Wednesday, January 18, 2023
Cantor Fitzgerald's Covenants Not to Compete Reviewed in DE Chancery Court
Last week, we reported on the Federal Trade Commission's new proposed rule to prohibit covenants not to compete in most trades. We also learned last week, thanks to Eric Chiapinelli, law prof and purveyor of champaign, that the Delaware Chancery Court took a hard look at restrictive covenants in a recent decision.
Plaintiffs in Ainslie v. Cantor Fitzgerald, L.P., six former partners of Cantor Fitzgerald (the Firm), were prohibited with competing with the Firm for one year and from soliciting business for two years (the No Breach Condition). In addition, the Firm's non-compete agreement allows the Firm to withhold four years of payments owed to the departing partners' capital accounts. The Firm is obligated to pay out 1/4 of those funds each year unless the partner engages in some competitive activity, even if that activity is not prohibited under the covenant (the Competitive Activity Condition). The Firm alleged that all six partners had engaged in competitive activities within a year of leaving the Firm. Vice Chancellor Zurn found both of the restrictive covenants at issue here facially overbroad and void against public policy. Accordingly, plaintiffs committed no breach in violating these unenforceable provisions and are entitled to the payments they sought.
Plaintiffs all left the Firm in 2010 and 2011. They sought recoveries, ranging from just under $100,000 to just under $5.5 million, of payments the Firm had withheld under the restrictive covenants due to alleged competitive activities.
The first issue contested by the parties was whether the conditioned payment provision relating to the departing partners' capital accounts was a contractual condition, as the Firm maintained, or an unenforceable penalty clause, as the plaintiffs claimed. The Vice Chancellor provides a handy "Primer On Promises, Breaches, Liquidated Damages And Penalty Provisions, And Conditions" beginning on page 26 of the opinion. This is a great review for first-year law students on the fundamentals of contracts law. The Vice Chancellor then applies its erudite exposition of the law and concludes that the conditioned payment provision was enforceable as a contractual condition precedent.Moving on to the main event, the Vice Chancellor sets out the applicable legal standard:
For the Restrictive Covenants to be enforceable under Delaware law, they must (1) be “reasonable in geographic scope and temporal duration, (2) advance a legitimate economic interest of the party seeking its enforcement, and (3) survive a balancing of the equities.” The reasonableness of the covenant’s scope is measured in relation to the employer’s legitimate interests: a greater scope must be supported by a greater interest.
The Vice Chancellor subjects the covenants to reasonableness review notwithstanding the plaintiffs' having stipulated in their employment agreements to the provisions' reasonableness. She also notes that the parties' stipulation that the provision may be amended does not require her to apply the "blue-pencil rule," according to which unenforceable provisions of a non-compete may be set aside/crossed out while the rest is enforced.
The Vice Chancellor found the No Breach Condition's global geographic scope unreasonable. She found the scope of those protected "patently unreasonable." She provides the following illustration of the breadth of the protections:
A former Cantor Fitzgerald partner who worked as a broker in the Hong Kong office could withdraw from the Partnership, move to Europe, and switch professions by taking a position as an accountant for a large international accounting firm. If that accounting firm provides services for a European-based entity in the “institutional brokerage business,” and the Managing General Partner determines that such accounting work “could be considered to be” “assist[ing] others in engaging in” indirectly competing with a Cantor Fitzgerald affiliate, then Cantor Fitzgerald could seek injunctive relief and withhold payment of all Conditioned Amounts.
To make matters worse, the determination of whether the provision has been violated is left to the sole discretion of the Managing General Partner. In light of the unreasonable geographic and scope provisions, the Vice Chancellor also found the duration of the No Breach Condition unreasonable. Balancing the equities, the Vice Chancellor concludes that the No Breach Condition is unenforceable.
The Vice Chancellor treats the Competitive Activity Condition as a "forfeiture-for-competition" provision. Such terms are subject to a reasonableness review akin to that accorded to those applied in the context of a sale of a business. Even under that more lenient standard, the provision fails the reasonableness test, as the Firm has no compelling interest to justify a four-year restriction on its former partners.
On my reading of the proposed FTC rule, even if the No Breach Condition survived review in the Chancery Court, it would still run afoul of the new rule. But with respect to the Competitive Activity Condition, the outcome is unclear. The proposed rule has an exception for covenants not to compete in the context of a sale of a business. This case does not involve the sale of a business, but the Vice Chancellor argues that the standard applicable to the sale of a business should also be applicable here. I don't know how a court should reconcile that state court opinion with the federal rule. In any case, the proposed rule would not have retroactive effect.