Trio of Delaware Cases Signal Stricter Review of Sale-of-Business Non-Competes
Republished in the May 2023 edition of The M&A Lawyer
Republished in the May 2023 edition of The M&A Lawyer
On March 16, 2023, the Delaware Chancery Court in Intertek Testing Services NA, Inc. v. Eastman found a sale-of-business non-compete was overbroad, given its worldwide geographic scope, and refused to modify it to make it enforceable. Intertek marks the third time in less than six months that a Delaware state court has refused to enforce or modify a non-compete under the more lenient sale-of-business standard. These cases signal a potential trend of Delaware state courts more closely scrutinizing non-competes under the sale-of-business standard to determine if they go beyond the legitimate business interests of the party seeking enforcement. Where overbreadth is found, these courts appear increasingly hesitant to modify or blue pencil the restrictions to make them enforceable. Companies should be mindful of these cases when drafting and enforcing sale-of-business non-competes governed by Delaware law.
With its well-developed corporate law and precedent, Delaware is generally viewed as a favorable jurisdiction for businesses. Because of this, many companies choose Delaware law to govern documents related to their corporate formation, transactions, and general business operations, including non-competition agreements. Under Delaware law, a restrictive covenant, such as a non-compete, generally is enforceable if it: (1) meets general contract law requirements; (2) is reasonable in scope and duration; (3) advances a legitimate economic interest of the party enforcing the covenant; and (4) survives a balance of the equities. Historically, Delaware courts have applied a “less-searching” inquiry to sale-of-business non-competes than non-competes in the employment context. This less-searching inquiry tends to favor enforcement, since the restricted individuals are selling their business, including their businesses’ confidential information, trade secrets, and goodwill, usually in exchange for monetary and other consideration. Delaware courts also have the discretion to blue pencil or modify non-competes they determine to be overbroad. As noted in Kodiak Building Partners, LLC v. Adams, 2022 WL 5240507 (Del. Ch. Oct. 6, 2022), however, courts applying Delaware law have generally not had to blue pencil or modify sale-of-business non-competes since they have found most sale-of-business non-competes enforceable.
Leading up to Intertek, two recent Delaware state court decisions authored by Vice Chancellor Zurn called into question the more lenient standard for reviewing sale-of-business non-competes under Delaware law.
As we previously reported, in Kodiak, the Delaware Chancery Court struck down a sale-of-business non-compete and refused to blue pencil it because the non-compete sought to prohibit the seller from competing against the buyer’s existing affiliated businesses outside the seller’s business and competing in territories in which the seller had not operated.
Then, on January 4, 2023, the Delaware Chancery in Ainslie v. Cantor Fitzgerald, L.P., 2023 WL 106924 (Del. Ch. Jan. 4, 2023), found a forfeiture-for-competition provision in a limited-partnership agreement unenforceable under the less-searching sale-of-business standard.
In the latest case, Intertek Testing Services NA, Inc. v. Eastman, 2023 WL 2544236 (Del. Ch. Mar. 16, 2023), a different Chancellor, Vice Chancellor Will, found that a non-compete with a global scope was overbroad and refused to exercise her discretion to blue pencil the restrictions.
These cases signal a potential trend for Delaware courts: (1) to more closely scrutinize the temporal, geographic, and functional scope of non-competes even under the more lenient sale-of-business standard; and (2) to be hesitant to blue pencil or modify those restrictions if the courts deem them overbroad. Indeed, in each of the three cases, the courts closely reviewed the restrictions to ensure they had a close connection to the business’s legitimate protectable interest, which they found was measured only by “the goodwill and competitive space” purchased from the seller and in the market the seller served. For example, these courts found the geographic and functional scope of the non-competes to be overbroad where they went beyond territories or businesses that the restricted seller had served. These courts also found that including affiliated entities in the scope of the non-compete was unenforceable where there was no showing that the restricted individual had obtained any confidential information of those entities or worked for them. As the Kodiak court noted,” [t]he acquirer’s valid concerns about monetizing its purchase do not support restricting the target’s employees from competing in other industries in which the acquirer also happened to invest.”
Although some Delaware courts have been reluctant to blue pencil restrictive covenants in the employment context, courts applying Delaware law have generally not had to consider whether to exercise their discretion for sale-of-business non-competes since those have typically been enforced. Indeed, the plaintiff in Kodiak noted that the restricted individual could not point to a single case where Delaware had struck down a sale-of-business non-compete.
With this recent string of cases, however, Delaware courts appear increasingly more reluctant to blue pencil sale-of-business non-competes, even where it seemingly would be easy to modify the non-compete to make it enforceable, such as narrowing the geographic term. We also observe that the Kodiak and Intertek courts relied on cases in the employment context to justify their decisions not to modify the sale-of-business non-competes. This potential blurring of the line between sale-of-business and employment non-competes by drawing on the equities of non-competes in the employment context to justify their refusal to blue pencil sale-of-business non-competes, makes this area even more challenging for practitioners and companies alike to navigate.
Although it is unclear whether other Delaware courts will follow these decisions, companies should be mindful of these cases when drafting or trying to enforce non-competes governed by Delaware law. Several points to keep in mind are as follows:
These cases also follow the growing trend of jurisdictions across the country, including Colorado, Illinois, the District of Columbia, and Washington, passing laws limiting the use of non-competes with employees. The trend of states regulating employee non-competes is expected to continue. Although many of these laws expressly carve-out non-competes entered into in connection with the sale of a business, companies should be mindful of the potential for their sale-of-business non-competes to be subject to these state laws or the more rigorous employment standards of review if those sale-of-business non-competes include employment concepts and terms.Some courts, for example, have applied more stringent employment standards to sale-of-business non-competes where the duration of the non-compete ran from the end of employment and not just the closing of the corporate transaction.
 Delaware law treats partnership agreements differently when it comes to penalties. As the court acknowledged, Delaware statute “departs from the common law in that it ‘authorizes LLC agreements to provide for remedies that would be unavailable in a standard commercial contract, most notably penalties and forfeitures.’” Ainslie v. Cantor Fitzgerald, L.P., No. 9436-VCZ, 2023 WL 106924, at *12 (Del. Ch. Jan. 4, 2023).