Georgia Appellate Court Finds Non-Compete Incident to Stock Purchase Agreement Is Subject to Lower Degree of Scrutiny (American Control Sys. v. Boyce)

Not all non-compete agreements are subject to strict scrutiny. Most covenants contained in employment contracts are, but that is not always the case.

A recent case out of Georgia illustrates an interesting exception to this rule.

Four shareholders, including Boyce, owned a computer services company from 1995 to 2001. In 2001, Boyce and one other shareholder sold certain shares to an LLC, which gained control of the company following the sale. In connection with the stock purchase agreement that Boyce signed, he entered into a new employment contract with the company, American Control Systems. His employment agreement contained an industry non-compete covenant, as well as a non-solicitation and non-disclosure agreement.

Several years later, Boyce resigned to work with his wife's information technology company. ACS filed suit, claiming his employment violated the non-competition covenant. Boyce argued for strict scrutiny of the covenants, claiming they were overbroad under Georgia's highly favorable law governing employee non-competes.

ACS disagreed and argued that strict scrutiny did not apply, contending the covenants were executed in connection with a stock purchase and should be subject to the sale-of-business analysis of low scrutiny. In Georgia, a sale-of-business covenant can be blue-penciled or reformed to make it reasonable. That is not the case with employment covenants. Classification of a covenant, therefore, can be outcome-determinative in a state like Georgia.

The Court of Appeals agreed with ACS, finding that although the covenant was contained in an employment agreement, it was a condition precedent to the stock purchase agreement between Boyce and the majority shareholder. Also relevant to the court's finding was Boyce's status as an existing shareholder and the fact he was in a relatively similar bargaining position as the covenantee.

Attorneys analyzing the enforceability of non-competes always must examine context. If the covenants were typical at-will employee covenants, strict scrutiny usually applies. If they were executed in connection with a business transaction, then it is far more likely a different reasonableness standard will apply.

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Court: Court of Appeals of Georgia, Third Division
Opinion Date: 3/29/10
Cite: American Control Systems, Inc. v. Boyce, 694 S.E.2d 141 (Ga. Ct. App. 2010)
Favors: Employer
Law: Georgia

Massachusetts Legislative Update

Though Illinois has legislation introduced in the House of Representatives, the state most likely to pass a new law reforming non-compete agreements is Massachusetts. Rep. Will Brownberger has been instrumental in driving reform, based primarily on the view among some in Massachusetts' high-tech community that a significant brain drain is occurring.

The new draft of the Massachusetts bill can be found by clicking here. It is employee-friendly as one would expect and takes bits and pieces of other legislative schemes across the country. It does not touch forfeiture-for-competition provisions, garden-leave clauses or non-solicitation (customer or employee) contracts. Some of the more notable features are a gross income requirement for validity ($75,000 annualized income), consideration of at least 10 percent of compensation for "afterthought" covenants, pre-hire notice that a non-compete must be signed, and explicit rejection of the inevitable disclosure doctrine. The attorneys-fee provisions are also favorable, even providing for payment of fees as part of an interlocutory order.

The bill, however, is silent on enforceability in the event of involuntary termination. Last July, the Boston Globe wrote an editorial about the need for reform, and emphasized that the bill concerning non-competes ought to deal with involuntary termination.

Strange Case on Duration of Non-Solicitation Clause Yields Perverse Results (Zep, Inc. v. Brody Chemical Co.)

It is not often these days to find a case where a court strikes down a non-solicitation or non-compete clause on the grounds that the durational limit is overbroad. The trend in drafting covenants is to extend the geographic scope and narrow the time limit to, say, 6 months or a year.

On its face, the employee and customer non-solicitation clause at issue in Zep, Inc. v. Brody Chemical did not appear overbroad. Zep, which sells industrial chemicals, had several employees defect to Brody Chemical, a direct competitor. The scope of their covenants with Zep did not seem to extend much further than was necessary to protect Zep's interest in customer goodwill. However, the court found that the 18-month and 12-month covenants were overbroad as to duration.

