Client Alert- Business-Friendly Delaware No Longer So Friendly to Over-Broad Restrictive Covenants – Even in the Case of a Sale of a BusinessApr 10, 2023
- FisherBroyles News
A copy of this Client Alert can be found HERE .
Delaware and its Court of Chancery, long viewed to be one of the most business-friendly jurisdictions in the country, have joined the ever-expanding list of jurisdictions that no longer give businesses the benefit of the doubt when it comes to restrictive covenants.
Traditionally, the Delaware Court of Chancery has applied a “less searching” inquiry into the fairness of a restrictive covenant when that covenant was entered into in the context of a sale of a business. In these cases, the Court of Chancery tends to enforce non-competes, because of the overall viewpoint that when an employee sells their business, they already receive significant financial compensation and actively negotiate the agreements using sophisticated counsel. Accordingly, courts do not have the same concerns about fairness as they do with a non-compete that an employee agrees to at the start of employment (when employees often sign whatever is put in front of them).
The Court of Chancery has changed its tune. In a trio of recent decisions, the Court has decried restrictive covenants that companies should have known were so overly broad so as not to protect their legitimate protective interests. It seems the Court of Chancery has not appreciated that employers have been taking advantage of the court’s willingness to blue-pencil (i.e., rewrite) restrictive covenants to ensure fairness.
As a refresher, Delaware courts generally enforce a restrictive covenant, such as a non-compete or non-solicitation provision, if it (1) meets Delaware’s requirements to be an enforceable contract; i.e., if there is (a) mutual assent; (b) expressed by a valid offer and acceptance; (c) adequate consideration; and (d) capacity; (2) is reasonable in scope (i.e., the types of activities that are prohibited, and the locations in which they are prohibited) and in duration (i.e., the length of the restrictive covenant); (3) protects the employer’s “legitimate protectible interest”; and (4) is, on the balance, equitable. As in most states, non-competes are typically subject to the highest scrutiny, non-solicitation provisions to somewhat less scrutiny, and non-competes in the sale of a business are traditionally subject to the lowest scrutiny.
Of the recent trio of cases, the first to call this traditional understanding into question was Kodiak Building Partners, LLC v. Adams (Del. Ch. Oct. 6, 2022). There, Kodiak Building Partners (“Kodiak”) acquired Northwest Building Components, Inc. (“Northwest”), a small manufacturer. Philip Adams (“Adams”) owned 8% of Northwest and worked as its General Manager. As part of the deal, Adams received around $1 million. In exchange, Adams signed a new agreement, which included both non-compete and non-solicitation provisions, and agreed not to engage in any activity that competed with the “Business,” which was defined to include services that were never offered by Northwest. Adams also agreed not to solicit customers or clients of Northwest or of the “Company Group,” which included the buyer, its subsidiaries, and their “affiliates.” The geographical scope was within 100 miles of any location where a “Company Group” member did business.
The Court of Chancery refused to enforce the non-compete and the non-solicitation provisions.
First, the Court of Chancery held that, while purchasers have a right to protect the goodwill of the business that they acquire, the agreement as written went far beyond that objective because it covered the business of the acquirer and other businesses in the Company Group as well: “Restrictive covenants in connection with the sale of a business legitimately protect only the purchased asset’s goodwill and competitive space that its employees developed or maintained.” The Court further held that buyers can not “restrict the target’s employees from competing in other industries in which the acquirer also happened to invest.” The Court of Chancery also found that the geographic scope was overbroad because it went beyond the territories in which Northwest had operated.
The next case in this recent triumvirate, Ainslie v. Cantor Fitzgerald, LP (Del. Ch. Jan 4, 2023), involved capital distributions to four partners over four years after they withdrew from the partnership. If, however, the partners competed during that four-year payout period, they would forfeit their distributions. The effect of the agreement was that the restricted period was four years in length. The Court refused to enforce the agreement.
Even under the more lenient “sale of business” standard, the Court still held that the forfeiture provision was unreasonable because of the four-year duration and the overly broad definition of “competitive activities.” That definition prohibited activities related to affiliates and not just the entity with which the former partner had been employed. The Court determined that there was no reason to believe that the former employees had any information regarding those entities, and, relying on Kodiak, the Court refused to blue-pencil the restrictions and rendered the entire agreement unenforceable.
Finally, most recently, in Intertek Testing Services NA, Inc. v. Eastman (Del Ch. Mar. 16, 2023), the Court of Chancery again refused to blue-pencil an overbroad agreement. In that case, Intertek Testing Services, NA, Inc. (“Intertek”) purchased Alchemy Investment Holdings (“Alchemy”), which provided workforce training and consulting to food and cannabis companies. Eastman, the co-founder, CEO, and a major stockholder of Alchemy, received $10 million in connection with the sale. Eastman also agreed to a five year non-compete prohibiting him from competing with any business anywhere in the world competitive with Alchemy or its subsidiaries, as conducted by them as of the closing date. The Court of Chancery determined that the global scope was overbroad, particularly because the buyer did not even allege that Alchemy engaged in a worldwide business. The Court of Chancery refused to blue-pencil the restrictions and struck the entire agreement.
What are the takeaways?
These cases signal the end of the well-worn practice by buyers of attempting to preclude competition against the buyer’s business as well as the acquired business. While acquirers have long gotten away with this practice due to the Court of Chancery’s willingness to blue-pencil restrictive covenants, such days are over. Thus, when drafting new restrictive covenants as part of an acquisition, acquirers must limit the scope to the target company’s business.
Moreover, if the Court of Chancery is applying this level of scrutiny in the context of a sale of a business, it certainly will apply at least this level of scrutiny to more routine restrictive covenants in the employment context. Thus, when an acquirer inherits employment agreements that already contain restrictive covenants, if those agreements (like the one in the Kodiak case), by their terms, prohibit the employee from competing with all present and future parents, subsidiaries, and affiliates, there is now a strong reason to believe that those agreements would not be enforceable in Delaware.
We strongly suggest that all companies relying on restrictive covenants under Delaware law review their agreements under the rubric of the three cases discussed here to determine whether new agreements are advisable. Relying on governing law in Delaware is no longer a panacea for overly broad restrictive covenants.
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