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Archive for the ‘Contracts’ Category

In a little noticed case reported on December 19, 2011, Condo v. Conners, the Colorado Supreme Court issued a decision on a common contract drafting problem – the effect of an anti-assignment clause.

Historically, when contracting parties wanted to prohibit each other from assigning the contract, a lawyer would include language reading something like: “A party shall not assign, sell or otherwise transfer its rights under this agreement without the written consent of the other party.”

Back in the day, that language accomplished the parties’ intent, because courts held it meant that a party did not have the power to assign a contract, and any assignment without consent would be void and treated as though it never happened. That is the “classical” or “historical” rule.

Over the last 10-20 years, a new rule has developed; some courts have held that language prohibiting assignment does not mean the parties can’t assign, it means that if they do it is a breach of the contract, but the assignment still stands. The foundation of the new rule is a public policy that the law favors assignability of contract rights. Under the new rule if a party assigns the contract without consent and in breach of the contract language, the other party could not bring an action to void or ignore the assignment, but could only bring an action for damages – a very bad outcome for someone who simply doesn’t want to be in a contract with a party he didn’t chose! Moreover, in most situations it is very difficult to measure and prove damages arising from a prohibited assignment.

Anti-assignment clauses are found in many types of contracts, but are particularly important in contracts where people are going into business together, like partnership agreements, joint venture agreements and limited liability company operating agreements. For example, if three people decide to join-up and start a business, they are usually counting on one another to contribute some special area of expertise, to invest time and money, and to be there for the others, at least until the business is established. They do not want to suddenly find they have a new business partner because one of them sold his interest or transferred it in a divorce, and that is exactly what happened in this case.

In Condo v. Conners, three people formed a Colorado limited liability company and signed an operating agreement that said “a member shall not sell, assign, pledge or otherwise transfer any portion of its interest in [the Company] without the prior written approval of all of the Members”. One of the members got a divorce, and as part of the divorce settlement he tried to assign his membership interest to his wife. The other two members did not consent, so he assigned his wife only the right to receive distributions, and also agreed to follow her instructions when voting his membership interest. When he later sold his membership interest to his partners, his ex-wife sued to void the sale and enforce the earlier assignment to her.

The outcome of the case hinged on the new rule versus classic rule debate – if the new rule applies, the assignment to the ex-wife in violation of the operating agreement is not void, but the two partners would have a breach of contract claim against the husband – the wife wins. If the classic rule applies, the wife loses because the assignment to the wife in violation of the operating agreement would be void and treated as though it never happened.

The dispute made it to the Colorado Supreme Court, where the wife argued that a Colorado LLC operating agreement should not be interpreted under contract law, but rather as a formation or governing document like corporation articles or bylaws. Fortunately, the Supreme Court disagreed. Looking to Delaware case law, In re Seneca Invs. LLC, 970 A.2d 259 (Del. Ch. 2008), the Supreme Court held that operating agreements are contracts and shall be interpreted under prevailing contract law. This part of the decision is important because limited liability company acts are divided into two categories: (1) those with extensive default rules governing the conduct of the company’s governance (like corporation acts), and (2) those with very few or no default rules, leaving all or most matters to the contract between the members (contractarian acts). The Delaware Act follows the contractarian view, and several years ago Colorado changed its limited liability company act to remove most of the default rules and became a contractarian act similar to the Delaware model. A holding by the Supreme Court that an LLC operating agreement was something other than a contract would have undermined the intent of the Colorado legislature in overhauling the LLC Act, and diminished one of the primary benefits of an LLC – the flexibility to constitute, govern and operate your company in the manner you wish, without extensive statutory constraints.

However, the Supreme Court also recognized that an LLC operating agreement is different from the average commercial contract, because it has a statutory scheme at its foundation – the Colorado Limited Liability Company Act. Each operating agreement must be interpreted as a contract, but within the language and requirements of the act. For example, the husband’s operating agreement prohibited assignment of “any portion of” the membership interest. The Supreme Court looked to C.R.S. Sec. 7-80-102(10), which says that a membership interest in an LLC includes the “right to receive distributions”, and C.R.S. Sec. 7-80-108(4), which requires the courts to give “maximum effect” to the operating agreement. Since the right to receive distributions is part of a membership interest, and the husband assigned his right to receive distributions, then he assigned a “portion” of his membership interest, in breach of the operating agreement.

In light of the breach, the court had then to decide whether to apply the modern rule and let the assignment stand anyway, or apply the classical rule and void the assignment. So, when faced with the opportunity to say which rule applies to contracts in Colorado, the Supreme Court…………punted. Instead of adopting a hard and fast rule for the interpretation of anti-assignment clauses, or even anti-assignment clauses only in operating agreements, the Supreme Court held that either rule might apply to a contract under Colorado law, and which rule applies can only be determined by discerning the intent of the parties and the facts of a specific case. In THIS CASE, the Supreme Court applied the classical rule, holding the assignment by the husband to his wife was void because the language of the operating agreement, read in conjunction with the language of the statute, indicated that the parties wanted to restrict who they would do business with and prevent any assignment without consent. The ruling implies that similar language in other operating agreements might be interpreted the same way, but it is not a rule. Moreover, the court specifically said it was not rejecting the modern rule, which might apply to other contracts, including other operating agreements, if the facts and intent warranted.

