Described broadly, a non-compete provision is essentially a promise not to compete with a business for a set period of time and within a certain geographic area. Such promises are commonly classified as “restraints of trade,” meaning that to be enforceable, they must pass a reasonableness test evaluating the temporal and geographic scope, as well as the breadth of the business interest being protected. Non-competes in the context of employment agreements are familiar, but these provisions are also frequently relied upon in (i) agreements for the sale of a business and (ii) the governance documents of limited liability companies, corporations, and partnerships. In the context of a business sale, a seller often agrees not to compete with the business being sold. After all, the seller is transferring ownership of the business for consideration. The last thing any buyer wants is for the former owner to turn around and build a new business that will compete with the buyer and impair the value the buyer paid to take over what the seller built.. Similarly, non-competes in operating, shareholder, and partnership agreements lay out the restrictions applicable to departing members, shareholders, or partners to limit the risk that a departing participant will start or work at a competing business.
In contrast to a traditional non-compete, a forfeiture-for-competition provision provides that the party agreeing to the restrictions will receive a payment, contingent on defined limitations on competitive activities. In other words, individuals get to choose between accepting compensation, which will require limitations on free activities, or forgoing such compensation but remaining free to compete. This choice is the distinguishing factor between forfeiture-for-competition provisions and traditional non-competes. While both agreements are aimed at limiting competition, traditional non-competes are treated as flat prohibitions, enforceable by injunctive relief through the courts. Forfeiture-for-competition, on the other hand, provides an economic incentive not to compete, with monetary damages being the only form of relief for breach. While forfeiture-for-competition provisions have been utilized less frequently than non-competes, recent decisions by Delaware courts suggest that this may not be the case for long.
Historically, Delaware courts have broadly enforced non-competes, a posture in line with their general business-friendly demeanor. For buyers or businesses looking to restrict former owners or partners, a non-compete along with a Delaware governing law or Delaware choice of law clause was a winning strategy. Even in cases where the terms of the non-compete did not meet the reasonableness standard in some respect (e.g., too long a duration), there was a sense of confidence that Delaware courts would blue-pencil or otherwise revise the problematic language and otherwise uphold the agreement. A recent string of Delaware Chancery Court decisions, however, indicate a shift away from this historical stance (See Kodiak Building Partners, LLC v. Adams; Intertek Testing Services NA, Inc. v. Eastman; Hightower Holding, LLC v. Gibson; refusing to blue pencil and reform language that was unreasonable in the former two cases and declining to uphold a Delaware choice of law provision in the latter.). The Delaware Supreme Court has not reviewed these cases.
Then, in Cantor Fitzgerald v. Ainslie, the Chancery Court went a step further than these prior anti-restriction decisions – ruling that the forfeiture-for-competition provision in a limited partnership agreement was – like a traditional non-compete – a restraint of trade and thus subject to review for reasonableness. The agreement in dispute in Ainslie required certain deferred payments in capital accounts to be forfeited upon engagement in competitive activities by a departing partner within four years of leaving the partnership. The Ainslie court found that this duration was unreasonably long and ran against public policy.
On January 29, 2024, the Delaware Supreme Court reversed on appeal, finding forfeiture-for-competition provisions to be clearly distinct from non-competition covenants. Specifically, the Court held that such provisions, which tie future payments to non-competition, are not restraints of trade subject to review for reasonableness. The significance of this decision is twofold: first, it finally clarifies Delaware’s position in the ongoing jurisdictional split over this issue; second, it opens the door to the use of materially longer durational periods when protecting against competitive activities than would be permitted under a traditional non-compete.
While Ainslie involved a forfeiture-for-competition provision within the context of a limited partnership agreement and between sophisticated parties, it is likely to be relied upon as support for the enforcement of such provisions in similar contexts. Still, it is uncertain exactly how far this ruling will extend. When drafting a forfeiture-for-competition provision, regardless of context, it is essential to underline the intent to provide the individual with a choice between compensation and competition, and to avoid characterizing the potential forfeiture as liquidated damages or a penalty. Additionally, drafters should consider: (i) choice of law provisions, given the jurisdictional split over treatment of forfeiture-for-competition provisions and (ii) potential conflicts with traditional non-compete provisions within the same or a related agreement. Amid increased scrutiny of non-competes and Delaware courts’ reluctance to reform “unreasonable” agreements, forfeiture-for-competition provisions present a possible alternative for protection against competition, especially in the context of agreements among owners.
