These requirements must be reviewed “holistically and in context.” As Vice Chancellor Laster explained,
[a] court must not tick through individual features of a restriction in isolation, because features work together synergistically. For example, “a court must consider how the temporal and geographic restrictions operate together” because the “two dimensions necessarily interact.” A covenant that restricts employment in a similar industry for two years might be reasonable if it only applies within a single town or county, and vice versa. All else equal, a longer restrictive covenant will be more reasonable if geographically tempered, and a broader restrictive covenant will be more reasonable if temporally tailored.
When a noncompete is entered into in connection with the sale of a business, the court must still evaluate its reasonableness, but the “inquiry is less searching than if the covenant had been contained in an employment contract.”
The fact-intensive nature of this inquiry does not lend itself to bright-line tests; however, the case law has revealed some common themes.
Geographic Scope
“[T]he reasonableness of a covenant’s scope is not determined by reference to physical distances, but by reference to the area in which a covenantee has an interest the covenants are designed to protect.” Courts have found noncompetes to be reasonable when limited to the areas where a company does business. Provisions that apply beyond the company’s area of operations, have worldwide or nationwide application, or include the company’s affiliates or subsidiaries have been heavily criticized.
While nationwide or worldwide restrictions are often considered overbroad, courts have enforced them when they are entered into in connection with the sale of a business.
A lack of geographical restrictions is unusual, but it does not render the restriction unenforceable per se. 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.
In Ainslie v. Cantor Fitzgerald, Limited Partnership, the Delaware Court of Chancery found that a four-year noncompete contained in a partnership agreement was unreasonable, but it suggested that such a duration may be “in the range of reasonable” if the scope of the restriction were appropriately narrowed.
Delaware courts have upheld longer durations when the provision arises in connection with the sale of a business or stock.
Legitimate Economic Interest
Like the other aspects of this analysis, the existence of a legitimate economic interest is highly fact intensive. In evaluating the alleged economic interest, courts have considered a variety of factors, including (i) the employee’s exposure to confidential information, proprietary technology, and other trade secrets; (ii) the level of training and skill that was required to perform the work; and (iii) the employee’s general role with 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 to be 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 to be enforceable.
Finally, the breadth of the restriction is also considered. As the court in Fortiline, Inc. v. McCall held, 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 routinely 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, and/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 (known as disintermediation) may constitute 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 everyday concern[s],” including that (i) the employee was generally “responsible for many . . . customer relationships,” or involved in “finding deals and fostering relationships” with customers; (ii) the employee would be able to use the technical expertise or general industry knowledge they gained while employed by the company against it; and (iii) the employee could use an important certification the company paid for them to get against it.
Balancing of the Equities
Finally, Delaware courts balance the company’s interest in preventing competition with the harm that would befall the employee if the covenant were enforced.
The recent case law suggests that this balance focuses on an employee’s ability to earn a living and the role the employee played in the company. Given Delaware’s concern for employees’ well-being, it is not surprising that courts have been critical of provisions that will prevent a person from earning a living. The role that the employee had with the company is also an important factor. Given the typically disparate bargaining power between a company and its employees, noncompetes with lower-level employees are routinely rejected as unreasonable. However, Delaware courts have been less critical of provisions applying to senior executives who received significant compensation or who were critical to the negotiation of the transaction that led to the creation of the noncompete.
The “Blue Pencil” Rule
As a court of equity, the Delaware Court of Chancery in the past has 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. As Vice Chancellor Laster explained in Sunder Energy, LLC v. Jackson,
revising an overbroad restrictive covenant creates a no-lose situation for employers because businesses can draft the covenant as broadly as possible, confident that the scope of the restriction will chill some individuals from departing. If someone does challenge the provision, then the worst case is that the court will blue-pencil its scope so it is acceptable. It also enables employers to extract benefits at the expense of employees by including unenforceable restrictions in their agreements.
In Labyrinth, Inc. v. Ulrich, the court denied a motion to dismiss because, even though the ten-year-long restrictive covenant was overbroad in several ways, the fact that the employee was personally and deeply involved in negotiating the covenant in connection with the sale of his business “may conceivably present a rare instance where equity and public policy might require blue penciling.”
