July 13 2011
Protection of goodwill by non-compete clauses
Protection of goodwill by non-compete clauses
A company's profitability depends significantly on its reputation with its customers, suppliers and other market participants (ie, its goodwill), as well as on the special market, production, marketing and other know-how of its employees. These assets are usually not protected by patents or similar IP rights. Therefore, the buyer of a business would be well advised to insist on a non-compete clause.
The economic impact of non-compete clauses can be seen in a recent International Chamber of Commerce (ICC) arbitral award. Energy company Areva was awarded €648 million plus interest in compensation from a former joint venture partner for the violation of a non-compete clause. The clause prohibited competition with Areva in the nuclear power industry for a period of eight years. However, the ICC arbitral tribunal reduced the validity of the non-compete clause from eight to four years. This ruling touches on the most important legal aspects of non-compete clauses under German law: what is the maximum period of a non-compete clause and can an excessively long clause be reduced to an acceptable duration?
There are no explicit statutory provisions on the vendor of a business regarding a non-compete obligation. Sections 60 and 74 of the Commercial Code, regarding non-compete obligations for commercial employees and commercial agents, are not applicable.
No compensation for non-competition
Company employees, agents and directors are subject to an implied non-compete obligation in their contract; this obligation generally ends when the contract is terminated. Post-contractual non-compete clauses constitute additional obligations which can significantly hinder an employee or agent's professional progress; therefore, the issue of adequate compensation is raised within this context.
However, when it comes to the sale of a business, the situation is different. The buyer will want to profit from the business's existing goodwill. This will require the vendor to refrain from using that goodwill for its own purposes immediately after the transfer of the business. Therefore, the seller is subject to an implicit contractual non-compete obligation for an appropriate period of time after the transfer of the business, without any particular compensation.
Under German law, non-compete obligations must not excessively hinder future competition by the vendor of the business. The relevant test refers to three criteria:
With respect to the maximum duration of a non-compete obligation, the jurisprudence has been labelled as confusing.(1) While two years appears to be always acceptable, it seems that the maximum duration of a non-compete obligation accepted by a German court has been five years,(2) whereas seven and 10 years were deemed as too long. Whether periods of up to five years are considered acceptable will depend on the circumstances of an individual case. There seems to be a trend to regard two years as the upper limit.(3) While the Federal Court of Justice has, in single cases, referred to Section 90a of the Commercial Code, which establishes a two-year limit for non-compete clauses binding commercial agents, there does not seem to be consistency in its decisions. Any longer periods (ie, between three and five years) must be justified by the seller as being in its legitimate interests.
Reduction to maximum duration
Where a non-compete period is considered to be too long, a court may reduce it to the acceptable maximum duration. Originally it was argued that a reduction to the acceptable maximum duration would encourage buyers to seek an exaggerated non-compete period, knowing that at worst, such a clause would be reduced to the acceptable maximum duration. Meanwhile, the jurisprudence argues on the basis of Section 139 of the Civil Code that where a clause can be split into several parts, single parts can be upheld as permissible. Accordingly, an excessive non-compete clause can be split into several time periods, of which only some exceed the maximum duration. However, complete (not partial) invalidity is assumed in cases of excessive non-compete clauses. Therefore, a non-compete obligation is totally invalid where sufficient protection could have been achieved through a simple customer protection clause. The situation is unclear with respect to excessive territorial restriction. The Federal Court of Justice has left this question open.(4)
Non-compete obligations always incorporate a certain antitrust relevance. Under German law, agreements which are entered into by companies for a common purpose are invalid if they restrict competition within markets with respect to the delivery of goods or the rendering of commercial services. However, no such prohibited common purpose within the meaning of the law exists where a non-compete obligation is justified to protect the legitimate expectations of a buyer in the framework of a business acquisition. In such cases the non-compete obligation aims at securing the main purpose of the agreement without showing a particular antitrust relevance. However, the legitimate expectations of a buyer can be protected only within the aforementioned limits of scope, geographic area and duration.
As far as EU law is applicable with respect to the impact of non-compete obligations on the EU market, the European Commission's notification on restriction of competition in the framework of mergers and acquisitions (2005/C-56/03) must be taken into consideration:
"In case a company is transferred together with its goodwill and the know-how, non-compete obligations are admissible for a period of 3 years. In case only the goodwill is transferred, such period is limited to the maximum of 2 years."
The Federal Court of Justice has explicitly referred to the above principle, even in cases where only German law is applicable.
A buyer is recommended to ask the seller for a long non-compete obligation. If it is too long, a German court will simply reduce the duration to the acceptable maximum duration.
If the buyer wants to bind the seller for more than two years, the buyer should (eg, in the recitals) indicate special circumstances to justify the period - for example, if the acquired company possesses special know-how that must be protected. In any case, the contract should contain a severance clause.
Moreover, the buyer should also define the scope and territorial area of the business in the recitals; where the non-compete obligation applies Europe-wide, it is practical to indicate that the acquired business operates throughout Europe. In contrast, from the seller's point of view, it would be advantageous to insist on a relatively narrow field of activity of the sold business in order to limit the non-compete obligation.
If it is unclear whether a customer protection clause is sufficient to protect the buyer's interests, the buyer should insist on a non-compete obligation that is clearly separated from the customer protection clause. This will improve the chances of the customer protection clause being upheld if the non-compete obligation is deemed invalid.
A non-compete-obligation should be accompanied by a penalty clause. Under certain circumstances it may be appropriate to include an additional non-solicitation clause.
The materials contained on this website are for general information purposes only and are subject to the disclaimer.
ILO is a premium online legal update service for major companies and law firms worldwide. In-house corporate counsel and other users of legal services, as well as law firm partners, qualify for a free subscription.
Karl von Hase