California Court of Appeal Rules that a partial sale of business can bind the seller-owner to a noncompetition agreement
In Samuelian v. Life Generations Healthcare, LLC, – Cal. App. App. App. Aug. 20, 2024), the California Court of Appeal answered two long outstanding questions of California law concerning the enforceability of noncompetition agreements in the context of the sale of a business:
Yes, a partial sale of an ownership interest in a business may support a noncompete under the rule of reason (even though the sale of business exception under Business & Professions Code Section 16601 permitting non-competes requires the sale of an entire ownership interest and associated goodwill, otherwise it is “void per se”); and
- Yes, status as a member of an limited liability company (“LLC”) can potentially support a noncompete during the period of membership if there is contract language imposing fiduciary obligations on the member.
- In Samuelian, two members of the defendant LLC sold part of their interest in the company, but retained a minority membership interest with voting and information rights. The operating agreement stipulated that all members of the company were bound by fiduciary duties, which included not being able to compete with the business during their membership. The company claimed that the two members who were partially selling their ownership interests had violated the noncompetition clause, which triggered its right to buy the remaining interest. In Ixchel Pharma, LLC. v. Biogen, INC., 9 Cal. In Ixchel Pharma, LLC v. Biogen, Inc., 9 Cal. The California Supreme Court rejected the common law “rules of reasonableness” in employment noncompete agreements and held that Business & Professions Code Section 16600 rendered such agreements void per se unless they fell under one of the statutory exemptions (generally the sale of a business interest and its associated goodwill).
It remained unclear after Ixchel as to how courts would apply the rule of reason standard to business transactions that were not part of the joint venture in the case. It was also unclear whether courts would expand the scope of the Business to Business exceptions beyond the three exceptions set out in Sections 16602.5, 16601 and 16602. In Samuelian the California Court of Appeal ruled that the reasonableness test also applies to partial business sales under certain circumstances. The Court looked at the purpose of Section 16600, which is “a settled legislative principle in favor of openness of competition and employee mobility.” To reach this conclusion, the Court first looked at the purpose of the section: “a settled policy in favour of openness of competition and employee movement.” . . and may hold some degree of control over its operations” and that “
ue to that ongoing connection, noncompetition agreements arising from a partial sale must be evaluated under the reasonableness standard to determine whether they have procompetitive benefits.” Under Samuelian, whether a noncompetition restriction will be upheld in connection with a partial sale of a business requires an evaluation of whether the restriction is more harmful or helpful to competition and is “reasonable in light of the seller’s ongoing connection with the company” when considering “the facts peculiar to the business in which the restraint is applied, the nature of the restraint and its effects, and the history of the restraint and the reasons for its adoption.”
The Court explained that after a partial sale, selling owners may owe the company a duty of loyalty that prohibits them from competing with it, and that adopting a “void per se” rule would “unnecessarily interfere with these fiduciary duties.” The Court also held that while the California Revised Uniform Limited Liability Act does not include a de facto imposition of fiduciary duties on members in a manager-managed company, those duties can be imposed contractually in the company’s operating agreement. The court’s decision confirms the validity of interm restrictive covenants within the employment context. [d]The Samuelian case fills a gap in California law regarding the partial sale of business interests. It also serves as a reminder to companies to consult with their counsel before imposing contractual fiduciary obligations on members of operating agreements. They should also consider how to structure noncompetition clauses and other restrictive covenants to ensure that they are reasonable, or fall within any of the statutory exemptions under Section 16600 and se
