Trio of 2021 New York Decisions Sharpens the Focus of Restrictive Covenants in M&A

8 min

A trio of decisions from the New York state and federal courts in 2021 provided a helpful snapshot of several important factors that courts in New York consider when analyzing noncompetition agreements. Historically, courts have taken a permissive approach to noncompetition covenants that are incidental to the sale of a business, and a skeptical approach to noncompetes in the employment context. In the context of a sale of a business, courts regularly enforce reasonable covenants not to compete against sellers based on the policy that the seller should not recapture through its competition the goodwill that it just sold. In contrast, the relative skepticism courts hold for noncompetes in employment agreements is rooted in New York's strong public policy favoring employee mobility. Three decisions issued last year put these distinctions in sharper relief and provide insight into how courts analyze these covenants. This article will review the facts that drove the courts' opinions in these cases.

In April and December of last year, the Appellate Division, First Department issued decisions enforcing noncompetition provisions against sellers who continued as employees of the buyer after selling their interests in a business acquired by the buyer. In the first of these decisions, Bruderman Bros., LLC v. Goldberg, 193 A.D.3d 478 (1st Dept. 2021), the seller sold his investment business to the buyer for millions of dollars and agreed to continue as the chief executive officer of the business after the sale, subject to a nationwide noncompete provision contained in the purchase agreement (incorporated by reference into seller's employment agreement) that ran through the later of six years from the date of closing or two years from the date of separation of employment with the buyer. After four years of employment, the buyer terminated seller from employment and sought an injunction against seller for alleged attempts by the seller to poach buyer's clients and employees and other actions that buyer alleged violated the restrictive covenants in the purchase agreement. Seller's primary defense was that he was unlawfully terminated based on discrimination and that he had not poached any clients, but had personal relationships with them that he believed would cause them to follow him to his new business venture. In issuing its injunction against seller, the trial court found that the large amount of consideration paid to seller in the business sale, along with buyer's prima facie pleading of allegations that seller was attempting to poach the buyer's customer base and valued employees, justified enjoining the seller from his actions to maintain the status quo while arbitration on the merits of the parties' claims proceeded. The First Department upheld the injunction based on a finding that the geographic scope and duration of the noncompetition provisions (nationwide and a maximum of six years or two years after separation from employment) were reasonable in light of the significant sum received by the employee through the sale of his business and employment. On appeal, the First Department also noted that seller's services were unique and extraordinary, perhaps in recognition of seller's argument regarding his personal relationships with buyer's clients. Interestingly, neither the trial court nor the First Department placed much weight on the fact that the employee was terminated involuntarily, which courts will factor into the enforceability analysis in the employment agreement context. Nor did either court parse the covenant that ran from the end of employment from the covenant that ran from closing (as some courts have done), presumably because the covenants both derived from the purchase agreement and were incorporated into the employment agreement only by reference. 

Similarly, in Newmark Partners L.P. v. Hunt, 200 A.D.3d 557 (1st Dep't 2021), the First Department reviewed and upheld an injunction issued by the trial court against the sellers of a real estate brokerage. In Newmark, three Colorado-based real estate brokers became employees of the buyer after the buyer purchased the brokers' interests in their former real estate brokerage for an aggregate amount of $1,500,000. Under the purchase agreement, which was governed by Delaware law, the three brokers agreed to a global noncompetition agreement that prohibited them from competing directly with the buyer for two years following their termination of employment, or for one year if they left employment with the buyer after performing at least seven years of service. The brokers worked for the buyer for six and a half years prior to resigning from employment with the buyer and joining a competitor along with five other employees of buyer whom the brokers induced to leave. The brokers argued that their six-year tenure as employees of buyer was sufficient time for the buyer to reap the goodwill stemming from the purchase of their former company and rendered the noncompetes unenforceable. In issuing an injunction, the trial court found that the equities favored the buyer because the brokers breached their agreements with knowledge of the consequences, they received millions of dollars in equity and loans from the competitor they joined along with a promise of employment even if the restrictive covenants were enforced, and the brokers poached five of buyer's employees on their way out the door. Notwithstanding these findings, the trial court used its discretion to narrow the geographic scope of the noncompetes from an overly broad worldwide scope to a narrower scope within Colorado only, and their duration from two years to one year. In affirming the injunction, the First Department rejected sellers' argument that the revenue they generated for buyer during employment and the equity and compensation they forfeited by leaving for the competitor was sufficient to compensate buyer for any loss of goodwill occasioned by their departure. The court reasoned that a noncompetition provision could still be enforced even after a long period of employment by sellers because of the irreparable harm that the sellers' competition would do to the goodwill of the buyer. Similar to the Bruderman Bros. case, the court clearly viewed the sellers' actions as brazen and unfair competition.