The rationale: Zep could not establish that the time period was necessary to put a different sales representative on the job and have the person demonstrate effectiveness to the customer. In Arizona, whose law governed the agreements, the employer must satisfy this test in order to show the time period of a non-compete or anti-piracy agreement is reasonable.

The key fact that undermined Zep's non-solicitation covenants concerned reassignment of accounts. Zep admitted that when one salesperson leaves, accounts are reassigned to other employees who have demonstrated effectiveness in cultivating relationships. This is hardly a novel concept. But because Zep was responsible and sensible enough to transfer accounts to solidly performing employees, the court held that the non-solicitation clause extended beyond the time period necessary "to put a different sales representative on the job" and become effective.

The decision, of course, may have been constrained by Arizona's rigid test to determine reasonableness. That still doesn't make it right. A better formulation of this test as to durational scope would be the one used by courts in Minnesota, which alternatively can consider the length of time necessary to obliterate the identification between the employee and employer in the minds of the customer.

The court's holding in Zep seems inconsistent with an employer's duty to mitigate damages for breach of contract. If an employer does not reassign accounts, it may be in a better position to argue that a non-solicitation clause of a certain time period was necessary to train a replacement. But then it leaves itself open to the argument that by failing to reassign an existing, experienced employee to save the account, it failed to mitigate damages. The law should not provide for such Catch-22 situations.

The Zep case is a good example of where rigid, bright-line tests often fail in practice.

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Court: United States District Court for the District of Arizona
Opinion Date: 4/6/10
Cite: Zep, Inc. v. Brody Chemical Co., Inc., 2010 U.S. Dist. LEXIS 33805 (D. Ar. Apr. 16, 2010)
Favors: Employee
Law: Arizona

The Key to Protection Is Good Drafting

Having drafted and reviewed non-compete agreements for 13 years, I have seen plenty of good and even more bad. It continues to surprise me how sophisticated companies make boneheaded drafting mistakes.

Drafting non-competes is not that difficult, but it does require attention to detail and consideration of individual circumstances. And it requires you not to buy something off Legal Zoom.

Here are some general, key principles for employers to remember. (Note to employees: Pay attention. This will help you determine whether your agreement might suffer from a fatal flaw or loophole).

1. Remember that each employee is different. Companies (and their attorneys) are often tied to forms. There is nothing wrong with having a template, but don't sacrifice enforceability for the sake of expediency. A non-compete for someone involved in sales should look different than one who is in product development. Also, depending on the applicable jurisdiction, a current employee asked to sign a non-compete for the first time may have to be given tangible consideration, like a bonus, for signing. Finally, if your employee works on-site at a client and you don't want the client stealing him or her, does your covenant strictly prohibit the employee from accepting a position with that client, or (more likely) does it just prohibit solicitation for competitive purposes?

2. Consider less restrictive alternatives. Not every employee needs to have a business non-compete. Particularly for salespersons, a well-drafted client non-solicitation provision may protect the employer more than adequately.

3. Define key terms. Nothing is more annoying than reading a contract where every fifth word is defined. But as I've written in the past, the dictionary is not necessarily your friend. For certain key terms - like "prospective customer" or "competitor" or "solicit" - consider defining the term so there is no quibble after the fact about what the employee's obligation really is.

4. Address proprietary rights. Standard employee confidentiality clauses don't pose much of a problem, but consider other protections too - such as an invention assignment clause (particularly for those employees charged with creating proprietary products, such as source code developers), a clause dealing with return of company information on termination, and (for those followers of the Computer Fraud and Abuse Act) a clause putting an employee on notice that s/he does not have authorization to use the company's computer system for any reason relating to post-departure competitive plans.

