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February 9, 2012

Court of Chancery Continues To Question Blue Pencil Rule

The Delaware Court of Chancery has once again indicated a reluctance to invoke the Blue Pencil Rule to reform overly broad restrictive covenants. Approximately 10 months ago, in his opinion in Delaware Elevator, Inc. v. Williams, Vice Chancellor Laster expressed his unwillingness to reform overbroad covenants, noting that “doing so puts the employer in a no-lose situation.” We discussed the opinion on this blog, urging drafters to exercise caution when drafting non-competition agreements and to give serious consideration to surrounding business circumstances when drafting. More recently, on December 21, 2011, during oral argument in Chesapeake Insurance Advisors, Inc. v. Williams Insurance Agency, Inc., et al., Vice Chancellor Noble echoed Vice Chancellor Laster’s position, quoting directly from Delaware Elevator.

In Chesapeake, the plaintiff-former employer sought to enforce a non-competition and non-solicitation agreement against several former employees, including the company’s former President. Oral argument was held to address the plaintiff’s dual motions for expedited proceedings and a temporary restraining order. In order to succeed on its motion for a temporary restraining order, plaintiff had to demonstrate, among other things, a colorable claim to relief. In order to demonstrate a colorable claim, the plaintiff had to present evidence that the underlying covenants are enforceable under Delaware law. Valid covenants must include reasonable temporal, geographic, and subject-matter restrictions.

Of significance here is the non-solicitation restriction, which prohibits the plaintiff’s former President from soliciting any of the plaintiff’s customers for 36 months following the termination of his employment. Delaware law has long recognized a presumption of reasonableness for restrictions extending no more than 24 months. Consequently, the plaintiff had an up-hill battle to convince the Court of the reasonableness of a 36-month restriction.

In an effort to cover his bases, the plaintiff’s counsel noted that in the absence of evidence justifying a 36-month restriction, the Court could always reform the covenant under the Blue Pencil Rule to limit the temporal restriction to a reasonable time period. Relying upon Vice Chancellor Laster’s decision, the Court stated that it would not “use the blue pencil to say ‘let’s make it 12 months or 18 months or 24 months.’ It’s not there. It’s gone.” Plaintiff’s counsel pointed out that the contract at issue had been fully negotiable, and that both parties had been represented by counsel. The Court was undeterred. While the Court recognized that “there is something of a divergence of opinion on that topic” between the Court of Chancery and the Delaware Supreme Court, it nonetheless indicated its intent to interpret the contract as written without modification.

Like the dicta in Delaware Elevator, the Court’s discussion in Chesapeake Insurance is not precedential. However, it provides a stronger indication (if one were needed) that the Court has little patience for needlessly broad restrictive covenants. Moreover, the relative bargaining positions of the parties is of little significance to the Court. Consequently, drafters should heed the Court’s warnings, and carefully consider the attendant business circumstances when drafting restrictive covenants. Among the issues to consider are: (1) the employee’s relative position within the company; (2) the extent of the employee’s business-related contacts; (3) the employee’s establishment within the field of business and the surrounding community; and (4) the realistic possibility of relocating or working outside of the geographical scope of the restrictive covenant. As an employee’s position within the company and access to customers and trade secrets increases, so does the employer’s ability to restrict his ability to compete and solicit current and prospective customers.

March 28, 2011

Court of Chancery Indicates It May Strike - Not Reform—Overly Broad Non-Compete Clause

When enforcing covenants not to compete, Delaware has long been viewed as a “reformation” state – meaning that when faced with an overbroad covenant, Delaware law allows the court to reduce the scope of the covenant and enforce it to the extent that the court deems reasonable. This view has developed among the lower courts in a number of decisions, but has never been fully addressed by the Delaware Supreme Court.chancerylogo60

However, as we noted in an earlier article, it is important to make certain the restrictive covenant you draft is reasonable both in its scope and duration. Employers should not count on a court to "reform" a poorly drafted restrictive covenant that is overly broad or vague. A recent case from the Court of Chancery demonstrates why.

