The Law of Trade Secrecy and Covenants Not to Compete in Colorado-part Ii

• Publication year: 2001
• Pages: 5

30 Colo.Law. 5 Colorado Lawyer 2001.

2001, May, Pg. 5. The Law of Trade Secrecy and Covenants Not to Compete in Colorado-Part II

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Vol. 30, No. 5, Pg. 5

The Colorado Lawyer
May 2001
Vol. 30, No. 5 [Page 5]

Articles

The Law of Trade Secrecy and Covenants Not to Compete in Colorado - Part II
by John F. Reha

In Part I of this article, which appeared in the April 2001 issue,1 the focus was on trade secrecy. In this Part II attention shifts to the law relating to covenants not to compete. As in the area of trade secrecy, the past ten years have seen a marked increase in activity regarding non-compete covenants. Colorado law is somewhat unique in that, in 1973 the Colorado General Assembly enacted a statutory prohibition against most non-compete agreements.2 The statutory prohibition is discussed in detail below, as well as the numerous cases that have arisen under the exceptions to the statute. This article also discusses the common-law factors that are still part of Colorado law regarding covenants not to compete, such as the rule of reasonableness for time and geographic restrictions. Finally, the article covers common drafting and litigation issues Colorado attorneys are likely to encounter

PROTECTING GOODWILL

Covenants not to compete protect the legitimate interest in goodwill of an established business.3 In turn, "(g)oodwill has no existence as property in and of itself, but rather is an incident of a continuing business having a particular locality or name."4 Goodwill is "the expectation of continued and repeated public patronage."5 When a business is liquidated, its goodwill ceases to exist, and a covenant not to compete that had been entered into to protect such business lapses as an unenforceable restraint of trade.6

Non-compete covenants are agreements that prohibit one or more persons or entities from competing with another, usually in a defined territory, for a set period of time. They may bar all competition or certain types of activities only, such as maintaining business relations with certain customers or co-employees. They arise most often in employment agreements,7 but are also common in sale of business transactions.8 On occasion, they are encountered in other contexts as well. For example, in Harrison v. Albright,9 a covenant not to compete was included as part of the collateral securing a business loan. In Marriage of Fischer,10 the Colorado Court of Appeals approved the imposition of a non-compete covenant in a divorce proceeding between a husband and wife who were also business partners. The business was awarded to the wife, while the husband was awarded cash equal to his half-interest. Finding that the husband was intricately involved in management, the covenant was imposed by the trial court in order to protect the business's viability.

THE COLORADO STATUTE AND EXCEPTIONS

In Colorado, a discussion of covenants not to compete in current practice must begin with a review of CRS § 8-2-113(2), which provides as follows:

Any covenant not to compete which restricts the right of any person to receive compensation for performance of skilled or unskilled labor for any employer shall be void, but this subsection (2) shall not apply to:

(a) Any contract for the purchase and sale of a business or the assets of a business;

(b) Any contract for the protection of trade secrets;

(c) Any contractual provision providing for recovery of the expense of educating and training an employee who has served an employer for a period of less than two years; and

(d) Executive and management personnel and officers and employees who constitute professional staff to executive and management personnel.

From its express language, it is clear that § 113(2) generally provides that covenants not to compete are void. Covenants that do not meet one of the exceptions are void ab initio.11 It is only through one of the exceptions set forth in subsections (2)(a) through (d) that a covenant not to compete may be enforceable in Colorado. The exceptions accordingly form much of the basis of the practice of law in Colorado regarding covenants not to compete. The exceptions to the rule of invalidity set forth in subsections (2)(a), (c) and (d) are examined below. The "trade secrets" exception of subsection (2)(b) was discussed in Part I of this article.12

John F. Reha, Littleton, is a partner in the firm of Arckey & Reha, L.L.C.?(303) 798-8546. Reha has a general business practice with an emphasis on intangible asset protection issues, including drafting and litigation issues related to trade secrecy and competition restrictions. The author would like to thank his partner, Tom Arckey, for his invaluable assistance with this article and "for keeping the (billable) home fires burning" while the author was busy writing this article.