5. Choose Law and Venue. Depending on what jurisdictions have an interest in a dispute, a clear choice of law clause can reduce a preliminary (and expensive) fight over conflicts of laws. If you conduct business in multiple states, consider what forum has the most favorable non-compete law and whether each contract can fix this law as the default.

6. Don't forget remedies. Liquidated damages clauses are fraught with drafting peril. They are not right for every occasion, but they may work well for non-solicitation or no-hire provisions. Finally, employers ought to consider adding an equitable tolling, or extension, provision that empowers a court to toll the period of time in which an employee has been in breach of the agreement so the employer, if it prevails, can obtain the full benefit of the contract.

These are by no means all the considerations employers must think about, but be wary of using one standard document for all employees. This usually leads to problems when someone jumps ship.

Texas Supreme Court to Review Key Non-Compete Issue (Marsh USA v. Cook)

Last year, I wrote a not-too-flattering piece on a Texas case where the appellate court in Dallas held that a grant of stock options does not constitute sufficient consideration for an employee non-compete agreement. The ruling was ridiculous.

The Texas Supreme Court has now agreed to hear an appeal in this case. Say what you will for Texas. The case law sucks for anyone with half a brain to try and make sense of, but at least the Supreme Court actually takes these cases on. In Illinois, the Supreme Court acts like this area of law doesn't exist.

I will continue to follow the Marsh case and opine on what I'm sure will be a reversal.

Supreme Court of Alaska Addresses First Sale of Business Non-Compete Case (Wenzell v. Ingrim)

Sale of business non-compete disputes are far less frequent than those in the employment context. For good reason; most such cases present very few novel questions regarding enforceability.

However, that is not always the case. In a dispute involving the sale of a dentist's practice, the Supreme Court of Alaska addressed its first sale of busines non-compete case, one with a fascinating set of facts and legal issues.

In 2006, Dr. Guy Ingrim sold his dentistry practice to Dominic Wenzell for the sum of $500,000. The price was allocated between goodwill, supplies and a non-compete. The terms of the non-compete were not that different than what one typically sees in a medical practice sale: 5-year term, with a radius of 15 miles for the first two years of the covenant, and 10 miles for the last three years. The activity restriction in the agreement barred Ingrim from engaging in the "practice of dentistry" within the proscribed territory. The agreement contained a fixed liquidated damages clause setting the price of breach at $250,000.

Ingrim moved to Mexico, but after his marriage fell apart, he came back to Alaska. Around 2007, he took a job with the Alaska Native Medical Center, a federally funded clinic that provides free dental services to Native Americans. Ingrim contended that this did not constitute the practice of dentistry, as that term was defined in the purchase agreement.

The Court disagreed and wisely held that it did meet the standard American Dental Association definition for "practice of dentistry." However, further proving that he who wears the white-hat stands to prevail, the Court had much more to say on the matter.

First, it held that its expansive definition of the restrictive covenant did not answer the question of whether Ingrim breached it. Instead, the Court held that it was a question of fact for the trial court to decide. Though the Court noted that in most sale of business cases, a court need not inquire into the degree of competition between buyer and seller, this case "presents a rare instance where a party is attempting to enforce a covenant not to compete against a person employed by a federally-funded non-profit organization that provides free or low-cost health services."

Second, the Court adopted other states' formulation for deciding how sale-of-business covenants were to be analyzed. It held that the court must consider whether the covenant was greater than necessary to protect the buyer's investment in goodwill and whether the buyer's need to protect its goodwill outweighed both the hardship to the seller and the public interest.

This case presented the rare opportunity for a court to actually give the "public interest" factor much consideration at all. Normally, it's not an issue. But given the unique nature of what Ingrim was doing following his move back to Alaska, it wasn't much of a stretch for the Court to go out of its way and emphasize that the interest of the public had to be considered in determining whether the non-compete was enforceable against Ingrim under the facts.

