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Commercial Litigation

Delaware Court of Chancery enforces non-compete agreement that it “Blue Pencils”

January 30, 2014

Commercial Litigation

Delaware Court of Chancery enforces non-compete agreement that it “Blue Pencils”

January 30, 2014

Back to Fish's Litigation Blog

 

Delaware Courts, unlike many jurisdictions (such as California), honor non-compete agreements.  However, Delaware Courts will find non-competes that impose unreasonable temporal or geographical limits on competition invalid.  Nevertheless, under certain circumstances, Delaware Courts may modify the restrictive covenant to make it valid.  These principles were recently discussed in DGWL Investment Corp. v. Giannini, C.A. No. 8647-VCP (Del. Ch. 2013).

In Giannini, the Defendant sold his shares of Arthur Dogswell, LLC (“Dogswell”), a highly successful provider of premium dog treats and dog foods to Plaintiff, a private equity investment firm. As part of the agreement, Defendant entered into a covenant restricting him from working in the premium dog snacks and dog foods market for five years following the sale of the business.

Before determining the merits of the preliminary injunction, the Court addressed Defendant’s argument that California law applied to the covenant not to compete – even though the parties, who were represented by counsel, explicitly agreed to have their contractual relationship governed by Delaware law.  Defendant’s argument was motivated by the fact that California is a “right to work” state that (unlike Delaware) disfavors noncompete agreements and restricts their enforceability.  Indeed, Defendant asserted that enforcement of the noncompete would violate California public policy.

To determine which state’s law applied, the Court analyzed Section 187 of the Restatement (Second) of Conflicts.  Under the Restatement, for California law to apply, Defendant had the burden of showing that “[1] enforcement of the noncompete under Delaware law would be contrary to a fundamental policy of California; [2] that California has a materially greater interest than Delaware in determining the enforceability of the noncompete; and [3] that California law would apply in this case had the parties not chosen Delaware law to govern their contract.”  Tr. at 7.  The Defendant failed to meet his burden.

First, the Court found that enforcement of the noncompete agreement was not contrary to California’s public policy because Defendant had transferred “goodwill” to the Plaintiff in the sale of the business. The transfer of goodwill is an exception to the prohibition against covenants not to compete.  Hill Medical Corp. v. Wycoff,  86 Cal. App. 4th 895 (Cal. Ct. App. Jan. 30, 2001).  While the agreement in Giannini was not explicit that goodwill was a component of the sales price, California courts have recognized that there can be “situations in which the parties have not allocated a specific portion of the purchase price to goodwill, and yet the parties recognized that goodwill was part and parcel of the transaction involving a substantial corporate interest.”  Tr. at 8 (quoting Wycoff).  For example, “evidence that the amount paid to the departing or selling shareholder approximates the amount the shareholder was expected to lose as a result of the covenant not to compete may be strong indicia that the sales price was intended to include goodwill,” and “an inference can be made that the price includes a value for goodwill” if fair market value is paid for the shares.  Id.  After considering “all factors of the sales arrangement,” the Court found that “the size and nature of the transaction in which [Defendant] completely surrendered control of Dogswell to [Plaintiff] suggests that the transaction did include goodwill.”  Tr. at 9.

Second, the Court found that although California had a significant interest in the resolution of the case because all of the parties were located in California and the agreement was negotiated in California, it was not materially greater than Delaware’s interest.  Indeed, the parties specifically chose Delaware law to govern their agreement. “When parties have ordered their affairs voluntarily through a binding contract, Delaware law is strongly inclined to respect their agreement, and will only interfere upon a strong showing that dishonoring the contract is required to vindicate a public policy interest even stronger than freedom of contract.”  Tr. at 11 (quoting Libeau v. Fox, 880 A.2d 1049, 1056-57 (Del. Ch. 2005)).  “Such public policy interests are not to be lightly found, as the wealth-creating and peace-inducing effects of civil contracts are undercut if citizens cannot rely on the law to enforce their voluntarily undertaken mutual obligations.”  Id.  Accordingly, the Court found that “protection of justified expectations and certainty, predictability, and uniformity of result are better served by the application of Delaware law in this case.”  Id. at 12.