Contractual Provisions Regarding Reasonableness
The “reasonableness” analysis cannot be avoided via contractual provisions. Companies may attempt to contract around the reasonableness requirement by including provisions pursuant to which the employee (i) agrees that the restrictions are reasonable, (ii) waives any defense that they are not, and (iii) agrees that a court may modify the provision if it is deemed unreasonable as drafted. However, Delaware courts have repeatedly held that such provisions are ineffective and do not relieve the court of its obligation to determine the reasonableness of the provision.
“Forfeiture for Competition” Provisions Recently Upheld
As the Delaware Supreme Court recently explained in Cantor Fitzgerald, Limited Partnership v. Ainslie, so-called “forfeiture for competition” provisions are not evaluated for “reasonableness.” Forfeiture for competition provisions are contract provisions that relieve the company of obligations to pay an employee deferred financial benefits if the employee breaches a noncompetition provision in the contract. As the Delaware Supreme Court held in Cantor, such provisions “stand on different footing” than noncompetes because they do not “limit a [person’s] ability to compete or otherwise obtain employment.” Unlike noncompetes, forfeiture for competition provisions are “a condition precedent that excuses [the company] from its duty to [make future payments] if the [employee] fail[s] to satisfy a condition to which they agreed to be bound in order to receive a deferred financial benefit.” As a result, forfeiture for competition provisions are not reviewed for reasonableness but rather enjoy the “court’s deference on equal footing with any other bargained-for-term” in a contract.
Statutory Limitations
Even if the provision satisfies the reasonableness standard, Delaware law prohibits the use of noncompetes in some narrow circumstances. By way of example, noncompetes between physicians that restrict the physician’s right to practice medicine in a particular area or for a particular time period are void (although provisions requiring the payment of money damages for a breach of such provision are enforceable).
Other states have gone even further than Delaware and enacted statutes prohibiting or strictly limiting the enforceability of such provisions.
The FTC’s Effort to Ban the Use of Noncompetes
Earlier this year, the Federal Trade Commission (“FTC”) issued a final rule (“Final Rule”) that, subject to certain specific exceptions, made it a violation of section 5 of the Federal Trade Commission Act for employers to enter into new noncompete agreements with workers of any level on or after September 4, 2024 (“Effective Date”). However, the Final Rule was barred from taking effect, and its future is uncertain.
Under the Final Rule, noncompetes in effect on the Effective Date are only enforceable against employees considered to be “Senior Executives”—that is, those in a “policy-making position” who meet or exceed a minimum compensation requirement. If an employee does not qualify as a Senior Executive, existing noncompetes are no longer enforceable. The Final Rule imposes strict time limits for companies to notify non–Senior Executives of that change.
While the Final Rule is a broad prohibition, there are several limitations and exceptions. First, it only applies to noncompetition provisions in employment contracts; it does not apply to noncompetes entered into in connection with the bona fide sale of a business or a franchise. Second, it does not prohibit causes of action for breaches of a noncompete that occurred prior to the Effective Date. Finally, enforcement of a noncompete does not violate the Final Rule if the company has a good-faith basis to believe that the Final Rule does not apply to that situation.
The Final Rule did not go into effect on September 4, 2024, as expected. On August 20, 2024, Judge Ada Brown of the U.S. District Court for the Northern District of Texas issued a permanent injunction setting aside the Final Rule and declaring that it “shall not be enforced or otherwise take effect on September 4, 2024, or thereafter.” Litigation regarding enforceability of the Final Rule is ongoing. Therefore, it remains possible that the Final Rule, or some modified version thereof, may still become law.
In sum, while Delaware is a contractarian state that defers to people’s right to privately order their affairs, that deference is tempered when a contract restricts a person’s ability to work. Noncompete agreements (unlike forfeiture for competition provisions) are judged by a “reasonableness” standard. Reasonableness, however, does not lend itself to a bright-line test, but requires analysis of several interrelated considerations—the agreement’s geographic scope and duration, the existence of a legitimate economic interest, and a balancing of the equities. While no one factor is determinative, Delaware courts have issued some guideposts (discussed above) and made it clear the concept is so important that parties cannot contract around the inquiry and that courts are hesitant to change an otherwise unenforceable contract. The time may come that the FTC’s final rule goes into effect and companies are prohibited from entering into noncompetes altogether. However, until then business leaders and legal practitioners must ensure that noncompetes are “reasonable” if they are to be enforced under Delaware law.
