In a recent case that may not bode well for the enforcement of noncompete agreements in Pennsylvania and New Jersey, the Virginia Supreme Court reversed twenty years of Virginia precedent relating to noncompetes, agreements pursuant to which an employee agrees not to compete with an employer for a period of time after the termination of employment. Until this recently, Pennsylvania, New Jersey and Virginia had similar laws relating to noncompetes. Historically, courts in all states have not looked favorably on such agreements, and have used various tools to limit or deny enforcement of noncompetes. Prior to the court’s decision in Home Paramount Pest Control v. Shaffer, the law in Virginia was similar to Pennsylvania law: a Court could re-write overbroad noncompete agreements so that the document was consistent with the employer’s protectable interests. In Home Paramount Pest Control, the court stated that it would no longer re-write such provisions, and that it was free to refuse to enforce a noncompete that was overly restrictive.

The former employee in Home Paramount Pest Control signed a noncompete agreement that prohibited him from competing with his former employer’s fumigation business in any manner, in any geographic area where he worked for Home Paramount Pest Control for a period of two years after his termination. Prior to this case, it was well settled that if the court found the restrictions of the noncompete broad, it could rewrite the document and enforce more reasonable provisions. The court generally exercised its re-writing power to limit the geographic or temporal scope of the document, or to find that specific conduct did not violate a noncompete if the employer could not articulate a protectable interest in prohibiting the conduct, even where the clear language of the agreement prohibited the competitive conduct. Generally speaking, “protectable interest” means that the employer has provided something to the employee that it has the right to protect, such as access to trade secrets, or specialized training. If the restriction on future employment did not match a protectable interest, the court would not enforce the restriction.  

In Virginia at least, this is no longer the case. The Virginia Supreme Court noted that it had “incrementally clarified” the law relating to noncompetes so dramatically over the past two decades that it was free to find the noncompete unenforceable in this case. Most interestingly, the court focused on language that lawyers generally believe is good drafting. The agreement in question contained a list of prohibited activities designed to address every conceivable kind of competition, as well as the ubiquitous “in any capacity whatsoever” catch-all for good measure. The court found that the employer could not articulate a protectable interest that would justify such a sweeping prohibition. Specifically, the court was looking for a nexus between the employee’s job duties, and the prohibitions imposed by the noncompete.

In the good old days, the court would simply have revised the agreement to remove whatever restrictions were too broad, such as the “in any capacity whatsoever” language. Or, the court may have found that there was no protectable interest in prohibiting the employee from engaging in his current employment. But the Virginia Supreme Court refused to do so, noting that incremental changes in the law required a different result. I will not bore the reader with the court’s very interesting discussion of how the doctrine of stare decisis applies to the case, except to note that the court recognized its decision as a departure from well-settled law.

While this case does not apply in Pennsylvania or New Jersey, many states have seriously limited the enforceability of noncompetes. We are making sure to discuss these issues with our clients, and draft noncompetes as narrowly as possible.   We are also thinking creatively about other solutions to the problem of competition, trade secrets and specialized training, such as non-solicitation provisions. The Virginia Supreme Court has given us new reasons to draft carefully.

It is not uncommon for a minority shareholder to cry foul when the corporation is sold and the shareholder believes he received less than fair value for his shares. Such claims often result in shareholder oppression suits, with the majority shareholder accused of having breached a fiduciary duty to the minority owner. Now it seems that controlling shareholders of even privately held corporations have another potential adversary: the Securities Exchange Commission. The SEC recently sued Stiefel Laboratories and its then-controlling shareholder and CEO Charles Stiefel, alleging that they defrauded current and former employee shareholders out of more than $110 million by buying back shares in the company at undervalued prices prior to the sale of the company to GlaxoSmithKline PLC.

The complaint alleges that the defendants misled the employee shareholders, who had acquired the shares as part of a stock bonus plan, by concealing material information about the potential acquisition of the company by GlaxoSmithKline. Information regarding several offers from private equity firms to acquire stock in the company at a higher price than the valuation provided to employees was also allegedly withheld from employees. The complaint further asserts that the valuation that the company provided to employees was prepared by an unqualified accountant who used flawed methodology. Adding insult to injury, a 35% discount incorporated into the valuation was not disclosed to the employees.

The complaint cites, among other things, the company's repurchase of 800 shares from employees at a price equal to $16,469 per share in the months leading up to the sale to GlaxoSmithKline, which acquired the company for $68,000 per share. As a result of the reduced number of outstanding shares, the remaining shareholders (consisting mostly of Stiefel family members) received a windfall.

The SEC warns that privately held companies and their officers should be aware that federal securities laws are intended to protect all shareholders, regardless of whether they acquire their shares in a private transaction such as a stock bonus plan or on a public market. Corporate officers in corporations with stock bonus plans should take care to obtain appropriate valuations to support stock repurchases from accredited professionals using commonly accepted valuation methodologies. Stock option plans and corresponding summary plan descriptions should be carefully reviewed, with a particular focus on their stock repurchase provisions. All material facts must be fully disclosed to plan participants in a timely manner.

