Background
The parties
Defendant Philip D. Adams was a general manager of Northwest Building Components, Inc. (Northwest), a Washington corporation. Northwest only has a single facility in Idaho, where it “manufacture[s] and sell[s] and deliver[s] roof trusses and … mostly lumber-based building products.” In addition to serving as a general manager, Adams also held an 8.33 percent interest in Northwest.
Plaintiff Kodiak Building Partners, LLC (Kodiak), on the other hand, is a Delaware limited liability company that, “[o]ver the course of several years, … has acquired at least nineteen wholly owned subsidiaries around the country through which it operates four business lines[.]” One such business line is “lumber and building materials, which may or may not include roof trusses, depending on the location[.]” Kodiak’s other three business lines are gypsum, construction supplies, and kitchen interiors.
The Acquisition
On June 1, 2020, Kodiak acquired Northwest (the Acquisition) pursuant to the terms of a stock purchase agreement (SPA) among Kodiak, Northwest, and Mandere Construction, Inc. (MCI), “an Idaho corporation that sells, manufactures, and delivers roof trusses.” Through the Acquisition, Kodiak acquired Northwest and MCI’s “Company Capital Stock” and “all of the assets, properties, rights, licenses, interests, Customer Deposits, Contracts and business, of every kind and description, wherever located, real, personal or mixed, tangible or intangible, owned, held or used by [Northwest or MCI] or in the conduct of [Northwest or MCI’s] business.” Kodiak also acquired “Northwest’s goodwill and Adams’s 8.33% interest in Northwest.”
The RCA’s restrictive covenants
In connection with the Acquisition, Kodiak also entered into a restrictive covenant agreement (RCA) with Adams and three other Northwest stockholders. The RCA ‒ which was intended to be effective for 30 months following the closing of the Acquisition ‒ contained the following restrictive covenants: “Non-Competition,” “Non-Solicitation,” “Confidentiality,” “Non-Interference,” and “Non-Disparagement.” The RCA also contained “language providing that Adams acknowledged the reasonableness and necessity of the restrictive covenants” and, further, that Adams waived any defense regarding the reasonableness of the covenants.
Adams resigns and starts working for BFS
Over a year after the Acquisition, in October 2021, Adams resigned from his position as a general manager at Northwest. Approximately two months later, he started working as a general manager for another company, Builders FirstSource, Inc. (BFS). Although not strictly relevant to the Court’s decision, BFS “supplies building materials such as lumber, roof trusses, and I-joists, and provides design services for roof trusses.”
Kodiak sues Adams and moves for a preliminary injunction
A few months after Adams started working for BFS, on March 17, 2022, Kodiak learned that it had lost business to Adams. “Later that same day, Kodiak and Northwest caused their counsel to send cease-and-desist letters to BFS and Adams.” Less than three weeks later, Kodiak filed its Verified Complaint for Injunctive Relief. Kodiak also filed a motion for expedited proceedings and sought preliminary injunctive relief with respect to its claims that Adams breached the non-compete and non-solicitation covenants in the RCA. Initially, Adams filed a motion to dismiss, but he ultimately answered the complaint, and the motion to dismiss was denied. Thereafter, Kodiak amended its complaint while the parties briefed Kodiak’s motion for a preliminary injunction.
The opinion
The Court denied Kodiak’s motion for a preliminary injunction because the disputed restrictive covenants were overbroad and, therefore, unreasonable (and unenforceable). Accordingly, Kodiak could not demonstrate a reasonable probability of success on the merits with respect to the alleged breaches of the RCA’s non-compete and non-solicitation covenants.
Applicable standards
In order to be enforceable, non-compete and non-solicitation provisions must be “(1) reasonable in geographic scope and temporal duration, (2) advance a legitimate economic interest of the party seeking [their] enforcement, and (3) survive a balancing of the equities.” However, it should be noted that “covenants not to compete in the context of a business sale are subject to a ‘less searching’ inquiry than if the covenant ‘had been contained in an employment contract.’” If non-compete or non-solicitation provisions “are unreasonable in part, Delaware courts are hesitant to ‘blue pencil’ such agreements to make them reasonable.”
Public policy prevents employees from waiving reasonableness as a defense
Before analyzing the reasonableness of the RCA’s restrictive covenants, Vice Chancellor Zurn addressed two provisions in the RCA that were intended to insulate it from judicial review: (i) a stipulation regarding the reasonableness of “each and every one of the restraints” contained in the RCA and (ii) a waiver of “any issue of reasonableness” as a defense “in any proceeding to enforce any provision of th[e] [RCA].”
In the opinion, Vice Chancellor Zurn acknowledged the dearth of relevant case law explicitly addressing the effect of such provisions. However, the Court discussed an earlier decision from Vice Chancellor Slights that involved restrictive covenants in grant agreements that also contained language stipulating to the reasonableness of the restrictions: FP UC Holdings, LLC v. Hamilton, 2020 Del. Ch. LEXIS 110 (Mar. 27, 2020). In that case, as the Court observed, “Vice Chancellor Slights still held the plaintiff to its burden of proving the reasonableness of the covenants and declined to blue pencil the agreements when the plaintiff fell short.” In any event, the Court held that the stipulation and waiver were unenforceable as a matter of public policy, explaining that “mechanical submission to an employee’s promise not to challenge a restrictive covenant would fly in the face of the public policy that compels review of that covenant.”
The overbreadth of the restrictive covenants
With respect to the specific restrictive covenants at issue ‒ i.e., section 1 (Non-Competition) and section 2 (Non-Solicitation) of the RCA ‒ Vice Chancellor Zurn held that they (i) did not protect a legitimate economic interest and (ii) were unreasonably broad in scope.
First, the restrictive covenants did not protect a legitimate economic interest because they went well beyond protecting “the assets and information [Kodiak] acquired in the [Acquisition].” Per the opinion, “Kodiak argues that it has a legitimate interest in protecting not only Northwest and MCI’s goodwill, but also that of Kodiak, [all of Kodiak’s subsidiaries and affiliates], and the Business.” But this expansive view of legitimate economic interest was not appropriate, especially in light of the RCA’s expansive definition of the term “Business,” which included business lines beyond Northwest’s and MCI’s respective operations. As succinctly noted in the opinion, “[t]he acquirer’s valid concerns about monetizing its purchase do not support restricting the target’s employees from competing in other industries in which the acquirer also happened to invest."
Second, the restrictive covenants were “unreasonable in their geographic scope and scope of restricted activities because they are broader than necessary to protect Kodiak’s legitimate economic interests.” The Court again explained that “Kodiak’s legitimate economic interest that can support restraining Adams’s employment is only in the goodwill and competitive space it purchased from Northwest in the market Northwest serves.” From a geographic perspective, the non-compete provision was “overbroad to the extent it prohibits competition in geographic areas around [Kodiak] subsidiaries other than Northwest,” and, in similar fashion, the non-solicitation provision was “overbroad to the extent it covers customers, clients, or prospective customers and clients of [Kodiak] subsidiaries other than Northwest.” Likewise, “[t]he scope of restricted activities [was] also unreasonable” because the restricted activities “encompassed more than just Northwest’s industry segment of roof trusses.”
Takeaways
- Delaware courts remain hesitant to “blue pencil” overbroad restrictive covenants to make them reasonable.
- Restrictive covenants secured in connection with a business sale should be reasonably tailored to protect the acquired assets and information.
- For public policy reasons, parties cannot insulate restrictive covenants from judicial review via contractual waivers or stipulations regarding the covenants’ reasonableness.
Client Alert 2022-400
