Delaware law has long been regarded as “business friendly.”  Delaware courts have consistently followed a “contractarian” view of contract interpretation, generally enforcing agreements as drafted, rather than importing and imposing external policy concerns.  Delaware is frequently seen as the “default” choice for the contractual choice of law in M&A transactions, assuring the parties they will receive what is stated in the contract.  Moreover, Delaware courts seemed quick to apply Delaware law where designated, and where at least one party was a Delaware entity.  This pattern seemed true not only with respect to M&A contracts in general, but specifically with respect to post-closing restrictive covenants, as Delaware courts recognize that “sale of business” noncompetes are subject to “less scrutiny” than employment related noncompetes.  See, e.g., Faw, Casson Co. v. Cranston, 375 A.2d 463, 465 (Del.Ch. 1977); Kodiak Building Partners, LLC v. Adams, C.A. No. 2022-0311-MTZ (Del. Ch. Oct. 6, 2022), Slip. Op. at 9. 

But in four carefully reasoned cases, issued over the course of just the past twelve (12) months, the Delaware Chancery Court forcefully upended this pattern and raised significant doubt about the wisdom of designating Delaware law for M & A noncompetes, where other choices are available.  The Court repeatedly declined to enforce “sale of business” noncompetes, refused to “blue pencil” overbroad noncompetes to make them enforceable, and left the restrictive covenants unenforced, even though in several of these cases, the competitive conduct was core conduct of the type a properly drafted noncompete should have covered.  These cases include Kodiak Building Partners, supra, as well as Ainslie v. Cantor Fitzgerald, L.P., (Del. Ch. Jan. 4, 2023), HighTower Holding, LLC v. Gibson, (Del. Ch. Feb. 9, 2023) and Intertek TestingServices NA, Inc. v. Eastman,(Del. Ch. Mar. 16, 2023). 

In Kodiak Building Partners v. Adams, Kodiak, the purchaser, operated nineteen subsidiaries around the country, in four construction related lines of business.  The acquired business, Northwest, was a truss company, operating from a single location in Idaho, manufacturing, selling and delivering roof trusses and other building materials. Its customers were located primarily within 30 to 60 minutes from Northwest’s location.  The defendant, Adams, was the long-time general manager of Northwest and owner of 8.33% of the company’s stock. 

The covenant agreed to restricted Adams from competing with the business of the purchaser and its subsidiaries, including in both Northwest’s line of business, and in the other construction industry lines of business of Kodiak’s other subsidiaries.  In addition, although the acquired company did business from one location in Idaho, the covenants barred Adams from competing in any of the locations where the acquiror did business.  Adams received approximately $900,000 in return for his interests in the acquired company; the bulk of the consideration went to the majority owners.

After staying with the acquired company for more than a year, Adams quit, and a few months later, went to work as general manager of BFS, at an office located twenty-four miles from Northwest.  BFS supplied building materials such as lumber, roof trusses, and I-joists, and provided design services for roof trusses. Its truss business was national.

In other words, after leaving Kodiak/Northwest, Adams went to work as general manager of a competitor of Kodiak/Northwest, located close to his former Kodiak/Northwest location, and competing within both the territory of Kodiak/Northwest and the larger Kodiak territory.  Suit was filed when Kodiak/Northwest lost a customer order to Adams and BFS.    

The Kodiak court declined to enforce the noncompete, a result many found surprising.  In forceful terms, the court held that “[r]estrictive covenants in connection with the sale of a business legitimately protect only the purchased asset's goodwill and competitive space … The 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.”  Slip.Op. at 22-23.  The court took issue with both the geographic and functional scope of the restraint: “Kodiak's legitimate economic interest that can support restraining Adams's employment is only in the goodwill and competitive space it purchased from Northwest in the market Northwest serves. … [t]he noncompete provision is overbroad to the extent it prohibits competition in geographic areas around subsidiaries other than Northwest, and the nonsolicit provision is overbroad to the extent it covers customers, clients, or prospective customers and clients of subsidiaries other than Northwest”. Slip.Op. at 27, 28.

