April 05, 2023

Delaware Is Increasingly No Longer a Safe Bet for Restrictive Covenants and Default Choice of Law Provisions

It’s no secret that employee non-compete — and, to a related extent, non-solicitation — restrictions are increasing disfavored and targeted across the U.S., both on a federal and state level. We’ve recently written about the Federal Trade Commission’s (FTC) Proposed Rule on Use of Non-Competition Agreements as well as recent legislative activity on the state level. Over the last decade, the landscape has shifted from a handful of states (most notably, California) being outliers in their hostility towards these restrictive covenants to a majority of states (both legislative bodies and courts) taking aggressive stances against such restrictions, whether in the form of near outright bans, protections directed at particular groups (e.g., lower wage earners) or cumbersome procedural hurdles (e.g., pre-hire and post-separation notice requirements).

With all of this change, it is tempting for employers to look to Delaware, a historically business friendly state, as a refuge. One particular strategy involves including restrictive covenants in equity grant documents (even when the grant or grant opportunity is relatively small), in place or addition to stand-alone restrictive covenant agreements or restrictions contained in offer letters or employment agreements. The employer then takes the additional step of inserting a Delaware choice of law provision — under the theory that Delaware is an appropriate choice if the company is incorporated or organized there.

For a while, this strategy had at least a decent chance of success. Delaware courts have historically recognized that equity documents, because they relate to matters of corporate structure, could be analyzed as to Delaware entities in Delaware, under Delaware law, even if the employee at issue rarely, if ever, set foot in the state. Things may be changing, however.

Indeed, back in 2020 we wrote about a Delaware Chancery Court opinion which discussed Delaware’s approach to judicially modifying, or “blue-penciling,” overly broad noncompete agreements and deferring to parties’ choice of law provisions. The case, FP UC Holdings, LLC, et al. v. James W. Hamilton, Jr., et al., C.A. No. 2019-1029-JRS (Del Ch. Mar. 27, 2020), demonstrated that even in Delaware — where employers often had been reassured by the safe harbor of courts’ relative willingness to blue-pencil problematic agreements and apply Delaware law to fact patterns that have developed in other states — there are limits to what restrictions and choice of law provisions Delaware courts would enforce.

Then last fall, in Kodiak Building Partners, LLC v. Adams, 2022 WL 5240507 (Del. Ch. Oct. 6, 2022), the Delaware Court of Chancery struck down a sale of business non-compete and refused to blue pencil it because the non-compete imposed restrictions that exceeded the scope of the business being sold. This case made clear that sale of business non-competes are also subject to close analysis and that the protection of such restrictive covenants in Delaware is limited to only the purchased asset’s goodwill and competitive space that its employees developed or maintained. This concept was reaffirmed by the same court just last month in Intertek Testing Services NA, Inc. v. Eastman, C.A. No. 2023-0853-LWW (Del Ch. Mar. 16. 2023), where the court struck down (rather than reformed) an overly broad sale of business non-compete because of the “incongruity between the geographic scope of the covenant and [the company’s] business.”

In February, in Hightower Holding, LLC v. John Gibson, C.A. No. 2022-0086-LWW, memo. op. (Del. Ch. Feb. 9, 2023), the Delaware Chancery Court went a step further. In that case, the defendant, Mr. Gibson, was a partner in a financial advisory firm that was acquired by Hightower. In connection with the transaction, Mr. Gibson (and the other business partners) signed a “Standard Protective Agreement” as well as an Amended and Restated LLC Agreement, each containing restrictive covenants, including non-compete provisions, and establishing Delaware law in the event of any dispute. After the transaction closed, and Mr. Gibson had received meaningful sale proceeds, Mr. Gibson resigned and started a new investment advisor firm. Hightower then brought suit, asserting claims for breach of contractual non-compete obligations, and sought a preliminary injunction enjoining Mr. Gibson from competing.

Hightower, and the affiliate that managed the acquired business, were Delaware entities. Mr. Gibson, however, was an Alabama resident. He also worked in Alabama, and his alleged breaches of the non-compete obligations stemmed from a competing business he created in Alabama.

The court denied Hightower’s request for a preliminary injunction, finding insufficient facts to uphold a Delaware choice of law provision, even though Hightower was a Delaware limited liability company and some of the restrictive covenants were in the limited liability agreement. In applying tougher Alabama law, and ultimately refusing to grant a preliminary injunction, the court noted that “[t]he entire purpose of the [applicable] … 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.” Id. at 24 (internal citations omitted).

The Hightower and other recent decisions out of Delaware show that defaulting to Delaware law for non-competition and non-solicitation clauses — even in underlying corporate documents applicable to Delaware entities — is no sure bet anymore. If the employee has little to no connection to Delaware, particularly if the company is largely disconnected from Delaware other than as a state of incorporation, there is a real risk that a Delaware choice of law provision will not be upheld. Employers thus need to review closely the law where the restricted employee works and ensure that it too — and not just Delaware law — supports enforcement. Employers may also want to select a choice of law other than Delaware in the applicable agreement, particularly in situations where there are multiple valid options, with one more favorable than the other(s). Lastly, Hightower, and now Intertek, make it clear that even where Delaware may have sufficient ties to support such a choice of law provision, parties can no longer be certain Delaware courts will blue pencil (let alone enforce outright) broad restrictive covenant clauses.

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