In the past decade, states across country have enacted new laws to curtail and limit the enforcement of non-compete and non-solicit agreements. Since just the start of 2022, Colorado, Illinois, and Washington, D.C. have amended their non-compete laws, and the Federal Trade Commission has proposed a new rule.
In the past year, Delaware entered the fray with three different legal decisions. The Delaware Chancery Court is one of the most prominent courts in the nation, known for its developed corporate and business case law. Businesses often include clauses in their contracts that designate Delaware as the location for adjudicating their legal disputes.
Beginning in October of 2022, the Delaware Chancery Court issued three decisions in which it determined a non-compete and a non-solicit were too broad and therefore unenforceable. Two of these cases involved a non-compete when a business or assets were sold.
Non-Competes in Business Acquisitions
Many non-compete disputes involve an employer attempting to enforce an agreement against a former employee. But non-competes can also exist in the context of a business acquisition. It is easier for a purchasing company to enforce a non-compete against a shareholder or owner of a selling entity than it is for an employer to enforce one against a former employee. Courts often apply a slightly different test in a business acquisition, in part because the acquiring company is purchasing the seller’s assets and good will, and the acquiring company wants to ensure it is receiving the full benefit of its purchase.
These recent Delaware cases, however, demonstrate that acquiring companies will need to review the non-competes they have sellers sign to ensure that the clauses are sufficiently narrowly tailored.
The first case was Kodiak Bldg. Partners, LLC v. Adams, C.A. No. 2022-0311-MTZ, 2022 Del. Ch. LEXIS 288 (Del. Ch. Oct. 6, 2022), in which a company purchased the assets of another company. One of the employees and stockholders for the seller resigned after the acquisition and began working for a new company. The purchasing company then sued that employee and stockholder for breaching the non-compete and the non-solicit.
The Delaware Chancery Court refused to enforce these restrictions. The Court explained the definition of the word “business” in the contract was too broad, and broader than the acquiring company’s interests in the assets it purchased. The Court also refused to modify, or “blue pencil,” the contract to make it enforceable.
A similar case was before the court in the spring of 2023. See Intertek Testing Services NA, Inc. v. Eastman, C.A. No. 2023-0853-LWW, 2023 Del. Ch. LEXIS 66 (Del. Ch. Mar. 16, 2023). The Delaware Chancery Court once again found that a non-compete and a non-solicit used in the context of a sale of business were too broad.
A Different Test for Forfeiture-for-Competition Disputes
Because a non-compete agreement is a restraint on trade, courts closely scrutinize these agreements to ensure that they do not unreasonably hurt the marketplace. That means courts try to ensure that non-compete restrictions are reasonable and drafted in a way that protects a legitimate business interest. This legal analysis is more complex than that used in most breach of contract situations, where courts do not usually determine the reasonableness of a contract’s terms.
In early 2023, the Delaware Chancery Court provided a lengthy opinion in Ainslie v. Cantor Fitzgerald, L.P., Ca. No. 9436-VCZ, 2023 Del. Ch. LEXIS 22 (Del. Ch. Jan. 4, 2023), which involved a forfeiture-for-competition clause.
In a “traditional” non-compete, an employer may seek an injunction from a court forbidding a former employee from engaging in certain conduct: prohibiting the employee from working in a certain role for a certain competing employer, or prohibiting the employee from soliciting certain clients, for example. Such agreements are usually the most difficult to enforce. In contrast, non-competes used in the acquisition of a business are generally somewhat easier to enforce.
With a forfeiture-for-competition agreement, if a former employee engages in competition, the former employer will either stop paying the former employee certain compensation, or the former employer will seek to “claw back” compensation that the employee has already received.
Some courts have held that forfeiture-for-competition clauses have the same chilling effect on employee mobility as a “traditional” non-compete, and therefore should be subject to the same legal test of determining whether the restrictions are reasonable. These courts have explained that imposing a significant financial penalty on a former employee has the same practical impact as enforcing an injunction that prevents the employee from working with a new employer.
However, the fact that a former employee chose to compete in exchange for forfeiting compensation has led other courts to apply a breach of contract analysis to these agreements. Instead of closely scrutinizing these clauses to ensure that the clauses are reasonable and protect a legitimate business interest, these courts will simply determine if a breach has taken place, given the existing contractual terms. This is the least exacting test.
In Ainslie, the Delaware Chancery Court reviewed forfeiture-for-competition agreements. After surveying cases from Delaware and across the country, the Court decided to employ the same test that would govern non-competes used in the sale of a business. The Court held that forfeiture-for-competition agreements qualify as non-competes, but are more similar to a situation involving the sale of a business. The Court also explained “Delaware courts do not mechanically enforce noncompete or nonsolicit agreements.”
By relying on the same test as that used in business acquisitions, and applying a reasonableness test, this decision raised the bar over a breach of contract analysis. Doing so makes these sorts of agreements harder for former employers to enforce, although they remain somewhat easier to enforce than a “traditional” non-compete.
What Do The Delaware Cases Mean?
What is striking about these three decisions is that (i) the Delaware Court did not modify these contracts to make them enforceable, (ii) two of the agreements were in the context of a sale of a business, and (iii) the test used for a business acquisition was applied to a forfeiture agreement dispute.
The general take-away here is that the trend to curtail non-compete and non-solicitation agreements is continuing. In addition to new state laws and federal rules, courts are narrowing the restrictions that can be applied to employees and are continuing to closely scrutinize such agreements.