Even though the actual competitive activity Adams engaged in, was well within the protectable territory and scope of business of Northwest, the acquired company, the court refused to “blue pencil” an agreement that was overbroad on its face, and to enforce to the extent reasonable. The court held that, where “noncompete or nonsolicit covenants are unreasonable in part, Delaware courts are hesitant to ‘blue pencil’ such agreements”, Slip.Op. at p.10.  Acknowledging that Delaware courts had sometimes blue penciled in the past, the Chancery Court nevertheless noted that “‘courts' willingness to modify non-competes creates confusion, encourages employers to overreach, and encourages litigation ‘by building a degree of uncertainty into every employment agreement’”. Id at n.49.  While the court repeatedly noted that this case involved a sale of business non-compete, and that sale of business non-competes were “subject to a ‘less searching’ inquiry” than employment covenants; the court’s inquiry was quite “searching”, and the court looked to employment cases in evaluating the noncompete in this sale of business context.  See Slip.Op. at 16, n.65.  As the court said, while its “concerns are more cogent in an employment agreement than in the sale of a business, they still undergird this Court's reasonableness review of all restrictive covenants.” Id. (emphasis added). 

Note that the Kodiak court did not address, and plaintiff apparently did not claim, that Adams had trade secrets or confidential information acquired or owned by Kodiak, which would enable Adams to have an unfair advantage over Kodiak and its subsidiaries other than Northwest.  Such claims are often at issue in cases of this nature. 

In Ainslie, “forfeiture for competition” (“FFC”) clauses were at issue. Defendant Cantor Fitzgerald is a Delaware limited partnership, operating under a Delaware limited partnership agreement (“LPA”) which contained provisions designed to restrict departing partners from competing, soliciting clients or employees, and from using the partnership's confidential information. The interlocking provisions included both Restrictive Covenants, under which Cantor could seek injunctive relief and damages, and “Conditioned Payments” – FFC clauses -- under which Cantor could withhold money otherwise payable from the departing partner’s capital account, and from other earned compensation, if the partner engaged in certain post-employment competitive activity such as violating the Restrictive Covenants. The scope of the entities “protected” under the LPA was very broad, and included Cantor and essentially all of its affiliates worldwide.  The individuals in Ainslie were all employees of Cantor Fitzgerald Hong Kong Limited (“Cantor HK”); each was also a Cantor limited partner and party to the LPA.  Each Plaintiff voluntarily terminated their employment and withdrew as a partner.

Under the FFC clauses, Cantor withheld amounts ranging from $100,000 to $5.5 million, based on the determination by Cantor’s Managing Partner, that each ex-partner had breached covenants under the LPA.  The six former partners sued in Delaware to obtain the withheld amounts and attacked the contractual provisions as unreasonable restraints of trade.  Injunctive relief was not at issue in the Delaware case, only the withheld payments.  A separate action for injunctive relief was brought by Cantor HK in Hong Kong, against certain of the ex-partners/employees, but was denied based on a finding that the employment agreements were unenforceable under Hong Kong law. 

The Delaware Chancery Court addressed two key issues: (1) whether the Restrictive Covenants were unreasonable restraints of trade, subject to striking or modification after judicial review (i.e., the matter typically at issue in noncompete cases), and (2) whether the FFC clauses were to be reviewed for reasonableness as restrictive covenants, or treated as conditional payment clauses, which would not involve judicial review of reasonableness.  According to the court, Delaware law was “not clear on whether such [FFC] provisions are restraints of trade that should be evaluated for reasonableness”, or whether “Delaware should adopt the ‘employee choice’ doctrine, which provides that courts should not review forfeiture-for-competition provisions for reasonableness so long as the employee voluntarily terminated her employment.” Slip.Op. at p. 55.  As stated by the court, “[t]he employee choice doctrine is driven by freedom of contract principles …  the employee made the decision to leave, and forgoing certain compensation or benefits is a part of that decision … forfeiture-for-competition provisions serve as a financial disincentive, rather than a per se bar on obtaining employment with a competitor (footnotes omitted)”.  Id., at pp. 55 – 57. 

The court articulated the Delaware standard for evaluating restrictive covenants as follows: “…to be enforceable under Delaware law, they must (1) be ‘reasonable in geographic scope and temporal duration, (2) advance a legitimate economic interest of the party seeking its enforcement, and (3) survive a balancing of the equities. (footnote omitted).’ The reasonableness of the covenant's scope is measured in relation to the employer's legitimate interests: a greater scope must be supported by a greater interest.” Slip.Op. at 43. 

