Delaware Court Stresses the Importance of Executing Employment and Non-Competition Agreements with Key Target Employees

June 15, 2009

Common issues confronting acquirors involve retaining the target company’s key employees and protecting against the loss of business to defecting employees.  A recent Delaware Court of Chancery decision addressed issues faced by an acquiror, where a group of the target company’s employees plotted to leave the target company and launch a competing business prior to the acquisition’s close.  The court’s decision in Ivize of Milwaukee, LLC v. Compex Litigation Support, LLC[1] will likely cause acquirors to more aggressively seek and obtain employment and/or non-competition agreements from key target employees, particularly where the success of the acquisition depends upon a relatively small number of key employees. 

The Case

 In early 2007, Compex Legal Services ("Compex"), a provider of legal support services to law firms, decided to divest its Milwaukee and Kansas City facilities.  Compex negotiated such divestures with another provider of legal support services, Ivize, LLC ("Ivize"), culminating in a simultaneous signing and closing on July 26, 2007 of a pair of Asset Purchase Agreements (one for each facility).

During the negotiations, Pete Cobb ("Cobb"), the manager of the Milwaukee facility, was advised of the transaction and that he would not be retained full-time after closing.  In response, Cobb discussed the transaction with key salespeople who accounted for roughly 90% of Compex’s sales.  Cobb and the key salespeople, in violation of existing non-competition agreements with Compex, (1) formed a rival entity ("Quantum"), (2) met multiple times to discuss Quantum business, (3) solicited key Compex employees, (4) rerouted business to Quantum, and (5) stole company records and equipment.

On the morning after closing, Ivize’s representatives found the Milwaukee facility abandoned and ransacked.  In the days that followed, Ivize and Compex jointly uncovered Cobb’s activities.

On August 10, 2007, Ivize filed suit against Compex, alleging that Compex breached the Asset Purchase Agreement’s representation that the Milwaukee facility had "operated only in the usual and ordinary course" since April 1, 2007 through July 26, 2007.  The Ivize Court found that the normal and ordinary course of business simply "does not include destroying business assets and planning to transfer the essence of the business to a competitor" and that  Compex’s untrue representation constituted a breach of the Asset Purchase Agreement.  Because the representation was not limited by any knowledge qualifier, Compex’s ignorance of its employees’ conduct was no defense.

The Ivize Court then turned to the damages calculation.  Ivize argued that it had suffered damages due to the business lost to Quantum.  The court rejected these "lost business" damages, noting that such business and the target’s goodwill was "inextricably tied up with" at least two key salespeople, but that Ivize did not sign (or condition closing upon the signing of) employment or non-competition agreements with such salespeople.  Rather, in the absence of any contractual lock-ups or similar requirements with respect to Compex employees, the Asset Purchase Agreement only provided Ivize with a "fair chance" to present the employees with an employment offer (and implicitly, only with a "fair chance" to keep the business inextricably tied up with such employees).  Therefore, the only damages that Ivize suffered was the difference in value between the clean shot at hiring the Compex employees that Ivize had negotiated and the limited opportunity to hire the employees following their defection that Ivize actually received.  Finally, because Ivize only argued for "lost business" damages, but did not present and conclusively prove such "fair chance" damages in court, the court rejected Ivize’s claim for over $800,000 in damages and awarded Ivize nominal damages in the amount of one dollar.

Observations and Lessons

While the Ivize decision may seem counter-intuitive and while Ivize may have been more successful if it had proven damages in a manner consistent with the court’s analysis, unless and until Ivize is revisited, employee and business retention will be more treacherous to navigate than previously thought. 

As the Ivize Court observes, a common method for ensuring that employees do not abscond with business following an acquisition is to require that they execute employment and non-competition agreements with the acquiror prior to signing or prior to closing the transaction.  Such conditions, however, can delay or jeopardize a transaction and put the fate of the entire acquisition in the hands of a few key employees.  In the past, parties could avoid such conditions, and instead rely upon the protection provided by seller’s general representations and covenants regarding the recent operations of the business.  The Ivize decision erodes such protection, and places the risk of losing target company employees (and potentially business) squarely on the acquiror’s shoulders, unless employment and non-competition agreements have been made conditions to the transaction.  Additionally, because non-competition agreements may not be generally enforceable in a number of states,[2] some acquirors may not be able to enjoy the protection afforded by non-competition agreements. 

Consequently, acquirors should consider seeking to lock-up a target’s key employees (particularly where the success of an acquisition depends upon a relatively small number of key employees) whenever possible and enforceable, and sellers should be prepared for acquirors to be more rigid in this regard.

 [1]  No. 3158-VCL and 3406-VCL (consolidated) (Del. Ch., April 27, 2009).

 [2]  See e.g., California Business and Professions Code Section 16600.

Gibson, Dunn & Crutcher LLP

Gibson, Dunn & Crutcher’s lawyers are  available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or any of the following:

Mergers and Acquisitions Practice Group
Jonathan K. Layne – Los Angeles (310-552-8641, [email protected])
Mark S. Lahive – Los Angeles (310-552-8580, [email protected])
Benyamin S. Ross – Los Angeles (213-229-7048, [email protected])

Labor and Employment Practice Group
Eugene Scalia – Washington, D.C. (202-955-8206, [email protected])
William D. Claster – Orange County (949-451-3804, [email protected])

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