The Enforceability of Non-Competition Covenants Incident to the Sale of a Business

6 min

Covenants not to compete are a critical piece of any M&A transaction, and practitioners (particularly acquirer's counsel) should take care to craft a covenant not to compete that will stand up to post-closing judicial scrutiny. In this article, we note the relevant standards of inquiry used to evaluate non-competes in both New York and Delaware. Second, we discuss covenants not to compete in the context of mergers and how a recent Delaware Chancery Court ruling in Cigna v. Audax Health Solutions (107 A.3d 1082 (2014)) might affect the common approach of placing such covenants in the letter of transmittal to be signed by shareholders following the closing of the merger. Generally, observing a few straightforward practice points should increase the likelihood of enforceability of a covenant not to compete.

Enforceability of Covenants Not to Compete

As a preliminary matter, in both New York and Delaware, courts distinguish between the law governing covenants not to compete when incident to the sale of a business, and the law governing non-competition agreements arising solely out of employment. See Shearson Lehman Bros. Holdings v. Schmertzler, 500 N.Y.S.2d 512, 516 (1986); Tristate Courier and Carriage, Inc. v. Berryman, 2004 WL 835886, at *10 (Del. Ch. Apr. 15, 2004). In contrast to restrictive covenants binding employees following cessation of employment (which generally receive skeptical scrutiny by courts), covenants not to compete relating to a sale of a business are more liberally enforced, on the premise that the buyer of a business should be permitted to restrict the seller's ability to take back the goodwill that was just sold. Shearson, 500 N.Y.S.2d at 516.

In New York, courts evaluate the restrictiveness of the proposed covenant against the consideration paid to the restricted party and apply a reasonableness standard to ensure the covenant is "not more extensive, in terms of time and space, than is reasonably necessary to the buyer for the protection of his legitimate interest in the enjoyment of the asset bought." Id. (citations omitted). Reasonableness may be evaluated in terms of the size of the shareholder – a smaller shareholder sells less goodwill and therefore should not be bound by an overly restrictive non-competition covenant – and/or in terms of the shareholder's current role in the business. The corporate plaintiff in Shearson sued its former managing director, who left the acquired company to work as an investment banker for a competitor. The court refused to enforce the non-compete against the former shareholder, because the equity interest sold by the shareholder was small and the banking role he sought at the competitor was distinct from the administrative role he held with the acquired company.

In Delaware, reasonableness is only one of the requirements for enforceability of a non-compete. Generally, a non-compete must (1) meet general contract law requirements, including the existence of adequate consideration, (2) be reasonable in scope and duration, (3) advance a legitimate economic interest of the party enforcing the covenant, and (4) survive a balance of the equities. Tristate Courier, 2004 WL 835886, at *10. In the context of a sale of a business, the court's inquiry is generally less probing than in the employment context. Kan-Di-Ki, LLC v. Suer, 2015 WL 4503210, at *19 (Del. Ch. July 22, 2015). In Delaware, the reasonableness inquiry includes a look into geographic scope, duration, and type of market that is being restricted. TP Group-CI, Inc. v. Vetecnik, 2016 WL 5864030, at *2 (D. Del. Oct. 6, 2016).

The Effect of Cigna on Enforceability

Even where reasonable consideration appears to be present, a non-competition covenant may be invalidated if the nexus between such covenant and the consideration being paid is not sufficiently clear.

In the case of Cigna v. Audax Health Solutions, the shareholders of the target company were required to execute a letter of transmittal following the merger in order to receive the consideration for their shares. While the merger agreement contained a cursory reference to this requirement and indicated that the letter must be in a form acceptable to the acquirer, no further detail was provided in the merger agreement as to its contents. One of the target's shareholders refused to agree to broad release language set forth in the letter of transmittal. While the acquirer argued that the release set forth in the letter of transmittal was "part and parcel of the overall consideration," the Delaware Court of Chancery determined that it was instead a new obligation imposed following the closing, because no indication was given in the merger agreement that the release would be included in the letter of transmittal. In the absence of a new consideration to support this new obligation, the court nullified the release.

While Cigna did not directly address the enforceability of a non-competition covenant set forth in a letter of transmittal, it is reasonable to conclude that a similar analysis may apply, and the Cigna opinion suggests some guidelines for maximizing the likelihood of enforceability.

The most instructive point from Cigna is that a merger agreement should incorporate the particular terms of any non-competition covenant to be contained in a letter of transmittal. This can be done either directly in the text of the agreement or by attaching a form of the letter of transmittal. Such an approach makes it clearer that the non-compete is part of the overall package being provided by the shareholders in exchange for the merger consideration. Gonzalez v. UniversalPegasus Int'l, Inc., 531 S.W.3d 276, 285 (Tex. App.-Houston [14th Dist.] 2017) (upholding a shareholder release contained in a letter of transmittal, where the merger agreement expressly incorporated the terms of the letter of transmittal).

In addition, acquirers should include non-competition covenants in employment agreements for key employees who will continue with the surviving entity following acquisition. An acquisition typically presents a good opportunity to put such employment agreements in place where they do not already exist and/or to update outdated employment agreements with insufficient employer protections. Restrictive covenants in employment agreements are generally respected by the courts for the duration of employment (which could wind up being longer than the non-compete term set forth in the letter of transmittal), and non-competes can survive employment if they are carefully crafted to comply with state law.

Finally, where certain large shareholders and/or founders will be entering into support agreements at the signing of the merger agreement, acquirers should attempt to include in such support agreements a non-competition covenant that will become effective upon the closing. Such an approach not only locks up shareholder support for the transaction, but also eliminates the competition risk posed by those that are presumably most able to compete and perhaps most likely to resist such a covenant following closing. Imposing the non-compete covenant on smaller/more passive shareholders may still be attempted through the letter of transmittal, but, given that these shareholders may pose a smaller competition risk, the implications of having such a covenant invalidated are presumably less severe.