In a blog earlier this year, we discussed the Delaware Chancery Court’s refusal to enforce a sale of business non-compete in Kodiak Building Partners, LLC v Adams. We wondered then whether Kodiak represented a one-off decision or whether it augured a trend that might give buyers of businesses pause. Delaware courts seem to have answered the question. In what constitutes a notable trend for buyers of businesses, Delaware courts have twice more refused to enforce non-competes under a sale of a business analysis.
In a decision issued by the Delaware Chancery Court in January of this year, Delaware court declined to enforce certain restrictive covenants in the context of a partnership agreement. Several of the Defendant’s former partners signed partnership agreements restricting them from engaging in a competing business for a period of one year following their withdrawal from the partnership. The Defendant claimed the limited partners’ failure to comply with the restrictive covenants discharged it from its obligation to pay the limited partners certain amounts owed to them under the partnership agreement. The “forfeiture-for-competition provision” “serve[d] as a financial disincentive, rather than a per se bar on obtaining employment with a competitor,” and the Delaware court chose to apply the more lenient sale of a business standard to its enforceability analysis.
Even applying the more lenient standard, the Delaware court found the non-compete unenforceable, reasoning that the worldwide geographic scope was overly broad. Additionally, the court held the scope of prohibited activities was overly broad, in part, because it included activities competitive not just with the Defendant entity but also with any of its affiliates. The court noted that the breadth of the restraint may result in a partner unknowingly engaging in a competitive activity. This latter analysis is consistent with some FTC decisions we previously discussed here. The Delaware court refused to blue-pencil the non-compete, instead holding it entirely unenforceable.
Then, in Intertek Testing Systems v. Eastman, 2023 WL 2544236 (Del. Ch. Mar. 16, 2023), the Delaware court ruled unenforceable a non-compete provision contained in a stock purchase agreement. The agreement contained various restrictive covenants restricting the Defendant from competing with the acquired business. The court found the geographic scope restricting Defendant’s employment “anywhere in the world” overbroad because the acquired business only operated nationally. “The incongruity between the geographic scope of the covenant and that of [the acquired] business” led the court to conclude that the non-compete was unreasonable. Like in the two matters already discussed, the Delaware court in Intertek Testing refused to blue pencil the covenant. The court opined that revising the non-compete to save the purchaser – a sophisticated party in the eyes of the court – “would be inequitable.”
This trio of cases represents a shift in how the typically non-compete friendly Delaware courts view restrictive covenants, even those in the sale-of-business context. As we have routinely cautioned, buyers would be wise to ensure non-competes, even in the sale of business context, are narrowly tailored to protect the legitimate business interests acquired in the transaction. Buyers cannot rely on courts saving overbroad covenants by blue-penciling or otherwise modifying them to make them enforceable.