To avoid post-transaction cries of foul play from former shareholders, we often include “tail” provisions that allow the former shareholders to enjoy the same economic benefit of a major company transaction such as a sale or merger that follows the sale of their shares. Such provisions are usually of limited duration (e.g., twelve months). This protects the company and senior management from claims like those raised by Stiefel Laboratories employees after the expiration of the tail period.

Topics deemed “hot” in the context of mergers and acquisitions ebb and flow just as they do in all other aspects of legal study.  When I first started practicing in the early 80s, I remember being taught to carefully include any post transaction covenant not to compete in the sale document as well as in a stand-alone agreement between buyer and seller(s). This seemingly unnecessary duplication of the post transaction obligation imposed on the seller(s) was required to provide multiple legal arguments for enforcing and amortizing the obligation and drive up the aggregate sums payable to the seller(s).  Specific party agreement as to the allocation of the purchase price (and completion of Form 8594 for asset acquisitions) was deemed worthy of considerable negotiation.

Recent Tax Court and First and Ninth Circuit opinions, and this office’s own fourth quarter 2011 transactional work, seem to suggest the elusive covenant not to compete and personal goodwill have again become  important tools for tax planning purposes.  Who owns the goodwill is particularly relevant in the context of hospital purchases of physician practices where the fair market value of hard assets might not be enough to cover malpractice tail insurance let alone justify the physicians’ loss of control over their practice.
 
Under Section 197, certain intangibles must be amortized by the buyer, on a ratable basis, over a 15 year period beginning with the month in which such intangible is acquired. A Section 197 intangible includes “any covenant not to compete…entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof.” But more and more courts refuse to enforce covenants not to compete in the context of the physician- patient relationship, concluding that such covenants are against public policy unless tailored to actually mean only non-solicitation.

Nevertheless, it has been common practice for business lawyers to continue to suggest that each physician in a group practice enter into an employment agreement or other entity document that imposes (or at least tries to impose) a covenant not to compete during and post-employment.  In the absence of such pre-existing non-compete and specific claim to ownership of patient records, however, the selling shareholders and not the entity are arguably possessed of “personal goodwill”, an intangible asset owned by the selling shareholders. To avoid the double tax imposed upon the sale by a C corporation,  maximize the benefits of a meaningful allocation of the purchase price in a sale transaction to intangibles or justify a larger signing bonus, it may be wise to reconsider owner non-compete provisions before the eminence of a sale transaction makes it too late to do so. 

Nobody wants a “Bad Actor” as part of its working group but, from the perspective of  the founder of a startup, the Securities and Exchange Commission’s proposed “bad actor” rules may wind up causing more injury than antidote. The good news is that the SEC is proposing amendments to its rules to implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act to disqualify securities offerings involving certain “felons and other ‘bad actors’” from reliance on the safe harbor from Securities Act registration provided by Rule 506 of Regulation D.  See 17 CFR Parts 230 and 239 (Release No.33-9211; File No. S7-21-11.  I agree with that effort but, since Rule 506 is one of the three exemptive rules for limited and private offerings under Regulation D, and by far the most popular, it is important that the definitions are carefully tailored.  Not all “disqualifying acts” are equal, and “covered persons” and the “bad actor” disqualification should apply only to issuer’s management and controlling equity holders rather than any holder of 10% or more of the entity’s equity.  And, even if those changes are not made, the reasonable investigation standard for determining whether “covered persons” are “bad actors” should be no more onerous than the current standard for accepting money from “accredited investors”. Without these changes to the proposed rules, the process of compliance will be beyond the budget and timeline of most startups. 

We’ve all heard of someone who hit the Enter key too quickly and sent an email he later regretted sending. Unfortunately, in some cases, the result is that the correspondents are deemed to have entered into a contract, without a formal writing and even in the face of evidence that the parties intended to later sign a formal contract. That was the case a few years ago when counsel for Amazon.com sent a one-word reply (“Correct”) to an email from opposing counsel outlining several specific terms of a settlement of a lawsuit. A Pennsylvania court faced a similar case in 2006, when it enforced an unsigned settlement agreement between Commerce Bank and First Union National Bank after concluding that the signing of the agreement was a mere formality since the parties had already evidenced their intent to be bound.

A company’s customer lists, price lists, marketing strategies, and other trade secrets are vital to its success. A smart business owner will ensure that key employees sign non-disclosure and non-compete agreements to protect the business if the employee leaves and takes a job with a competitor. But what if the company is sold? Does the buyer enjoy the benefits of the restrictive covenants contained in the selling company’s employment agreements? The answer is “it depends.” In Pennsylvania, if the purchase is structured as an asset purchase transaction, the buyer does not receive the benefit of the restrictive covenants contained in the seller’s agreements with its employees unless those agreements specifically state that the covenants are assignable. This is because these covenants are viewed as trade restraints that impair a former employee’s ability to earn a living and therefore are interpreted as narrowly as possible to protect the employer’s legitimate business interest.