Delaware Chancery Court Finds Scope of Restrictive Covenants Unreasonable in the Context of a Business Sale

A recent Delaware Chancery Court decision addressed whether a restrictive covenant agreement was enforceable against a defendant who entered into that agreement willingly (and who waived his right to contest its reasonableness) as part of a sale of a business. Kodiak Building Partners, LLC v. Adams (Del. Ch. Oct. 6, 2022). The court held that the restrictive covenants were unreasonable in their geographic scope and scope of restricted activities because they were broader than necessary to protect the acquirer’s legitimate economic interests. This decision provides lessons for lawyers seeking to draft clear, effective and enforceable restrictive covenant provisions.

Plaintiff Kodiak Building Partners (Kodiak) is a Delaware LLC that acquires and operates smaller companies in the construction industry nationwide. Kodiak acquired defendant’s former employer, Northwest Building Components, Inc. (Northwest), through a stock purchase agreement entered into in June 2020. As part of the transaction, Kodiak acquired defendant’s 8% interest in Northwest and entered into a restrictive covenant agreement with defendant. This agreement prohibited defendant, among other things, from soliciting Kodiak’s customers and clients and competing with Kodiak’s business within the states of Idaho and Washington or 100 miles from any of Kodiak’s businesses during a 30-month term. A few months after the acquisition, defendant resigned from Northwest and took a position with a roof truss and lumber business located 24 miles away from Northwest. In response, Kodiak sued defendant for breach of the restrictive covenant agreement and sought a preliminary injunction.

While the court acknowledged that noncompete and nonsolicit covenants included as part of a business sale are generally examined with less scrutiny than similar covenants in employment agreements, it still asserted its right to apply the common law reasonableness test to the covenants to further the “public interest of competition.” The court further noted that it had the power to review this restrictive covenant despite the fact that defendant initially agreed that the covenant was reasonable, and also initially agreed to waive challenges to its reasonableness.

Despite the voluntary nature of the agreement, the court stated that “[p]ublic policy requires Delaware courts to evaluate noncompetition and nonsolicitation contracts holistically, carefully, and nonmechanically, with an eye towards reasonableness, equity, and the advancement of legitimate business interests.” The court thus held that the parties could not avoid a public policy examination of the agreement’s reasonableness. This was a crucial decision in light of the fact that, when it comes to overbroad restrictive covenants, Delaware courts are more likely to find them entirely invalid rather than “blue pencil” the agreements to make them enforceable.

In relevant part, the agreement sought to impose noncompete and nonsolicit provisions against defendant relating to activity similar to, or in competition with, any of Kodiak’s “Business.” “Business” was defined broadly as “manufacturing, marketing, selling, distributing, installing and/or delivering of trusses; roof, floor and stair components; framing; siding and other building materials and supplies, and providing services with respect thereto, including design, engineering, turn-key solutions, project management and trade coordination services,” which includes more services than Northwest offers. Defendant was involved only in truss and lumber operations.

While Kodiak had a “legitimate economic interest” in protecting its purchased assets, the court found that its noncompete and nonsolicit covenants were impermissibly overbroad. Importantly, the court held that “[r]estrictive 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,” but does not allow restricting an employee “from competing in other industries in which the acquirer also happened to invest.” Therefore, the court held that the restrictive covenants could not serve to limit defendant’s participation in business lines “unrelated to truss and lumber operations,” and therefore were unenforceable.

The court also held that the geographic scope of the restrictive covenants was overbroad in that it purported to prohibit competition and solicitation in areas around Kodiak’s subsidiaries other than Northwest and, as such, Kodiak failed to show that the geographic scope was necessary to protect its legitimate economic interests in Northwest.

In light of Kodiak, transactional lawyers should proceed with caution when drafting restrictive covenant agreements in the context of a business sale. These agreements risk being invalidated entirely by Delaware courts rather than blue-penciled, even if entered into voluntarily and with a reasonableness waiver. As a result, lawyers should carefully consider the purpose, scope and necessity of such agreements and narrowly tailor them to the acquirer’s interest in the purchased assets.