The court had little trouble determining that the Restrictive Covenants in this case were unreasonable and unenforceable. As the court held:

“The Restrictive Covenants' worldwide geographic scope is unreasonable. ‘[T]he absence of a geographic limitation does not render [a] restrictive covenant unenforceable per se’: it can be enforceable if the restriction is narrowly tailored to serve the employer's interests … But Cantor Fitzgerald makes only the conclusory argument that Cantor Fitzgerald is a global business and therefore a global restrictive covenant is necessary. This is not sufficient.  The Restrictive Covenant is most patently unreasonable in its scope of who it protects. ‘Competitive Activities’ includes prohibited actions taken not just against Cantor Fitzgerald, but also ‘any Affiliated Entity,’ defined as ‘the limited and general partnerships, corporations or other entities owned, controlled by or under common control with’ Cantor Fitzgerald. Prohibited solicitation is not limited to successfully convincing a Cantor Fitzgerald partner to withdraw and work for a competitor: it also includes acting in concert with others to attempt to ‘solicit, induce or influence’ a consultant to terminate ‘other business arrangements’ with Cantor Fitzgerald, and inducing a customer or employee of a Cantor Fitzgerald affiliate to ‘adversely affect their relationship’ with an affiliate. *** Cantor Fitzgerald has advanced no convincing rationale as to why this broad and vaguely defined scope is necessary to protect Cantor Fitzgerald's good will and customer relationships. … There is no indication that Plaintiffs had access to any kind of information—proprietary or otherwise—that would warrant that restriction. Cantor Fitzgerald argues only that Plaintiffs have profited from Cantor's other business lines. … overbreadth is exacerbated by how the LP Agreement defines whether it has been breached. A partner breaches a Restrictive Covenant not when she actually competes, but when the Managing General Partner determines she has competed. This language expands the scope of prohibited employment from competing to employment that may not actually compete, and therefore not harm any legitimate Cantor Fitzgerald interest, so long as the Managing General Partner believed in good faith that the employment was a Competitive Activity. Cantor has not advanced any argument showing why this expansive condition is necessary.”  Slip Op. at 45 - 50. 

The court ruled that the FFC clauses would be evaluated under a reasonableness standard, as restrictive covenants would be, holding that the relevant provisions of the LPA were “intended to dissuade partners from competing: it states that partners will suffer a forfeiture if they ‘engage[] in any Competitive Activity,’ which pulls in the same exact conduct as the Restrictive Covenants.  And Plaintiffs did not have the opportunity to negotiate any aspect of the LP Agreement: it was provided on a take-it-or-leave-it basis as a condition of joining the Partnership. (footnotes omitted).” Slip.Op. at 65.  While the court ruled that this part of the evaluation would be under the more “lenient or employer-friendly” sale of business standard, the court further held that, even under that standard, the restraints were unreasonable and unenforceable. 

Here again, no real consideration was given by the court to “blue penciling.”  The restrictions were stricken, and defendant ordered to make the relevant withheld payments. 

Ainslie is on appeal to the Delaware Supreme Court, where the scope of review for FFC clauses will be a key issue, and where the court may also provide some review off the Chancery Court’s recent analysis of non-competes.

In HighTower Holding, LLC v. Gibson, supra, the Delaware Chancery Court refused to honor a Delaware choice of law clause for a post-closing noncompete in an acquisition context, where the new entity formed to conduct the acquired business was organized under Delaware law, but where the Court found that Alabama law applied to the noncompete, and that, under Alabama law, the noncompete at issue was void.  As the court held, Delaware follows the Restatement (Second) of Conflicts of Laws (“Restatement”), under which a contractual choice of law will generally govern, unless “‘enforcement of the covenant would conflict with a ‘fundamental policy’ of the default state’s law, and the default state ‘has a materially greater interest in the issues … than Delaware.’” Slip. Op. at 12 (citing cases and the Restatement at §§ 187-188).  The court held that Alabama was the “default state” — i.e., the state whose law would apply absent a contractual choice of law — since the relevant agreements “… were negotiated and executed in Alabama. The … business acquired … was located in Alabama. The relevant agreements were performed in Alabama.  The alleged infringement also centers on Alabama … and Gibson [the defendant] is registered as an investment advisor representative in Alabama … [and] has resided in Alabama at all relevant times.” Slip. Op. at 13.  The court noted that a different determination of “default state” might be applicable, where the business entities are organized under Delaware law, and performance is split among several states, rather than occurring essentially in only one. Id., at n.55. 

