Delaware Supreme Court Upholds Forfeiture for Competition Provisions, Holding Departed Partners Bargained Away Their Right to Have Their Cake and Eat It, Too

On January 29, 2024, the Delaware Supreme Court unanimously reversed a major Delaware Chancery Court decision that had analyzed the “forfeiture for competition” provisions in a limited partnership agreement using a traditional restrictive covenant reasonableness standard and found them unreasonable and unenforceable.

Post-employment forfeiture for competition contractual provisions are designed to allow one party to a contract to withhold certain financial benefits from the second party in the event the second party exits the business relationship and then engages in directly competitive conduct. Generally, a forfeiture for competition provision does not prohibit competition, but does impose a condition precedent that must be satisfied in order to receive or retain a specified contingent financial benefit. In some jurisdictions, this is referred to as the “employee choice” doctrine, i.e., the employee can “choose” to compete but will forfeit certain benefits as a result.

In Cantor Fitzgerald L.P. v. Brad Ainslie, et al., six partners voluntarily executed limited partnership agreements that included forfeiture for competition provisions. Although these contractual provisions did not prohibit competition in the event the partners left the partnership, the provisions did offer the withdrawing partners a choice in the event they voluntarily withdrew from the partnership: (a) they could choose to compete against that partnership after their departure and relinquish their rights to significant financial benefits, or (b) they could abstain from competing with the partnership for one year and receive those contingent financial benefits.

All six partners voluntarily withdrew from the partnership and then, within the year that followed, engaged in competitive activities with the partnership. After the partnership refused to remit to each of these partners certain contingent financial benefits (ranging from $100,000 to over $5 million), the former partners sued and asked the court to declare that their forfeiture provisions were unenforceable.

The former partners argued that the forfeiture for competition provisions in the limited partnership agreement flouted Delaware’s strong public policy of promoting free and fair competition and facilitating commerce. The departed partners also contended that the provisions were unenforceable penalties and should be declared invalid under the same “reasonableness” test that courts apply when evaluating the enforceability of traditional non-compete agreements.

The partnership contended that the forfeiture for competition provisions did not constitute an unenforceable penalty and instead asserted that the provisions merely outlined that certain (albeit significant) conditional financial benefits would not be recoverable if a condition precedent was not satisfied. Moreover, the partnership argued that the financial-based restrictions in the forfeiture for competition provisions were distinguishable from traditional non-competition restrictive covenants and should not be analyzed under the same lens.

The Delaware Chancery Court, in a January 2023 decision, sided with the former partners, holding that the forfeiture for competition clauses were restraints of trade akin to non-competition agreements and must be analyzed under a traditional reasonableness standard. Under that standard, the Chancery Court ruled the provisions were unreasonable and unenforceable. 

However, the Delaware Supreme Court agreed with the partnership and reversed the lower court ruling. The court held that “when sophisticated parties agree in a limited partnership agreement that a partner, who voluntarily withdraws from, and then competes with, the partnership, will forfeit contingent post-withdrawal financial benefits, public-policy considerations weigh in favor of enforcing that agreement.” Although the court cautioned that forfeiture for competition provisions in partnership agreements could conceivably be disregarded based on “a public policy interest” or “an inequitable outcome,” the court strongly supported and upheld the interest in freedom of contract that is held in “high—some might even say, reverential—regard” in Delaware.  In that sense, the decision is highly encouraging for entities seeking to utilize forfeiture for competition provisions to incentivize the behavior of co-parties to business relationships. Indeed, the court explicitly contrasted a post-employment non-compete to a forfeiture for competition provision:

In the restrictive-covenant context, the former employee is effectively deprived of his livelihood and, correspondingly, exposed to the risk of serious financial hardship. This gives rise to the strong policy interest that justifies the review of unambiguous contract provisions for reasonableness and a balancing of the equities, two exercises typically foreign to judicial review in contract actions. By contrast, however, forfeiture-for-competition provisions, which, unlike restrictive covenants, are not enforceable through injunctive relief, do not prohibit employees from competing and remaining in their chosen profession, and do not deprive the public of the employee's services, present no such concern.

Following a number of recent decisions by the Chancery Court in Delaware that have evinced an increasing hostility to restrictive covenants, this decision by the Delaware Supreme Court swings the pendulum back a bit in the other direction. Littler’s Unfair Competition and Trade Secret Practice Group is closely monitoring these decisions and companies are strongly encouraged to consult with counsel to discuss the parameters of any existing or contemplated agreements containing forfeiture for competition provisions or other restrictive covenants.

Information contained in this publication is intended for informational purposes only and does not constitute legal advice or opinion, nor is it a substitute for the professional judgment of an attorney.