M&A attorneys representing buyers, and their private equity and strategic clients, have long felt comfortable that the courts would uphold restrictive covenants in an acquisition. Even if the restrictive covenant at hand was perhaps somewhat broader than necessary, buyers and their counsel believed that the courts would judiciously apply their “blue pencil” to reform an overbroad covenant to make it enforceable. They also believed that by picking Delaware law and Delaware courts to hear any dispute, their restrictive covenants would be upheld by a court that has a well-deserved reputation for enforcing contracts.
In a very recent opinion on October 6, 2022, by the Delaware Chancery Court, Kodiak Building Partners, LLC v Adams, Vice Chancellor Zurn ruled that the restrictive covenants imposed on a stockholder in an acquisition were overbroad and unenforceable. In addition, the court declined to apply its blue pencil to reform the overbroad restrictive covenants on the basis that to do so would not be equitable. In this article, the authors, a non-compete litigator and an M&A attorney, will discuss the background of this case, the ruling that has surprised many M&A attorneys, and some key takeaways for the future.
As described on its website, Kodiak Building Partners, LLC (“Kodiak”) was founded in 2011 to acquire family-run businesses in the building material sales and distribution industries. It was founded by a group of investment bankers who had analyzed the construction industry, and wanted to build a decentralized and entrepreneurial consolidator in the building materials industry. In the June 2, 2020, press release announcing the transaction that is the subject of the Kodiak opinion, it stated that Kodiak had acquired over 81 locations in 16 states through 25 acquisitions. Kodiak operates four business lines: (i) lumber and building materials which, depending on the location, may or may not include roof trusses; (ii) gypsum, which includes drywall and related supplies; (iii) construction supplies, which are primarily steel, rebar and structural steel, and (iv) kitchen interiors, such as kitchen appliances, flooring, cabinets and countertops.
For 17 years, Philip Adams (“Adams”) was a general manager of a truss manufacturer, Northwest Building Components, Inc. (“Northwest”). Founded in 2004, Northwest has only one line of business, the manufacture and sale of roof trusses and other mostly lumber-based building supplies. As a general manager, Adams was responsible for the overall performance of the business unit, such as scheduling, and handling certain customer accounts. What is very important to the outcome in this case is that Northwest operated out of a single location in Rathdrum, Idaho, which is approximately 30 miles northeast of Spokane, Washington. Northwest’s customers are primarily located within 30 to 60 minutes of its one location.
On June 1, 2020, Kodiak entered into a stock purchase agreement with Northwest and Mandere Construction, Inc. (“MCI”). MCI is an Idaho corporation that sells, manufactures, and delivers roof trusses. Kodiak acquired all of Northwest and MCI’s assets, including goodwill and Adams’ 8.33% interest in Northwest. Adams received approximately $900,000 for his 8.33% interest in Northwest, meaning that Northwest had an enterprise value of approximately $10 million. In connection with the acquisition, Kodiak entered into a restrictive covenant agreement with Adams and the three other Northwest stockholders which included “Non-Competition” and “Non-Solicitation” restrictive covenants which restricted Adams for 30 months after closing.
Adams resigned from Northwest on October 11, 2021. Approximately two and one-half months later, on December 27, 2021, he joined a competitor of Northwest, Builders FirstSource, Inc. (“BFS”), as its general manager. BFS supplies building materials, such as lumber, roof trusses, I-joists, and provides design services for roof trusses. BFS has two locations in Spokane, Washington, and the location Adams worked at was only 24 miles from Northwest’s one location in Rathburn, Idaho. On April 5, 2022, Kodiak filed a lawsuit against Adams, ultimately seeking both a preliminary injunction for Adams’ alleged violation of the Non-Competition and Non-Solicitation Covenants, and damages.
The court’s rulings on the restrictive covenants
Vice Chancellor Zurn ruled that the Non-Competition and Non-Solicitation Covenants were overbroad, and accordingly unenforceable. She further declined to “blue pencil” the restrictive covenants to make them reasonable.
To reach these rulings, Vice Chancellor Zurn first laid out Delaware law for non-competition and non-solicitation covenants:
- Delaware courts “carefully review” these covenants to ensure they are (i) reasonable in geographic scope and duration, (ii) advance a legitimate economic interest of the party seeking enforcement, and (iii) survive a balancing of the equities.
- Delaware courts have favored the public interest of competition in their review of these restrictive covenants.
- Non-competition covenants in the context of a business sale are subject to a “less searching” inquiry than if they were in an employment agreement.
- Where restrictive covenants are unreasonable, Delaware courts are hesitant to “blue pencil” such agreements to make them reasonable.
Vice Chancellor Zurn first focused her review of the restrictive covenants on the second prong of the Delaware standard of review, that the restrictive covenants must advance a legitimate business interest of the party seeking enforcement. In the context of a sale of a business, the buyer has a legitimate business interest to protect the assets and goodwill it acquired in the sale. Kodiak, however, went far beyond trying to protect the business that it had acquired from Northwest. Instead, the Non-Competition and Non-Solicitation Covenants extended to:
(i) any member of Kodiak’s extended operating units and locations (i.e., multiple operating units with 81 locations), rather than the one location operated by Northwest in Rathburn Idaho; and
(ii) an expanded definition of “Business” that encompassed all of Kodiak’s lines of business, rather than Northwest’s single line of business focused on roof trusses.
