In Samuelian v. Life Generations Healthcare, LLC— Cal. App. 5th —, 2024 WL 3878448 (Cal. App. Aug. 20, 2024), the California Court of Appeals answered two long-standing questions of California law regarding the enforceability of non-compete agreements in the sale of a business:
- Yes, a partial sale of an ownership interest in a business can support a non-compete agreement under the Rule of Reason (although the exception for the sale of a business under Section 16601 of the Business & Professions Code, which allows non-compete agreements, does not support the sale of a entire Ownership share And associated goodwill, otherwise it is ‘per se void’); and
- Yes, membership in a limited liability company (“LLC”) may potentially give rise to a non-compete agreement during the term of membership if there are contractual provisions that impose fiduciary duties on the member.
In Samuelictwo members of the defendant LLC sold a portion of their interest in the company but retained a minority interest with voting and information rights. The operating agreement imposed fiduciary duties on all members of the company, including a provision that they could not compete with the company while they were members. The company alleged that the two partially selling members had breached the non-compete clause, which triggered the company’s right to acquire their remaining ownership interests. The members argued that the non-compete clause was invalid per se under California law, while the company argued that the non-compete clause must be evaluated under a “rule of reason.” Until SameulianIn no case were the issues raised by this case addressed.
In Ixchel Pharma, LLC v. Biogen, Inc.9 Cal. 5th 1130 (2020), the California Supreme Court clarified that the “void per se” standard applies in the context of employment contracts and the sale of a business, while a “reasonableness” standard applies to contracts between businesses. ie“Agreements restricting commercial relations and business activities”. Previously, in Edwards v Arthur Andersen LLP44 Cal. 4th 937 (2008), the California Supreme Court had rejected the common law “reasonableness rule” for non-compete agreements in employment relationships and instead held that Business & Professions Code Section 16600 voids non-compete agreements per se unless they fall within one of the statutory exceptions (generally, the sale of an entire interest in a business and the goodwill associated with it).
It was unclear after Ixchel how courts would apply the new rule of reason standard to business-to-business transactions outside the joint venture context of this case, and whether courts would expand the scope of the business-to-business exceptions beyond the three statutory exceptions in sections 16601, 16602, and 16602.5. Samuelicthe California Court of Appeals ruled that the reasonableness standard also applies to partial sales of a business under certain circumstances. In making that decision, the court first examined the purpose of Section 16600: “a stated legislative policy in favor of open competition and labor mobility.” The court reasoned that in a partial sale of a business, “the seller retains ownership of the business… and may have some degree of control over its operation” and that “because of this continuing connection, non-compete agreements arising from a partial sale must be evaluated under the reasonableness standard to determine whether they have pro-competitive benefits.” Under Samuelicthe maintenance of a non-compete obligation in the context of a partial sale of an undertaking requires an assessment of whether the prohibition is more harmful or more conducive to competition and is ‘proportionate in view of the seller’s continuing link with the undertaking’, taking into account ‘the particular facts of the undertaking to which the prohibition applies, the nature of the prohibition and its effects, as well as the history of the prohibition and the reasons for its introduction’.
The court explained that after a partial sale, selling owners may owe a fiduciary duty to the company that prohibits them from competing with it, and that imposing a “per se invalid” rule would “unnecessarily interfere with those fiduciary duties.” The court also held that while the California Revised Uniform Limited Liability Act does not provide for the de facto imposition of fiduciary duties on members of a manager-managed company, those duties may be contractually imposed in the company’s operating agreement. With this decision, the court affirmed the continuing validity of non-compete agreements in the employment context.
The Samuelic The decision fills an important gap in California law regarding the partial sale of a business interest and is a reminder that companies should consult with counsel to carefully consider whether to impose contractual fiduciary duties on members in operating agreements, as well as how to structure any non-compete and other restraints of competition so that they are reasonable or otherwise fall within one of the statutory exceptions under Section 16600. ff.
