Download the broad reach of california`s ban on non-compete clauses

CALIFORNIA NON-COMPETE AGREEMENTS MAY BE VALID IN
CONNECTION WITH THE SALE OF A BUSINESS, IF THE SALE
INVOLVES GOODWILL
One of the few exceptions to California’s ban on non-compete agreements is if
the non-compete is given in connection with the “sale of a business”. This exception can
be found at Business & Professions Code Section 16601 which reads:
“Any person who sells the goodwill of a business, or any owner [ ] selling
[ ] all of his or her ownership interest in the business entity, or any owner
[ ] that sells [ ] all or substantially all of its operating assets together with
the goodwill [ ] may agree with the buyer to refrain from carrying on a
similar business within a specified geographic area in which the business
so sold [ ] has been carried on so long as the buyer [ ] carries on a like
business therein”. (Emphasis added).
A literal interpretation of “all of his or her ownership interest in the business”
suggests that if someone sells all their shares in a company, however small that number
may be, that person may be subject to a non-compete. That is not the law. If the sale
involves the sale of shares, goodwill must be part of the sale. Before looking at how
courts determine if goodwill is involved, it is helpful to see how the present Section
16601 exception came about.
As originally enacted in 1872, the “sale of business exception” was found at Civil
Code §1674 and read as follows: “one who sells the good will of a business may agree
with the buyer to refrain from carrying on a similar business within a specified county,
city . . . .” In Merchants’ Ad-Sign Co. v. Sterling, 124 Cal. 429, 57 P. 468 (1899), the
defendant owned shares of plaintiff company and sold “all his interest, direct and
indirect, in the plaintiff and his interest in the good will of the business of plaintiff”.
Defendant also agreed that he would not operate a competing business in the Los Angeles
area. Despite this promise, defendant opened a competing business and plaintiff brought
an action to enforce the non-compete covenant. The court held the non-compete was
unenforceable because, despite the language of the agreement, defendant had sold only
his shares and not the goodwill of the company. The court noted that, “a stockholder
cannot transfer the good will of the corporation . . . defendant, as a stockholder, did not
and could not transfer the good will of the corporation”.
In 1945, the statute was amended to add the following: “or any shareholder of a
corporation selling . . . all of his shares . . . .” When originally enacted in 1872 and later
when the Merchants’ Ad-Sign decision was handed down, small corporations were
practically unheard of. They had become more prolific by 1945 and the amendment was
recognition that selling an interest in a business through the sale of shares was
increasingly common. However, the sale of shares alone could not be the basis for an
enforceable non-compete. Otherwise, as noted in Bosley Medical Group v. Abramson,
161 Cal.App 3d 284, 207 Cal.Rptr. 477 (1984), “literally applied, section 16601 would
permit a major public corporation to require an employee to purchase one of several
million shares and enter into an agreement not to work for a competitor - an absurd
result”.
In Bosley, the defendant joined plaintiff’s hair replacement practice as a doctor.
Defendant was required to buy nine shares of the plaintiff company, representing a 9%
interest, for $10,000. Defendant was also required to sign a non-compete, agreeing not to
open a competing business within a certain area for three years. Defendant left plaintiff’s
company and sold his shares back to plaintiff as he was required to do for the purchase
price plus 10% per year (this was the agreed-upon repurchase formula). Defendant
immediately opened a competing business. In a subsequent lawsuit, the court held the
non-compete was unenforceable and the sale of shares was a sham designed solely to
circumvent the ban on non-compete agreements. Bosley held that the sale of all of a
person’s shares in a corporation must “involve [ ] a substantial interest in the corporation
so that the owner, in transferring ‘all’ of his shares, can be said to transfer the goodwill of
the corporation”.
In Hill Medical Corp. v. Wycoff, 86 Cal.App.4th 895, 103 Cal.Rptr.2d 779
(2001), defendant joined plaintiff’s medical practice. He was required to buy 100 shares,
representing 1/14th of the outstanding shares, for $10,200. Upon departure, he was
required to sell the shares back to plaintiff “at a price measured by net book value, i.e.,
assets minus liabilities”. He also had to sign a seven and a half mile, three-year noncompete. Defendant left plaintiff’s practice after almost twenty three years and sold his
shares back to plaintiff for $217,000. He then started work at a competing practice
within the “prohibited” radius. The court in subsequent litigation held the non-compete
was unenforceable because the sale of shares did not include goodwill:
“The repurchase price is an indicator as to whether business goodwill was
a factor in the purchase of [defendant’s] shares by [plaintiff]. The
repurchase price of $217,000 was not fair market value. It represented
[plaintiff’s] assets minus liabilities. The price did not include any
payment for goodwill . . . according to testimony, the appropriate
valuation for a medical business and radiology practice was one to three
times the gross annual receipts. [Plaintiff’s] gross receipts for the year
1998 were approximately $12.5 million. One to three times this amount
would have been between $12.5 million and $37.5 million. [Defendant’s]
1/14th share of that valuation would have been a sum far exceeding the
$217,000 he was to receive upon the sale . . . the trial court found there
was nothing to indicate that goodwill was part of the repurchase
transaction”.
The Hill Medical court said it was not forcing parties to adopt a particular
repurchase formula, but noted that a fair market value price “may indicate that
goodwill is part of the transaction, as an inference can be made that the price
includes a value for goodwill.”
Vacco Industries, Inc. v Van Den Berg, 5 Cal.App.4th 34, 6 Cal.Rptr.2d 602
(1992) is an example of where the sale of shares did involve goodwill such that a noncompete was held enforceable. In Vacco, defendant worked for the plaintiff company for
twenty three years, rising up through the ranks to eventually become operations manager
and an officer of the company. During this time, defendant also voluntarily purchased
stock of the company, eventually acquiring 3% of the outstanding shares. Vacco entered
into an agreement with another company, Emerson, whereby Emerson would buy all of
Vacco’s shares for $23 million. In anticipation of the sale to Emerson, Vacco entered
into “key man” agreements with certain employees, including defendant, whereby
defendant would sell all his shares to Vacco and agreed to a five-year non-compete.
Defendant sold all his shares to Vacco for $500,000, later left Vacco and started a
competing company.
In subsequent litigation, the court held the non-compete was valid and
enforceable. The court found that defendant was “a substantial shareholder. He was the
ninth largest shareholder in the corporation and was one of its principal officers.” The
court also found that the purchase of defendant’s stock was “essential to Emerson's stated
goal of acquiring all of Vacco's stock”. Although not readily apparent from the holding,
it must also have been significant that the price paid to defendant for his 3% interest,
$500,000, was not far off 3% of the $23 million purchase price, $690,000. Since $23
million was a fair market value figure, defendant received essentially fair market value
for his shares, which price by inference included goodwill. Moreover, defendant bought
his shares voluntarily, unlike the defendants in Bosley and Hill Medical who were
required to buy and resell their shares at agreed-upon prices. Although not by itself
dispositive, the voluntarily purchase of shares over two decades can hardly be
characterized as a sham transaction.