Seventh Circuit Certifies Question on Forfeiture for Competition Provisions Under Delaware Law

Forfeiture for competition clauses have an effect similar to non-competes, but they achieve the common aim through a different vehicle. They prohibit a corporation’s former employees from leaving the firm and joining a competitor on pain of forfeiture of a realized benefit from the original employer. Last year, in Cantor Fitzgerald v. Ainslie, Delaware’s Supreme Court determined that forfeiture-for-competition provisions in limited partnership agreements are not reviewable for reasonableness. However, that case involved sophisticated parties. In LKQ Corporation v. Rutledge, the Seventh Circuit was asked to determine whether reasonableness review applied to such a provision in the contract of a “key employee” who lacked the sophistication of the parties in Ainslie. 

For over ten years, Robert Rutledge managed a Florida plant for LKQ Corporation (LKQ). In exchange for signing various restrictive covenant agreements, Mr. Rutledge was entitled to restricted stock unit awards, available to only two percent of LKQ’s employees. One of these agreements precluded Mr. Rutledge from working for a competitor within nine months of leaving LKQ’s employ. Mr Rutledge sold his LKQ restricted stock on the open market. The amount of his profits is disputed but the court puts it in excess of $600,000. He took up work with LKQ’s direct competitor five days after quitting his job with LKQ.

LKQ brought suit, alleging breach of the restrictive covenants and unjust enrichment. The District Court dismissed the unjust enrichment claim, given that the parties' relationship was governed by contract. Relying on the Delaware Chancery Court’s opinion in Ainslie, an opinion subsequently reversed, the District Court concluded that the forfeiture-for-competition provision was subject to reasonableness review. Finding the provision an unreasonable restraint on trade, the District Court entered judgment in favor of Mr. Rutledge on the breach of contract claims as well. 

On appeal, the Seventh Circuit affirmed the dismissal of LKQ’s unjust enrichment claim. The Court then reviewed LKQ’s restrictive covenants with Mr. Rutledge. These included a more conventional non-compete, which the Seventh Circuit, like the District Court, found unreasonable, as it entailed a nine-month ban on Mr. Rutledge working for any competitor in any capacity. Moreover, the ban was geographically overbroad, applying to companies within a 75 mile radius of LKQ’s Florida facility. The effect was that Mr. Rutledge would either have to change industries or move if he wanted to continue to work.

Moreover, Mr. Rutledge’s new job involved remote work in connection with facilities located hundreds of miles from LKQ’s Florida facility, and LKQ nonetheless attempted to enforce its restrictions on Mr. Rutledge’s post-resignation employment because he was working from his home, which was within the 75-mile geographic restriction. Given the unreasonableness of the restrictive covenants as a whole, the Seventh Circuit declined LKQ’s offer to take a blue pencil to some of their provisions.

I am a bit baffled as to why forfeiture-for-competition provisions should be treated any differently from regular non-competes. I have certainly seen non-competes reviewed for reasonableness when the employer was a partnership. In such cases, each of the partners had the right to enforce the non-compete against their departing peers. I have been struck by the oddity that a court will strike down a non-compete among doctors in a partnership when, there but for fortune, a defendant might have become the plaintiff challenging the non-compete and the plaintiff may be among those trying to enforce it. Notwithstanding the reciprocity in the agreement and the sophistication of the parties, the courts do not rend their garments over the grievous blows inflicted on the principle of freedom of contract when such non-competes are cast aside on public policy grounds. However, the Seventh Circuit notes that courts are split with respect to forfeiture-for-competition provisions. While some courts treat them like other non-competes, the majority position sides with freedom of contract. An employee subject to a forfeiture-for-competition clause can still work for a competitor; the clause only imposes a financial disincentive to doing so. The majority rule treats this as a matter of choice. 

In Ainslie the Delaware Supreme Court sided with the majority, but it did so in reliance on Delaware’s Uniform Limited Partnership Act, which expressly states as one of its aims “to give maximum effect to the principle of freedom of contract.” This case is distinguishable from Ainslie in many ways, but the Ainslie opinion includes language that suggests that the Delaware Supreme Court intended for it to have effect beyond the context of the Uniform Limited Partnership Act. The Seventh Circuit indicated that giving effect to the forfeiture for competition provision would have harsh — and likely unreasonable — effects. While a partner may be on either side of the enforcement of a forfeiture-for-competition provision, Mr. Rutledge was a middle manager with a salary of $109,000. For employees like him, the provision operates as a penalty clause that can claw back incentives that may have been realized years earlier.

Given the uncertainty of the scope of Ainslie, the Seventh Circuit wisely chose to certify the following questions to the Delaware Supreme Court:

(1) Whether Cantor Fitzgerald precludes reviewing forfeiture-for-competition provisions for reasonableness in circumstances outside the limited partnership context?

(2) If Cantor Fitzgerald does not apply in all other circumstances, what factors inform its application? For example, does it matter what type of agreement the forfeiture provision appears in, how sophisticated the parties are, whether the parties retained counsel to review the provision, whether the forfeiture involves a contingent payment or claw back, how far backward a claw back reaches, whether the employee quit or was involuntarily terminated, or whether the provision also entitled the company to injunctive relief?

Other than the certified issue, the Seventh Circuit affirmed the decision of the District Court. It would be nice to have these issues resolved. That said, for Mr. Rutledge’s sake, I hope that LKQ just gives up this battle.