Corporate & Securities Blog

What Is Reasonable in Scope for Restrictive Covenants in M&A Transactions

The legal landscape around the enforceability of restrictive covenants, such as non-compete and non-solicitation provisions, is clearly changing. Businesses and their attorneys would do well to pay attention to these changes and learn the lessons being handed down at the state and federal levels.

Recent Developments
In the context of employment-based restrictions, the trend over the last several years has clearly been to disfavor restraints on an employee’s ability to earn a living utilizing their training and skills. California has long prohibited non-competition restrictions in the employment setting. Massachusetts enacted legislation in 2018 curtailing the permitted scope of non-competition agreements, requiring advance notice to employees and providing an opportunity to consult with counsel. States such as Colorado, Illinois, Oregon and Washington DC have all made recent changes limiting the enforceability of post-employment non-compete agreements, and a growing number of states, including New York, New Jersey, Connecticut, Maryland, Maine, New Hampshire, Rhode Island and Oklahoma are considering changes or have pending legislation. And though the regulation and enforcement of non-competition agreements have traditionally been by the individual states, President Biden issued an executive order in July 2021 calling upon the Federal Trade Commission (FTC) to undertake greater scrutiny of non-compete clauses indicating the growing disfavor of restrictive covenants has also reached the federal level.

Restrictive covenants imposed on sellers in conjunction with the sale of a business have traditionally been afforded greater leeway than those in employment agreements, and courts throughout the U.S. have long found that buyers have a legitimate business interest to protect the assets and goodwill acquired in a sale/purchase. This is especially true in situations where sophisticated parties represented by counsel have knowingly negotiated such restrictions as part of the overall transaction. M&A attorneys have historically believed that courts would generally uphold restrictive covenants in acquisitions or at least apply the “blue pencil” rule to reform overly broad covenants to make them enforceable in order to allow a business to protect its bargained-for-interests. There are, of course, overriding antitrust considerations that must be part of this analysis, but most states have not taken a proactive approach to restrict contractually agreed upon restrictive covenants on sellers of businesses so long as they are reasonable in scope. As an example, California, where all non-competes have been generally disfavored, allows an exception to this in the sale of a business context to protect the goodwill/assets acquired, but such restrictive covenants are only enforceable to the extent they are reasonable and necessary to protect the buyer’s specific and immediate interests resulting from a particular transaction.

While most of the focus on reining in non-competes and other restrictive covenants has been in the employer/employee context, there is a clear and increasing trend for all restrictive covenants to be disfavored, including those found in the M&A context, as a recent opinion from the Delaware Chancery Court and an FTC, settlement demonstrate.

Delaware – Kodiak Building Partners, LLC v. Adams
Delaware law with respect to non-competition and non-solicitation covenants calls for courts to carefully review such restrictive covenants to ensure they are (i) reasonable in geographic scope and duration, (ii) advance a legitimate economic interest of the party seeking enforcement and (iii) survive a balancing of the equities.

On Oct. 6, 2022, in the case Kodiak Building Partners, LLC v. Adams (Kodiak), the Delaware Chancery Court ruled that a restrictive covenant imposed on a stockholder in an acquisition was overbroad and unenforceable. Moreover, and perhaps both surprising and reflective of recent trends, the Court declined to revise the covenants to such reasonable limitations as would make them enforceable. In this case, Kodiak Building Partners, LLC, a serial acquirer of businesses in the building materials, sales and distribution industries, entered into a stock purchase agreement to acquire all of the assets of two companies (which operated from a single location), including goodwill, and the 8.33% equity interest of the target company’s general manager, Phillip Adams. As part of the deal, Adams agreed to non-competition and non-solicitation restrictions for 30 months after closing that included a geographic scope of 100 miles within any one of Kodiak’s 81 locations (including those of what was defined as the Company Group so as to pick up Kodiak affiliates) across 16 states, not just the single location acquired in the immediate transaction. The Court found that Kodiak went beyond what was reasonable to include (i) a geographic scope far wider than pertaining to the single location involved in the transaction and (ii) an overly broad definition of “Business” and the Company Group covered by the restrictive covenants to cover all lines of business of Kodiak and its affiliated companies, not just the single line of business (roof trusses) engaged in by the acquired companies. The Court reasoned that protectable goodwill should be limited to the immediate transaction and the competitive space in which the target company operates.

