Is Your Non-Compete Enforceable?

 

It is not unusual for a business owner to require certain employees or the sellers of the business to enter into an agreement not to compete with the business for a period of time after they leave the business. Some people assume that if the non-competition agreement (or “non-compete”) is written by an attorney, and if it has enough “bells and whistles,” it must be valid and enforceable. Others assume the opposite, that non-competes are rarely, if ever, enforced. Neither assumption is correct.

The stakes in enforcement of a non-compete are high indeed. If the former executives or owners of a business are allowed to compete without restriction, the business could easily lose its key customers and good will, depriving the business of profits and possibly the ability to survive. On the other hand, individuals who are restricted by a non-compete may be deprived for an extended time of the ability to work in the profession and marketplace to which they have devoted their careers, and in which they can be most productive for the economy.

The Colorado legislature has attempted to balance these interests in a statute declaring that covenants not to compete shall be void, with certain significant exceptions. Some of the exceptions apply to contracts for the purchase and sale of a business or assets of a business; contracts for the protection of trade secrets; or covenants by “[e]xecutive and management personnel and officers and employees who constitute professional staff to executive and management personnel.”

If a particular case is found to fall within one of the statutory exceptions, and if the restrictions on competition are found reasonable under the circumstances, the courts will enforce an agreement not to compete. To be reasonable, a non-compete agreement must not be broader than necessary to protect the promisee’s (e.g., the business’s) legitimate interests, and it must not impose hardship on the promisor (e.g., the seller or employee).

The Reed Mill Case.

A recent decision by the Colorado Court of Appeals illustrates the issues involved, and the difficulty in predicting whether a non-compete will be enforced under varying circumstances. Under the particular facts of Reed Mill & Lumber Co., Inc. v. Jensen, the court held unenforceable an agreement not to compete which had been made between the buyer of a company (Reed Mill) and a person named Jensen, who had been its general manager and part owner. The agreement had provided that Jensen would not compete with the company in a 100 mile radius for three years from the termination of his employment. The Court of Appeals notes that covenants (i.e., promises) not to compete within distances of 100 miles and for terms up to five years are commonly upheld.

However, the court found the duration of the covenant to be unreasonable under the facts of the Reed Mill case, where Jensen’s employment with Reed Mill did not terminate until six years after the agreement not to compete was made. The appellate court upheld the findings of the trial court, including findings that three years was a sufficient time for the buyer to take over the business, learn the trade, and be free of competition from the former owners of Reed Mill; and under the circumstances, it would pose an undue hardship on Jensen to require that he not participate in employment in the only area in which he had experience. Considering that the three-year covenant not to compete did not begin to run until after Jensen’s termination from employment, and his termination did not occur until six years after the agreement was made, the Court of Appeals observes that, “Had the trial court allowed Reed Mill to enforce the agreement, Reed Mill would have expanded that [three-year] period to nine years.”

In its analysis, the court treats the non-compete agreement as only being made in connection with the purchase and sale of assets of a business, to protect the value of good will. It rejects arguments by the new owner of Reed Mill that the statutory exception for executives and management applies to the facts.

The court treats as significant the recitals made in the agreement regarding why the non-compete was made. The court notes that the non-compete explicitly states that it was made “pursuant to” the agreement for purchase of company assets. It does not state the buyer directly compensated Jensen for entering into the agreement. Instead, a portion of the amount the buyer paid for Reed Mill’s assets was allocated to good will and non-competition, and old Reed Mill distributed the proceeds of the sale to its shareholders. In addition, the non-compete agreement was not a condition of the buyer’s offer of employment to Jensen in an executive or managerial capacity. The court also discusses the fact that, though Jensen had been employed as a general manager at the time of the agreement, his responsibilities had diminished by the time he terminated employment. Thus, the court finds the executive-management exception does not apply.

Concurring Opinion.

One of the three judges on the Court of Appeals panel concurs in the result of the case, but for different reasons than are given in the majority opinion. The concurring judge states, “In my view, it is not the latency period [i.e., the time before Jensen’s employment terminated and the covenant went into effect] which renders the covenant unreasonable (I believe that aspect of the covenant is reasonable), but rather the length of the period during which competition is prohibited (three years) and the size of the geographic area in which competition is prohibited during that three-year period.”

The concurring judge cites various factors why he considers the three year period and geographic area to be unreasonable under the circumstances. Among them, he notes that Jensen only owned 8.6% of the Reed Mill before its assets were sold, he was not involved in the negotiations to sell the business assets, and he did not have equal bargaining power for making the non-compete. In the judge’s opinion, “the sum Jensen received for his covenant not to compete, $9,857, is nowhere near sufficient to allow him to temporarily support himself without the practical need to engage in the only type of business in which he has worked.” The judge perceives “a gross imbalance” between the scope of Jensen’s covenant and what is necessary to protect the buyer’s interest in that good will.

Implications.

The Reed Mill case not only illustrates differences of opinion that can result from a non-competition agreement, the decision also has implications for future cases. It has been common for covenants not to compete to begin to run from the end of an employee’s employment, a date which may be uncertain when the agreement is made. But the majority opinion in Reed Mill indicates that an indefinite “latency period” such as this may make the covenant not to compete have an unreasonably long duration.

The court’s opinion further demonstrates that recitations in an agreement about the reasons for making the covenants, as well as the amount paid in consideration for the non-compete, will be scrutinized by a court. The court will consider such facts when it is deciding whether the covenants fall within one of the statutory exceptions that allow certain non-competes, and whether the covenants are reasonable to enforce.

These and other factors should be reviewed with legal counsel whenever one is preparing to enter into a non-competition agreement, or to engage in new employment possibly restricted by an existing non-compete, or to enforce a covenant not to compete. Careful analysis may help the parties evaluate the likelihood of enforceability, risks and benefits of a non-compete, and options for how to proceed.

G. Roger Bock is a shareholder with Frascona, Joiner, Goodman and Greenstein, P.C., a Colorado law firm. His practice areas include Litigation, Real Estate, and Employment . Contact Roger Bock.

Disclaimer -- Content is general information only. Information is not provided as advice for a specific matter, nor does its publication create an attorney-client relationship. Laws vary from one state to another. For legal advice on a specific matter, consult an attorney.

G. ROGER BOCK