In contrast to these two state court decisions, a decision last year out of the United States Court for the Southern District of New York rejected enforcement of a noncompetition agreement that it viewed as too attenuated from the sale of the business to qualify for the more permissive standard of review and the terms of which it viewed as overly broad. The case of Steelite Intl. U.S.A., Inc. v. McManus, No. 21-cv-2645 (LAK), 2021 U.S. Dist. LEXIS 80528 (S.D.N.Y. Apr. 27, 2021) arose out of the sale of a tableware business, which included the sale of the seller's trademarked name “Kenny Mack.” The seller entered into a purchase agreement that conveyed ownership of seller's trademarked name, and the seller signed an employment agreement to continue employment with the business which contained a 12-month noncompetition provision. A few years after the business sale, the buyer sold the business to another company. As part of this second sale, the original seller Kenny Mack was terminated from employment with the original buyer and offered a severance agreement that included broader restrictive covenants than the purchase agreement or his prior employment agreement. After signing the severance agreement, the seller sought to continue his tableware business using his Kenny Mack name, and the second buyer sued for an injunction.

In its detailed analysis of the noncompetition provisions of the severance agreement, the court identified three types of contracts that allow for enforcement of restrictive covenants and laid out the standards for each: (1) contracts for the sale of a business, which are usually enforced to protect the goodwill of the purchased asset; (2) employment contracts, which are strictly construed to avoid the loss of an employee's livelihood; and (3) ordinary commercial contracts, which are analyzed for reasonableness by balancing competing public policies favoring robust competition and freedom to contract. The court found that the severance agreement was not entered into contemporaneously with the original sale of the business and contained new terms that did not exist at the time the seller sold his assets, so the permissive standard of review for sale of business covenants did not apply. Interestingly, the court also found that the severance agreement did not fit into the employment contract context either, since it was negotiated to resolve a dispute over the seller's termination from employment. Under the simple rule of reason applied to commercial contracts, the court found that the noncompetition restrictions were unenforceable. Specifically, the court held that the covenants were not limited to the geographic scope where the buyer did business and were not limited in time at all, the definition of competing business was not limited to the industry and business in which the buyer competed, and certain key terms defining the prohibited activity, such as “designs” and “food service industry,” were impermissibly vague and overbroad and not sufficiently tailored to protect a legitimate business interest. Finally, the court examined the negotiations that produced the severance agreement and noted that seller was forced to either sign the severance agreement or face termination for cause, which denied him any meaningful choice in the negotiation, even though he was an experienced businessperson and was represented by counsel during the negotiation.

These cases reinforce the need for a sophisticated approach to the drafting and enforcement of restrictive covenants that arise from deals. Noncompetition agreements related to the sale of a business are permissively enforced, but drafters must focus on the specific circumstances of each seller, and tailor covenants with precision to ensure they are reasonably definite in their terms. Employers are highly encouraged to contact the authors of this article or any other attorney in Venable's Labor and Employment Group with questions regarding the drafting, negotiation, and enforcement of noncompetition agreements.

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