Covenants Not to Compete In Delaware Law

NB: We're covering Delaware law because much contracting is done under that State's laws. Readers should be aware that many states have highly restrictive common law and statutory restrictions on covenants not to compete. If your situation is not covered by Delaware law, this blog doesn't apply.

Delaware case law indicates that noncompete provisions are under closer scrutiny. Courts assess the reasonableness of noncompetes but tend to be less strict when agreements are made in connection with a business sale. The reasonableness analysis generally covers issues like geographic scope, duration, the presence of a legitimate economic interest, and the balancing of equities. This analysis cannot be bypassed through contractual provisions.

The Reasonableness Test

 Delaware courts do not mechanically enforce or deny noncompetes but closely scrutinize them as restrictive of trade.

A noncompete will be enforced only if it (1) is reasonable in geographic scope and temporal duration, (2) advances a legitimate economic interest of the party seeking its enforcement, and (3) survives a balancing of the equities.

The nature of this inquiry does not lend itself to bright-line tests. There are some common themes.

• Geographic Scope

  • Physical distances do not determine the reasonableness of a covenant’s scope, but rather the area in which a business has an interest that the covenants are designed to protect.

  • Courts have deemed noncompetes reasonable if they are restricted to the areas where a company operates.

  • Provisions that apply outside the company’s area of operations, have nationwide or worldwide scope, or include the company’s affiliates or subsidiaries, have faced heavy criticism.

  • Although nationwide or global restrictions are often viewed as overly broad, courts have upheld them when they are part of the sale of a business.

  • Having no geographical restrictions is uncommon, but it doesn't automatically mean the restriction can't be enforced.

  • If the other aspects are reasonable, Delaware courts may still enforce the noncompete.

  
  

• Duration

  • As a general matter, the longer a restrictive covenant applies, the narrower its geographic and subject matter scope must be.

    
    

  • Delaware law does not provide a specific reasonable duration. Noncompetes lasting two years are the most commonly approved.

    
    

  • However, Delaware courts have found that restrictions lasting one year and three years were reasonable.

  • Delaware courts have upheld longer durations when the provision arises in connection with the sale of a business or stock.

  
  

• Legitimate Economic Interest

  • Like other parts of this analysis, determining a legitimate economic interest is fact-specific. When evaluating the claimed economic interest, courts have looked at various factors, including (i) the employee’s exposure to confidential information, proprietary technology, and other trade secrets; (ii) the level of training and skills needed to perform the work; and (iii) the employee’s general role within the company.

    
    

  • The specificity of the applicable language is also important. Vague terms, such as similar to or substantially the same as, when referring to the company’s business, have been found too vague to demonstrate a legitimate economic interest.

  • Noncompetes prohibiting conduct that directly competes with, or is similar to, the business of the company, and only the company, have been found enforceable.

  • The breadth of the restriction is also considered. A broader restriction requires a broader legitimate interest. Noncompetes that cover a company’s affiliates or that broadly define a company’s business have been rejected as not being tailored to the employee’s role while employed.

  • Delaware courts have held that protecting a company’s goodwill, confidential information, customer base, or competitive advantage gained through the employee’s efforts may each be a legitimate economic interest.

  • The identity of a company’s referral sources may be protectable provided that those sources are not transient in the industry.

  • A company’s desire to prevent its employees from working directly for its clients may be a legitimate economic interest in appropriate circumstances.

  • However, courts have rejected claims that a noncompete was necessary when the interests being protected were vague and common concerns, including that (i) the employee generally handled many customer relationships or was involved in finding deals and building relationships with customers; (ii) the employee could use the technical expertise or general industry knowledge gained during employment against the company; and (iii) the employee might use an important certification paid for by the company against it.

Balancing Equity

Delaware courts weigh the company’s interest in preventing competition against the harm that could happen to the employee if the covenant is enforced.

Recent case law indicates that this balance emphasizes an employee’s ability to earn a living and their role within the company. Given Delaware’s emphasis on employee well-being, it is not surprising that courts have been critical of provisions that prevent a person from earning a living.

The role of the employee within the company is also an important factor. Due to the often-unequal bargaining power between a company and its employees, noncompetes involving lower-level workers are frequently considered unreasonable and rejected. Delaware courts have been less critical of provisions that apply to senior executives who receive substantial compensation or who played a key role in negotiations leading to the creation of the noncompete.

The “Blue Pencil” Rule

The Delaware Court of Chancery has historically revised the scope and/or duration of a noncompete.

But this process, known as using a “blue pencil,” has been criticized and rarely applied in recent years.

Contractual Provisions On Reasonableness

Reasonableness analysis can't be bypassed by contract. Companies may include clauses where employees agree that restrictions are reasonable, waive defenses, and consent to court modifications if found unreasonable. However, Delaware courts have consistently ruled these provisions ineffective, maintaining the court's duty to assess reasonableness.

Forfeiture for Competition Provisions

Forfeiture for competition provisions are contractual clauses that release the company from obligations to pay an employee deferred financial benefits if the employee violates a noncompetition agreement. These provisions differ from noncompetes because they do not restrict a person’s ability to compete or seek employment elsewhere.

Unlike noncompetes, forfeiture for competition clauses are a condition precedent that excuses the company from its obligation to make future payments if the employee fails to meet a condition they agreed to in order to receive a deferred financial benefit.

As a result, forfeiture for competition provisions is not reviewed for reasonableness but rather enjoys the court’s deference on equal footing with any other bargained-for term in a contract.