Business Sales:
CRS § 8-2-113(2)(a)

Under subsection (2)(a) "contract(s) for the purchase and sale of a business or the assets of a business" are exempt from the rule of invalidity.13 By its terms, subsection (2)(a) exempts both stock and asset acquisitions. Accordingly, all transactions in which the entirety of the stock or assets of a business are sold are exempt. In Boulder Medical Center v. Moore,14 the Court of Appeals applied the sale of business exception to, what at least appears to be, the sale of a minority ownership position under the "buy-sell" provisions of an agreement between shareholders of a group medical practice. In Albright,15the court applied the sale of business exception by analogy to a situation where a private investor loaned start-up capital to an electrical contracting concern. One of the principals of the business elected to resign and open a competing contracting firm. The court affirmed the enforcement of a covenant not to compete contained in the collateral provisions securing the loan, noting that such situation was akin to the sale of a business.16

Although the express terms of subsection (2)(a) look to the "sale and purchase of a business or the assets of a business," it is uncertain whether Colorado would apply the sale of business exception to a situation in which compensation is given to an employee in the form of ownership of a minority interest in the company seeking enforcement (as with stock bonuses). However, it does appear that the exception will be enforced, as in Moore,17 when a key principal in a closely held concern sells his or her ownership interest back to the entity or other principals.

A "sale" may also be imposed. In Marriage of Fischer,18 a divorce court imposed a covenant not to compete against a husband when it awarded the divorcing couple's business to the wife. The Colorado Court of Appeals found "the transfer of a business interest to one spouse as part of the disposition of property in a dissolution action is analogous to a sale of the business and, therefore, falls within the exception of § 8-2-113(2)(a)."19 Although covenants not to compete are disfavored in Colorado and the exceptions are accordingly narrowly construed, those arising under the sale of business exception will be construed more liberally than those arising out of employment relationships.20

Trade Secrecy Agreements: CRS § 8-2-113(2)(b)

This exception was discussed in detail in Part I of this article.21

Education and Training
Expense Recoupment:
CRS § 8-2-113(2)(c)

Although this provision is set forth as an exception to the general rule of invalidity of covenants not to compete, it does not necessarily relate to such agreements. In practice, this "exception" allows employers to recoup expenses of training and education for employees who have been employed less than two years at termination.22 Recoupment of such expenses will be allowed, however, only where an agreement expressly providing for such recoupment exists between the employer and employee.23

Executives, Managers,
And Professionals:
CRS § 8-2-113(2)(d)

Under subsection (2)(d), covenants with those persons who qualify as executive or management personnel or "professional staff to management" are exempt from the general rule of invalidity. The determination of whether an employee is a manager or executive is an issue of fact.24 Generally, if an employee is "in charge" of a significant portion of the plaintiff's business or other employees and/or if such person "act[s] in an unsupervised capacity," such person will fall within the exception.25 The U.S. District Court for the District of Colorado has stated that "(t)o be part of the group 'executive and management personnel' an employee must have significant responsibility for the business and act in a supervisory capacity."26

Cases making determinations as to inclusion of an employee within the management, executive, and professional exception include Marriage of Fischer,27 where the husband/business partner was "in charge of" a photo finishing business, and Albright,28 where the partner in an electrical contracting business "was the only person who possessed the knowledge, skills, and the licenses to make the business a possible success" and was therefore "the key man and very heart of the business."

In Atmel Corp. v. Vitesse Semiconductor Corp.,29decided in February 2001, the Court of Appeals found unsupported by the evidence a conclusion reached by the trial court that a certain "technical liaison" employee who left to join a competing venture came within the management executive, or professional exception. After noting that the exception "applies to those employees who are 'in charge' of the business and who act in an unsupervised manner,"30 the court found that the employee in question did not supervise any other employees and, in fact,...