Finally, the Court was decidedly unimpressed with the liquidated damages clause, reasoning that it made no attempt to forecast actual damages. The real problem with the clause was that it was static; it applied uniformly to any breach and did not decrease over time. Presumably, to have any relation to the buyer's investment in goodwill, the clause should have been drafted to calculate damages in a declining amount over time. A breach on the first day, however, was equal to that on the last. That formulation is suggestive of a penalty, rather than an attempt to pre-determine actual damages.

On remand, Wenzell faces a herculean task. The Court's opinion, though extremely well-reasoned, left little doubt that the trial court ought to be skeptical of Wenzell's claim in light of the fact that Ingrim really wasn't competing for private patients or soliciting anyone.

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Court: Supreme Court of Alaska
Opinion Date: 4/9/10
Cite: Wenzell v. Ingrim, 2010 Alas. LEXIS 39 (Alas. Apr. 9, 2010)
Favors: N/A
Law: Alaska

Employees' Non-Competes Executed In Sale of Business Subject to Lower Scrutiny (Mohr v. Bank of New York Mellon Corp.)

It is common in the sale-of-business context for the seller's principal to stay on as an employee of the buyer for a period of time following closing. Particularly in professional services firms, it is essential to the transition of the business that the seller be affiliated in some way to help migrate accounts and relationships to a new firm.

As one would expect, the buyer in such a deal has a right to have its financial investment in the acquisition protected, and it is common for lengthy non-competes to be issued. When the seller's principal stays on following sale, the most prevalent approach is to have the seller sign a long-term employment contract with a covenant not to compete triggered upon one of two events. Normally, the contracts are written so the covenant runs from the longer of (a) a period from the closing date, or (b) termination of the seller's employment.

Because the non-compete often is issued in the context of an employment contract, sellers sometimes argue that it is subject to the employee rules governing non-competes - which are far more exacting than those involving covenants in the sale of a business. This is exactly what happened in the dust-up between Bank of New York and two employees who had sold their investment management firm to BONY in 2003.

A federal court in Georgia bought the employees' argument and determined that the non-competes were employment covenants subject to strict scrutiny. In Georgia, this is a key issue because the blue-pencil rule does not permit any modification of employee non-competes and (at least for the time being) Georgia law is very employee-friendly on the issue of what types of restraints are reasonable.

That is not quite the same in the sale-of-business context. Even in Georgia, where covenants are highly disfavored, sale-of-business non-competes are subject to a much lower degree of scrutiny and can be blue-penciled.

The Eleventh Circuit in Mohr v. Bank of New York reversed the district court's finding that a non-compete contained in an employment contract executed at the same time as an asset purchase agreement was subject to strict scrutiny. Instead, the court found the multiple cross-references among the contracts, the incorporated terms and definitions, and the overall purpose of the transaction resulted in a "unitary contractual scheme in which [BONY] sought to purchase both the clients lists owned by [the seller] and its goodwill, that is, the client relationships." Accordingly, the covenant was subject to far less scrutiny.

Attorneys who represent buyers in business transactions where the seller is staying on certainly would be well-advised to make reference in the employment contract that it is ancillary to the sale of a business. Also, a signed employment contract or covenant not to compete ought to be a scheduled seller delivery at the time of closing. This should remove any doubt as to whether the covenant is characterized as ancillary to employment or a sale of business.

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Court: United States Court of Appeals for the Eleventh Circuit
Opinion Date: 3/24/10
Cite: Mohr v. Bank of New York Mellon Corp., 2010 U.S. App. LEXIS 6309 (11th Cir. Mar. 24, 2010)
Favors: Employer
Law: Georgia

When the Dictionary Isn't Good Enough... (ACS Partners, LLC v. Caputo)

Ambiguity can be the death of restrictive covenants.

Common everyday words used in a non-compete agreement seem to take on a life of their own. Terms such as "solicit" or "compete" or "client" may intuitively be easy to define, but in hotly-contested competitive disputes, there is often room for defendants to parse these terms and claim ambiguity. If these claims are successful, an employer's non-compete could be at risk for non-enforcement.

