Recently, there have been myriad developments that seem like an attack on the enforceability of noncompete clauses in contracts–not only in the context of employment, but also in the context of partnership arrangements and post-closing M&A deals.
Typically, noncompete clauses are included in various types of contracts that govern various business relationships, including employment, partnership arrangements, and post-closing M&A deals.
Most readers are aware of California’s general limitations on noncompete clauses and the recent proposal by the FTC to ban (or perhaps limited to a narrow set of employees) noncompete clauses in the context of employment.
The FTC proposal, however, might be overshadowing three recent decisions by Delaware trial courts pertaining to the scope and the resulting (non)enforceability of noncompete clauses in other business relationships, beyond the standard employment context—partnership arrangements and post-closing M&A deals.
Partnership (LLC) arrangements
In January 2023, a Delaware trial court (Ainsle v. Cantor Fitzgerald L.P.) did not enforce a non-compete clause in a partnership agreement against a partner because they were too broad–for two reasons.
First, geographically, the non-compete prohibited competition “worldwide” even though the partnership’s business was generally limited to operations within the United States.
Second, the non-compete was too broad because it prohibited competition against the partnership’s affiliated (related) businesses—with which the departed partner did not have any substantive business dealings.
It seems logical to presume that similar reasoning would be applied to LLCs whose principals (members) sign Operating Agreements. That presumption is buttressed by another recent Delaware case. In February 2023 (Hightower Holding, LLC v Gibson), a Delaware trial court did not enforce a noncompete clause in an LLC Operating Agreement that was subject to Delaware law. Although it deferred to Alabama courts to decide the merits of the noncompete based on Alabama law, the Delaware court acknowledged limitations on noncompete clauses under Delaware law, similar to the reasoning in recent previous cases (such as the Ainsle case).
Post-closing M&A deals
In October 2022, a Delaware trial court (Kodiak Building Partners, LLC v. Adams)issued the first recent opinion regarding the enforceability of a noncompete clause in the context of an M&A deal. The court found that a noncompete clause in an M&A deal contract between the buyer and shareholder/seller of a business was not enforceable as written.
The noncompete clause prohibited the seller from competing in any similar business in the U.S. because the buyer’s business was generally spread throughout the United States. In contrast, the seller’s business was generally limited to the Northwest area of the United States.
The court found that “Delaware law has not affirmatively recognized a legitimate business interest in protecting all the acquirer’s preexisting goodwill that predated the acquirer’s purchase of the target.” Instead, the buyer’s legitimate business interest is limited to protecting the goodwill of the business that it purchased from the seller. Thus, because the noncompete was not limited to the geographic area in which the seller conducted its business, the court did not enforce the non-compete.
Similarly, in March 2023, a Delaware trial court (Intertek Testing Services, NA, Inc. v. Eastman) held that a noncompete clause “must be tailored to the competitive space reached by the [M&A] seller and serve the buyer’s legitimate economic interests.” The court found that the noncompete clause applied to competition “anywhere in the world,” which was too broad because the seller provided services only in the United States. Thus, again, the court rejected the notion that the non-compete in an M&A deal can be broad enough to cover more than the legitimate business interests of the acquired business.
Conclusion
Buyer beware . . . . Noncompetition clauses should be reviewed carefully and applied to a narrow set of circumstances—even if they are within the context of an M&A deal, where historically non-competes have been perceived to be more enforceable than in the context of an ordinary employment relationship.