  While the court recognized that, generally, covenants not to compete in the context of a business sale are subject to a “less searching” inquiry than if the covenant “had been contained in an employment contract,” the court closely scrutinized the restrictive covenants and denied Kodiak’s motion for a preliminary injunction for two primary reasons:

1. The restrictive covenant agreement’s waiver provision is against public policy and does not preclude the court from reviewing the restrictive covenants for reasonableness.

In the restrictive covenants agreement, Adams agreed that “each restraint in this Agreement is necessary for the reasonable and proper protection” of the assets (including goodwill) acquired by Kodiak in the Northwest acquisition and expressly waived any defense to the contrary.  Kodiak argued this language precluded the court from reviewing the restrictive covenants for reasonableness.  Adams argued that a waiver of the right to contest a restrictive covenant’s validity violates public policy, as it seeks to avoid the court’s policy-based review of that restrictive covenant.

The court first acknowledged that no other Delaware opinion directly addressed the enforceability of a noncompete provision where the restricted party has stipulated to its reasonableness or a contractual waiver of the right to contest reasonableness of a restrictive covenant.

After analyzing the issue, the court determined that “an employee’s promise not to challenge the reasonableness of his restrictive covenants cannot circumvent this Court’s mandate to review those covenants for reasonableness.”

2. The restrictive covenants protecting all of Kodiak’s business lines are unenforceable because they are broader than Kodiak’s legitimate business interest.

The court then analyzed the reasonableness of the restrictive covenants.  The court ultimately found that the restrictive covenants were overbroad in relation to the legitimate business interests they were intended to protect.  The court stated that, in the context of a sale of a business, those legitimate business interests are limited to protecting “the assets and information [the buyer] acquired in the sale.”

Among other things, the restrictive covenants in question (i) restricted competition with Kodiak’s other portfolio companies, beyond merely the business of Northwest, (ii) restricted solicitation of any current or prospective client or customer of Kodiak’s other portfolio companies, beyond merely the clients and customers of Northwest, and (iii) defined Confidential Information to include information relating to Kodiak’s other portfolio companies.

The court noted that, while Delaware law recognizes Kodiak’s legitimate economic interest in protecting what it purchased when it acquired Northwest, it has not affirmatively recognized a legitimate interest in protecting all of the buyer’s preexisting goodwill that predated the buyer’s purchase of the target company.  After a fact specific analysis, the court held that “[t]he acquiring company’s valid concerns about monetizing its purchase do not support restricting the target’s employees from competing in other industries in which the acquirer also happened to invest.” 

Notably, the court declined to “blue pencil” the agreement to alter the restrictive covenants’ scope and impose a reasonable set of restrictions to make them enforceable, despite language in the agreement explicitly permitting it to do so.  In declining to blue pencil the restrictive covenants, the court referenced a 2011 case that explained that disparate bargaining power between employers and employees leads the court to conclude that when a restrictive covenant is unreasonable, the court should strike the provision in its entirety instead of blue penciling restrictive covenants to create a “no-lose” situation for employers.  Interestingly, the court did not explain its reliance on blue pencil precedent from the employer-employee context in its refusal to blue pencil the “sale of a business” restrictive covenant at issue in this case.  It stands to reason that the “disparate bargaining power” consideration in the employer-employee context should not be relevant (or at least as relevant) in the sale of a business context.  It is not clear from the opinion whether the parties briefed this issue.

Practical Guidance

In light of the Kodiak case, buyers and their counsel should consider the following:

• For private equity firms and other buyers with existing businesses/portfolio companies in different industries and geographies, the Kodiak case shows that they cannot rely on “sale of the business” restrictive covenants to cover/protect their preexisting businesses and assets. Despite the wider latitude given to “sale of the business” restrictive covenants, the court determined that the restrictive covenants in Kodiak were overbroad in relation to the legitimate business interests they were intended to protect.  In the context of the sale of a business, the court made clear that a buyer’s legitimate business interests are limited to the assets/goodwill and information that the buyer obtained in the acquisition.
• If Kodiak stands, the typical boilerplate language included in restrictive covenants regarding reasonableness becomes inconsequential in Delaware. As a matter of public policy, Delaware courts will always review the reasonableness of restrictive covenants, despite the presence of an acknowledgment by the restricted party of the reasonableness and necessity of the restrictions or a waiver of any issue of reasonableness as a defense.  The court also declined to “blue pencil” the agreement, despite language in the agreement explicitly permitting it to do so.  A buyer cannot assume that the court will save an overly-broad restrictive covenant by imposing reasonable conditions.
• Be careful what you ask for, even if the restricted party agrees to it. Buyers should carefully consider and identify which legitimate business interests require protection via restrictive covenants.  While this more disciplined approach may leave some protection on the table, an overbroad set of restrictive covenants could leave the buyer with no protections at all.