Delaware Courts Are Striking Overly Broad Non-competes — Even In the Sale of A Business
Traditionally, companies have viewed Delaware’s Court of Chancery to be one of the most business-friendly jurisdictions in the country. Recently, Delaware has joined the ever-expanding list of jurisdictions that no longer give businesses the benefit of the doubt when it comes to restrictive covenants — especially non-competes.
Partners Christina Bost Seaton, Carl Neff, and I explored this issue in a recent “Client Alert,” which I explain for you here.
Wait, What’s This All About Anyway?
Usually, the Delaware Court of Chancery (“Delaware Court”) is pretty lenient on restrictive covenants involved in the sale of a business.
They pretty much enforce such covenants, reasoning that when an employee sells their business, they already receive a ton of money and use lawyers to do their negotiating for them.
This is a far cry from the restrictive covenants your average employee signs when they join a company, i.e., often, whatever is in front of them.
The Delaware Court has changed its tune and recently, in three decisions, struck overly broad non-competes, sending shock waves through the M&A community.
Oh, You Need A Refresher? OK, Let’s Go Back
Here’s the tea.
Delaware courts generally enforce a restrictive covenant, like a non-compete or non-solicitation provision, if it (1) is an enforceable contract; (2) is reasonable in scope and in duration; (3) protects the employer’s “legitimate protectible interest”; and (4) is, on balance, fair.
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.
Makes Sense. So What Changed? Enter Case #1
First came 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. As part of the deal, the GM and 8% shareholder received around $1 million.
In exchange, the GM agreed not to engage in any activity that competed with the “Business,” defined to include services that Northwest never offered and not to solicit customers or clients of Northwest or of the “Company Group,” which included the buyer, its subsidiaries, and their “affiliates.”
The Delaware Court refused to enforce the non-compete and the non-solicitation provisions.
First, the Delaware Court deemed the agreement overly broad because not only did it cover the business of the acquirer, but 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.”
Ok, got it. Point made.
Then Came Case #2
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 Delaware 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.
Huh? What’s blue-penciling?
In some jurisdictions, like, traditionally Delaware, courts can reform or “blue-pencil” a restriction to make it enforceable.
Finally, And Most Recently…
In Intertek Testing Services NA, Inc. v. Eastman (Del Ch. Mar. 16, 2023), the Delaware Court again refused to blue-pencil an overbroad agreement. In that case, Intertek Testing Services, NA, Inc. (“Intertek”) purchased Alchemy Investment Holdings (“Alchemy”). The co-founder, CEO, and major stockholder of Alchemy (“CEO”), received $10 million in connection with the sale and 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 Delaware Court struck the non-compete entirely. Wouldn’t even blue-pencil the restrictions.
The Court determined that the global scope was overbroad, particularly because the buyer did not even allege that Alchemy engaged in a worldwide business.
What Are The Takeaways?
That is the question, right?
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. The dog days of relying on the Delaware Court’s willingness to blue-pencil restrictive covenants seem to be over – acquirers must limit the scope to the target company’s business.
Moreover, employers, if the Delaware Court applies this level of scrutiny in the context of a sale of a business, watch out for your more routine non-competes in employment agreements.
Companies relying on restrictive covenants under Delaware law may want to consult counsel to review their agreements under the rubric of the three cases discussed here to determine whether new ones make sense.
Relying on governing law in Delaware is no longer a panacea for overly broad restrictive covenants.