Non-Compete Agreements in Connection with Partial Sale of LLC Interest
With certain narrow exceptions (including in connection with the sale of the “goodwill” of a business), agreements restraining competition face an uphill battle in California. As a matter of public policy, California law protects the important legal right of people to engage in businesses and occupations of their choosing.
Restraints on competition are either void per se (without regard to their reasonableness) or evaluated under a reasonableness standard (which considers the specific facts of the business, the nature of the restraint and its effects, and the history of the restraint and reasons for its adoption). Under established law, the void per se standard applies to restraints arising from “termination of employment or the sale of interest in a business” and the reasonableness standard applies to “agreements limiting commercial dealings and business operations.”
The void per se standard has been applied to non-compete restraints arising from the sale of an entire business interest. But what standard applies to a non-compete restraint arising from the sale of only a partial business interest?
An opinion recently published by California’s Fourth Appellate District — Samuelian v. Life Generations Healthcare, LLC — tackles the issue.
Facts: LLC owners sell part of their ownership interest and sign a non-compete
Robert and Stephen Samuelian co-founded Life Generations Healthcare, LLC with Thomas Olds, Jr. in 1998. The LLC operates skilled nursing and related healthcare facilities in California and Nevada.
Tensions arose between the owners over the LLC’s direction. In 2007, the parties agreed to a partial buyout of the Samuelians’ interest. The Samuelians sold nearly half of their interest for $61 million, leaving them with a combined 23.9% ownership interest. In connection with the sale, the LLC adopted a new operating agreement.
Around the time of the partial interest sale, the Samuelians resigned from most of their positions at the LLC, but retained their voting rights as partial owners. Under the LLC’s new operating agreement, the Samuelians – despite their reduction of ownership interest — remained on the compensation committee, retained the right to view financial statements, and their consent was required for certain actions.
The operating agreement also provided that, despite the LLC being manager-managed, all members owed certain fiduciary duties to the LLC. Further, the operating agreement provided that no member or manager could engage in a similar business within the State of California except on behalf of the LLC, and that all related opportunities must be presented to the LLC. Breach of these provisions would allow the LLC to purchase all or any portion of the breaching party’s ownership interest.
The LLC allegedly discovered in 2015 that the Samuelians had breached the non-compete and corporate opportunities provisions, and sent notice that it elected to buy their entire remaining ownership interest, tendering payment of $19.5 million. The Samuelians denied any wrongdoing and refused the payment, but they were cut out of the LLC’s operations and profit distributions.
The Samuelians initiated an arbitration. Significantly, the parties’ agreement for arbitration limited the arbitrator’s power to commit errors of law, and allowed any awards to be vacated on the grounds that the arbitrator committed such error.
Arbitration: non-compete invalid per se
The arbitrator found the non-compete and corporate opportunities provisions were unenforceable and invalid per se under Business and Professions Code section 16600 because they were made in connection with the partial sale of the Samuelians’ interest in the LLC. He also ruled that the Samuelians owed no fiduciary duties to the LLC because they were mere members, not managers.
As such, the arbitrator held, the LLC’s forced buyout of the Samuelians was invalid. The arbitrator determined the LLC owed the Samuelians $21.1 million in unpaid distributions plus interest, and awarded them $5.7 million in attorney fees and costs.
If the arbitration clause had not allowed for judicial review based on legal error, this likely would have been the end of the story.
Trial court: arbitration award confirmed; non-compete invalid per se
The Samuelians filed a petition to confirm the arbitration award, which the trial court granted. The court agreed that the per se standard applied since the non-compete was formed in connection with the sale of a business interest.
The LLC (along with the other owners) appealed.
Court of Appeal: reversed; reasonableness standard applies, not the per se standard
The Court of Appeal reversed, holding the arbitrator legally erred by applying the void per se standard instead of the reasonableness standard. The court held that while the per se standard applies if the restrained party sells its entire interest in the business, the reasonableness standard applies if the sale is only partial and the restrained party retains a significant interest in the business.
As summarized by the court, “the seller remains an owner of a business following a partial sale and may hold some degree of control over its operations. Due 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.”
The court cited prior opinions confirming that the restrictions on non-competes in section 16600 “does not affect limitations on an employee’s conduct or duties while employed” and during employment “an employer is entitled to its employees’ undivided loyalty.” “Section 16600 is not an invitation to employees to bite the hand that feeds them.” The court continued:
An owner that sells their entire interest in a company is in a similar position to a terminated employee: his or her connection to the business has been severed. But similar to current employees, owners that only sell a partial ownership interest remain owners of the company and may still have a significant connection to it. Following a partial sale, the selling owner could still be involved in operational decisions and/or receive confidential financial information about the company. Given these potential connections following a partial sale, a restriction barring the selling owner from competing with the company is not so inherently anticompetitive as to warrant application of the per se standard. Rather, such restrictions may have procompetitive benefits. For example, they could ensure that owners are invested in improving the company’s products or services, motivated to optimize the company’s resources to expand into related lines of business, and/or are not using private information to create or assist competing businesses, among other things.
The court noted that even after their partial sale, the Samuelians still remained involved in the LLC. Their consent was required for several operational and governance decisions. And the LLC was required to send the Samuelians its private financial information.
The court also noted that following a partial sale, the selling owner may continue owing the company a fiduciary duty of loyalty that prohibits direct competition. Here, the LLC’s operating agreement validly imposed such fiduciary duties on all of the LLC’s members, not just the managers. (And in member-managed LLC, all members would owe such duties pursuant to statute.)
Last, the court held that the exception in section 16601 (involving the sale of business “goodwill”) did not apply because there was no evidence that the partial sale here included any consideration of goodwill as a component of the sales price.
The court reversed the judgment and the award of attorney fees, and directed the trial court to enter a new order vacating the entire arbitration award.
Lesson
Under the Samuelian opinion, a non-compete agreement in connection with the sale of a partial business interest will be evaluated under the reasonableness standard and is not void per se.