In  HighTower, the court held that Delaware’s “contractarian” policies were not sufficient to outweigh Alabama’s strong policy on non-competes: “Alabama has a strong policy opposing the enforcement of non-competes. Against this is Delaware’s interest in freedom of contract and in ‘upholding a lingua franca for sophisticated commercial parties.’ The entire purpose of the Restatement analysis is to prevent parties from contracting around the law of the default state by importing the law of a more contractarian state, unless that second state also has a compelling interest in enforcement.’ Here, Alabama’s interest in preventing the enforcement of non-competes against an Alabama resident working in Alabama is more significant than Delaware’s general contractarian policies.” Slip. Op. at pp. 24-25. 

While parties often designate Delaware choice of law in M & A acquisitions --  with the expectation that Delaware courts would honor that choice and enforce the covenants -- one could also argue that HighTower was not a change in Delaware law.  For one example, in Ascension Insurance Holdings, LLC v. Underwood, 2015 Del. Ch. LEXIS 19 (Del. Ch. Jan. 28, 2015), the court applied the Restatement test and similarly rejected a contractual choice of Delaware law.  But Ascension involved a California employee of a California based company, which was organized as a Delaware limited liability company.  While the analysis in Ascension was very similar to that of HighTower, the Ascension court specifically found that the statutory, “sale of goodwill exception” to the California noncompete ban, Calif. Bus. and Corp. Law §16,601, did not apply.  So, Ascension, unlike HighTower, was not a “sale of business” case, but an employment case, and involved a California employee, of a company headquartered in California. The impact of Ascension was further muted by the subsequent adoption, in California, of California Labor Code § 925(e), under which a California employee who is represented by counsel, can contract around California’s well known non-compete restriction.  On this basis, Delaware later accepted Delaware law designations for California noncompetes, where the parties qualified under §925(e). See, e.g.,  NuVasive, Inc. v. Miles,2018 WL 4677607 (Del. Ch. Sept. 28, 2018); Nuvasive, Inc. v. Miles, C.A. No. 2017-0720-SG, at *4 n.2 (Del. Ch. Aug. 26, 2019).  There was previous litigation, similar to Ascension, involving Nebraska law, see Cabela’s LLC v. Higby, 362 F. Supp. 3d 208 (D. Del. 2019), aff'd, 801 Fed.Appx. 48 (3d Cir. 2020), but this case did not prompt widespread attention and concern, and, while the employees involved did own company stock which they received in return for signing a restrictive covenant agreement, the court analyzed the case as essentially an employment case, not a “sale of business.”

The HighTower court rejected plaintiff’s argument that a “Delaware court will enforce a Delaware choice of law provision so long as there is a ‘material relationship’ to Delaware. … [and] the Delaware choice of law provision and the presence of Delaware entities constitute ‘material relationships’ [citing Delaware cases]”.  Slip. Op. at p. 14, n.57.  This view -- together with the corollary view that, once Delaware law is applied, “sale of business” noncompetes would be enforced under the more lenient Delaware “sale of business” standard, essentially without judicial modification – has often been the “conventional wisdom”, a view widely held by the bar.  Indeed, many federal and some state cases adopted this view, relying on 6 Del. C. § 2708, and a non-precedential Third Circuit case, Coface Collections N.Am., Inc. v. Newton, 430 F. A’ppx. 162, 166 (3d Cir. 2011) ("[I]t is only in rare circumstances that Delaware courts do not honor the choice-of-law provisions agreed to by parties in a binding contract."). See, e.g., FinancialApps, LLC v. Envestnet, Inc., Civil Action No. 19-1337-CFC-CJB, at *7 n.4 (D. Del. July 6, 2020) (“Because one of the MSA's signatories is a Delaware corporation (Yodlee), this choice of law provision would be enforceable, as Yodlee's incorporation in Delaware would demonstrate that Delaware had some substantial relationship to the transaction. [citing Coface]); Advanced Reimbursement Mgmt., LLC v. Plaisance, C.A. No. 17-667 (MN), at *10 (D. Del. June 17, 2019) (“The Third Circuit has acknowledged ‘that it is only in rare circumstances that Delaware courts do not honor the choice-of-law provisions agreed to by parties in a binding contract. [citing Coface]’”); Sensus U.S., Inc. v. Franklin, C.A. No. 15-742-RGA, at *7 (D. Del. Apr. 14, 2016); Opengate Capital Grp. LLC v. Thermo Fisher Scientific Inc., C. A. No.: 13-1475-GMS, at *22 (D. Del. July 8, 2014). 

