BILL ANALYSIS
SENATE JUDICIARY COMMITTEE
Martha M. Escutia, Chair
2001-2002 Regular Session
AB 601 A
Assembly Member Leach B
As Amended June 3, 2002
Hearing Date: June 18, 2002 6
Business and Professions Code 0
GMO 1
SUBJECT
Sale of Business Entities: Noncompetition Clauses
DESCRIPTION
This bill would allow general partners, limited partners,
limited liability partners and limited liability company
members selling their interest and goodwill in their
respective business entity to enter a noncompetition
agreement with the buyer. The bill would make conforming
changes in related statutes.
The bill also would delete the reference to "county or
counties, city or cities, or parts thereof" as they relate
to a noncompetition agreement in these statutes, and
replace the clause with the more generic term "geographic
area," thus leaving the specific geographic coverage of a
noncompetition covenant up to the parties to negotiate in
the sale agreement.
BACKGROUND
Generally disliked by the courts, noncompetition agreements
have been struck down time and again when executed in the
context of an employment relationship. However, in the
context of the sale of a business, courts have upheld the
right of a business seller and buyer to enter into a
noncompetition agreement in conjunction with the sale
agreement. "Where a covenant not to compete is executed as
an adjunct of a sale of a business then there is an
(more)
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inference that the business had a "goodwill" and that it
was transferred." [ Monogram Industries, Inc. v. Sar
Industries, Inc. (1976) 64 Cal. App. 3d 692, quoting
Mahlstedt v. Fugit (1947) 79 Cal. App. 2nd 562.]
CHANGES TO EXISTING LAW
Existing law allows a person who sells the goodwill of a
business, or a shareholder of a corporation disposing of
all of his or her shares, or a corporation that sells all
or substantially all of its assets, together with its
goodwill, to enter into a noncompetition agreement with the
buyer of the business or the interest in the business.
[Business and Profession Code Section 16601. All references
are to the Business and Professions Code, unless otherwise
indicated.]
Existing law permits a partner in a partnership to enter
into a noncompetition agreement in the area where the
partnership business has been transacted, when the
partnership is dissolved, the partner dissociates from the
partnership, or the partner sells or disposes of his or her
interest in the partnership. [Sec. 16602.]
Existing law permits a member of a limited liability
company to enter into a noncompetition agreement within a
specified county or counties, city or cities or parts
thereof where the limited liability company has transacted
business, when the limited liability company is dissolved
or the member sells his or her interest in the limited
liability company. [Section 16602.1.]
This bill would extend the rules of Section 16601 to
general partnerships, limited partnerships, limited
liability partnerships, and limited liability companies to
allow the owner of an interest in those business entities
to enter a noncompetition agreement in connection with the
sale of his or her interest, together with goodwill. The
bill would use the term "business entity" to refer to the
business or interest being sold, and extend its meaning to
include a corporation, partnership, limited partnership,
limited liability partnership, and limited liability
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company.
This bill would delete the reference to "county or
counties, city or cities, or parts thereof" as to the
locations encompassed by noncompetition agreements, and
instead replace these terms with the more generic term
"geographic area."
The bill would define "business entity," "owner of a
business entity," "ownership interest" and "subsidiary" as
those terms are used in Section 16601.
COMMENT
1. Need for the bill
According to the sponsor, while current Section 16601
allows noncompetition covenants to be enforced in equity
transactions (stock sales) and in asset transactions
(sale of substantially all of the assets and related
goodwill), current Sections 16602 (dealing with general
partnerships) and 16602.1 (dealing with limited liability
companies) allow noncompetition covenants to be enforced
only when there is an equity transaction (the dissolution
of the partnership, a partner's dissociation from the
partnership, or a partner's or member's sale of their
equity interest in the business entity). Further, those
statutes are silent as to noncompetition agreements
involving the sale of assets of a limited partnership or
a limited liability partnership.
Proponents state that this bill is necessary to eliminate
the current unfair and unnecessary distinction between
corporations, partnerships and LLCs, and treat all
businesses in the same manner with respect to covenants
not to compete.
AB 601 would extend the rule now applicable only to
corporations to all other types of business entities
(general partnership, limited partnership, limited
liability partnership, limited liability company). This,
the sponsor states, "will allow a buyer of substantially
all of the assets and goodwill of a partnership or LLC to
enforce a noncompetition agreement against the seller in
the same way as the law currently allows a buyer of
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substantially all of the assets and goodwill of a
corporation to enforce the restrictive covenant against
the selling corporation."
2. Allowing noncompetition covenants in sale of business
Noncompetition agreements in the sale of corporate assets
and goodwill have been recognized in case law for
sometime. For example, the current jury instructions on
covenants not to compete ("a covenant not to compete will
be enforced to the extent that it is reasonable and
necessary in terms of time, activity and territory to
protect the buyer's interest") was taken verbatim from
Monogram Industries, Inc. v. Sar Industries, Inc. (1976)
64 Cal.App.3d 692, 698.
While current statutory law validates such noncompetition
covenants where the business being sold is a corporation
or substantial assets of a corporation or its subsidiary
or division, even when the corporation itself does not
dissolve, the law is not so clear as it applies to the
other types of business entities in California. Thus,
this bill would allow buyers and sellers of any business
entity to enter into a valid and enforceable covenant not
to compete as a part or condition of sale of the business
entity (whether a corporation, general partnership,
limited partnership, limited liability partnership, or
limited liability company).
A practical application of why noncompetition clauses are
used in agreements to sell a business is described by the
sponsor. For example, a purchaser of a business wants to
acquire the business assets without assuming known
liabilities (as in a buyer purchasing an LLC). In this
case, in order to protect itself against potential claims
and to ensure that adequate funds would exist to pay
these unknown claims, a prudent buyer may purchase the
assets of the LLC but require that the LLC agree to
indemnify the buyer against the claims and that the LLC
agree not to dissolve and to retain funds from the sale
for the purpose of settling claims. Here, the buyer may
want the members of the LLC to also sign non-competition
covenants in order to provide more value to the LLC
assets that are being sold.
