Look Past Delaware for ‘Sale of Business’ Non-Compete Enforcement

Since October 2022, the Delaware Chancery Court has issued several thoroughly reasoned decisions concerning non-competition agreements, agreed to in connection with sales of businesses.

Taken together, these call into question conventional wisdom that “business-friendly” Delaware courts have a pro-enforcement attitude toward restrictive covenants in the “sale-of-business” context, and that designating Delaware as the contractual choice of governing law is a good choice.

There long has been a general expectation that post-closing non-competes—agreed to as part of a Delaware-related M&A or sale of business transaction—will be enforced largely as written, without greater judicial scrutiny that would be given in an employment context or by another jurisdiction. Delaware courts are generally “contractarian,” enforcing sophisticated parties’ agreements as written.

But in several recent cases, Delaware courts refused to enforce “sale of business” or mixed non-competes, and also declined to “blue pencil” or modify the agreements to make them enforceable.

In these cases, the court found the covenants were overbroad and unreasonable as drafted, and thus, unenforceable, and would not be “blue-penciled,” that is, judicially reformed to prevent overreach.

Rather, the covenants were left unenforced, even though, in several cases, the defendant’s competitive conduct was the type a properly drafted noncompete should have covered.

The Delaware Chancery Court refused to enforce both restrictive covenants and forfeiture for competition covenants. The cases included Intertek Testing Services NA, Inc. v. Eastman, Kodiak Building Partners, LLC v. Adams, Ainslie v. Cantor Fitzgerald, L.P., and HighTower Holding, LLC v. Gibson.

While the Delaware Supreme Court has yet to weigh in on these cases, these were not decisions by a runaway jury or rogue judge, but were issued by Vice Chancellors Morgan Zurn and Lori Will, key judges on the powerful and well-respected Delaware Chancery Court.

Perhaps the most concerning element of the courts’ decisions has been the refusal to “blue-pencil” and modify or limit contractual language.

Restrictive covenants agreed to in connection with a “sale of business” are recognized as being subject to less scrutiny than in an employment context, so it’s concerning that the “business-friendly” Delaware courts closely scrutinized these agreements, and refused to blue-line in any of the cases.

Ultimately, there will be additional Delaware cases, and the Delaware Supreme Court will likely address some of these issues, but these recent cases suggest a change in view by the Delaware judiciary.

Course of Action

To the extent anyone thought Delaware courts would bail businesses or employers out of poorly drafted or overbroad non-competes, think again. As has always been the case, restrictive covenants should be drafted with reasonable, defensible restrictions that can be justified to a court, based on the company’s protectable interests.

Those interests include the goodwill actually purchased in a transaction, the locations and customers actually serviced by the acquired company, the confidential information actually at issue, and the actual work of the employee.

Companies should avoid including overbroad, blanket restraints as courts in every jurisdiction are acutely aware that blue-penciling can incentivize the employer to demand overbroad restrictions.

Where a choice of law is to be made, consideration should be given to what would obtain if that choice were rejected by the court. As HighTower noted, the choice of law upheld may differ depending on whether all relevant activity is centered in one state, or whether performance is split over many states, and the state of incorporation is Delaware. It may be that transactional terms can be negotiated and adjusted, so that key deal terms will be enforced, regardless of which law is found to govern.

But that may not be possible. Consideration should be given to designating a different choice of law for the restrictive covenants, versus other deal terms, and to attempt to incorporate restrictions that will be enforceable under the law that’s likely to be applied.

And, in considering choice of law, both substantive law and the relevant state’s attitude toward blue-penciling should be considered. In some states, courts are mandated to blue-pencil, while in others blue-penciling is prohibited.

Where blue-penciling is permitted, some courts are more reluctant than others to modify overbroad agreements. Delaware now looks like a state where blue-penciling is permitted, but where courts are extremely reluctant to do so.

In a sale of business context, New York law has consistently been protective of the purchaser. Under New York law, the seller of a business and its goodwill is under a permanent implied covenant, obligating the seller to permanently refrain from soliciting former customers. This implied covenant arises at law, not by express covenant, and is not subject to termination by passage of time.

In addition, a purchaser may further protect itself by restrictive covenant as “[r]easonable restrictive covenants ancillary to the sale of a business ‘are routinely enforced’ to protect the goodwill paid for by the purchaser.”

While all contractual noncompetes in New York are in jeopardy because of pending legislation that could make them unenforceable, given the standard described by Intertek, and the other recent Delaware cases, it may be time to consider designating the law of a state other than Delaware in these circumstances.

Additional Takeaways

Based on this series of recent cases, if Delaware law is designated for the restrictive covenants, consider the following in addition to the points raised above:

The geographic and business activity scope of a “sale of business” noncompete should be limited to those of the acquired company’s business and customers, not the acquiror’s business and customers.

The contractually designated choice of law should pass the choice of law tests of the Restatement (2d) of Conflicts of Law, Sections 187 and 188.

The restrictions formulated should be evaluated under the law of each of the states that could be designated, and this analysis, together with the analysis from the Restatement, should inform the actual contractual choice of law for the restrictive covenants.

Consider different choices of law for the restrictive covenants and the other deal terms, when such a choice can be justified by choice of law principles.

Delaware, despite its contractarian bias in construing contracts, should not be seen as the automatic default state for “sale of business” non-competes. Don’t expect Delaware courts to bail sophisticated parties out of an overbroad noncompete. It’s time to re-evaluate the conventional wisdom.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Abraham (Avi) Y. Skoff is partner and leader of the trade secrets, noncompete & unfair competition litigation at Moses Singer, and a former Assistant US Attorney and Deputy Chief for the Eastern District of New York.

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