Second Department Clarifies Law Relating to Restrictive Covenants in Ordinary Commercial Contracts

Recently, in Twitchell Tech. Prods., LLC v. Mechoshade Sys., LLC, 2024 N.Y. Slip. Op. 01744 [2d Dep’t Mar. 27, 2024], the Second Department had the opportunity to consider an issue that was not extremely developed in New York case law, specifically the factors to consider when evaluating the enforceability of a restrictive covenant in an ordinary commercial contract.  In addition, the Court was called on to decide whether courts have the power to sever and grant partial enforcement of an overly broad restrictive covenant contained in an ordinary commercial contract.

The case involved a manufacturer of solar roller shades, Mechoshade, and its contractual partner Twitchell, the manufacturer of Mechoshade’s fabrics, with whom Mechoshade had jointly developed fabrics that could withstand the process of rolling and unrolling.  Among other contracts, the litigants were parties to a North America distribution agreement that contained a restrictive covenant limiting Twitchell’s ability to sell certain products to Mechoshade’s competitors, even after the agreement had been terminated.  The restrictive covenant at issue contained no geographic or temporal limitations.  Twitchell commenced a declaratory judgment action seeking a declaration that the covenant was invalid and then moved to dismiss Mechoshade’s related counterclaim for a declaration that it was fully enforceable.  The Second Department was considering the Supreme Court’s denial of that motion.

The Court and the parties agreed that restrictive covenants are enforceable in three types of contracts – sale of a business, employment and ordinary commercial – and that this case involved the third of those categories.  While recognizing that is there not a “large body of guidance” with respect to restrictive covenants in ordinary commercial contracts, the Court stated that it agreed with those courts that had analyzed such provisions under the “simple rule of reason” that balances public policies that favor robust competition with the freedom to contract.

The factors examined under this rule are:  “(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.”  The Court further explained that, although this test is similar to the one related to restrictive covenants in employment contracts, with respect to ordinary commercial contracts, “courts should accord more deference to parties’ freedom to contract.”

In analyzing whether the covenant protects a legitimate business interest, the Court stated that the “basic question is whether the acts complained of are fair or unfair,” which is a fact-intensive inquiry that is inappropriate for determination on a motion to dismiss.  Because Mechoshade alleged that it invested its own time, skill and money in developing the fabrics with Twitchell, which were to remain the exclusive designs of Mechoshade even after the expiration of the agreement, the Court found that a legitimate business interest had been adequately alleged for purposes of a CPLR 3211 motion.  The court similarly found that the provision under the agreement that allowed Twitchell to sell certain related items rendered the determination of degree of hardship unable to be determined on a motion to dismiss.

With respect to the reasonableness of geographic scope and temporal duration, the Court stated that a restrictive covenant is not necessarily overbroad because it lacks one or the other.  However, it agreed with Twitchell that the lack of both rendered the restrictive covenant at issue overly broad on its face.  Nevertheless, in light of Court of Appeals precedent holding that courts possess the ability to sever and grant partial enforcement of restrictive covenants in employment agreements (Brown & Brown, Inc. v. Johnson, 25 N.Y.3d 364 [2015]; BDO Seidman v. Hirshberg, 93 N.Y.2d 382 [1999]), the Court held that “overly broad restrictive covenants in ordinary commercial agreements may be capable of partial enforcement to the extent necessary to protect a legitimate business interest.”  It also cautioned that this ability is “not always justified by the circumstances of the particular case” and that a court should consider whether  (1) “the unenforceable portion is an essential part of the agreement;” (2) “there was overreaching;” (3) “there was the coercive use of dominant bargaining power;” (4) “there was other anticompetitive misconduct;” or (5) “there was other evidence of bad faith in the inclusion of the restrictive covenant.”  Finally, the Court advised that it was not opining on whether both the geographic scope and temporal limitation would have to be limited to render the restrictive covenant enforceable or which of the two would need to be limited.  The only thing that the Court decided was that the lack of limitation as to both is overly broad on its face.

In the case at hand, the Court found that both parties were sophisticated business entities that were represented by counsel in the agreement, which was negotiated at arm’s length with no suggestion that Mechoshade engaged in overreaching or used coercive dominant bargaining power.  As a result of the foregoing, the Court found that dismissal was not appropriate and affirmed the denial of Twitchell’s motion.

While it is not surprising that the Court affirmed the denial of a motion to dismiss on the record described in the opinion, the Court provided significant analysis in an area of the law that was not significantly developed in New York.  Litigants dealing with restrictive covenants in ordinary business contracts, particularly within the jurisdiction of Second Department, now have a better understanding of what factors the Court will consider in determining whether those provisions are enforceable.

Jarrett M. Behar is the Co-Chair of the Litigation Practice Group at Certilman Balin Adler & Hyman, LLP, where he focuses on Commercial Litigation, and a past Dean of the Suffolk Academy of Law and Director of the Suffolk County Bar Association.  He can be reached at 631-979-3000 and jbehar@certilmanbalin.com