Non-Competes and Forfeiture-for-Competition Provisions – The Reasonableness Override Under Delaware Law

Delaware courts are regarded as reliably contractarian in their interpretation and enforcement of written agreements. That means that Delaware courts do not re-write agreements that parties make, and will enforce both good deals and bad deals in accordance with the written terms. But Delaware’s contractarianism is mediated through long-standing common-law rules that sometimes do refuse to enforce the terms of an otherwise voluntary agreement, even one entered into by sophisticated parties. Two recent Delaware Court of Chancery decisions, both by Vice Chancellor Zurn, illustrate the effect of a common-law override to strict contractarianism respecting the enforcement of non-compete agreements and forfeiture-for-competition provisions, both in the sale of business and in the employment context.

In the fall of 2022, Vice Chancellor Zurn, in Kodiak Building Partners, LLC v. Adams, 2022 WL 5240507 (Del. Ch. Oct. 6, 2022), surprised many deal lawyers by declaring unenforceable a non-compete entered into by a selling stockholder and employee of a target business in favor of the acquirer of that target business. The reason for that surprise was the assumption by many that Delaware non-competes entered into as part of the acquisition of a business were generally exempt from the strict scrutiny that non-competes require in other contexts. But while Vice Chancellor Zurn acknowledged that “covenants not to compete in the context of a business sale are subject to a ‘less searching’ inquiry than if the covenant ‘had been contained in an employment contract,’” a covenant not to compete in the sale of a business must still be limited to the “purchased asset’s goodwill and competitive space that its employees developed or maintained.”

In Adams, Vice Chancellor Zurn determined that the non-compete entered into as part of business sale impermissibly extended to the “goodwill and competitive space [that the buyer had] acquired in other transactions with other Company Group members in other industry segments.” In other words, the non-compete covered the buying company’s existing business, not just this particular target’s business. Having found that the non-compete was overbroad and, therefore, unenforceable, Vice Chancellor Zurn also noted that Delaware courts were reluctant, and she was not prepared, to “blue pencil” the non-compete to make it protect only the legitimate interest of the acquirer in the target business (and this was apparently true even had the non-compete purported to require such a blue penciling). As a result, the non-compete was essentially written out of the agreement, even as to that legitimate interest. The refusal to “blue pencil” the non-compete meant that even though the selling stockholder had apparently engaged in competitive activities that were within the limited legitimate interest that could have been protected by a less broad non-compete, the overbroad nature of the non-compete rendered the non-compete completely unenforceable.[1]

Then, even more recently, in Ainslie v. Cantor Fitzgerald L.P., 2023 WL 106924 (Del Ch. Jan. 4, 2023), Vice Chancellor Zurn declared unenforceable a limited duration non-compete binding on former partners, and a lengthier conditional payment scheme that conditioned payments of otherwise earned benefits on the former partners not competing with the partnership or its affiliates. Both of the unenforceable provisions were contained in a limited partnership agreement.

The non-compete prohibited the former partners from competing with the partnership for one year and soliciting customers for two years. The conditional payment scheme conditioned payout of the former partners capital accounts on the partners not having breached the non-compete provision or the non-solicit provision, and upon the former partners not having otherwise competed with the partnership or its affiliates for the four year payout period contemplated by the limited partnership agreement for the former partners capital accounts. In other words, the former partners were technically only prohibited from competing with the partnership for one year and soliciting customers for two years, but would be denied payments if they breached those provisions within the first two years, or if they competed at any time within the four year capital account payout after withdrawal from the partnership, even though they were only prohibited from doing so for the first year. This second, lengthier, competitive activity condition to payment was referred to by Vice Chancellor Zurn as a “forfeiture-for-competition provision,” which many states treat as substantively different than an actual non-compete (and not subject to the typical review for reasonableness). The difference in a forfeiture-for-competition provision being that an employee can choose to leave their employment and compete (without fear of a suit for damages or injunctive relief), as long as they are prepared to forgo the payments that are conditioned upon the employee not competing.