In the case of Delaware Elevator, Inc. v. John Williams, No. 5596-VCL (Del. Ch. March 16, 2011), the plaintiff-employer sued its former employee alleging a violation of the employee’s non-competition agreement. Because the employee admitted that he had engaged in conduct that violated the terms of the non-competition agreement, the only question before the Court was whether the non-competition agreement was overly broad, and therefore unenforceable.

The non-competition agreement at issue had both a non-competition and a non-solicitation provision, each of which restricted the employee’s conduct for 3 years after he left his employment. The non-competition provision prohibited the employee from competing with the employer within 100 miles of its Newark, Delaware office. Under the non-solicitation provision, the employee was prohibited from soliciting any customer who had been a current or prospective client of the employer during the last 6 months of the employee’s employment.

The employee resigned his position with the employer in 2010. Shortly thereafter, the employer discovered that he was competing within 100 miles of the Newark Office, and that he was using a customer list that he developed while he was employed by the employer. When the employee refused to cease and desist, the employer brought suit, seeking to enjoin his violation of the agreement.

The non-competition agreement included a Maryland choice-of-law provision, so the Court’s analysis was conducted under Maryland law. After determining that the 3-year, 100-mile restriction was overly broad, the Court was faced with the question of whether to strike or reform the provision. The Court concluded that Maryland law required reformation under the blue pencil rule. However, the Court declared that it would have handled the question differently under Delaware law.

The Court stated that reformation of overly broad contracts puts an employer in a no-lose situation. If the agreement will be enforced to some lesser extent even if overly broad, an employer has no incentive to draft a reasonable provision in the first place. The Court also noted that for every employee who challenged the provision, others would choose not to, thereby harming consumers and interfering with labor and product markets.

The Court was further troubled by the disparity in bargaining power between low and mid-level employees and their employer. Where such employees are involved, the Court noted, there is no real choice as to whether to sign the non-competition agreement. Moreover, even if there were a choice, most employees do not have the savvy or access to legal advice to bargain effectively. As a result, the Court noted that Delaware law might require that an unreasonable restrictive covenant be struck in its entirety.

While the Court’s statements regarding Delaware law are dicta, they provide a strong indication that overly broad restrictive covenants might not be enforced in any manner by the Delaware Court of Chancery. As a result, employers should exercise caution when drafting non-competition agreements. These agreements should consider, among other things, (1) the employee’s relative position within the company, (2) the extent of the employee’s business-related contacts, (3) the employee’s establishment within the field of business and the surrounding community, and (4) the realistic possibility of relocating or working outside of the geographical scope of the restrictive covenant. As an employee’s position within the company and access to customers and trade secrets increases, so does the employer’s ability to restrict his competition and solicitation of current and prospective customers.

By Scott Holt and Lauren Moak

June 8, 2010

Chancery Court Utilizes Two-Step Analysis for Enforcement of Non-Competes

The Delaware Court of Chancery generally employs a two-step analysis to determine the enforceability of a covenant not to compete in the employment context. The first step of the analysis is a question of basic contract law. The Court looks to whether there was mutual assent between the parties, whether adequate consideration was exchanged, and whether a material breach of the other party excuses performance.

Assuming that the covenant is valid under ordinary contract principles, the Court then determines whether four additional, covenant-specific conditions are satisfied. First, the temporal restrictions of the covenant must be reasonable in scope and duration. Second, the geographical limitations (if any) must be reasonable. Third, the covenant must advance a legitimate economic interest of the employer at the time enforcement is requested.

Fourth, the covenant must survive a balance of the equities test. Here, the Court looks to the harm likely to be caused to each party should their position be unsuccessful. The Court then balances the harms to ensure that no one party will suffer unfairly. This fourth condition is grounded in the equitable nature of the injunctive remedy being sought. As a result, a covenant not to compete may be valid but may not be specifically enforceable in the circumstances presented at the time of the application for enforcement.