Trio of Delaware Cases Signal Stricter Review of Sale-of-Business Non-Competes

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.

Background on Delaware Sale-of-Business Non-competes

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.

The Kodiak and Ainslie Cases

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.

• Facts: The case involved Kodiak purchasing several companies from four stockholders, including a general manager, Adams, who received around $1 million in the transaction. As part of the transaction, Adams agreed to a 30-month non-compete covering “Idaho, Washington, and 100 mile radius of any other location outside those states in which [seller] or any member of the Company Group have sold products or provided services within the 12 months prior to Closing.”

• Geography and Company Group Overbroad: In its analysis, the court explained that it does “not mechanically enforce” non-competes, but rather non-competes “must be closely scrutinized as restrictive of trade.” Despite there being no dispute that Adams breached the non-compete by joining a competitor operating in the same industry as the sold business, the court reasoned that the buyer could not show a legitimate interest to bar Adams from competing against each of the businesses in the “Company Group,” even though many of those entities were in the same industry as the business that was sold. The court noted that acquirers in the sale-of-business context have a legitimate interest in protecting “only the purchased asset’s goodwill and competitive space that its employees developed or maintained”—not in “restricting the target’s employees from competing in other industries in which the acquirer also happened to invest.” Accordingly, the court found the geographic term overbroad because it restricted Adams from competing in the 100 mile radius around each of the buyer’s subsidiaries, which went beyond the territories in which the sold business operated.

• Refused to Blue Pencil: Although the court recognized long-standing Delaware precedent giving it discretion to modify the non-compete to make the non-compete enforceable, it refused to exercise that discretion and, instead, struck the non-compete entirely.

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.

• Facts: Ainslie involved former partners who had a partnership agreement allowing them to receive capital distributions over four years after their withdrawal from the partnership. The partnership agreement, however, required the partners to forfeit those distributions if they competed during that four-year payout period, effectively extending the restricted period to four years.

• Duration and Affiliated Entities Overbroad: In determining the enforceability of the forfeiture-for-competition provision, the court considered what standard of review to apply.[1] The court considered three options: (1) the employee choice doctrine, which provides that courts should not review forfeiture-for-competition provisions for reasonableness so long as the employee voluntarily terminates his or her employment; (2) the searching reasonableness standard reserved for restrictive covenants in employment agreements; or (3) the “more lenient” or (in the court’s words) “employer friendly” standard for sale-of-business non-competes. The court opted to apply the sale-of-business standard to the restriction. Yet, it found the forfeiture provision unreasonable under that standard because the four-year duration and the scope of “competitive activities” prohibited other actions related to entities affiliated to the company. The court reasoned that the legitimate interest “in years one and two is stale by years three and four.” The court also found prohibiting competition with other “unspecified affiliates” overbroad because, among other things, there was no evidence that the partner had access “to any kind of information—proprietary or otherwise—that would warrant the restriction,” and the partnership had discretion to determine whether the partner had breached the restriction (as opposed to proving an actual breach).

• No Blue Pencil: The court also declined to blue pencil the restriction, citing Kodiak’s holding that “Delaware courts are hesitant to ‘blue pencil’ [non-competes] to make them reasonable,” even where the agreement allows modification.

The Intertek Case

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.

• Global Territory Overbroad: Intertek filed a suit, seeking, among other things, to enforce the non-compete. Eastman filed a motion to dismiss, arguing that the non-compete was unenforceable because its geographic scope was overbroad. The court agreed. Relying, in part, on Kodiak, the court found that the restriction that prohibited Eastman from working “anywhere in the world” went beyond the buyer’s legitimate interest. The court noted that the buyer did not even allege it provided services globally and, at best, it only conducted business nationwide.

• Refusing to Blue Pencil: The court also refused to blue pencil the non-compete, reasoning that “revising the non-compete to save Intertek—a sophisticated party—from its overreach would be inequitable.”

Practical Takeaways

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:

• Non-competes should be drafted in a manner that can support the legitimate business interests for those restrictions, including the jurisdictions and related corporate entities that are covered.

• If the non-compete will cover a buyer’s existing businesses, consider whether the existing businesses are in the same industry as what the buyer is acquiring and whether the company could show a legitimate business interest in covering those related entities if it tried to enforce the restriction.

• If the seller will continue as an employee with the buyer post-acquisition, the buyer may also want to consider having the seller enter into a separate employment non-compete in addition to having a non-compete related to the sale of business.

• Avoid relying on a court to blue pencil or modify the restriction as a guaranteed fail-safe. The three recent cases show that courts appear hesitant to modify non-competes to make them enforceable.
• Consult with counsel to consider whether there is another jurisdiction or forum with a sufficient connection to the contracting parties that may be more favorable for enforcement than Delaware.

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.

[1] 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).