Wider Latitiude Given to Noncompetes in Business Sales and Settlement Agreements than to Noncompetes in Traditional Employer/Employee Agreements

A noncompete entered into as part of a settlement agreement to end litigation between an employer and former employee receives more latitude than a traditional noncompete signed before or during the employment period.

In a recent case, Plaintiff McClain & Co. Inc. sued a former employee for breach of an agreement not to compete that was included in a post-employment settlement and release contract to which the two parties agreed.

McClain accused the former employee of misappropriating $285,793 of McClain’s funds while he was an employee by submitting false payroll records for employee services that the employees did not actually perform. The parties then entered into a Settlement Release and Agreement a few months after the former employee was no longer employed by McClain where McClain released him from claims relating to his supposed misconduct in exchange for a payment of $250,000, and his compliance with a noncompete restrictive covenant, among other things.

The covenant provides:

The former employee agrees that for a period of thirty (30) months immediately following the Termination Date . . . , he shall not provide perform or undertake any Competing Services anywhere in the territory . . . (ii) instruct, hire, engage, or contract with any other person or entity to provide, perform, or undertake any Competing Services anywhere in the Territory; and (iii) own . . . , serve as director, officer or manager of, or control . . . any entity or business that provides, performs or undertake Competing Services anywhere in the Territory.

McClain accused the former employee of establishing a competing business, MPT, just six days after signing the settlement agreement. As a result, McClain sued for breach of contract against the former employee for violation of the non-competition covenant in the contract as well as conversion and tortious interference with contract.

The former employee moved to dismiss on the ground of failure to state a claim for which relief can be granted because the noncompete is unenforceable as a matter of law. His motion was denied as to the breach of contract and conversion counts.

The court decided that McClain’s allegation that the former employee established a business on a certain date that competed with McClain’s business is sufficiently specific and factual in nature to pass muster under Federal Rule of Civil Procedure 8. The court also held that the phrase “upon information and belief” can be used when the factual basis supporting a pleading is only available to the defendant at the time of the pleading.

The former employee’s other attack on the breach of contract is a claim that the non-competition clause is unenforceable. “In considering the enforceability of restraints on trade, Virginia courts focus on the reasonableness of the restraint because the law looks with favor upon the making of contracts between competent parties upon valid consideration and for lawful purposes and therefore courts are averse to holding contracts unenforceable on the ground of public policy.” Opinion at 7 (internal citations omitted).

The court held that agreements not to compete in the employer/employee context as part of an employment contract are subject to more careful scrutiny. The test is whether the contract is narrowly drawn to protect the employer’s legitimate business interest, and is not unduly burdensome on the employee’s ability to earn a living, and is not against public policy. Id., quoting Omniplex World Servs. Corp. v. U.S. Investigations Servs., 270 Va. 246, 249 (2005).

The court noted that a noncompete like the one in this case which is part of a post-employment agreement has yet to be reviewed in Virginia. The court stated that greater latitude is allowed in determining a convenant’s reasonableness when it’s a covenant not to compete between a vendor and buyer than when it’s related to an employment contract.

Restraints are given more leeway for being acceptable when the noncompete is between a buyer and seller than between an employer and employee because “employees often have comparatively little bargaining power and less leverage for negotiating a fair deal, while the sale of a business more typically involves sophisticated parties coming to an agreement after an arms-length negotiation process.” Op. at 9, citing Centennial Broad., LLC v. Burns, 2006 U.S. Dist. LEXIS 70974, at *27-29 (W.D. Va. Sept. 29, 2006). “Restrictions on an employee’s means of procuring a livelihood for himself and his family” are more likely to threaten public policy interests than restrictions on a seller . . . .” Op. at 9, citing Centennial Broad., 2006 U.S. Dist. LEXIS 70974, at *28-29. The court noted that this same reasoning applies with the noncompete is between partners in a professional firm. Op. at 9.

In the instant case, the court held refused to hold the noncompete to the more restrictive standard applicable in employment cases because the former employee was not an employee when it was made and it was negotiated at arm’s length while the former employee was represented by counsel. There was consideration for both parties and it was not a “take it or leave it” situation where the former employee was concerned with securing a job. The court concluded that bargaining power was more equally distributed and reasonable in general. Therefore the noncompete was sufficiently circumscribed to survive the former employee’s facial attack on a motion to dismiss.

As we begin to see more categorization of noncompete agreements, Virginia courts are giving wider discretion to noncompetes in business sales and settlement agreements than to traditional noncompetes in employer/employment agreements. This raises the question whether a different standard may be applied to even more potential categories of noncompetition agreements.