July 4, 2022

Volume XII, Number 185

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July 01, 2022

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California Nonsolicitation Clause Held Enforceable Under Narrow Exception for Sale of a Business

California law generally prohibits the enforcement of nonsolicitation agreements, but the law includes a narrow exception associated with the sale of a business. In Blue Mountain Enterprises, LLC v. Owen, a recent decision from the Court of Appeal of the State of California, First Appellate District, the appellate court upheld a ruling in favor of the buyer of a business under this exception.

California Business and Professions Code Section 16600

In California, contractual provisions that prevent a person from engaging in a profession, trade, or business are generally void, according to Business and Professions Code section 16600. As the Supreme Court of California has noted, “section 16600 evinces a settled legislative policy in favor of open competition and employee mobility.”

California courts have ruled that this statute prohibits the enforcement of noncompetition agreements, customer nonsolicitation agreements, and perhaps even employee nonsolicitation agreements. While employers may often succeed in enforcing these types of restrictive covenants in other states, enforcement is not guaranteed in California.

But there is an important exception to this law. Section 16601 states: “Any person who sells the goodwill of a business, or any owner of a business entity selling or otherwise disposing of all of his or her ownership interest in the business entity … may agree with the buyer to refrain from carrying on a similar business within a specified geographic area in which the business so sold, or that of the business entity, division, or subsidiary has been carried on, so long as the buyer … carries on a like business therein.”

This exception became the central issue in the Blue Mountain case, described below.

A Californian Sells His BusinessAgrees Not to Solicit … but Then Gets Fired and Solicits

The dispute in Blue Mountain arose out of a transaction in which a business owner, Gregory Owen, sold his heating, ventilation, and air conditioning (HVAC) business to an investment group. The transaction involved four contracts and took place in several steps. First, Owen transferred his entire ownership interest to a newly formed limited liability company (LLC). Owen owned 100 percent of the new LLC upon formation, but four days later, the investment group purchased 50 percent of that LLC, for which Owen received $3 million. Owen retained the other 50 percent. In a contemporaneous employment agreement with the LLC, Owen agreed to serve as the new company’s chief executive officer. The employment contract contained a restriction: upon the termination of his employment, Owen could not solicit the LLC’s customers for a period of three years.

About four years later, the company discharged Owen. Before the three-year nonsolicitation clause expired, Owens formed a competing business and sent emails to several customers of the LLC. He informed them that he had started a new business “with greater perspective, more resources and a much stronger team.” The team included two former employees of the LLC. Owen concluded his letter with this note: “I thank everyone who supports us in this transition and look forward to the remarkable opportunities we have ahead with our new company.”

Soon after, one of the LLC’s customers invited Owen to bid on a project. In addition, Owen submitted bids to several other customers.

The LLC sued, alleging breach of contract, among other claims, and it requested injunctive relief to prevent Owen from soliciting customers. The court granted the injunction, which ultimately remained in place until the end of the three-year restrictive period. The court also awarded the LLC $596,114 in fees and $84,125 in costs.

Nonsolicitation Covenant Is Enforceable

The appellate court held that the three-year nonsolicitation clause found in Owen’s employment agreement was enforceable.

Owen argued that the seller exception found in section 16601 should not apply. He pointed out that when he transferred his interest to the new LLC, he owned 100 percent of the LLC. Four days later, the investor bought 50 percent of the new LLC. In his view, he merely “consolidated all of his businesses into one LLC through a Contribution Agreement,” and he “did not sell or dispose of any of his business or membership interests” to the investors.

The court rejected this contention. Looking at the whole transaction, which had occurred though several agreements entered into over several days, the court found that Owen had “‘sold’ or ‘otherwise disposed of’” all of his interests in his business to the newly formed LLC. The fact that he held an ownership interest in the new LLC did not matter.

The court also rejected Owen’s argument that because the nonsolicitation clause was found in his employment contract, rather than the corporate sale agreement, it could not be enforced. The court determined that the employment contract was part of the entire transaction, which involved several agreements that “must be read together.” The court stated, “[The LLC’s] ability to enforce the nonsolicitation covenant is not undone by the fact that this provision is found in one contract in a multi-contract joint venture rather than another.”

Court Addresses the Meaning of “Solicitation”

The appellate court also determined that the communications Owen sent to customers counted as “solicitation” in violation of his agreement.

The court began with the premise that a solicitation does not include a general announcement or advertisement informing the public of a new business. Quoting from a prior case, the court stated that “‘[m]erely informing customers of one’s former employer of a change of employment, without more, is not solicitation. Neither does the willingness to discuss business upon invitation of another party constitute solicitation on the part of the invitee. Equity will not enjoin a former employee from receiving business from the customers of his former employer, even though the circumstances be such that he should be prohibited from soliciting such business.’”

However, when the communication does more than merely announce a new business, but also entices customers with a competitive alternative and invites customers to discuss it, the communication may constitute a solicitation.

The court found that Owen’s letter included elements of solicitation. “The letter was specifically addressed to his ‘past and potential future clients,’” the court wrote. “He boasted that his new venture … was a superior alternative to [the LLC], having ‘greater perspective, more resources and a much stronger team,’ including two former [LLC] employees ‘who combined [brought] over 100 years of experience in the HVAC industry.’” The court stated that “[t]he letter was a direct appeal for future work and was sent directly to select representatives of [the LLC’s] corporate customers. Thus, the letter constituted a solicitation as a matter of law.”

Accordingly, the appellate court upheld the trial court’s determination. Furthermore, the appellate court determined that the trial court had properly awarded the buyers $596,114 in attorneys’ fees and $84,125 in costs.

Key Takeaways

Generally, noncompete and nonsolicitation agreements are unenforceable in California courts. Employers may want to review nondisclosure agreements, confidentiality agreements, and nonsolicitation agreements to determine their viability in California.

A narrow exception applies to the seller of a business who sells all of his or her interest. Courts may look to the entirety of a transaction to determine if this exception applies. An employment agreement containing a restrictive covenant might be enforceable if it is part of a global transaction involving the sale of a business. Businesses may want to take care to properly structure business acquisitions in such a way that nonsolicitation agreements may be enforceable in California.

If the narrow exception applies, general announcements or advertisements likely do not amount to solicitation. Language that constitutes a direct appeal for future work in a communication sent directly to select customers may violate a nonsolicitation agreement.

© 2022, Ogletree, Deakins, Nash, Smoak & Stewart, P.C., All Rights Reserved.National Law Review, Volume XII, Number 98
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About this Author

Christopher W. Olmsted, Ogletree Deakins, Employment Law Compliance Attorney, Retaliation Claims Lawyer,
Shareholder

Christopher Olmsted is a shareholder in the firm's San Diego office.

Mr. Olmsted helps businesses avoid employment-related legal claims by providing California employment law compliance advice. He also defends employers in a variety of litigation matters. Mr. Olmsted's employment law compliance and litigation experience includes: California FEHA and Title VII discrimination, harassment and retaliation claims; wrongful termination claims; wage and hour compliance and defense of claims and labor agency audits; California CFRA, federal FMLA and...

858-652-3111
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