New York, N.Y. (May 22, 2024) - Somewhat surprisingly, given New York's reputation as a business hub and trendsetter for business law rulings, there has been a lack of clarity from the judiciary concerning how to evaluate the enforceability of a restrictive covenant, such as a covenant not to compete, in an ordinary commercial contract. The New York Appellate Division, Second Department recently waded into these waters and attempted to provide some needed clarity in Twitchell Tech. Prods., LLC v. Mechoshade Sys., LLC, 2024 NY Slip Op 01744, decided March 27, 2024. The Court noted that, although there is a dearth of New York state case law on this issue, it was appropriate to adopt the standard used in several prior decisions that analyzed such covenants under "a rule of reason, considering (1) whether the covenant protects a legitimate business interest; (2) the reasonableness of the geographic scope and temporal duration; and (3) the degree of hardship upon the party against whom the covenant is enforced."
Additionally, the Court's decision addresses "whether courts have the power to sever and grant partial enforcement of overly broad restrictive covenants in ordinary commercial contracts." Based on the New York Court of Appeals' holding that courts have such power with regard to overly broad restrictive covenants in employment agreements (BDO Seidman v. Hirshberg, 93 NY2d 382, 395 (1999), it ruled that "courts have the power to sever and grant partial enforcement of overly broad restrictive covenants in ordinary commercial contracts and may do so under the appropriate circumstances."
At issue in this case was a dispute between Twitchell and Mechoshade about two agreements under which Mechoshade produced window shading products that Twitchell would distribute. Both agreements contained identical restrictive covenants providing that, in the event of termination, Twitchell would not sell Mechoshade's products, but could sell dissimilar window shading products. When a dispute arose about the parties' post-termination conduct, Twitchell sued seeking a declaration that these covenants were unenforceable. Mechoshade interposed counterclaims seeking a declaration that they were enforceable. Twitchell moved to dismiss Mechoshade's counterclaims. The lower court denied that motion. The Second Department affirmed. After addressing various procedural issues, the Court opined concerning how to determine the validity of the restrictive covenants.
The Court noted that, under New York law, the enforceability of a restrictive covenant depends in part on the nature of the underlying contract. Restrictive covenants in contracts for the sale of a business are generally enforceable, whereas covenants in employment contracts are more severely restricted. This case involved a third category: restrictive covenants in ordinary commercial contracts. Noting that other courts have recognized that New York state court decisions offered little guidance as to covenants not to compete within ordinary commercial contracts, the Court agreed with several prior federal court decisions that analyzed these types of covenants under a simple rule of reason, which entails balancing the competing public policies in favor of robust competition and freedom to contract.
The Court held that, under this rule of reason, courts should consider: "(1) whether the covenant protects a legitimate business interest; (2) the reasonableness of the covenant with respect to geographic scope and temporal duration; and (3) the degree of hardship upon the party against whom the covenant is enforced." Further, courts should accord more deference to parties' freedom to contract than would apply as to employment contracts. The Court stressed that the application of these factors depends on the totality of circumstances.
Applying these factors, the Court held that, at least at the motion to dismiss stage, Twitchell failed to establish that the covenants did not protect Mechoshade's legitimate interest in protecting itself from unfair competition. The Court focused on Mechoshade's allegations that it had invested time, skill, and money in developing fabrics that, pursuant to the agreements, were to remain Mechoshade's exclusive designs after expiration. Based on the limited record, the Court could not determine whether Mechoshade was attempting to use the broad language of the covenants to restrict legitimate competition or whether enforcing the covenants would impose a hardship on Twitchell.
The Court also addressed the often-litigated issue of geographic scope and temporal duration, holding that a covenant not to compete is not necessarily unenforceable merely because it lacks a temporal limitation or geographic restriction. The Court held that "the reasonableness of a covenant not to compete with respect to geographic scope and temporal duration depends upon the facts of each case."
This decision also addressed the frequent practice of New York courts to exercise their inherent power to sever and grant partial enforcement of overly broad restrictive covenants. In appropriate cases, the court will "conduct a case specific analysis, focusing on the conduct of the employer in imposing the terms of the agreement. Under this approach, if the employer demonstrates an absence of overreaching, coercive use of dominant bargaining power, or other anti-competitive misconduct, but has in good faith sought to protect a legitimate business interest, consistent with reasonable standards of fair dealing, partial enforcement may be justified."
This analysis requires consideration of whether: the unenforceable portion is an essential part of the agreement; there was overreaching; there was the coercive use of dominant bargaining power; there was other anticompetitive misconduct; and there was other evidence of bad faith in the inclusion of the restrictive covenant. The Court declined to opine as to whether both the geographic scope and temporal duration would need to be limited in order to render the restrictive covenants reasonable or whether other portions of the restrictive covenants would need to be severed or limited in order to render the restrictive covenants reasonable.
The Court ultimately ruled that it was premature to determine on a limited record whether the unlimited duration and geographic scope of these restrictive covenants were appropriate and whether the agreements could be partially enforced without impermissibly rewriting the agreements.
It is anticipated that the guidance provided by this Appellate Division decision will be of assistance in enabling business and attorneys to forecast the extent to which restrictive covenants in commercial contracts may be permitted and the extent to which even overly restrictive agreements may be rendered enforceable via a court's blue-pencil modifications. While the Second Department has jurisdiction over only several New York City boroughs and adjacent counties, we can expect the decision to be more widely cited and relied upon in the absence of other similar guidance from New York State appellate courts.
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