California Court of Appeal Decision Highlights Importance of Tying Non-Competes to Sale of Business

September 20, 2012

On August 24, 2012, in the case of Fillpoint, LLC v. Maas, a California appellate court issued an opinion reinforcing both California’s general public policy against covenants not to compete and the important exceptions to that rule.  While California Business and Professions Code § 16600 generally declares void any covenant that restrains an individual from engaging in a lawful profession, trade or business, § 16601 provides an exception to this rule for covenants executed in connection with the sale of a business.  The Fillpoint case instructs that, to qualify for § 16601’s sale-of-business exception, employers must thoroughly document and tether any non-compete covenant to the sale of a business.

Fillpoint: Factual Background.

In Fillpoint, Michael Maas worked for and owned stock in Crave Entertainment Group, Inc., a video game distribution and publishing company.  When Handleman Company acquired Crave in 2005, Maas entered into a stock purchase agreement with Handleman, selling his stock in Crave to Handleman and agreeing to a three-year covenant not to compete, measured from the date of sale.  As part of the stock purchase transaction, Maas entered into a three-year employment agreement with Crave which included a covenant not to compete or solicit customers or employees for one year following the expiration of the employment agreement or the earlier termination of Maas’s employment.  Maas resigned exactly three years after the employment agreement was signed, thus fulfilling the three-year term of the employment agreement and the three-year non-compete provision of the stock purchase agreement.  Approximately six months later, Maas became the president and CEO of Solutions 2 Go, a competitor of Crave.  Fillpoint, LLC, the assignee of Crave’s rights under the employment agreement, sued Maas for breach of that agreement’s non-compete provision. 

Following Fillpoint’s opening statement at trial, defense counsel moved for a nonsuit, arguing that the employment agreement’s one-year non-compete was not enforceable.  The trial court granted the motion, and Fillpoint appealed.  

The Fillpoint Court’s Analysis.

The California Court of Appeal for the Fourth District first considered whether the stock purchase agreement and the employment agreement must be read together.  Observing that the two agreements were between the same parties, the agreements referenced each other, and the employment agreement contained an integration clause providing that the terms of the stock purchase agreement would prevail in the event of a conflict, the court found that the agreements must be read together as an integrated agreement.  In so doing, the court rejected the contention that § 16601 required that a non-compete covenant be contained in a merger or acquisition document to qualify for the sale-of-business exception; instead, the covenant must merely be executed "in connection with" the sale of the business.

The court then turned to the enforceability of the employment agreement’s one-year covenant not to compete.  The court found that this provision was not sufficiently linked to the protection of Crave’s goodwill to invoke the § 16601 sale-of-business exception.  Unlike the stock purchase agreement’s three-year covenant, which protected the goodwill of Crave and "served the purpose" of § 16601, the employment agreement’s one-year covenant was much broader and "affected Maas’s rights to be employed in the future," thereby "targeting [his] fundamental right to pursue [his] profession." 

Finally, the court stated that the nonsolicitation terms in the employment agreement were unenforceable.  Specifically, the court reasoned that the employment agreement’s restriction on the solicitation of potential customers was "too broad" and inconsistent with the purpose of § 16601.  The court did not comment separately on the nonsolicitation of employees provision.  Because Fillpoint never contended that Maas had violated the nonsolicitation of employees clause of the employment agreement, this latter portion of the ruling would likely be considered dicta with limited precedential value.

Implications of Fillpoint under Current California Law.

The Fillpoint case has several implications for the current status of California law as it relates to restrictive covenants:  

• Fillpoint reinforces the viability of both § 16600’s limitations on restrictive covenants and § 16601’s sale-of-business exception to that rule.  It is thus consistent with the holding of Edwards v. Arthur Andersen LLP, 44 Cal. 4th 937 (2008), in which the California Supreme Court held that a classic non-compete covenant (i.e., an employee agreement not to work for a competitor for a certain amount of time after termination) is generally unenforceable under § 16600 unless it falls within an applicable statutory exception. 
• The Fillpoint decision also adds to the current legal landscape by emphasizing the importance of tying restrictive covenants to the sale of business through integration clauses, references and recitals, for purposes of invoking § 16601’s exception.  While it is not necessary that the covenant appear in the merger or acquisition agreement itself, the document in which the covenant appears should (i) reference that agreement, (ii) contain an integration clause where appropriate, and (iii) explicitly recite the reason for the covenant–to protect the goodwill of the business, in consideration for the merger or acquisition.
• The long-standing rule in California has been that employee nonsolicitation covenants, unlike other types of restrictive covenants, are generally enforceable because they "only slightly affect" the employees’ employment opportunities and therefore are not unreasonable or illegal restraints on trade.  Loral Corp. v. Moyes, 174 Cal. App. 3d 268, 279-80 (1985).  Contrary to the suggestion of some commentators, the Fillpoint decision does not signal the weakening of this rule.  In fact, the Fillpoint court did not critique the employee nonsolicitation provision of the Maas employment agreement, nor did it cite or address the holding in Loral.  Instead, in dicta, the court restricted its critique to the customer nonsolicitation provision, a covenant less favored by California courts, and made no effort to separately analyze the enforceability of the respective customer nonsolicitation, employee nonsolicitation and employee no-hire provisions contained in the Maas agreement.  Thus, Fillpoint cannot reasonably be read as limiting the long-standing rule of Loral.  Indeed, at least one federal court, while interpreting § 16600 to prohibit the enforcement of employee no-hire covenants, went on to uphold the enforceability of employee nonsolicitation covenants on the basis of Loral‘s continuing authority (see Thomas Weisel Partners LLC v. BNP Paribas, 2010 U.S. Dist. LEXIS 11626 (N.D. Cal. Feb. 10, 2010)).  Notwithstanding this federal decision, California appellate courts have not yet squarely addressed whether employee no-hire provisions are necessarily void.  

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