Blue Pencils Down: The Recent Delaware Non-Compete Case Trifecta
May 11, 2023
By Lowell E. Thomas and Travis N. Atwood
Over the past six months, the Delaware Court of Chancery has issued a series of decisions narrowing the scope of permissible non-compete agreements, while declining to “blue pencil” those provisions to render them enforceable. Notably, two of those decisions were delivered in connection with the sale of a business, which may come as a surprise to many industry leaders and M&A attorneys who have long viewed Delaware courts as a reliably “pro-contractarian” venue, where unambiguous contracts would be enforced as written.1
Kodiak Building Partners, LLC v. Adams
The opening move in this series of decisions came in Kodiak Building Partners, LLC v. Adams, 2022 WL 5240507 (Del. Ch. Oct. 6, 2022), when Vice Chancellor Zurn declined to enforce a restrictive covenant agreement between the buyer of a business and a minority shareholder and key employee of the target, finding that the restrictive covenants were overbroad and did not protect any legitimate business interests of the buyer.
The case involved the sale of Northwest Building Components, a small manufacturer of roof trusses, to Kodiak, a much larger integrated construction business. Defendant Adams was the general manager and an eight percent shareholder of Northwest who, in connection with the sale, entered into a 30-month restrictive covenant agreement containing standard non-compete and non-solicit provisions covering “Idaho, Washington, and within a 100-mile radius of any other location outside those states in which [seller] or [Kodiak and its portfolio companies] have sold products or provided services within the 12 months prior to Closing.”
While Vice Chancellor Zurn pointed out 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,” she nevertheless determined that the restrictive covenants were unenforceable. Specifically, the court reasoned that Kodiak’s legitimate economic interest in “restraining Adams’s employment is only in the goodwill and competitive space it purchased from Northwest in the market Northwest serves.” Because the non-compete applied to all of Kodiak’s business lines and geographic areas, rather than tailored to roof trusses and the area where Northwest had operated, its scope was overbroad and did not protect a legitimate business interest. Furthermore, the non-solicit provision was overbroad because it covered all of Kodiak’s customers, clients, or prospective customers and clients, rather than those it had acquired from Northwest or that Adams had business relationships with.
Additionally, the restrictive covenant agreement contained two separate provisions, where Adams agreed that the terms of the agreement were reasonable and purportedly waived his ability to challenge the reasonableness of the covenants. Nevertheless, the court reviewed this as a matter of public policy because Delaware courts must evaluate restrictive covenants for “reasonableness, equity, and the advancement of legitimate business interests,” and “mechanical submission to an employee's promise not to challenge a restrictive covenant would fly in the face of the public policy that compels review of that covenant.”
Vice Chancellor Zurn also declined to blue pencil the terms of the non-compete, or modify the terms so that they would be reasonable and enforceable, even though the agreement expressly authorized the court to do so, stating that “[w]here non-compete or non-solicit covenants are unreasonable in part, Delaware courts are hesitant to ‘blue pencil’ such agreements to make them reasonable.”
Ainslie v. Cantor Fitzgerald L.P.
In Ainslie v. Cantor Fitzgerald L.P., 2023 WL 106924 (Del. Ch. Jan. 4, 2023), Vice Chancellor Zurn once again declined to enforce restrictive covenants, this time in the context of a partnership agreement.
Ainslie involved financial services firm Cantor Fitzgerald and several of its former partners whose partnership agreements restricted them from engaging with a competing business for a period of one year following their withdrawal from the partnership, but allowed them to receive capital distributions over a period of four years, with such payments conditioned on the partners not breaching the non-compete or non-solicit provisions. Within a year of their departure, Cantor Fitzgerald determined that each of the former partners had breached and terminated payment of the capital distributions, which ranged from $200,000 to $5.5 million.
This “forfeiture-for-competition provision,” differed from a standard non-compete in that it “serve[d] as a financial disincentive, rather than a per se bar on obtaining employment with a competitor.” The former partners could freely work for a competitor knowing that they would sacrifice their capital distributions, but would not be sued over such an action. For this reason, Vice Chancellor Zurn chose to apply the more lenient sale of a business standard rather than analyzing it as a restriction on employment.
Even with the more forgiving standard, the court found that the restrictive covenants were “unreasonable and therefore unenforceable,” reasoning that the worldwide geographic scope was overly broad under the circumstances and, additionally, the scope of prohibited activities was unreasonable because it covered activities competitive with any affiliated entity of Cantor Fitzgerald regardless of if it was related to the business that the partners had been involved in. Furthermore, the court also found that Cantor Fitzgerald could provide no reason why the “broad and vaguely defined scope” was “necessary to protect Cantor Fitzgerald’s good will and customer relationships” or identify “any legitimate business interest that could be served by protecting all its unspecified affiliates.”
