January 31, 2024

Non-Competes: Del. Supreme Court Upholds Forfeiture for Competition Provision

Recent Delaware case law addressing non-competes has been decidedly unfavorable to those attempting to enforce them, but a new Delaware Supreme Court decision suggests that there may be more room to maneuver when a non-compete covenant isn’t used to preclude future employment, but instead as a condition to an obligation to make future payments to the party who agreed to it.

Earlier this week, in Cantor Fitzgerald v. Ainslie, (Del.; 1/24), the Delaware Supreme Court overruled a prior Chancery Court decision and held that a partnership agreement’s contractual provision requiring forfeiture of certain future payments in the event that a former partner engaged in competitive activity was enforceable. The litigation involved provisions of Cantor Fitzgerald’s partnership agreement that will likely be familiar to many of the law firm partners among our readers. Under the terms of the agreement, withdrawing partners were subject to a restrictive covenant providing that they would forfeit certain conditional payments if they engaged in competitive activity during the four years following their withdrawal.

The plaintiffs argued that the forfeiture for competition provision was unenforceable because, among other things, it and the related restrictive covenant were restraints of trades subject to reasonableness review, and that the forfeiture provision was an unenforceable penalty provision. Cantor Fitzgerald argued that the forfeiture provision was simply a condition precedent to its obligations to make the conditional payments, and not Cantor Fitzgerald’s duty to make the conditional payments, not as a per se restraint of trade, and that because it was not seeking to enforce the restrictive covenants, they were only relevant to the issue of whether the plaintiffs had breached the agreement and permitted Cantor Fitzgerald to withhold payment.

The Supreme Court noted that in deciding that the forfeiture for competition condition should be evaluated for reasonableness, the Chancery Court relied heavily on Delaware precedent questioning liquidated damages clauses enforcing non-competes. The Supreme Court concluded that this reliance was misplaced:

The two liquidated damages cases on which the Court of Chancery grounded its policy discussion—Faw, Casson & Co., L.L.P. v. Halpen, and Lyons Insurance Agency, Inc. v. Wark,— are distinguishable from this case. Both Wark and Halpen dealt with lawsuits initiated by former employers seeking to enforce liquidated damages provisions contained in employment agreements against former employees—an insurance agent and accountant, respectively. In both cases, the court considered whether the damages the employer demanded for breach of the restrictive covenant were reasonable in light of the employees’ actions and concluded that damages provisions untethered to an employer’s reasonable interests in preventing competition, and unrelated to any action taken by a former employee, were unreasonable restraints of trade.

Here the claims under review were not brought by an employer seeking to enforce a liquidated damages provision for an employee’s breach of a restrictive covenant in an employment agreement; rather, this is a lawsuit initiated by former limited partners against the partnership requesting that a forfeiture-for-competition provision be declared invalid under the same test as applied to traditional noncompete agreements. Unlike in Halpen and Wark, the provision at issue here is not a penalty enforced against an employee based on the breach of a restrictive covenant; it is a condition precedent that excuses Cantor Fitzgerald from its duty to pay if the plaintiffs fail to satisfy the condition to which they agreed to be bound in order to receive a deferred financial benefit.

The Court also cited Delaware federal court precedent holding that the considerations underlying courts’ approach to a traditional noncompete, such as a restriction on the ability to obtain employment, were absent from a provision calling only for a forfeiture of benefits.  Ultimately, the Court concluded that Delaware’s case law on liquidated damages in the noncompete context was insufficient to outweigh the strong interest in enforcing contracts as written – particularly in light of the limited partnership statute’s strongly pro-freedom of contract bias.

John Jenkins