But after the decisions of the last several months, this “conventional wisdom” needs to be re-examined. 

Not only did the HighTower court distinguish the cases cited by plaintiff on choice of law, but the court expressly distinguished certain cases as not being decided in the restrictive covenant context, suggesting that concerns related to restrictive covenants would affect the determination.  As the Chancery Court said in Kodiak, the "’…contractarian view has its limits when such enforcement is inimical to public policy, however.  In certain limited circumstances, our courts will decline to enforce contractual obligations, no matter how clear or sincerely intended when entered.’" Kodiak, Slip.Op. at p. 14, quoting, Lyons Ins. Agency, Inc. v. Wark, 2020 WL 429114, at *1 (Del. Ch. Jan. 28, 2020).

Coface and other cases long have recognized that the choice of law determination requires the balancing analysis provided for under Section 187(2) of the Restatement to determine whether a contractual covenant “‘…would conflict with a ‘fundamental policy’ of the default state’s law, and [whether] the default state ‘has a materially greater interest in the issues … than Delaware.’” HighTower, Slip.Op. at p. 12.  See, e.g., Advanced Reimbursement Mgmt., LLC v. Plaisance, C.A. No. 17-667 (MN) (D. Del. June 17, 2019), Slip. Op. at p.10 – 11.  This is not new. 

But after reviewing the case law, one is left with the distinct impression that something has changed, significantly.  The legal test may be the same, but the same facts, analyzed a few years ago, and found to support a Delaware choice of law and enforcement, might today be found to require application of another State’s law, and/or to preclude enforcement.  Where Delaware courts previously were open to blue penciling, the Delaware Chancery Court has essentially rejected this option. Kodiak, supra, at 10, fn. 49.  Where previously, upholding a Delaware choice of law clause seemed likely, e.g., Coface, supra, application of Delaware law may no longer be presumed. HighTower, supra.  Indeed, comparing Coface and HighTower is instructive.  While there are clearly some differences, the posture of the Coface defendant, was not that different from the HighTower defendant. As the court held in Coface:

"Newton [defendant in Coface] is a citizen of Louisiana, he signed the Agreement in Louisiana, and his competing business is headquartered there. However, the District Court concluded, and we agree, that these geographical contacts do not support the conclusion that Louisiana has a 'materially greater interest' in determining the effect of the covenant not to compete. This is not a case where both parties are Louisiana citizens. As the District Court emphasized, Coface is a national company. Moreover, Delaware has a substantial interest in enforcing this voluntarily negotiated contract clause that explicitly designates Delaware law to govern. That interest is not overcome by any other state's materially greater interest." (emphasis added). Coface Collections North Am. v. Newton, supra, 430 F. App'x  at 168. 

And, even where a Delaware court concludes that Delaware law will apply, we can expect a fairly close analysis of whether to enforce the noncompete.  See, e.g., Centurion Serv. Grp. v. Wilensky, Civil Action 2023-0422-MTZ (Del. Ch. Aug. 31, 2023). 

Intertek TestingServices NA, Inc. v. Eastman is the fourth of the recent high-profile cases.  In Intertek, the defendant, Eastman, was the major stockholder and CEO of Alchemy, the acquired company, who received $10,000,000 for selling his interest under a Stock Purchase Agreement (“SPA”).  The SPA prohibited Eastman from competing with the acquirer, Intertek Alchemy, anywhere in the world, for a period of five years. Slip. Op. at p. 3.  Eastman worked for Intertek for a few months after the closing and then voluntarily resigned.  Two years later, Eastman went to work for his son’s company, which was alleged to do business “nationwide”, in the cannabis industry.  Slip. Op. at 5. 

