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Key Takeaways

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The Delaware Supreme Court posited that forfeiture-for-competition provisions are not restraints of trade because, unlike non-compete provisions in employment contracts, they do not prohibit employees from engaging in competitive work but merely deny them the right to some financial benefit if they choose to do so.

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The ruling will come as a relief to the general partners of investment vehicles in the alternative assets industry, as well as other businesses that are commonly structured as Delaware limited partnerships. Forfeiture-for-competition provisions are widely used in the financial services industry, so the Chancery Court’s now-overturned decision had cast doubt on the enforceability of key contractual arrangements.

In upholding the enforceability of forfeiture-for-competition provisions, the Delaware Supreme Court cited the state’s strong contractarian tradition and noted that the Delaware Revised Uniform Limited Partnership Act is designed to give maximum effect to the principle of freedom of contract.

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The Delaware Supreme Court yesterday upheld the enforceability of forfeiture-for-competition provisions in limited partnership agreements, reversing the Court of Chancery, which had reasoned that such provisions should be subject to the same “reasonableness” analysis applicable to employment-based non-competes (Cantor Fitzgerald v. Ainslie). Citing Delaware’s “reverential” regard for freedom of contract, the court held that parties to a limited partnership agreement must abide by their contractual undertakings absent unconscionability, bad faith or other extraordinary circumstances.

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The Chancery Court’s now-overturned opinion, which had found that Cantor Fitzgerald LP owed six former partners nearly $9 million, had prompted additional lawsuits over the firm’s agreements and raised questions about the enforceability of similar contracts throughout the financial services industry. Cantor Fitzgerald successfully argued on appeal that, “if left to stand, the ruling would wreak havoc on a variety of Delaware contracts, numerous limited partnership agreements that provide for financial consequences based on the actions of partners, and a host of other financial arrangements between companies and individuals that are routinely upheld without non-compete scrutiny.”

Yesterday’s opinion distinguished between an employment non-compete, which gives rise to a strong public policy interest in balancing the equities because it precludes a former employee from earning a living in their chosen field, and a forfeiture-for-competition provision, which is not enforceable through injunctive relief, does not prohibit the employee from remaining in his or her chosen profession, and does not deprive the public of the employee’s services. In the latter case, the Delaware Supreme Court held, the diminished public policy interest is insufficient to override the Delaware Revised Uniform Limited Partnership Act’s directive to “give maximum effect to the principle of freedom of contract and the enforceability of partnership agreements.”

In coming to its conclusion, the Delaware Supreme Court also referenced the “employee choice” doctrine, under which courts do not review forfeiture-for-competition provisions for reasonableness so long as the employee voluntarily terminated his or her employment. The Chancery Court had declined to apply the employee choice doctrine, even as it acknowledged that it is the majority approach among other jurisdictions.

Over the past year and a half, non-competes have become increasingly disfavored across the United States.

In January 2023 the Federal Trade Commission (FTC) proposed the Non-Compete Clause Rule, which would categorically ban employers from using non-compete clauses with workers, though it contains a narrow exception for non-compete clauses between the seller and buyer of a business when the person restricted by the non-compete clause holds at least a 25% ownership interest in the target prior to the sale. The FTC is expected to vote on the Non-Compete Clause Rule in April.

A number of states have adopted statutory limitations on non-competes, including California, North Dakota and Oklahoma, which maintain blanket bans on non-compete agreements. Eleven other states and the District of Columbia have enacted statutory limitations on employers’ use of non-compete agreements, forbidding non-competes for lower-wage employees.

In December 2023, Gov. Kathy Hochul vetoed a bill that would have broadly banned non-compete agreements in New York State. The legislation called for a total prohibition, without limitations commonly found in other states, such as a minimum salary threshold or a carve-out for agreements made in connection with the sale of a business. It is widely expected that new legislation will be introduced in New York in 2024.

Delaware meanwhile has been striking non-competes that the Chancery Court determines are not reasonable in geographic scope and temporal duration and refusing to blue-pencil the offending language.

In October 2022, the Court of Chancery, in Kodiak Building Partners v. Adams, invalidated a non-compete in connection with the sale of a business because it imposed restrictions that exceeded the scope of the business being sold. In March 2023, the court reiterated that position in Intertek Testing Services NA v. Eastman, striking down an overly broad sale of business non-compete because of the incongruity between the geographic scope of the covenant and the company’s business.

Last year also saw the Delaware Chancery Court declining to apply Delaware law to non-competes. In February, it refused to uphold the application of Delaware law to restrictive covenants contained in the operating agreement of a Delaware limited liability company, where the individual competing lived and worked in Alabama (Hightower Holding v. Gibson). In August, the court dismissed an Illinois-based medical equipment supplier’s non-compete suit against a former employee because the non-compete violated Illinois’ fundamental policies and material interests, even though it contained a Delaware choice of law provision (Centurion Service Group LLC v. Wilensky).

In Frontline Technologies Parent LLC v. Murphy, decided in August 2023, the Chancery Court blocked a software company’s attempt to stop two former employees from working for a competitor because the restrictive covenants at issue only applied to the holding company parent, not its operating subsidiary.

In December, the Chancery Court took the unusual step of certifying for interlocutory appeal a case relating to non-compete covenants in a limited liability company operating agreement, Sunder Energy, LLC v. Jackson, C.A. The Chancery Court cited the need for guidance on substantial legal questions and expressed concern about the “problematic and unsustainable” trend of companies using Delaware’s legal system to bypass other states’ laws in non-compete disputes.

While the holding in Cantor Fitzgerald v. Ainslie is based on the Delaware Revised Uniform Limited Partnership Act, Sunder Energy, LLC v. Jackson, C.A. may provide guidance with respect to the Delaware Limited Liability Company Act.

New York

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Margaret Isa Butler

Steven H. Goldberg

Business

Delaware Supreme Court Upholds Enforceability of Forfeiture-for-Competition Provisions in Limited Partnership Agreements, Rejecting Chancery Court’s Application of ‘Reasonableness’ Scrutiny from the Employment Non-Compete Context

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