Interestingly, the Court in Kodiak repeatedly referred to Adams as an employee throughout the opinion focusing on the impact of the restrictions on him as an employee even though they discuss the result in the context of an acquisition. Although Kodiak alleged Adams was a senior executive of the acquired company and that he had expressly agreed to the reasonableness of the scope, he was a minority owner, and it was not alleged that he separately negotiated his restrictive covenants nor that he was separately represented by counsel in the negotiations (which might have made a difference in the analysis of the allocation of risk as noted in another case cited in a footnote in the decision). It is at least worthy of questioning whether the Court would have looked at this differently or at least given more weight to Kodiak’s arguments as to contractually getting the benefit of its bargain if Adams had been (i) a majority or more significant owner represented by experienced legal counsel, (ii) more actively involved in the sale negotiations or (iii) a recipient of more substantial consideration. Kodiak did argue that the proceeds he received from the sale were more than token consideration at seven times Adam’s annual compensation, but again the Court appeared to look at this in the context of Adam’s as an employee and not primarily with the lens of Adams as a sophisticated selling stockholder. Perhaps further worth noting is that the Court made this determination in the context of a request for a preliminary injunction which is a very high standard – they ultimately determined the restrictive covenants were not enforceable in such context, which focuses on whether it was more likely than not that Kodiak would succeed on the merits in the ultimate case.

FTC Settlement – ARKO/Corrigan
Earlier this year, the FTC issued an administrative complaint in response to an acquisition of ARKO Corp. of 60 gas stations from Corrigan Oil Company in Michigan and Ohio, taking issue with certain non-compete provisions that were alleged to be unreasonably overbroad in geographic scope and beyond what was reasonably necessary to protect a legitimate business interest. The terms of the non-competition agreement restricted Corrigan’s ability to compete not only in the local markets around those locations acquired as part of the deal but also in any other markets in which ARKO operates.

The final Decision and Order effectively rewrote the ARKO/Corrigan Asset Purchase Agreement limiting the scope of non-compete covenants to only apply to locations acquired in the transaction, limiting the terms to be no broader than three years in duration and no more than three miles from the acquired locations, along with a number of other requirements signaling the FTC’s willingness to be proactive in protecting sellers where a buyer might overreach. As Lina Khan, Chair of the FTC, shared in her statement on the matter, “[F]irms may not use a merger as an excuse to impose overbroad restrictions on competition or competitors” and that “[a] general desire to be free from competition following a transaction is not a legitimate business interest.”

Takeaways for Businesses and Practitioners
The Kodiak opinion and ARKO settlement should be taken as cautionary tales for M&A attorneys and acquirers to carefully construct restrictive covenants so that they are narrowly tailored to protect the legitimate business interest of the acquirer in protecting the value and goodwill associated with the business being acquired, tethered to the specific geographic locations and operations of the acquired company. Courts may be more and more unlikely to rewrite overbroad restrictive covenants where taking the “blue pencil’ to reform such covenants could be seen as inequitable. In negotiating a deal, buyers should ensure that any restrictive covenants, such as non-competes or non-solicitation provisions, are appropriately limited with respect to the time, geographic scope and industry/business such that the focus is on the target, not the overall business of a buyer and its affiliated companies prior to the acquisition. It would also be wise to avoid catchall definitions that are overly broad.

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Lori Smith

Lori Smith is chair of the emerging companies & venture capital practice and is an active participant in the firm’s health law and mergers and acquisitions groups. Lori has been a trusted adviser to foreign and domestic companies for over 30 years, ranging from startups to large corporations, including entrepreneurs and angel, venture capital, and private equity investors. She represents public and private companies in the negotiation of mergers and acquisitions, leveraged buyouts, equity and debt financings, private placements, strategic alliances, partnerships and joint ventures.

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