On January 29, 2024, the Delaware Supreme Court issued an important decision addressing the enforceability of restrictive covenants. As detailed below, in Cantor Fitzgerald v. Ainslie, the court upheld forfeiture-for-competition provisions set forth in a limited partnership (LP) agreement and ruled in favor of the partnership not having to pay out millions to former partners.
In Cantor Fitzgerald, the Delaware Supreme Court decision relied significantly on the following factors in enforcing the LP agreement as written and determining that the disputed provisions were, in fact, enforceable:
- The restrictive covenant did not bar the claimants from engaging in competitive activities.
- Rather, the provisions in question provided, in part, that receipt and retention of prior conditional awards of a portion of their compensation would be subject to the condition precedent that the recipient refrained from competing – in other words, these were forfeiture-for-competition provisions.
- These forfeiture-for-competition provisions were not liquidated damages provisions (triggered by a breach of contract); rather, these provisions set up a condition precedent (not competing with the employer) to the employees’ receipt of the amounts that had been held back.
- The “employee choice doctrine” suggests that courts do not review forfeiture-for-competition provisions for reasonableness where, as here, the employee voluntarily terminates employment (as opposed to remaining employed and vesting in the contingent compensation amounts).
By way of background, since the early 1900s, Delaware has been the preferred state of formation for business entities. For context, over 60 percent of Fortune 500 companies are incorporated in Delaware. Many companies select Delaware as their home base because the state is business-friendly, offering convenience, flexibility, and predictability. Additionally, Delaware is home to the country’s oldest business court—the Delaware Court of Chancery. The Delaware Court of Chancery is best known for its robust body of case law interpreting the Delaware General Corporation Law and has earned a reputation for integrity, fairness, and expertise in corporate litigation.
Generally, Delaware courts will uphold a non-compete clause if it (1) is reasonable in geographic scope and temporal duration; (2) advances a legitimate economic interest of the party seeking enforcement; and (3) survives a balancing of the equities. When analyzing “reasonableness,” Delaware courts focus on whether the provision is essential for the protection of the employer’s economic interests. In New York, employee non-competes are permissible so long as they are reasonable in temporal and geographic scope. To be reasonable, a non-compete must be necessary to protect an employer’s legitimate business interest, which in turn necessitates a highly fact-specific inquiry based upon the particular industry, position, and individual at issue.
Courts often, however, view forfeiture-for-competition provisions more favorably than employee non-compete clauses. Indeed, in recent years, the Delaware Court of Chancery has subjected non-compete clauses to increased scrutiny. For example, in Frontline Techs. Parent, LLC v. Murphy, 2023 Del. Ch. LEXIS 336 (Del. Ch. Aug. 23, 2023), the Delaware Court of Chancery refused to enforce a non-compete provision that was “expressly tailored” to prohibit competition with the company’s Parent—not the company. One week later, in Centurion Serv. Grp., LLC v. Wilensky, 2023 Del. Ch. LEXIS 354 (Del. Ch. Aug. 31, 2023), the Delaware Court of Chancery also refused to enforce a non-compete clause that was overly broad and “limitless” in scope. The court’s analysis reinforced the principle that Delaware courts are hesitant to revise and “blue pencil” noncompetition provisions and will instead reject enforcement.
By contrast, in New York, under the employee choice doctrine, courts may uphold a non-compete, regardless of its reasonableness, if the employee has been given the choice of either not competing (and maintaining benefits) or competing (and risking forfeiture). This applies so long as the employee left employment voluntarily and the former employer demonstrated its continued willingness to employ the individual who agreed not to compete. For example, in Post v. Merrill Lynch, Pierce, Fenner & Smith, 421 N.Y.S.2d 847 (1979), the New York Court of Appeals held that a forfeiture-for-competition clause is unenforceable if an employee is terminated without cause (though there has been some debate in recent decades about the extent of the decision’s reach).
Employee non-competes have been subject to increased scrutiny and regulation in recent years. Last year, the Federal Trade Commission proposed a rule that would limit their use. Also last year, the New York State legislature introduced legislation that would ban non-competes in New York; that bill was recently vetoed.
The Cantor Fitzgerald decision
In Cantor Fitzgerald, former partners sued the partnership alleging that it breached the LP agreement by not paying certain post-withdrawal amounts. In support of those arguments, the former partners alleged, among other things, that the forfeiture-for-competition contained in the LP agreement was not appropriately limited in temporal or geographic scope. The Delaware Chancery Court sided with the former partners and held that the provision was unenforceable. It reasoned that such provisions must be assessed for reasonableness – similar to employee restrictive covenants – and that the state’s interest in protecting competition outweighs its interest in enforcing private contracts.
On appeal, the Delaware Supreme Court reversed the Chancery Court and ruled that it erred in imposing “the notion of reasonableness” (i.e., the “same test as applied to traditional non-compete agreements” with employees). The court underscored that there is a “significant” distinction between an employee non-compete and an agreement that allows former partners to compete so long they forgo a contingent benefit. It reasoned that forfeiture-for-competition provisions, unlike employee non-competes, “are not enforceable through injunctive relief, do not prohibit employees from competing and remaining in their chosen profession, and do not deprive the public of the employee’s services, present.” The court also discussed that the interests at issue when assessing an employee non-compete are weakened, if not, obviated, when competition is permitted and the subject individual is highly compensated.
It is important to note that the Cantor Fitzgerald decision was in the context of an alternative entity (i.e., a partner withdrawing from a limited partnership). In such circumstances, as noted by the court in its ruling, Delaware courts give maximum effect to freedom of contract for sophisticated parties. To that end, the court explained that – absent unconscionability, bad faith, or other extraordinary circumstances – departing partners should be held to their partnership agreements, particularly given that Delaware’s partnership law is designed to afford deference to such agreements.
The Cantor Fitzgerald ruling is a positive outcome for the business community, particularly for those legally-based in Delaware or operating in the professional services industry and utilizing forfeiture-for-competition clauses when contracting with partners or shareholders. It is also a good reminder that, despite recent efforts to curtail the use of non-compete agreements, such agreements can be enforceable if properly tailored and the circumstances warrant it.
However, given the stark distinction the court drew between forfeiture-for-competition provisions and employee non-competes, the ruling may have limited applicability in the broader employment law context.