Businesses frequently choose Delaware as the governing law and venue for enforcement when drafting many kinds of agreements, including non-competition covenants. Delaware is attractive for several reasons, including robust non-compete enforcement and sophisticated commercial courts. Recent opinions, however, are tightening the rules for getting into the Delaware courts, and for enforcing restrictive covenants once inside.
Delaware has long been a safe haven for all sorts of business matters. Companies are frequently formed in Delaware, and corporate transactional documents often select the state for governing law. In fact, more than 1,000,000 business entities have selected Delaware as their chosen domicile. However, most of those companies are headquartered elsewhere, and their employees have no connection with the state at all, other than perceived friendliness to business interests. In a series of recent opinions, the state’s Chancery Courts have been changing this narrative.
In recent months, Delaware Chancery Courts have made headlines by refusing to enforce restrictive covenants that would have historically passed muster — notably, even in covenants relating to the acquisition or sale of a Delaware-based business. Courts are taking a closer look at the choice of law provisions and diving deeper into what — if any — connection the dispute has to Delaware. Where the only connection to the state lies on paper (such as formation documents and choice of law) and the employee and business operated in another location, the courts have declined to apply Delaware law, instead applying the law of the state where the employee actually works.
For example, in Hightower Holding LLC v. Gibson, the court was asked to enforce a non-compete against John Gibson, a partner in a business acquired by Hightower. While the documents selected Delaware for the venue and governing law of any dispute, Mr. Gibson lived and worked in Alabama. The Chancery Court refused to enter Hightower’s requested injunction, deciding that Alabama law and public policy had a greater connection to the dispute. The court concluded that under Alabama law, the non-compete was fatally overbroad and invalidated the covenant.
Even when the courts honor the selected choice of law, stricter scrutiny is increasingly applied. Chancery Courts are frequently choosing not to reform overly broad agreements, instead nullifying the covenants completely. Transactional documents related to the purchase and sale of businesses often default to a broad scope of restraint in the restrictive covenants, assuming that a reviewing court will simply revise or narrow the scope in the event of a dispute. Recently, however, Delaware courts have elected to simply reject the overreaching covenants completely rather than rewriting the terms. In Kodiak Building Partners, LLC v. Adams, the Chancery Courts reviewed a restrictive covenant obtained in connection with the sale of a business. The court concluded that the scope of the covenant was overbroad and did not credit the contractual provision purporting to waive an objection to the breadth of the restraint. Rather than blue-pencil the scope of the restrictions, the Chancery Court simply invalidated the entire covenant.
This pattern has continued outside the merger and acquisition space as well. The Chancery Court was asked to review restrictive covenants in a partnership agreement in Ainslie v. Cantor Fitzgerald, LP. Cantor Fitzgerald sought to enforce a non-compete against certain partners leaving the firm. After review, the court concluded that the firm could not show that the terms of the restraint were reasonable. Once again, rather than reforming the terms, the Chancery Court struck down the covenant.
These recent cases send a clear message: the Delaware Chancery Courts will not issue a rubber stamp approval in non-compete cases. Practitioners must take a thoughtful approach to drafting restrictive covenants. First, ensure there is a connection between the parties and the state — a mere state of formation is not enough. Second, apply reasonable terms consistent with the legitimate interests and goals of the parties, and don’t rely on judicial reformation to salvage the deal. The Delaware courts will no longer step in to save the day — businesses will.