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From left to right: Jeremy Ben Merkelson, James K. Goldfarb, Gerald Stein, and Travis J. Distaso (photos courtesy of Davis Wright Tremaine LLP)
Equity and capital forfeiture for competition provisions given less scrutiny than other post-employment restrictive covenants
Companies subject to Delaware law were handed a welcome surprise in a recent Delaware Supreme Court decision bolstering the enforceability of certain post-employment restrictive covenants. The provisions at issue are so called “forfeiture for competition” provisions. They condition post-employment equity interests, distributions, return of capital, or other benefits upon a departing employee’s continuing compliance with certain post-employment restrictive covenants. Forfeiture for competition provisions frequently are at play in equity award agreements with executives and business partners. The recent decision provides for an alternative avenue for securing post-employment restrictive covenants when traditional non-competes may otherwise be unenforceable.
In the recently decided case of Cantor Fitzgerald, L.P. v Ainslie, –A.3d—, 2024 WL 315193 (Del. Jan. 29, 2024), the Delaware Supreme Court has made clear that it sides with the minority of states and treats these provisions as contracts between sophisticated parties that will be enforced to their maximum effect, absent unconscionability, bad faith or other extraordinary circumstances, and not treated as employee restraints of trade subject to more rigorous scrutiny. This ruling contradicts the direction of the Chancery Court which made two notable decisions in 2022 and 2023 that took a more skeptical view of post-employment restrictive covenants.
The Ainslie decision reverses the Delaware Chancery Court holding in Ainslie v. Cantor Fitzgerald L.P., 2023 WL 106924 (Del Ch. Jan. 4, 2023), in which Vice Chancellor (V.C.) Zurn treated a forfeiture for competition provision as an employee restraint of trade subject to a more rigorous reasonableness test than an ordinary contract. Under that test, V.C. Zurn declared unenforceable a limited duration non-compete that sought to bind former partners, and a lengthier conditional payment scheme in a limited partnership agreement that conditioned payments of otherwise earned benefits on the former partners’ not competing with the partnership or its affiliates. The conditional payment scheme conditioned payout of the former partners’ capital accounts on the partners’ not having breached the non-compete provision or the non-solicit provision and upon the former partners’ not having otherwise competed with the partnership or its affiliates for the four-year payout period for return of the former partners’ capital accounts. V.C. Zurn referred to the latter as a “forfeiture-for-competition provision,” which many states treat as substantively different from an actual non-compete, and which is not subject to the typical review for reasonableness under Delaware law. (State law is key on this question.) V.C. Zurn held that the instant non-compete failed not because it was a forfeiture provision per se, but because when viewed through the lens reasonableness, four years was simply too much. A world-wide restriction not tied just to the business of the partnership, but also to any of its affiliates, was too broad for V.C. Zurn to accept as reasonable.
The Delaware Supreme Court, on January 29, 2024, reversed and remanded the case back to V.C. Zurn to inspect the provision under a less rigorous standard. The court recognized that the debate surrounding the enforceability of forfeiture-for-competition devices raises important, and often divergent, policy considerations: policies favoring “enforcing private agreements on [the] one hand, and disfavoring restraints of trade and allowing individuals to freely pursue their profession of choice, on the other.” The Court recognized the Chancery Court’s decision to be “thoughtful,” but it disagreed with the test that V.C. Zurn had applied to Cantor Fitzgerald’s competition forfeiture provision. The Court stated:
Under the circumstances of this case, we balance the relevant policy interests differently. When sophisticated actors avail themselves of the contractual flexibility embodied in the Delaware Revised Uniform Limited Partnership Act—a statute that is expressly designed “to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements”—and agree that a departing partner will forfeit a specified benefit should he engage in competition with the partnership, our courts should, absent unconscionability, bad faith, or other extraordinary circumstances, hold them to their agreements. As we have observed, “[p]arties have a right to enter into good and bad contracts[;] the law enforces both.” Here, the Court of Chancery erred by imposing its notion of reasonableness on the very provisions that, when enforced against other departing partners, redounded to the plaintiffs’ benefit during their tenure as partners.
The Ainslie decision is notable because it is also somewhat in tension with the holding of Kodiak Building Partners, LLC v. Adams, 2022 WL 5240507 (Del. Ch. Oct. 6, 2022), in which the Delaware Chancery Court surprised the bar by declaring unenforceable a non-compete entered into by a selling stockholder and employee of a target business in favor of the acquirer of that target business. Most deal lawyers considered that sellers of a business were generally exempt from the strict scrutiny that non-competes require in other contexts. Vice Chancellor Zurn did acknowledge 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.'” Still, a covenant not to compete in the sale of a business must be limited to the “purchased asset’s goodwill and competitive space that its employees developed or maintained.” The court held that the non-compete at issue impermissibly extended to the “goodwill and competitive space [that the buyer had] acquired in other transactions with other Company Group members in other industry segments.” Said differently, the non-compete extended into the entire company’s existing business, not just this particular target’s business. Given that ruling, deal lawyers drafting non-competition and other restrictive covenants into definitive M&A agreements have to take extra care to ensure that they are narrowly crafted to meet the required scrutiny under the reasoning of Kodiak Building Partners, LLC.
While we continue to wait and see if the FTC will issue a final rule invalidating post-employment restrictive covenants nationwide (and we very much believe such rule would be enjoined and not immediately enforced), this January 29, 2024, Ainslie’s decision is instructive: it provides a pathway for post-employment restrictive covenants that bypass the reasonableness test altogether. Certainly, at least in Delaware, such a ruling has the impact of suggesting that employers who have substantial benefits to confer upon employees’ post-termination may do so with forfeiture provisions tied to compliance with restrictive covenants, provided the contracts otherwise meet ordinary contract requirements.
Takeaways
There are several key takeaways from this decision for employers with agreements subject to Delaware governing law.
- Review all workplace agreements with restrictive covenants clauses, including equity incentive agreements, restrictive stock grants, stock option awards, limited partnership agreements, management or executive shareholder agreements, and similar types of arrangements.
- Employers, including private equity-backed businesses and deal teams advising them on transactions, should consider adding or strengthening the restrictive covenants in employee-related equity agreements with forfeiture of benefits provisions. While pure post-employment restrictions will need to be narrowly tailored to meet the reasonableness test for employee restraints, the benefit forfeiture provisions, with Ainslie‘s guidance, will be held to a different standard of review. Consider developing benefits forfeiture provisions now if you have not before.
- Though equity forfeiture provisions may be enforceable in Delaware, recognize that the landscape for other employee non-competition and non-solicitation covenants is not as employer-friendly in most of the country, and Delaware will still hold those provisions (i.e., in employment or severance agreements) to a more rigorous standard. To protect competition-sensitive data in this climate, remind employees of their ongoing duty to preserve, and not to disclose, company proprietary information and/or trade secrets and conduct training modules requiring employees to acknowledge these obligations.
- Take technical measures to protect your most valuable data. Implement access-control protocols (i.e., network, file, and individual document access levels) that safeguard company proprietary information and/or trade secrets. Implement data-security policies and procedures that further describe employees’ roles and responsibilities, coordination among organizational entities, and allow for regular compliance monitoring. Eliminate all information-system access when no longer required. Consider data encryption and other technical measures to protect data when transmitted electronically.
- Implement a robust out-boarding process with departing employees that emphasizes an ongoing duty to protect, and to not disclose, company proprietary information and/or trade secrets. Establish procedures for employees to return all company-owned property prior to departure.
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