By Mark Poerio and Jordan Mamorsky
The enforceability of non-compete provisions continues to be in the national spotlight. In a very recent Delaware Supreme Court decision, Cantor Fitzgerald, L.P. v. Ainslie, involving a partnership dispute at the investment firm, Cantor Fitzgerald, the court upheld the enforceability of a forfeiture-for-competition provision, instructing that courts in Delaware should not second guess the reasonableness of a contractual forfeiture-for-competition provision, and the contractual provision should be legally enforceable as a matter of law. This case has serious implications given that many legal entities are formed under Delaware law and employers should therefore consider applying forfeiture-for-competition provisions in their contracts (executive, partnership etc.) as a valid and binding way to protect against harmful competitive conduct from departing employees.
The Supreme Court of Delaware has a long history of providing soundly-reasoned business decision. On January 29th, that tradition carried forward with Cantor Fitzgerald prevailing – to the tune of $9 million — over former limited partners who allegedly violated their non-competition obligations in forfeiture-for-competition provisions
The facts of this matter were that: Cantor Fitzgerald maintains a “Capital Account” for each of its partners that, by default, was to be paid out in annual installments over four years following a partner’s withdrawal and includes “HDII Units” that the partner elects to purchase as well as the partner’s profit share. However, under the firm’s Limited Partnership Agreement if it was determined in good faith that a departing partner engaged in certain competitive conduct to Cantor Fitzgerald within a certain “restricted period” the departing partner could forfeit certain continued rights to the Units and profit sharing the former partner would have otherwise been entitled to.
Plaintiffs, former partners of Cantor Fitzgerald, that had joined alleged competitors of the investment firm, challenged the forfeiture of amounts ranging from just under $100,000 to over $5 million. Plaintiffs had previously been victorious in convincing the lower Delaware Chancery Court that, as a matter of law, the court was required to determine whether the forfeiture-for-competition provisions were reasonable or not, and that the provisions could not be reasonable given that they were liquidated damages penalizing them for their freedom to work at an employer of their choosing. In ruling for Plaintiffs, the Chancery Court emphasized: “Delaware’s distaste for liquidated damages provisions that restrain trade by requiring employees to pay former employers if they compete—even unknowingly and in an amount untethered to the employer’s loss.”
The Supreme Court, however, focused on a different Delaware policy consideration in reversing the decision of the Chancery Court noting that: “The courts of this State hold freedom of contract in high—some might say, reverential—regard.” (emphasis added).
Rather than inject itself into a matter of private contract and essentially evaluating as a matter of law whether the restrictive covenants were unreasonable, the Delaware’s Supreme Court emphasized that the contract at issue involved “sophisticated actors” who were not being prohibited from engaging in competitive work through the forfeiture-for-competition provision but merely were being denied “the right to some financial benefit if [they chose] to engage in competitive activity.” That distinction led the court to “disagree with the Court of Chancery’s conclusion that forfeiture-for-competition provisions like the one at issue here are restraints of trade subject to review for reasonableness.” Instead, the Supreme Court sided with Cantor Fitzgerald’s argument that —
we should be guided by the employee-choice doctrine, which “assumes that an employee who elects to leave a company makes an informed choice between forfeiting a certain benefit or retaining the benefit by avoiding competitive employment.” [quoting with approval Lucente v. Int’l Bus. Machines Corp., 310 F.3d 243, 254 (2d Cir. 2002)].
Accordingly, Delaware’s Supreme Court held that
the provision at issue here is not a penalty enforced against an employee based on the breach of a restrictive covenant; it is a condition precedent that excuses Cantor Fitzgerald from its duty to pay if the plaintiffs fail to satisfy the condition to which they agreed to be bound in order to receive a deferred financial benefit.
Advice for Employers
It would be a mistake to consider the floodgates open for the enforcement of forfeiture-for-competition provisions. Notably, Delaware’s Supreme Court dealt with a limited partnership agreement, not an employment agreement. However, annual bonuses, stock awards, and other long-term incentives for executives could be structured to provide for post-termination executive compensation that could be forfeited if the departing executive engages in competitive conduct.
From a policy perspective, a connection could be made between deferred compensation credited to a departing executive and profit-sharing money owed to a departing partner. In this respect the Court noted that the Cantor Fitzgerald partners benefitted while employed when the forfeiture provision was enforced against other departing partners. Of course, executives of any company may benefit – directly or indirectly – when forfeitures of deferred compensation occur. That is a design possibility to consider.
More generally, Cantor Fitzgerald’s success in Delaware suggests a smart route for employers who want to discourage key employees from violating their post-employment restrictive covenants. There are two sides to the strategy: first, design the right approach for the deferred compensation; second, package the deferred compensation within an agreement or plan that conveys an iron-fisted approach to the enforcement of forfeiture provisions.
It is entirely possible to redirect part of an executive’s pay into deferred compensation, and to delay paying all or some of it until expiration of non-competition and/or, non-solicitation obligations. Annual credits of deferred compensation may result from a formula as simple as a percentage of salary. A formula could, of course, be more complex, e.g., tying deferrals to corporate, divisional, or individual performance goals. Likewise, the rate of return on deferred compensation may be performance-based. For public companies, stock price is often the measure. For private companies, return on equity or other measures of growth or profitability may be suitable.
Beyond the broad range of financial and payout alternatives, the Cantor Fitzgerald case (and those cited extensively within it) signal the importance of drafting agreements and plans in a manner that creates an “in terrorem” result for those who violate their post-employment restrictive covenants. That calculus starts with building deferred compensation to levels that encourage executives to honor their covenants rather than risk forfeiture.
State non-competition laws, and ERISA, are critical to consider in order to construct the most effective approach. Employers should be very careful to design executive compensation plans with a firm understanding and close consideration of law governing the plan. ERISA plans, for example, should be carefully drafted with a focused eye as to ERISA’s top hat rules, with significant strategic value coming from ERISA’s preemption of contrary state laws. Forum selection, fee shifting for litigation costs, and internal statutes of limitations for any claims are all key employer protections.
Fortunately, employers have the opportunity to opt for a simplified approach to all of the above, with more complex features (such as performance-based customization) being sometimes worth the extra effort and expense. In all cases, it is our experience that a simple terms sheet usually provides the best starting point for discussion. Once that framework establishes the general parameters, the art comes from the document drafting.
Overall, the recent Cantor Fitzgerald Case demonstrates that there is reason for optimism for employers who want to buttress deferred compensation with forfeiture-for-competition provisions, and thereby place the fear of god (and mammon) in those who would leave employment to join a competitor, solicit customers or employees, or steal trade secrets.