The lessons from this decision are not new. Courts seldom adopt a hard and fast rule when it is unnecessary to decide the case before them – doing so often invokes the law of unintended consequences, and restricts the flexibility of courts to fashion justice in other cases. It is up to the parties to say what they want. Since at least 2003 and possibly earlier, legal commentators have been advising lawyers who want to strictly prohibit assignment of a contract to address this very issue. In Negotiating and Drafting Contract Boilerplate (ALM Publishing 2003), Tina Stark dedicates an entire chapter to this issue (Chapter 3, Assignment and Delegation).

Recommendation

An anti-assignment clause in an important contract should not be thrown in as “standard language” or culled from form boilerplate. If you might want to assign the contract or certain rights or obligations in the future, but don’t want to raise the issue during negotiations, then vague language of the type used in Condo v. Conners may be best – leave that fight for another day. But if it is important to you that the contract not be assigned, language of the following type will avoid the type of analysis and uncertainty reflected in Condo v. Conners:

No party may assign its rights or delegate its obligations under this Agreement, without the written consent of the other party. Any purported assignment or delegation in breach of the preceding sentence shall be void.

Problem solved!

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In 2009 the Colorado Court of Appeals decided two important cases on the scope and enforceability of non-compete agreements in Colorado.

Colorado is one of several states that have laws severely restricting the application of non-compete agreements.  Colorado law 8-2-113 says that non-compete restrictions are void, except (1) as part of the purchase of a business, (2) for the protection of trade secrets, (3) if the business paid for its employee’s education, and (4) for executives, officers, professional staff and “management personnel”.  I’ll discuss this more below, but the two cases need to be considered in the context of this Colorado law.

Lucht’s Concrete

The first case, Lucht’s Concrete Pumping, Inc. v. Horner, is particularly interesting.  In Lucht’s Concrete the court held that if a business and an employee enter into a non-compete agreement after the employee has already begun work, the business must provide additional consideration to the employee for the non-compete agreement to be enforceable – continued employment is not sufficient consideration.

Lucht’s Concrete needs to be watched, because it invalidates a fairly common practice – businesses often request or require employees to enter into non-compete agreements at some point during the life of the company, and in the past many of those businesses, and their lawyers, assumed that allowing the employee to keep his job was sufficient consideration to enforce the non-compete agreement.  Particularly considering that under the law of contracts, a mere “peppercorn of consideration” is generally sufficient to keep a contract from failing for lack of consideration.

Start-up, emerging growth and restart companies often launch their business with minimum capital, and even less legal advice.  As the business and revenue grow, the founders seek out legal services to “clean up” business documents, reduce their risk and protect their intellectual property and confidential information by getting contracts in place.  One of the first questions business lawyers usually ask these clients is whether they have employment and non-compete agreements with the key employees.  Usually, they do not, and it is common to require key employees to sign some form of non-compete agreement as a condition to continued employment.  The court in Lucht’s Concrete invalidated that practice, holding that since the employee was not given a pay increase, bonus, promotion or any additional benefits for the non-compete commitment, the non-compete was unenforceable for lack of consideration.

Not surprisingly, on February 1, 2010 (after initial publication of this article) the Colorado Supreme Court granted certiorari to review the single question “Whether the court of appeals erred in concluding that the continued employment of an existing at-will employee was not adequate consideration to support a noncompetition agreement.”  Lucht’s Concrete may well be overturned by the Colorado Supreme Court.

Unless the Colorado Supreme Court overturns  Lucht’s Concrete, Colorado companies that have employees who signed non-compete agreements after they began employment, and without paying any new consideration, may need to enter into new non-compete agreements with those key employees the next time the employee receives a raise, bonus, promotion or other increase in compensation or benefits.  You should work with your business lawyer, employment lawyer, general counsel or HR professional to implement the appropriate program.

DISH Network

The court decision in DISH Network Corporation v. Altomari is a bit more helpful to businesses.  In DISH the court clarified that the “management personnel” under the statute who may be bound by a non-compete agreement includes non-executive managers who are mid-level managers, so long as those persons supervise other employees, have decision making authority and a “certain level of autonomy”.  The DISH employee supervised 50 employees and was at the top of the compensation scheme for like persons, which may have also been factors.

Action

In light of DISH Colorado businesses may now be able to extend their non-compete agreements to lower level management employees than previously thought.  Each case will be decided on its particular facts, but DISH sets out a test for “management personnel”, and Colorado businesses who believe non-compete agreements are important to their business should re-visit the level and class of employees who it requires to enter non-compete agreements – the requirement may extend further down the org-chart than before.

Non-Competes in Massachusetts

There is an interesting discussion over at VC Experts about the effort to enact legislation in Massachusetts that is similar to the Colorado and California laws restricting non-compete agreements.   Apparently, venture capital groups in the Boston high-tech corridor have been lobbying Massachusetts legislators to restrict or prohibit non-compete agreements (which are currently allowed in Massachusetts), on the grounds that non-compete agreements stifle new start-ups and potential innovation (in other words, VC inventory).  It’s an interesting point of view.  Consider that the average VC fund has a 10 year life, and intends to divest itself of each portfolio investment in 3-5 years.   Consider that many entrepreneurs want to build a company with long-term prospects and lasting returns, and most employees do not want to have to change jobs every 5-10 years.  A cynic could argue that the VC funds want to prohibit non-compete agreements so that key employees and entrepreneurs are free to leave the company that the VC fund just sold, to start a new company that the next VC fund can invest in, thus creating and churning inventory for the VC’s.  The VC’s argue that competition is important to innovation and economic growth.  Either way, the Massachusetts legislature is considering legislation that will restrict non-compete agreements in that state.

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