Enforcement of Restrictive Covenants in Business Sales

When you challenge the enforceability of a restrictive covenants in Virginia, the court is going to apply one of two standards. Either the court will closely scrutinize the restrictive covenant, if it is between an employer and employee, or the court is going to apply a more relaxed standard, if it was signed during the sale of a business.

How does a Virginia court know which standard to apply? What happens if you sell a business but keep working as an executive? Will the court apply the sale of business standard because you sold the company, or will the court apply the employer and employee standard because you kept working there?

Under Virginia law, the Court will apply the less restrictive sale of business framework when there is some form of corporate transaction separate from the parties’ employment relationship. See, e.g., W. Insulation L.P. v. Moore, 2006 WL 208590, at *6 (E.D. Va. Jan. 25, 2006) (applying the sale of business framework because the case “involves a sale of a business”); McClain & Co. v. Carucci, No. 3:10cv65, 2011 WL 1706810, at *6 (W.D. Va. May 4, 2011) (applying the sale of business standard when the parties agreed to a covenant not to compete in concert with a settlement of claims).

In deciding which standard to apply, the court will look at two factors.

First, the sale of business context applies when the non-compete was drafted to permit “the owner of a business to convey its full value on its sale, by contracting not to destroy of that business by immediate competition.” 6 Williston on Contracts § 13:9 (4th ed.). In other words, the sale of business standard applies if the agreement is “attributed more to the sale of goodwill than to the employment contract.” Restatement (Second) of Contracts § 188 Rptr’s Note b; see Carucci, 2011 WL 1706810, at *6 (applying the sale of business framework because the “primary purpose” of the non-compete was unrelated to employment).

Second, the sale of business standard governs if the non-compete is the result of an arms-length negotiation between sophisticated parties of comparable bargaining power and for substantial consideration. See Roto-Die Co., Inc. v. Lesser, 899 F. Supp. 1515, 1519 (W.D. Va. 1995) (refusing to apply the sale of business standard because the employee lacked bargaining power and was a minority shareholder in the company).

These are the principles that guide whether to apply the more lenient, less restrictive sale of business standard:

  • The non-compete arose in a context separate from employment
  • The non-compete resulted from arms-length negotiations
  • The parties were sophisticated
  • The parties received substantial consideration

If the sale of business standard does not apply, then a Virginia court will apply the employer-employee standard. A non-compete in the context of an employer-employee is scrutinized more closely than a non-compete ancillary to a sale of a business. Alston Studios, Inc. v. Lloyd V. Gress and Assocs., 492 F.2d 279, 284 (4th Cir. 1974). The restrictive covenant must be narrowly drawn to protect the employer’s legitimate business interest, not unduly burdensome on the employee’s ability to earn a living, and otherwise consistent with public policy, based on its functional limitation, duration, and geographic scope. Modern Env’ts v. Stinnett, 263 Va. 491 (2002).

Since Virginia courts are increasingly reluctant to enforce non-competes in employment relationships, as opposed to sales of business, companies will often fight to apply the sale of business standard in any non-compete dispute.

In a recent case, Capital One Financial Corporation v. John Kanas and John Bohlsen, Case No. 1:11-cv-750 (E.D. Va. 2012), a Richmond federal court reviewed whether the sale of business standard applied to two executives who sold their company, stayed on as employees, then left to compete.

Here is a summary of what happened. Kanas and Bohlsen sold their regional bank to Capital One and received a nearly $42 million in stock as consideration. The business sale agreement included a non-compete. However, rather than leave, they continued working as executives at Capital One. Within a couple years, they left, and on their way out, they signed new non-competes under a employee separation agreement.

Capital One moved to enforce a five-year non-compete against the executives. They argued that the less restrictive sale of business standard applied because the executives had sold their bank, thus giving rise to the restrictive covenant.

The federal court disagreed. Although the executives had sold the company, they kept working at the new venture as employees. Therefore, the applicable standard was not the less restrictive, sale of business standard, but the more restrictive, employer-employee standard. After all, the executives had signed employee separation agreements.

Even though the Court denied the company’s request for the sale of business standard, the Court nonetheless upheld the non-compete under the employer-employee test. After all, the executives had received sufficient consideration for their stock and would not have much difficulty earning a livelihood.

The key takeaway for Virginia businesses is that restrictive covenants can and will be enforced in sale of business agreements. However, if the newly acquired company’s executives will continue on as employees, the court will apply a higher standard to any non-compete agreements with the executives. Therefore, it is imperative to keep contracts updated with the latest changes in Virginia law.

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These articles are provided for general informational purposes only and are marketing publications of Gentry Locke. They do not constitute legal advice or a legal opinion on any specific facts or circumstances. You are urged to consult your own lawyer concerning your situation and specific legal questions you may have.