One of the more common problems employers run into concerns the term "prospect" or "prospective client." In customer non-solicitation covenants, it is not unusual for the restraint to extend both to actual customers of the employer and prospects. The best practice is to define "prospective client" within the contract itself so as to eliminate the chance an employee will claim the non-solicitation provision is too broad or ambiguous to be enforced.

On this score, employers' counsel should define prospect so that it includes only identifiable prospective clients with whom an employee interacted or to whom he made a business proposal for services within a defined period of time, say, 6 months prior to departure. Including within the definition all prospective accounts in the company, even those not known to the restrained employee, is problematic due to lack of notice; that employee may simply not know who other salespersons' have been prospecting.

Absent a defined term like this, an employer is left to rely on the dictionary and argue the term be given its usual and ordinary construction. Unfortunately, this doesn't help much for some terms. As a federal district court in North Carolina recently noted, the dictionary definition of "prospect" means expected, likely or future. This clarifies nothing, since anyone could be a future client - regardless of whether they have been contacted or even identified within the records of the company. (The problem is particularly acute in states like North Carolina where its restrictive "blue-pencil" rule severely limits a court's ability to equitably modify the terms of an overbroad non-compete.)

It is cumbersome to load up an employment contract with defined terms. But certain core terms ought to be identified right away so an employee cannot later claim that the average construction of a key word within the non-compete is too ambiguous to be enforceable. The term "prospect" or "prospective customer" is one that always should be defined with some precision.

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Court: United States District Court for the Western District of North Carolina
Opinion Date: 2/12/10
Cite: ACS Partners, LLC v. Caputo, 2010 U.S. Dist. LEXIS 19907 (W.D.N.C. Feb. 12, 2010)
Favors: Employee
Law: North Carolina

Illinois Court Refuses to Modify Overbroad Non-Compete (Oce North America v. Brazeau)

In the aftermath of a relatively significant 2007 appellate court case, Illinois courts are increasingly unlikely to blue-pencil or modify overbroad non-compete agreements. That decision, Cambridge Engineering, Inc. v. Mercury Partners 90 BI, suggested that patently overbroad non-compete agreements cannot be reformed on the grounds that reformation would violate a fundamental public policy in Illinois. Since that decision, courts in Illinois have been hesitant to blue-pencil covenants to make them reasonable, and they appear willing to do so only when the blue-pencil remedy comports with the original intent of the contract.

The most recent example of this involved a dispute in the business services printing industry. Andre Brazeau, a former Vice-President of Sales for Oce North America, left his employer to join InfoPrint, a joint venture of IBM Printing Systems and Ricoh. Brazeau's 2007 non-compete agreement prohibited him from becoming associated with any competing business anywhere in the United States.

The court found that this restriction was overbroad under Illinois law and could not be modified under the blue-pencil rule. In particular, the court noted that while a nationwide covenant could be enforced, the contract normally must contain some other tempering limitation in the covenant. This normally is accomplished by defining precisely what activities - sales management, purchasing, recruiting - are off-limits. A blanket ban on employment with a competing enterprise, which is what Brazeau's contract provided, contains no such tempering limitation.

In light of the Cambridge Engineering case, the court declined to modify the restriction. Employers in Illinois must be aware of courts' reluctance to deploy the blue-pencil remedy in cases where the original contract is worded far too broadly to meet the reasonableness standard. A close miss usually will enable the court to reform the contract, particularly in light of a clear breach or untoward conduct by a departing employee. But a big miss often times is not salvageable at all.

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Court: United States District Court for the Northern District of Illinois
Opinion Date: 3/18/10
Cite: Oce North America, Inc. v. Brazeau, 2010 U.S. Dist. LEXIS 25523 (N.D. Ill. Mar. 18, 2010)
Favors: Employee
Law: Illinois