After determining the applicability of Delaware law, the Court considered whether Plaintiff was likely to succeed on showing that covenant not to compete was enforceable.  Under the agreement, Defendant was bound by the terms of the covenant not to compete until the fifth anniversary of a “Company Sale,” which was defined to mean the sale of all or substantially all of Dogswell’s assets to a person or entity not affiliated with Plaintiff, or any transaction that results in one or more persons not affiliated with Plaintiff owning more than 50 percent of Dogswell’s voting securities.  Tr. at 15-16.  The Court found that the duration of the noncompete was “indefinite,” and thus unreasonable.  Id. at 16. “Plaintiffs have cited no cases in which a noncompete of comparably indefinite duration was upheld under Delaware law, nor is this Court aware of any such cases. Although it may be possible under a highly unique set of facts for an indefinite noncompete to be reasonable, those facts, whatever they may be, are not present here; and I find that plaintiffs are not likely to succeed in proving that the contingent duration of the noncompete applicable to [Defendant] is temporally reasonable.”  Id. at 16-17.

However, the Court modified the noncompete to make it reasonable and thus enforceable.  In doing so, the Court distinguished Delaware Elevator, Inc. v. Williams, 2011 WL 1005181 (Del. Ch. Mar. 16, 2011) and Chesapeake Insurance Advisors, Inc. v. Williams Insurance Agency, Inc. (transcript).  In Delaware Elevator, Vice Chancellor Laster held that Delaware courts should refuse to rewrite, or “blue pencil,” overbroad restrictive covenants for “low to mid-level employee[s].”  Tr. at 17.  Because of disparities in resources, bargaining power, and access to information, Vice Chancellor Laster stated that it was “naïve” to think that low to mid-level employees “freely agree[d]” to restrictive covenants, and stated that the risk of unenforceability should fall on the employer rather than the employee.  Id.  In Chesapeake Insurance, Vice Chancellor Noble applied Delaware Elevator’s logic and refused to “blue pencil” the employment agreement of a company president that had an invalid temporal restraint.  The Court distinguished Delaware Elevator on the basis that Defendant was a “top dog” executive, not a low or mid-level employee, and was not convinced that Chesapeake applies where a corporate founder and CEO received $10 million in exchange for control of his company and his promise not to compete.  Id.  at 18.

The Court went on to state that “Delaware Elevator and Chesapeake raise interesting and important questions about the state of the law as to ‘blue penciling’ in Delaware. As Vice Chancellor Noble recognized, there is something of a divergence of opinion on that topic. Whether Delaware is currently a ‘blue-pencil’ state and the extent to which judges in a jurisdiction where ‘blue-penciling’ is permitted still should decline to modify extreme provisions are issues that will need to be addressed further after a trial on the merits of this case.”  Id. at 19.  In concluding that Plaintiff demonstrated a likelihood of success in showing the noncompete could be modified, the Court stated that I am not convinced at this stage that Delaware does not adopt ‘blue penciling’ in any form. Under Delaware law, a judge generally may, in appropriate circumstances, ‘blue pencil’ an unreasonable restrictive covenant and make it enforceable.”  Id. at 20.  In so holding, the Court noted Defendant’s consent in the agreement to allow judicial modification of the covenant not to compete if a court found it unreasonable, and relied on Hammermill Paper Co. v. Palese, 1983 WL 19786 at *6 (Del. Ch. 1983) (holding that judicial modification is “permissible under this State’s law concerning the review” of restrictive covenants and is “consistent with the expressed intentions of the parties embodied in the agreement itself permitting and accepting” such modification).

Instead of delineating “precisely what length of time would be reasonable” for Defendant to be preliminarily enjoined from not competing, the Court found that Plaintiff was “likely to succeed in proving that [Defendant] reasonably can be subjected to at least a one-year noncompete.”  Tr. at 21 (stating that “Delaware law generally holds that one-year noncompetes are valid”). The Court did not believe that “a more refined assessment of duration” was necessary for purposes of the preliminary injunction and expected the case to be resolved on its merits within one year that Defendant was terminated from Dogswell.  Id. at 21.

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