In response to Intertek’s suit, Eastman argued that Alchemy, as of the time of the closing, was not involved in the cannabis business, and that therefore, Intertek’s attempt to restrain him, was an unlawful restraint of trade. Eastman also argued that the restrictive covenant was unenforceable, as a matter of law, due to its geographic overbreadth. 

Rather than blue penciling the geographic territory, and then evaluating the competitive overlap and other issues, the court struck the entire noncompete because of its facial geographic overbreadth.  Compare Newmark Partners, L.P. v. Hunt,  200 A.D.3d 557, 160 N.Y.S.3d 23 (1^st Dept. 2021). As was true in Kodiak, the court declined to modify and enforce, even though the actual activity engaged in by Eastman was within the geographic territory in which the acquiring company was entitled to protection.   In the process, the court reaffirmed Kodiak, drew upon the several recent Delaware cases, and summarized Delaware law as follows: "Delaware courts do not 'mechanically' enforce non-competes." Instead, "[t]o be enforceable, a covenant not to compete must," among other things, "be reasonable in scope and duration, both geographically and temporally," and "advance a legitimate economic interest of the party enforcing the covenant."…"Although relatively broad restrictive covenants have been enforced in the sale of a business context, such covenants must be tailored to the competitive space reached by the seller and serve the buyer's legitimate economic interests. Delaware courts have declined to enforce non-compete provisions that are not. In Kodiak[]for example, the challenged provision prohibited the defendant from competing in two states "and within a 100-mile radius of any other location" served by the purchased business or its subsidiaries. The court held that the provision was overbroad because it covered areas not essential to the protection of the buyer's legitimate interests in the acquired company. The provision here similarly extends to markets untouched by Alchemy's business. … The legitimate economic interests that Intertek might have to support such a restraint, however, are measured only by "the goodwill and competitive space it purchased from [Alchemy] in the market [Alchemy] serve[d]." Intertek does not allege that Alchemy provided services globally. The Complaint--viewed in the light most favorable to Intertek­- states that Texas-based Alchemy served clients "nationwide." The incongruity between the geographic scope of the covenant and that of Alchemy's business leads me to conclude the non-compete is unreasonably broad and unenforceable. (footnotes omitted) Slip. Op. at 8 – 10. 

On the issue of blue lining, the court again rejected it: “Intertek urges me to ‘blue pencil’ the non-compete provision if I conclude that it is unreasonable in breadth.  Although the Court of Chancery has, at times, blue penciled expansive non-competes to supply judicious limitations, it ‘has also exercised its discretion in equity not to allow an employer [or covenantee] to 'back away from an overly broad covenant by proposing to enforce it to a lesser extent than written.’’   In my view, revising the non-compete to save Intertek -- a sophisticated party -- from its overreach would be inequitable. ‘[A] court should not save a facially invalid provision by rewriting it and enforcing only what the court deems reasonable." (footnotes omitted).” Slip. Op. at 12. 

The court also made a significant observation concerning geographic scope: “‘the reasonableness of a covenant's scope is not determined by reference to physical distances’ but by ‘the area in which a covenantee has an interest the covenants are designed to protect.’ *** While most judicial opinions regarding the reasonableness of the geographic extent of employee non-competition agreements speak in terms of physical distances, the reality is that it is the employer's goodwill in a particular market which is entitled to protection.” Slip.Op. at 8, 10, n.39.  How this observation will play out has yet to be seen. 

Conclusions

Delaware courts have put up some key limitations on the enforcement of post-closing restrictive covenants, following the sale of a business.  The strong anti-noncompete sentiment that has been prevalent in many states, appears to have had a significant impact on Delaware courts. Ultimately, there will be additional Delaware cases, and the Delaware Supreme Court will likely address some of these issues in Ainslie. But these recent cases call conventional wisdom into question and need to be seriously considered. Counsel and transactional parties should no longer assume that Delaware will be the best choice of law for M&A transactions.  Rather, the specifics of the transaction should be considered, and the best choice of law determined, according to needs of the transaction.