Kodiak argued that it had a legitimate interest in protecting not only Northwest’s goodwill, but also that of Kodiak and its extended operating units and locations. Vice Chancellor Zurn disagreed by stating that Delaware law did not recognize a legitimate business interest in protecting all of Kodiak’s goodwill that existed prior to the Northwest acquisition. Instead, she said that “Restrictive covenants in connection with the sale of a business legitimately protect only the purchased asset’s goodwill and competitive space that its employees developed or maintained.” In discovery, Kodiak had admitted that only six of its operating units, including Northwest, made and sold roof trusses. Kodiak had a legitimate interest to protect the business purchased from Northwest, but that interest did not extend to restricting Northwest’s employees from competing in other Kodiak businesses unrelated to roof trusses.
Vice Chancellor Zurn then focused on the geographic scope of the Non-Competition and Non-Solicitation Covenants. The Non-Competition Covenant prohibited Adams from competing anywhere in the states of Idaho and Washington, and within a 100 mile radius of any other location outside of those states in which Kodiak or any of its operating units had sold products or services in the 12 months prior to closing. The Non-Solicitation Covenant prohibited Adams from soliciting customers of Kodiak or any of its operating units. Vice Chancellor Zurn found that these restrictions were geographically overbroad since they restricted Adams from seeking employment in geographic areas around Kodiak’s operating units other than Northwest. Further, the Non-Solicitation Covenant was overbroad because it covered customers of Kodiak’s operating units other than Northwest. Finally, both restrictive covenants were overbroad because the definition of “Business” encompassed more than Northwest’s industry segment of roof trusses, and were unreasonable because they were broader than necessary to protect the goodwill purchased from Northwest.
Kodiak argued that the balance of equities weighed in its favor since Adams received approximately $900,000 in the sale, was a senior executive of Northwest and went to work for a competitor only 24 miles away from Northwest that sold roof trusses just like Northwest. Vice Chancellor Zurn was unpersuaded, ruling that the restrictive covenants were more restrictive than Kodiak’s legitimate interests justified, so it would not be equitable to enforce these unreasonable covenants against Adams.”
Vice Chancellor Zurn declined to apply her “blue pencil” even though Adams appeared to have violated the portions of the restrictive covenants that were supported by Kodiak’s legitimate business interest—he was working for a Northwest competitor only 24 miles away which also sold roof trusses. She stated that where non-competition or non-solicitation covenants are unreasonable, Delaware courts “are hesitant to ‘blue pencil’ such agreements to make them reasonable.” To support that statement, she approvingly cited in a footnote cases and law review articles that had argued that the discretion of courts to blue-pencil an overbroad non-competition covenant creates a “no-lose” incentive for employers. They can ask for an overbroad covenant since if it goes to court, the employer will at least get a narrowed non-compete from the blue pencil process. In Kodiak, since the restrictive covenants were overbroad and unreasonable, she felt that the inherent inequities in blue-penciling a non-compete did not require her to do so in this situation.
Running throughout this case seemed to be the court’s concern for the uneven power dynamic between Kodiak and Adams. Kodiak had argued that Adams was a sophisticated senior executive, who was the second in charge at Northwest and one of only four stockholders. As a result, Kodiak argued that Adams should be held to the contract that he had signed. The court was unpersuaded, and noted situations in which unsophisticated parties might need protection. She also noted that that the record did not reflect that Adams had been personally represented by separate counsel for either the transaction or the restrictive covenants.
Takeaways for M&A attorneys
Injunctive relief by definition is equitable relief. The Kodiak decision is more than a cautionary tale for M&A attorneys to ensure that restrictive covenants are reasonable in order to be enforceable; rather, it reflects an unmistakable trend for courts to use their equitable power to strike down restrictive covenants unless they are narrowly tailored to protect the legitimate business interest of the requesting party. This judicial trend is also being reflected in state legislatures which have adopted new laws to restrict the enforceability of restrictive covenants—especially non-competition agreements. Here are some takeaways for future deals.
- Restrict non-competition and non-solicitation covenants to the goodwill of the business being acquired. For Kodiak to attempt to extend its restrictive covenants to all of its operating business units and multiple locations was a blatant overreach with no justification. Restrictive covenants should be narrowly tailored to the geographic locations and business of the acquired company, which is the protectable business interest of the buyer that courts will recognize.
- Consider bi-furcating restrictive covenants between principal stockholders and small minority stockholders. “One-size” does not always fit all situations or all stockholders. There is a difference between the principal stockholders who ran the business and received the bulk of the consideration, and the smaller stockholders who had more limited control of the business and received a smaller portion of the proceeds from the sale. If Kodiak had narrowly tailored the restrictive covenants for Adams to apply only to a radius around Rathburn, Idaho, or even to the states of Idaho or Washington, and only to the business of making and selling roof trusses, the court probably would have upheld them. Also likely is that Adams never would have challenged the enforceability of the restrictive covenants in the first place.
- Don’t take any comfort in the power of courts to “blue pencil” overbroad restrictive covenants. Courts are unlikely to take the time and effort to completely re-write a clearly overbroad restrictive covenant. The court in Kodiak had no patience for Kodiak’s request to blue pencil the restrictive covenant, saying that to do so would be inequitable. Instead, courts would be more inclined to “tweak around the edges” of a restrictive covenant that was generally fair, but only needed minor changes to make it enforceable under the circumstances.
- Consider insisting on separate counsel for small minority stockholders. This case may have turned out differently if Adams had separate counsel to advise him on the restrictive covenants. The judge in Kodiak pointed to Adams’ lack of separate counsel as a possible factor to show that Adams was an unsophisticated party who deserved protection in a court of equity.