A recent case out of the Eastern District of New York raises interesting questions about the use of non-compete agreements in connection with merger talks. Let’s take a look:
Calico Cottage, Inc. is a New York company engaged in the wholesale fudge business. That’s right. Calico sells both the ingredients needed to make fudge, fudge mixes and finished fudge to retailers throughout the country. These retailers then resell the products under their own brand names. TNB, Inc. is a Florida company that does business under the name The Nutty Bavarian. TNB sells equipment and supplies needed to glaze and roast nuts. In the fall of 2006, Calico and TNB began talks about a possible partnership. In connection with these merger talks, the parties entered an agreement entitled Agreement of Non-Disclosure, Non-Use and Non-Competition.
The Agreement contained non-disclosure provisions that prevented each party from using or disclosing the other party’s confidential information. But most significantly, the Agreement contained a five-year non-compete provision that would run from January 30, 2007 until January 29, 2012. During that term, the parties agreed not to enter the business of the other party. Beyond this, the parties agreed to a number of other restrictions. Under the Agreement, neither party would:
• Employ any employee of the other party
• Interfere with any customer relationship of the other party
• Engage the services of any representative of the other party
• Utilize employees or representatives of the other party to sell products
Let’s stop right there: This is somewhat unorthodox. Often, when companies engage in talks regarding a merger, joint-venture or other joint endeavor, they enter a confidentiality and non-disclosure agreement. These agreements generally prohibit the parties from using or disclosing any of the other side’s confidential information. In the instant case, the parties took it a step further and added a non-compete provision to the mix.
In March 2007, TNB’s president met with Calico’s management. During that meeting, Calico disclosed certain financial and business information to TNB. Shortly after the meeting, TNB terminated the merger talks. Sometime thereafter, TNB apparently began selling fudge mixes and – in fact – sold some fudge mixes to Cabela, a retail chain and long-time Calico customer. Predictably, Calico sued alleging breach of the Agreement. After discovery, both parties moved for summary judgment. Defendant TNB argued (1) that the Agreement was unenforceable for lack of consideration and (2) that the non-compete and non-solicitation restrictions were unenforceable for lack of a legitimate business interest.
First, the court evaluated the question of consideration. Under New York law (which is consistent with the law of many other states on this point), courts do not consider the adequacy or value of consideration. Instead, it’s a yes or no question: Was their consideration or not. To the casual observer, it seems that the issue of consideration would operate as follows: Both parties had to give something (the consideration) to support the Agreement, which contained various restrictive covenants. In this instance, that something was supposed to be confidential information. The parties exchanged confidential information (the consideration) in exchange for the Agreement and the restrictive covenants contained therein.
Defendant TNB argued that this framework could not apply because Calico never gave it any information that actually was confidential. If there was no confidential information exchanged, then there was a failure of consideration and the Agreement should be unenforceable. That makes sense to me. But the Court disagreed. Instead, the Court held that the Agreement was supported by consideration in the form of the mutual promise not to enter each other’s business for the next five years. In my view, this logic strains credulity: The Agreement itself was an agreement not to enter each other’s business. That’s like saying, “The agreement not to compete is sufficient consideration to support the non-compete agreement.” I don’t buy it.
After disposing of the consideration issue, the Court moved on to the restrictive covenants. TNB argued that the restrictive covenants were not enforceable under New York law for lack of a legitimate business interest. The Court applied a rule of reason analysis.
Many people (including practitioners) seem to forget that agreements not to compete are restraints of trade and potentially antitrust. State non-compete statutes merely codify a variant of the rule of reason analysis. Under New York law, courts analyze enforceability of restrictive covenants in ordinary commercial contracts under the rule of reason. In applying the rule of reason, the court considers (1) whether Plaintiff has demonstrated a legitimate business interest that warrants the enforcement of the restrictive covenants; (2) the reasonableness of the geographic scope and temporal duration; and (3) the degree of hardship that enforcing these covenants would inflict upon Defendant.
Calico argued that the restrictive covenants contained in the Agreement were necessary to protect its confidential information and to prevent TNB from using that information to engage in unfair competition. TNB countered by arguing that none of the information at issue was confidential. During the Parties’ merger talks, both sides exchanged information. The Plaintiff made a presentation of various financial data that included the potential combined profits of a joint Calico-TNB enterprise, both parties pre-tax profits for 2006, a chart listing sales to customers they had in common, and a chart of Calico’s fudge sales to those common customers.
