Getting It Right: The"Sale of Assets" Exception to California's Ban on Non-Competes and the Limits of Choice of Law Provisions

As many business owners know, California is one of a handful of states that ban or sharply limit non-competition agreements. An important exception to California's general prohibition of non-competes exists in the context of a sale of a business or the goodwill of a business, the idea being that a buyer should be permitted to bargain for assurance that the seller will not turn around and start competing in the same market immediately following the sale. However, a recent Delaware case applying California law illustrates that the devil is in the details.

In Ascension Insurance Holdings, LLC v. Underwood et al., the Delaware Court of Chancery refused to enforce a non-compete agreement between a California resident and a Delaware company doing business in California—despite provisions calling for Delaware venue and choice of law. This result may seem surprising given that Delaware strongly favors enforcement of contracts in general and non-competition agreements in particular. But even though the plaintiff had acquired the business at issue in an asset purchase from the defendant, and even though the defendant had entered into a non-competition agreement with the plaintiff, the Delaware court found that California’s “sale of business” exception did not apply because the non-compete was not a negotiated part of the asset purchase. The non-compete was actually part of the defendant’s later purchase of an interest the parent company, not his original sale of the business at issue.

The case would undoubtedly have come out differently had the Court applied Delaware law. But the Court applied California law, citing the following principle from the Restatement (Second) of Conflict of Laws: “[W]here the parties enter a contract which, absent a choice of-law provision, would be governed by the law of a particular state (which I will call the ‘default state’), and the default state has a public policy under which a contractual provision would be limited or void, the Restatement recognizes that allowing the parties to contract around that public policy would be an unwholesome exercise of freedom of contract.” In the Ascension case, one party to the non-competition agreement was a California resident, the other had its principal place of business in California, and the agreement was executed in California. Thus the agreement would have been governed by California law in the absence of the Delaware choice-of-law provision. Applying the Restatement rule, the Delaware Court held that the parties could not avoid California public policy simply by including a Delaware choice-of-law provision.

The Ascension case is a reminder of the caution necessary when dealing with California non-compete law. Notably, the rule applied in the Ascension decision is the same rule used by courts in many states when considering conflict of law questions. Those looking to acquire a business in California cannot rely solely on a choice-of-law provision, whether it calls for the application of the law of Delaware or the law of another favorable jurisdiction, to avoid the implications of California non-compete law. To take advantage of the "sale of business" exception, a buyer must ensure that all statutory requirements are met, and, further, should consider appropriately crafted nondisclosure agreements and other provisions to help protect their competitive interests.