The plaintiffs had each been employed by the Hong Kong affiliate of the partnership, but were limited partners of the main partnership. Each of the plaintiffs had voluntarily terminated their employment and withdrew from the partnership. The plaintiffs had each been determined by the partnership’s general partner to have breached the non-compete during the first year after the former partners had withdrawn from the partnership. The partnership had apparently not sought to actually enforce the terms of the limited partnership’s non-compete, but instead had treated the alleged breach of that non-compete as being the failure of a condition precedent to the obligation of the partnership to make payments owed to the former partners on their capital accounts.[2] The amounts owed to the former partners ranged from a low of approximately $200,000, to a high of over $5 million.

While there is some interesting discussion as to the difference between the withheld payments being treated as a penalty for the breach of the non-compete or instead as a forfeiture of otherwise earned benefits based on the failure of a condition precedent, it all really didn’t make a difference because the underlying non-compete was determined to be unenforceable as to scope and geographic application. In other words, because the non-compete was rendered void by its unreasonable scope (it was world-wide and covered not only the business of the partnership but any of its affiliates), it could not be breached so as to give rise to a penalty, or constitute a failed condition precedent resulting in a forfeiture.

Having concluded that the breach of the non-compete could not form the basis for the failure of a condition to the payment of the plaintiff’s capital account amounts, the court then turned to the alternative question of whether the separate provision that conditioned payment on the plaintiffs having not engaged in competitive activities (which by definition was not premised upon a breach of the otherwise unenforceable non-compete) was somehow exempt from the analysis that otherwise accompanied the enforcement of a non-compete. While it is apparently the majority view that these “forfeiture-for-competition” provisions are not subject to the same reasonableness review as an actual non-compete obligation, Vice Chancellor Zurn determined that she would review the forfeiture-for-competition provision for reasonableness and concluded, for the essentially the same reasons that the actual non-compete was unenforceable, that the forfeiture-for-competition provision was unenforceable.

Once again, the overbreadth of the competitive activities that were either prohibited by the non-compete, the breach of which was a condition to the payment of otherwise earned benefits, or which were not prohibited after year one but which engaging in during year two through year four resulted in a forfeiture of otherwise earned benefits, rendered both the non-compete and the forfeiture-for-competition provision unenforceable. And no blue pencil was available to cure that overbreadth, even when the actual competitive activity was probably well within what could have been reasonably constrained (or served as a condition to payment) had the provisions not attempted to do more than what was reasonable.

While the Delaware Supreme Court may yet have something different to say with respect to both of these decisions, we should all be careful to constrain our non-competes and forfeiture-for-competition provisions governed by Delaware law[3] so “that they ‘(1) [are] reasonable in geographic scope and temporal duration, (2) advance a legitimate economic interest of the party seeking its enforcement, and (3) [will] survive a balancing of the equities.’”[4] This may all be moot, of course, if the proposal to effectively ban non-competes on a federal level, which was published the day after the Cantor Fitzgerald decision was issued, becomes law.[5]

[1] The rationale for courts refusing to blue pencil overbroad non-competes is apparently to discourage persons with superior bargaining power (typically employers) from insisting on overbroad non-competes that they can threaten to enforce and, even if they can’t enforce completely, can still get a court to give them the benefit of their legitimate interest. See Kodiak Building Partners, LLC v. Adams, 2022 WL 5240507, at *4, n. 49, (Del. Ch. Oct. 6, 2022).

[2] The Hong Kong affiliate of the main partnership (as well as the Europe affiliate) had sought injunctive relief against certain of the plaintiffs in a Hong Kong court based on a non-compete that was contained in separate employment agreements with the Hong Kong affiliate, but the Hong Kong court apparently “concluded that the non-compete in [the Hong Kong affiliate’s] employment agreement was unenforceable under Hong Kong law.”

[3] Several states have statutorily banned or severely limited non-competes, and each state that permits non-competes have their own nuanced approach to their enforcement.

[4] Ainslie v. Cantor Fitzgerald L.P., 2023 WL 106924, at *8 (Del Ch. Jan. 4, 2023).

[5] See Federal Trade Commission, Non-Compete Clause Rulemaking, Jan. 5, 2023, available here.