February 2023 in Brief: Mergers & Acquisitions

Selling Stockholder’s Non-Compete Invalidated by Delaware Chancery Court: Kodiak Building Partners, LLC v. Adams (Del. Ch. Oct. 6, 2022)

By Sachin V. Java, Ulmer & Berne LLP

This recent decision denying a motion for a preliminary injunction from the Delaware Court of Chancery addressed whether a restrictive covenant agreement was enforceable against a defendant who entered into that agreement as part of a sale of a business. In reaching its decision, the court held that the restrictive covenant analysis as to a selling stockholder is limited to the Buyer’s economic interest in the goodwill and information it acquires, carving out any preexisting interests of the acquiring company.

Relevant Facts and Background

This case arose out of the acquisition of Northwest Building Components (Northwest), a roof truss manufacturer with a single location in Idaho, through a Stock Purchase Agreement by Kodiak Building Partners, LLC (Kodiak, or Buyer), a serial acquirer in the construction industry with operations in multiple business lines. The Defendant in the matter, Adams was the general manager of Northwest and oversaw the day-to-day operations and “the overall performance of the business unit.” He earned $84,000 in base compensation and owned 8.33% of Northwest’s stock (worth ~$900,000 in deal consideration).

In connection with the acquisition, Adams entered into a restrictive covenant agreement (RCA) lasting thirty months, which restricted him from competing with any business in Kodiak’s broad portfolio of construction-related companies, and in geographic areas beyond the locations Northwest served. The RCA also restricted him from soliciting any client or customer of Kodiak and its affiliates. In the agreement, Adams acknowledged the covenants were reasonable in scope and agreed that he would not contest them.

Approximately sixteen months following closing, Adams resigned from Buyer, and two months later joined a competing company, located within the restricted geographic territory.

Relevant Findings

To begin with, citing public policy the court held that neither the waiver by Adams of his right to contest the scope of the restrictive covenant nor his acknowledgement that the covenant was reasonable precluded him from challenging the covenant or the court from considering its reasonableness.

Next, the court held that the scope of restricted activities and geography were overly broad. Buyer’s legitimate interest in protecting the goodwill of the acquired businesses was exceeded when the language attempted to protect the pre-existing goodwill of the Buyer, its subsidiaries and their respective affiliates, in business lines that Northwest did not offer, in locations Northwest did not operate.

The court also declined to “blue pencil” the covenants to make them narrower and therefore enforceable, despite language in the agreement explicitly permitting it to do so. In so declining, the court noted that it would be inequitable and against public policy to allow an employer who entered into such an overbroad agreement to rely on blue penciling to place it in a “no-lose” situation.

Practice Points

Drafters should consider narrowly tailoring the restrictive covenants, as an overbroad or overreaching agreement could leave the employer with no protections at all. Restrictive covenants applicable to activities carried on by the buyer could be included in other agreements (such as an employment agreement) if a seller has a post-closing relationship with the buyer. Alternatively, the drafter could choose a choice of law provision from a state where courts have exercised less scrutiny of restrictive covenant provisions.