Non-Compete Agreements Between Businesses More Likely to Be Held Enforceable

Noncompete agreements are typically found in employment agreements between employers and their employees. But that’s not the only place these clauses are found. Sometimes you’ll have two sophisticated companies of roughly equal bargaining power who, for whatever reason, wish to enter into a binding agreement placing restrictions on the one of the entity’s ability to compete with the other. Perhaps one company has acquired or merged with another and needs to ensure that the target company’s former officers and directors don’t immediately form a competing business and take their old clients with them. Or perhaps, as was the case recently in the dispute between wood-flooring contractors Lumber Liquidators and Cabinets To Go, two businesses with overlapping ownership simply seek to reach an agreement to reduce competition and minimize the sharing of confidential information. The important thing to note is that most of the reasons Virginia courts disfavor noncompete agreements have to do with fairness to the employee and do not apply when the two contracting parties are both businesses. Therefore, courts are much more likely to enforce noncompete agreements found in a business-to-business context than in an employment setting.

The basic facts of Lumber Liquidators v. Cabinets To Go are as follows. About 10 years ago, hardwood flooring retailer Lumber Liquidators learned that its Chairman and largest shareholder, Thomas D. Sullivan, was also involved in the ownership and operation of Cabinets To Go, which sold kitchen and bath fixtures and building supplies. Concerned that Sullivan might divert business opportunities or confidential business information over to Cabinets To Go, Lumber Liquidators entered into a number of agreements with Cabinets To Go. Among the agreements formed between the companies was a pair of “reciprocal restrictive covenants” in which Cabinets To Go agreed not to engage in the sale of hardwood flooring anywhere in the world during the term of the agreement and a period of two years thereafter. Lumber Liquidators similarly agreed not to sell kitchen cabinets.

According to Lumber Liquidators, Cabinets To Go started selling hardwood flooring before the term of the agreement had even expired. It sued for breach of contract in Henrico County, and Cabinets To Go removed the action to federal court in Richmond. Once there, it moved to dismiss, arguing that the noncompete agreement was unenforceable as a matter of Virginia law. Relying on cases like Modern Environments v. Stinnett, it argued that the restraint (1) is greater than necessary to protect a legitimate business interest, (2) is unduly harsh or oppressive, and/or (3) is unreasonable in light of public policy. The court disagreed, pointing out that the test applicable to the validity of noncompete clauses in employment contracts did not apply to similar two-towers-300x200clauses found in agreements between two sophisticated businesses.

Under Virginia law, a restrictive covenant between two businesses will generally be enforceable unless it is (1) unreasonable as between the parties or (2) injurious to the public. (See Merriman v. Cover, Drayton & Leonard, 51 S.E. 817, 819 (Va. 1905)). The party seeking to enforce a restrictive covenant has the burden of showing a legitimate business interest to protect and that the provision is not so large as to interfere with the public interest. (See Therapy Servs. v. Crystal City Nursing Ctr., Inc., 389 S.E.2d 710, 711 (Va. 1990)).

In the business-to-business context, it is not necessary to show that the restriction is no greater than necessary to protect the legitimate business interest, or that the restriction is not unduly harsh. This is because the ability of employees to earn a living is simply not implicated in these cases. When the noncompete agreement is between two sophisticated market actors, the concern is with the effect of anti-competitive conduct on the economy as a whole, rather than about an employee’s ability to earn a living. “Where two business entities agree to a restrictive covenant,” the court wrote in a footnote, citing a New York case, “there is generally no concern about the loss of individual’s livelihood or an imbalance of bargaining power.” Therefore, the court held, a less-restrictive test for enforceability was appropriate.

In this particular case, the court declined to decide the reasonableness issue on the pending motion to dismiss. Noting the Virginia Supreme Court’s preference for evidentiary hearings to determine reasonableness, the court denied the motion to dismiss, indicating that it would eventually want to hear evidence about the interests sought to be protected, information about the relevant market, and whether the noncompete agreement had any effect on the public interest. Lumber Liquidators would not, however, be required to produce evidence to address the factors applicable to the employer-employee context. Because the noncompete at issue was between two sophisticated businesses, Lumber Liquidators should have a much easier time persuading the court that the agreement is reasonable and enforceable.