Being a Seller Forever Bound by an Implied Duty Not to Solicit Customers
In an asset divestiture, a selling entity transfers tangible assets—such as furniture, fixtures, and equipment (FFE)—and intangible assets—such as a trade name and the goodwill associated therewith (Goodwill). In a stock divestiture, the principal shareholder of a selling entity transfers his/her entire, or at least a controlling, interest in the selling entity which owns tangible assets—such as FFE—and intangible assets—such as Goodwill. In connection with either transaction, the principal shareholder, who is often the chief executive of the selling entity, transfers his/her personal goodwill—meaning the goodwill tied directly to his/her individual relationships and reputation rather than to the seller entity—and becomes an employee of the buyer.
Typically, in an asset or stock purchase agreement and in a post-closing employment agreement, there is a trifecta of express covenants: non-disclosure, non-competition, and non-solicitation. However, it is possible to not see the trifecta of covenants, but only a non-competition provision. This was the situation in the New York landmark case of Mohawk Maintenance Co. v. Kessler wherein Kessler, the former principal shareholder of Mohawk Maintenance Co., was bound by only a non-competition provision in the stock purchase agreement and a post-closing employment agreement upon the transfer of his controlling interest in the company.
Generally, at the time of a divestiture, whether of assets or stock, a principal shareholder tends to ultimately agree to be bound by a non-competition covenant but not be concerned at all with a non-solicitation covenant, as he/she is often not looking to the potential of future income, but only to the current realization of a purchase price. However, after the end of a non-competition period, should the principal shareholder want to establish another business in the same industry, he/she will discover that it is not easy to do so unless he/she can contact the customers of his/her former business. And, if such principal shareholder is not bound to an express non-solicitation covenant limited by a specific time period, will discover that he/she is bound forever by an implied duty not to solicit the customers of the former business.
In New York, it is called the Mohawk Doctrine. It can extend a non-solicitation obligation indefinitely. Under this doctrine, which was set forth in Mohawk Maintenance Co. v. Kessler, if a principal shareholder is deemed to have transferred personal goodwill upon a transfer of a business, he/she may well be permanently barred from soliciting former customers. In the words of the New York Court of Appeals in Mohawk Maintenance Co. v. Kessler (quoting Von Bremen v. MacMonnies quoting Trego v. Hunt): “‘A man may not derogate from his own grant; the vendor is not at liberty to destroy or depreciate the thing which he has sold; there is an implied covenant, on the sale of good will, that the vendor does not solicit the custom which he has parted with; it would be a fraud on the contract to do so.’”
This creates a complex legal reality: While a two-year non-competition covenant may seem temporary, the sale of personal goodwill without an express limitation of a time period can lead to a perpetual restriction on the solicitation of former customers under the Mohawk Doctrine, binding a principal shareholder far beyond what he/she may have anticipated. Understanding these nuances is critical for a principal shareholder considering the sale of the stock or assets of his/her business entity, as the long-term implications can deeply affect his/her ability to establish a new business entity engaged in the same industry.