The California Court of Appeal recently held that a partial sale of an ownership interest in a business may support a noncompete under the rule of reason. The Court said that one of two standards applies to determine if noncompetition agreements are void under Bus. & Prof. Code, § 16600.
Background
Two members of an LLC sold part of their interest in the company; however, they kept a minority membership interest with voting and information rights. The operating agreement imposed fiduciary duties on all of the company’s members. It stipulated that the members couldn’t to compete with the company during their membership. The company claimed that the two members in question violated the noncompetition provision, which activated the company’s right to purchase their remaining ownership interest.
The members argued that the noncompetition provision was per se void under California law, and the company responded that the noncompetition provision had to be evaluated under a “rule of reason.” That rule state that a noncompetition agreement was invalid per se under section 16600. The Court of Appeal noted that the Supreme Court of California has observed that “under the common law, as is still true in many states today, contractual restraints on the practice of a profession, business, or trade, were considered valid, as long as they were reasonably imposed.”
Samuelian v. Life Generations Healthcare, LLC provided the Court of Appeal to address these issues for the first time.
Ixchel Pharma, LLC v. Biogen, Inc.
In a 2020 decision, the California Supreme Court clarified that the “void per se” standard applies in the context of employment agreements and the sale of a business, and the “reasonableness standard” applies to business to business agreements, i.e., “agreements limiting commercial dealings and business operations.”
The California Supreme Court rejected the common law “rule of reasonableness” for employment noncompete agreements in 2008. Instead, the Court held that Bus. & Prof. Code, § 16600 made noncompete agreements per se void, unless the agreement fell within one of the statutory exceptions (generally, the sale of an entire business interest and associated goodwill).
It wasn’t clear after Ixchel the way in which courts would apply the new rule of reason standard for business to business transactions outside joint ventures and whether courts would expand the scope of the business to business exceptions beyond the three statutory exceptions found in §§ 16601, 16602, and 16602.5.
In Samuelian, the California Court of Appeal held that the reasonableness standard also applies to partial sales of a business in some circumstances. The Court reasoned that the Supreme Court concluded the noncompetition agreement was invalid per se under section 16600. However, the Legislature “rejected the common law ‘rule of reasonableness,’” by enacting Civil Code § 1673, which was later replaced by former § 16600.
“In the years since its original enactment as Civil Code section 1673, our courts have consistently affirmed that section 16600 evinces a settled legislative policy in favor of open competition and employee mobility,” Acting Presiding Judge Eileen C. Moore noted in her opinion. “Under the statute's plain meaning … an employer cannot by contract restrain a former employee from engaging in his or her profession, trade, or business unless the agreement falls within one of the exceptions to the rule.”
Judge Moore explained that like a terminated employee, an owner that sells their entire interest in a company generally has no further connection or involvement with the company. However, where a partial sale occurs, the owner remains an owner of the company and may be involved with its operation. “That ongoing connection separates a seller of a partial interest from a terminated employee,” the judge reasoned.
The sale of a partial business interest differs drastically from the sale of an entire business interest, Judge Moore wrote. After a partial sale, the seller remains an owner of the company and may still exercise some degree of control over its operations. Given this context, a noncompetition provision arising from a partial sale cannot be deemed inherently anticompetitive and invalidated per se under section 16600. Instead, it must be scrutinized under the reasonableness standard to determine whether it has procompetitive benefits given the nature of the selling owner's continuing connection to the business.
Because of their potential procompetitive benefits, anticompetition restrictions after a partial sale require some scrutiny to determine if they’re reasonable in light of the seller's ongoing connection with the company. Such restrictions should be evaluated under the reasonableness standard to determine if they’re more harmful or helpful to competition by considering the following:
- The facts peculiar to the business in which the restraint is applied;
- The nature of the restraint and its effects; and
- The history of the restraint and the reasons for its adoption.
Duty of Loyalty
In addition, the Court noted that after a partial sale, the selling owners may owe their company a duty of loyalty that prohibits them from competing with it. Judge Moore reasoned that adopting a per se standard to noncompetition restraints following partial sales would unnecessarily interfere with these fiduciary duties and erode a company's ability to ensure its owners make decisions that benefit the company.
And while the California Revised Uniform Limited Liability Company Act (RULLCA, Corp. Code, § 17701.01) doesn’t impose fiduciary duties on members in a manager-managed company, as is the case here, it permits an operating agreement to impose such duties on members. As such, the Court of Appeal confirmed the continuing validity of in-term restrictive covenants in employment. Samuelian v. Life Generations Healthcare, (California Court of Appeal, 4th Dist. 8/20/24).
Bottom Line
A partial sale of an ownership interest in a business may allow a noncompete under the rule of reason (despite the sale of business exception in Bus. & Prof. Code, § 16601 permitting non-competes requires the sale of an entire ownership interest and associated goodwill, otherwise it is “void per se”).
In addition, a member of an limited liability company (“LLC”) can potentially support a noncompete during the period of membership if there’s contract language imposing fiduciary obligations on the member.