Key Takeaways:

• The Seventh Circuit has asked the Delaware Supreme Court to further articulate the scope and breadth of its recent Cantor Fitzgerald v. Ainslie decision, which upheld the use of forfeiture-for-competition provisions under the employee choice doctrine.
• If the Delaware Supreme Court responds fully to the Seventh Circuit’s inquiry, the Delaware Supreme Court will definitively answer the question of whether the employee choice doctrine applies beyond the application of the Delaware Limited Partnership Act – which embodies the state’s strong contractarian tradition to give maximum effect to the principle of freedom of contract – and the fact pattern presented in Cantor Fitzgerald v. Ainslie.
• The outcome could have significant ramifications for entities governed by the Limited Liability Company Act, which contains almost identical language to the Limited Partnership Act, but also corporations and other entities that utilize forfeiture-for-competition provisions with their employees or other non-partner or owner individuals.

Less than two months after the Delaware Supreme Court provided the employers, investment partners and other business leaders that trust in the stability of Delaware law to protect their critical business interests with the comfort of knowing that their forfeiture-for-competition agreements (i.e., non-competes supported by post-employment equity) would remain enforceable, the Seventh Circuit has asked the Delaware Supreme Court for clarification on the scope of its decision. The Delaware Supreme Court’s much-anticipated ruling in Cantor Fitzgerald v. Ainslie, which reversed the Court of Chancery’s 2023 finding that forfeiture-for-competition provisions should be evaluated by the same “reasonableness” standard as employee non-competes, brought Delaware in line with New York in adopting the employee choice doctrine, which supports the enforcement of these provisions without a “reasonableness” inquiry. However, in a March 15, 2024 Order, the Seventh Circuit in LKQ Corporation v. Robert Rutledge, while evaluating a forfeiture-for-competition provision in a restricted stock award governed by Delaware law, questioned the breadth of the Cantor Fitzgerald holding.

A key issue for the circuit court appears to be the difference between the forfeiture of “contingent” payments, which were governed by the Delaware Limited Partnership Act, as was at issue in Cantor Fitzgerald, and the clawback of stock that was granted, vested and sold many years ago, in the non-partnership context, in the LKQ case.

In Cantor Fitzgerald, the Delaware Supreme Court held “that forfeitures in limited partnership agreements should enjoy this court’s deference on equal footing with any other bargained-for-term in a limited partnership agreement” and therefore no “reasonableness” inquiry was required. Indeed, “the plaintiffs [in Cantor Fitzgerald] voluntarily entered into the partnership and the Agreement, elected to compete with the partnership upon their departure, and thereby assumed the risk of the forfeiture.” Accordingly, the Delaware Supreme Court held that “[w]hen 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.”

However, in LKQ, the Seventh Circuit certified the following questions to the Delaware Supreme Court:

• “Whether Cantor Fitzgerald precludes reviewing forfeiture-for-competition provisions for reasonableness in circumstances outside the limited partnership context?”
• “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?”

Notably, these two questions arise against the backdrop of the Seventh Circuit having already concluded that the former employee in LKQ, Rutledge, was subject to an “unreasonable” non-compete (a nine-month restriction from working within 75 miles of his place of work) under Illinois law, and the Seventh Circuit “decline[d] the invitation” to “blue pencil” the offending provisions.

Among the key considerations, and differences from the Cantor Fitzgerald case, identified by the Seventh Circuit in asking Delaware for clarification, are:

• The strong policy considerations raised by the Limited Partnership Act in Cantor Fitzgerald, which were not present in LKQ. Rutledge did not agree to the forfeiture provision in a partnership agreement or other specialized contract. Rather, he signed an ordinary corporate contract as part of LKQ’s restricted stock program.
• Rutledge was not a partner or company executive represented by counsel. He worked his entire career at LKQ as a middle manager for a national supplier of salvage and recycled automobile parts in Florida.

The Cantor Fitzgerald decision was based in part on the supreme importance and stability of the Limited Partnership Act, with Cantor Fitzgerald successfully arguing on appeal that:

If left to stand, the ruling would wreak havoc on a variety of Delaware contracts, numerous limited partnership agreements that provide for financial consequences based on the actions of partners, and a host of other financial arrangements between companies and individuals that are routinely upheld without noncompete scrutiny.

Thus, the Delaware Supreme Court concluded that “[w]hen sophisticated actors avail themselves of the contractual flexibility embodied in the Delaware Revised Uniform Limited Partnership Act – a statute that is expressly designed ‘to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements’ – . . . our courts should . . . hold them to their agreements.” Accordingly, the Seventh Circuit concluded that “[t]he facts make it hard to see how the Limited Partnership Act’s directive to give maximum effect to freedom of contract applies here” and ultimately questions whether the Cantor Fitzgerald holding applies beyond the Limited Partnership Act (and likely the Limited Liability Company Act, which contains almost identical language).

Further, the Seventh Circuit observed that:

• The consequences of a breach differ. In Cantor Fitzgerald, the breach excused the company from paying contingent distributions of a limited partner’s earned capital. In LKQ, however, Rutledge’s alleged breach would forfeit the grant of stock or any proceeds from the sale of those shares.
• LKQ’s agreements also did not limit how far back the forfeiture applied. In application, that would allow LKQ to claw back stock proceeds long vested and sold, worth at least $600,000, “from a middle manager making a modest salary (about $109,000).”

The refence to Rutledge’s salary is interesting, particularly since Illinois law – which the Seventh Circuit would surely be familiar with – does impose a low-wage threshold ($75,000) on the use of employee non-competes, but that level is meaningfully below Rutledge’s salary. Further, as a practical matter, the former Cantor Fitzgerald partners were denied further payments from Cantor Fitzgerald, while it appears that Rutledge would have to affirmatively pay LKQ due to his breach.

Finally:

• LKQ’s agreement provides it with the ability to seek injunctive relief, whereas “[a] hallmark of forfeiture provisions is that they are not enforceable through injunctive relief.” Thus, even though LKQ never acted on this right, “[t]his, too, differs from the circumstance before the Delaware Supreme Court in Cantor Fitzgerald.”

The Seventh Circuit’s questions, and the distinctions highlighted by the court, distill to the point that the court “cannot discern with confidence [] whether the holding in Cantor Fitzgerald applies outside the context of highly sophisticated parties” – i.e., those operating under the Limited Partnership Act – and “including where the mandated forfeiture is expansive in scope.” Ultimately, there is no question that there are differences between the fact patterns in Cantor Fitzgerald and LKQ – including the applicable Delaware law and forfeiture structure. It can be argued that this is precisely what removing the “review for reasonableness” under the employee choice doctrine is meant to address. However, for now, practitioners and those entities that rely on Delaware to enforce these business provisions will again anxiously await the Delaware Supreme Court’s decision on whether these distinctions merit any consideration (reasonableness or otherwise) in the application of law to fact.

[View source.]