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While already permitted by statute, noncompetition
clauses in sale agreements involving small businesses,
e.g., where the business is one generated by the owner's
trade or profession, have been guarded by the courts, to
prevent the owner's loss of livelihood for instance. The
sponsors state that generally, the courts have validated
these clauses in cases where the duration of the
noncompetition clause is no more than one or two years,
but certainly no longer than five years. Also, besides
the limitations on duration, the courts have looked at
the geographic boundaries involved in the context of the
particular business, as well as the type of activity
covered by the noncompetition covenant. These
limitations, while not in the statute, have evolved
through litigation over the enforceability of these
noncompetition covenants.
This bill would not provide any specific limitations on
the time, activity or geographic boundaries that a
noncompetition agreement or covenant may cover, leaving
such terms and conditions to negotiations between the
parties, and interpretation by a court, should any
dispute arise as to the enforceability of the covenant.
3. Non-competition agreements: new rule regarding
geographical limitations
Section 16601 was amended in 1941 to extend the
application of a covenant not to compete from "a county,
city, or part thereof" to "a county or counties, city or
cities, or a part thereof," apparently in recognition of
the expanding market of a business that provides value to
the business when sold with the goodwill. Later
amendments related to other language in the statute.
In Fleming v. Ray-Suzuki (1990) 225 C.A. 3d 574, the
court held that the covenant (to not compete) is not
limited to state boundaries by federal regulation of
interstate commerce, and the "counties and cities"
provision of the statute (Section 16601) did not limit
the covenant to California. Accordingly, the seller of a
worldwide mail order business was held liable to the
buyer for violation of its covenant not to compete "in
the United States." The court cited Monogram, supra,
and said: "We think the language of Business and
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Professions Code Section 16601 limiting the scope of
covenants to 'counties and cities' cannot rationally be
limited to California. Monogram upheld a covenant of
national scope because it covered the area of business
dealings represented by the goodwill that was sold. That
analysis is applicable to this case? The territory
encompassed here was merely an accumulation of those
cities and counties impacted by the market area of the
business which was sold."
In fact, Monogram held that "in the provisions of Section
16601 the area where a business is 'carried on' is not
limited to the locations of its buildings, plants and
warehouses, nor the area in which it actually made sales.
The territorial limits are coextensive with the entire
area in which the parties conducted all phases of their
business including production, promotional and marketing
activities as well as sales?Considering the nature of the
market being addressed by the parties, city, county or
even state boundaries are not significant?" The court
went on to state that the extent of coverage of the
covenant appears to be what is reasonably necessary to
protect Monogram's interest.
In light of the new rule described above, which permits
noncompetition agreements to apply to business beyond
cities and counties and indeed, the state, when a
business entity is sold with its goodwill, the bill has
been amended to conform Sections 16601, 16602 and 16602.5
with the generic reference to "geographic area" instead
of to "city or cities, county or counties, or parts
thereof." This would leave the specific geographic
boundaries, if any, of such a noncompetition covenant to
the parties to negotiate.
However, the language of the statute and the intent of
this bill would not allow overreaching by a buyer to
restrict a seller's ability to enter the same business in
a geographic area that is outside the area where the sold
business had been carried on ("[a seller]?may agree with
the buyer to refrain from carrying on a similar business
within a specified geographical area in which the
business so sold?has been carried on, so long as the
buyer?carries on a like business therein"). Should a
small mom-and-pop specialty grocery in San Francisco, for
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example, sell the grocery and its goodwill together with
a covenant not to compete within Northern California,
when the grocery sold goods only to San Francisco
residents and businesses, a court asked to enforce the
covenant not to compete when the mom-and-pop grocers open
a store in Sacramento would most likely find that the
buyers overreached by establishing a vast greater
geographic region than the seller contemplated and the
statute intended.
4. Non-competition agreements as applied to law firms
organized as partnerships or limited liability
partnerships
Partnerships involving attorneys, while subject to
Business and Professions Code 16602 (which allows
noncompetition agreements when a partnership dissolves, a
partner dissociates, or a partner sells or disposes of
his or her partnerhsip interest) are nevertheless
governed by the Rules of Professional Conduct I-500.
Rule I-500 prohibits noncompetition agreements involving
law partnerships or LLP's, except under certain
circumstances.
This bill, while extending Section 16601 to partnerships,
limited partnerships, and limited liability partnerships,
would not affect the current application of Rule I-500 to
partnerships involving attorneys.
5. Definitions: owner, interest, subsidiary
This bill would define the terms "owner of a business
entity," "ownership interest," "business entity," and
"subsidiary" for purposes of Section 16601.
Of note is the expansion of the definition of
"subsidiary" contained in current Section 16601. Current
language defines "subsidiary" as a "corporation, a
majority of whose voting shares are owned by the selling
corporation."
This bill would define "subsidiary" as "any business
entity over which the selling business entity has voting
control or from which the selling business entity has a
right to receive a majority share of distributions upon
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dissolution or other liquidation of the business entity
(or has both voting control and a right to receive these
distributions)."
This definition is in keeping with more recent
permutations of businesses or interests in businesses
that may be owned or affiliated with another, and sold.
Support: None Known
Opposition: None Known
HISTORY
Source: Business Law Section, State Bar of California
Related Pending Legislation: None Known
Prior Legislation: None Known
Prior Vote: Asm. B & F. (Ayes 10, Noes 0);
Asm. Flr. (Ayes 77, Noes 0)
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