Although the Court denied cross motions for summary judgment on this issue, it was skeptical of Calico’s claims: Calico failed to explain – in any specific terms – how TNB could have used the information at issue to engage in unfair competition. As the Court put it:
“Plaintiff’s argument can be summarized as follows: the parties agreed to a non-compete for five years in order to facilitate merger discussions, Plaintiff shared what it considers to be confidential information, and Defendant did in fact compete within that five-year period; therefore, Defendant is liable. Plaintiff skips the critical step of connecting the disclosed information with the subsequent, alleged unfair competition.”
The Court then made quick work of the remaining issues, denying cross motions for summary judgment on TNB’s counterclaims. Those were Lanham Act claims based on allegations that Calico was cybersquatting on TNB domains and redirecting those domains to its own website. It appears that the case is set for trial.
Some things to note:
(1) The case has been in litigation for 3 years. Back in 2011, Calico sought a preliminary injunction, which the Court rightfully denied. Recall that Calico’s entire case was built on the allegation that TNB got into the fudge business and sold some fudge to one of its customers. So at issue is this one Calico customer. Predictably, Calico tried to use these facts as the basis for an argument about its goodwill. Calico argued that TNB’s selling fudge to one of its customers was a tremendous threat to its goodwill and that the Court should essentially presume irreparable harm. The Court rejected that argument out of hand, noting that under New York law, the loss of a customer, without something more, some special damage, did not constitute irreparable harm.
(2) A comparative note about irreparable harm: Some states actually presume that irreparable harm flows from the breach of a valid restrictive covenant. For instance, Florida, which is the most aggressively pro-non-compete state in the country, presumes irreparable harm. This presumption is supposed to be rebuttable. In practice, however, Florida state courts usually treat the presumption as conclusive. This leads to an interesting question regarding the interplay between state law presumptions of irreparable harm and the Federal Rules of Civil Procedure. Federal courts must apply federal procedural law. In my view, a presumption of irreparable harm in the context of a preliminary injunction is procedural. As such, federal procedural law should trump and movants should be required to establish irreparable harm. Yet, there are some federal non-compete cases in which courts appear to accept state law procedural presumptions of irreparable harm. In my view, this is in error. Preliminary injunctions are an extraordinary remedy and the party seeking such an injunction should be required to affirmatively carry its burden.
(3) Non-compete vs. non-disclosure: In my experience, when companies are discussing possible mergers or joint ventures, they sign confidentiality and non-disclosure agreements. This is sufficient to protect their interests. In the instant case, the parties added a non-compete agreement to the mix. This is problematic for a number of reasons. First, if there really was confidential information at stake, then there would be a legitimate need to prevent either side from unfairly utilizing confidential information it obtained during the courting process. That can be accomplished via a standard confidentiality agreement that prohibits use or disclosure. A non-compete provision, in this situation, is a greater restraint than necessary to protect any legitimate business interest.
Think about this: You have two companies that are in technically different markets, but markets with a good deal of overlap (e.g. the candy business at large). And more significantly, one of the parties (TNB) is interested in entering the other’s market. So TNB is a potential market entrant and potential rival of Calico. You have potential rivals agreeing not to compete. To me, that’s a problem.
The case is Calico Cottage, Inc. v. TNB, Inc., 11-CV-0336, 2014 WL 4828774 (E.D.N.Y. Sept. 29, 2014).
Jonathan Pollard is a trial lawyer and litigator based on Fort Lauderdale, Florida. He focuses his practice on defending non-compete and trade secret claims. Jonathan routinely represents doctors, corporate executives and other high level employees who are switching companies, or, who have started their own ventures. Beyond litigation, Jonathan advises employees, companies and business owners regarding restrictive covenant issues in connection with employment contracts, separation agreements, hiring decisions, the purchase or sale of business interests and the execution of commercial leases. Jonathan has been interviewed about non-compete issues by reporters from INC Magazine, the BBC, the National Federation of Independent Business and The Tampa Bay Times. In addition to his background in non-compete and trade secrets work, Jonathan has broad experience as a competition lawyer, generally, and has litigated numerous cases under both the Sherman and Lanham Acts. He is licensed in all Florida federal and state courts and routinely represents clients in Miami, Fort Lauderdale, West Palm Beach, Fort Myers, Tampa, Orlando and Jacksonville. His office can be reached at 954-332-2380. For more information, visit http://www.pollardllc.com.