And building on her decision in Kodiak, Vice Chancellor Zurn again declined to blue pencil the provisions and also expressly stated that the agreement’s reasonableness stipulation did not “insulate the agreement from a reasonableness review under Delaware law.”
Intertek Testing Systems v. Eastman
The decisions in Kodiak and Ainslie should not be viewed as the decisions of a rogue judge, as even more recently, in Intertek Testing Systems v. Eastman, 2023 WL 2544236 (Del. Ch. Mar. 16, 2023), Vice Chancellor Will struck a noncompete on similar grounds.
In this case, the defendant, Jeff Eastman, had been a co-founder, major stockholder, and Chief Executive Officer of Alchemy Investment Holdings, Inc., when Intertek acquired it. The stock purchase agreement contained several restrictive covenants, including a non-compete that restricted Eastman from engaging with any business or person competitive to any portion of Alchemy’s business “anywhere in the world.” More than two years after the sale, Eastman invested in, and joined the board of directors of, a company founded by his son that provided “nationwide...services to the cannabis industry workforce.”
Intertek claimed that, because Alchemy had served businesses within the cannabis industry, Eastman was now in violation of the non-compete. However, Vice Chancellor Zurn granted Eastman’s motion to dismiss, noting an incongruity between the non-compete’s “anywhere in the world scope” and Alchemy’s business that made the covenant overly broad to the point that it was not “tailored to the competitive space reached by the seller” and did not “serve the buyer’s legitimate economic interests.”
Furthermore, Vice Chancellor Will followed Vice Chancellor Zurn’s lead from Kodiak and Ainslie and declined to blue pencil the provision, opining that:
Although the Court of Chancery has, at times, blue penciled expansive non-competes to supply judicious limitations, it “has also exercised its discretion in equity not to allow an employer [or covenantee] to ‘back away from an overly broad covenant by proposing to enforce it to a lesser extent than written.’”
In my view, revising the non-compete to save Intertek—a sophisticated party—from its overreach would be inequitable. “[A] court should not save a facially invalid provision by rewriting it and enforcing only what the court deems reasonable.”
All three cases show that despite Delaware’s contractarian reputation, there are overriding public policy considerations that compel Delaware courts to review these agreements for reasonableness, even when the language is the unambiguous result of an arm’s length transaction between sophisticated parties that have expressly stipulated that such language is reasonable.
Also, these cases demonstrate that the days of the free pass where a Delaware court would blue pencil such covenants may be short lived. Parties who hope to have enforceable restrictive covenants would be well advised to follow Vice Chancellor Zurn’s advice in Ainslie and draft so they “(1) [are] reasonable in geographic scope and temporal duration, (2) advance a legitimate economic interest...and (3) [will] survive a balancing of the equities.”
It may be premature to declare that these cases constitute a reliable rule, particularly before the Delaware Supreme Court has had the chance to weigh in on the issue. However, the decisions may indicate a trend in a particular direction and one that is consistent with a larger national trend towards restricting non-compete provisions.
California, Oklahoma, and South Dakota already prohibit non-competes in most employment instances, with several other states recently constraining them in some way. At the federal level, the FTC proposed a rule earlier this year that would ban non-competes in employment contracts and nullify existing non-compete clauses.2 Those three states, as well as the FTC’s proposed rule, carve out exemptions for non-competes tied to the sale of a business, but could signal growing momentum against non-competes that may eventually impact restrictions tied to the sale of a business.
Key Takeaways for Buyers and Deal Counsel
- Be careful what you ask for. Buyers can no longer take an aggressive stance and request very broad restrictive covenants from sellers with the expectation that, even if they go too far, Delaware courts will step in and blue pencil them to be enforceable.
- Buyers and M&A practitioners should narrowly tailor restrictive covenants with respect to the scope of restricted activities, geography, and timeframe in order to protect a specific and legitimate business interest. While buyers may leave some protection on the table this way, they will gain the security of knowing that a reasonably drafted restrictive covenant is more likely to be enforced.
- Typical boilerplate language stipulating as to reasonableness may now be irrelevant in Delaware as courts will always review as a matter of public policy. Market language will likely evolve and deal lawyers should take care to monitor future developments.
Lyons Insurance Agency, Inc. v. Wark, 2020 WL 429114 (Del. Ch. Jan. 28, 2020)
Snell & Wilmer has already published a thorough review of the FTC’s proposed rule which can be found here.
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