Distinguishing Between Ownership of an Entity and the Entity Itself

Failing to distinguish between a parent entity and its operating subsidiary can have devastating consequences in the drafting and interpretation of written agreements.  A recent Delaware Court of Chancery decision, Frontline Technologies Parent LLC v. Murphy, 2023 WL 5424802 (Del. Ch. Aug.23, 2023), is a case in point.

Frontline involved a dispute over the effect of a non-competition agreement contained in Equity Incentive Grant Agreements entered into between a parent entity, fund entities of the parent’s private equity owners, and employees of an operating subsidiary of that parent entity. Through the Equity Incentive Grant Agreements the employees received equity units in the parent, and in exchange agreed to certain non-competition covenants.  But the operating subsidiary employer was not a party to the Equity Incentive Grant Agreements and the non-competition provision only prohibited the operating subsidiary’s employees from going to work for a competitor of the parent.

Specifically, the Equity Incentive Grant Agreements prohibited the employees from “‘directly or indirectly participate[ing] in any activity’ that would ‘qualify as Competition in the Territory.’” “Competition” was basically defined as any business or business line in which the “Company” was engaged.  “Company,” however, was defined to only mean the parent.   

The employees terminated their employment with the operating subsidiary and went to work for what was alleged to be a direct competitor of the operating subsidiary.  But alas the parent’s business was owning the operating subsidiary, not engaging in the business in which the operating subsidiary engaged.  Ouch!

According to the Vice Chancellor Will:

  • If the plaintiffs wanted the non-compete provisions to apply to [the operating subsidiary’s] business or business line, they could have defined Competition to include “a business or business line that the Company [or its Affiliates] is conducting.” They did not. Although the term Affiliates is mentioned elsewhere in the Equity Agreements—and even in the non-compete provisions—it is excluded from the definition of Competition. The plaintiffs must now live with the restrictive covenants they agreed to.

Some would ask why wasn’t this a clear case of mutual mistake?  Why wouldn’t the court just reform (or, as our English colleagues say, “rectify”) the equity agreements so that the non-compete covered the operating subsidiary?  Well, the answer is that the plaintiffs seeking to enforce the restrictive covenants did not appear to ask the court to reform the agreements, but instead asked that the agreements be equitably rescinded (based upon mutual mistake) to the extent they did not in fact restrict the former employees from competing with the operating subsidiary.  The effect of an equitable rescission of course would be to eliminate the equity grants in favor of the employees.  But whether used as a basis for equitable rescission or reformation, “[m]utual mistake requires a showing ‘that the parties came to a specific prior understanding that differed materially from the written agreement’ or that the counterparty ‘knew of … [the] mistake and remained silent’ to capitalize on it.” According to the court, no showing was made here that the parties had reached “a specific prior understanding that differed materially from the written [equity grant] agreements” that were signed by the parties.  And simply failing to properly draft the restrictive covenant in a manner the plaintiff may have intended, to thereby support the equity grant that was given to the employee, was not, according to the court, a mutual mistake.

It would appear that Sergeant Phil Esterhaus’ admonition that he uttered at the morning roll call to all of his officers in virtually every episode of the 80’s television series, Hill Street Blues, applies equally to those engaged in drafting important private equity agreements:  “Hey, let’s be careful out there!”  Vice Chancellor Will acknowledged that what was intended by the non-competition agreement “was to prevent the employees from working for a competitor of its operating subsidiary.”  But what was intended and what was said were in this case two different things.  And it’s what was said that mattered.