The Georgia Court of Appeals recently clarified two issues about the application of Georgia’s Restrictive Covenants Act (RCA) to covenants in an LLC’s operating agreement:
- Does the RCA govern restrictive covenants in an operating agreement that bind a member who is also an employee of an LLC?
- Does a noncompete or non-solicitation clause that could theoretically be indefinite in duration violate the RCA?
The RCA’s Application to Operating Agreements of an LLC
Mullally v. CU Capital Market Solutions, LLC involved three partners that formed a business that provides consulting services to federal and state chartered credit unions. One of the members, Mullally, grew dissatisfied and resigned. However, he did not relinquish his ownership in the LLC. The remaining partners then sent him a letter demanding that he cease and desist providing services to former clients. They based this demand on restrictive covenants in their operating agreement.
In response, he filed a lawsuit seeking a declaratory judgment that his covenants are unenforceable. The basis for his claim was that the RCA did not apply to the operating agreement.
The RCA only applies to certain types of contracts: those between
(1) an employer and employee;
(2) distributor and manufacturer;
(3) lessor and lessee;
(4) partnership and partner;
(5) franchisor and franchisee;
(6) seller and purchaser of a business or commercial enterprise; and
(7) two or more employers. O.C.G.A. § 13-8-52(a).
While contracts or agreements between a partnership and one of its partners are expressly listed, operating agreements between members of an LLC are not. Thus, Mullally argued that the covenants in the operating agreement were not governed by the RCA. Instead, Mullally argued they were governed by Georgia’s old common law—a much stricter legal regime.
The Court of Appeals rejected this argument. The Court concluded the RCA is not concerned with the nature or character of the contract or agreement. Rather, it is concerned with the relationship between the contracting parties. Here, Mullally was not only a member of the LLC, but also an employee. Therefore, the agreement was between “an employer and employee” and the RCA applied.
Theoretically Indefinite Restrictive Covenants under the RCA
Mullally also argued that the covenants were indefinite and therefore infirm and invalid. Under the operating agreement, members could not transfer their ownership shares in the LLC without unanimous consent from other members.
In addition, the noncompete and non-solicitation covenants applied while a member owned shares and for a specified period after disposing of shares. In other words, the covenants did not begin their two and three-year durations only after a member transferred the shares back.
This meant the other members of the LLC could hypothetically force a member to hold their shares in the LLC indefinitely. This effectively keeps the restrictive covenants running forever. Mullally argued this rendered the covenants invalid.
The Court of Appeals was not persuaded. It did not judge the reasonableness of the covenants on their potentially indefinite duration. Instead, the Court viewed the covenants through the lens of their actual duration. And the LLC had already redeemed his shares, triggering the start of the two and three-year covenants. Therefore, the hypothetical indefiniteness problem did not materialize. And the theoretical flaw in the duration was not a basis for invalidating the covenants.
Takeaways from this Decision
Unlike in other decisions, this time the Court of Appeals construed the RCA broadly. Under Mullally, where a member of an LLC is also an employee, the RCA will apply to restrictive covenants imposed on that member in an operating agreement. The decision leaves open the question of whether a covenant binding a passive member who is not also employed by the LLC is governed by the RCA.
If you have questions about the restrictive covenants in your company’s operating agreement or any other agreements you have in place, please let us know if we can help.