Background
So-called “forfeiture-for-competition” provisions allow companies to protect their business interests. A forfeiture-for-competition provision involves an employee contractually committing not to compete with their employer for a period of time after termination of employment in exchange for compensation or another benefit. If the employee competes, they will forfeit their compensation or benefit, in certain cases, whether or not it has already been paid to the employee.
Earlier this year, the Court ruled in Cantor Fitzgerald, L.P. v. Ainslie [2] that a Delaware limited partnership provision allowing the partnership to withhold unpaid distributions from a withdrawing partner who competes was enforceable. In Cantor Fitzgerald, the Court endorsed the “employee choice” doctrine, which establishes that the reviewing court should treat a forfeiture-for-competition provision as an enforceable term subject to ordinary breach of contract defenses rather than a restraint of trade subject to reasonableness review. The Cantor Fitzgerald decision did not address whether forfeiture-for-competition provisions would also be considered enforceable against employees.
Summary of LKQ Corp. v. Rutledge
Robert Rutledge worked as a plant manager for LKQ Corporation (“LKQ”). Given his role and designation by LKQ as a “key employee,” he was eligible to receive equity compensation in the form of restricted stock units (“RSUs”) that were documented in RSU award agreements. The RSU award agreements contained a forfeiture-for-competition provision that required him to forfeit his RSUs and any stock issued after the RSUs vested if he engaged in a competitive activity within nine months following the termination of his employment.
Rutledge resigned in April 2021 and joined a competitor within the nine-month non-compete period. LKQ filed suit in Illinois federal court to enjoin Rutledge from working for a competitor under certain restrictive covenant agreements he had signed with LKQ and to demand repayment of the proceeds from all LKQ shares that Rutledge had received and sold under the RSU award agreements.
The Illinois district court held that the restrictive covenant agreements were unreasonable restraints on trade and therefore not enforceable under Illinois law. It also concluded that the competition restrictions contained in the RSU award agreements were unreasonable restraints of trade under Delaware law and therefore not enforceable. Following an appeal by LKQ, the U.S. Court of Appeals for the Seventh Circuit affirmed the Illinois district court’s ruling that the restrictive covenant agreements were overbroad and unreasonable and certified two questions to the Court with respect to the RSU award agreements: 1) whether Cantor Fitzgerald precludes reviewing forfeiture-for-competition provisions for reasonableness in circumstances outside the limited partnership context and 2) if Cantor Fitzgerald does not apply in all other circumstances, what factors inform its application? [3]
The parties’ arguments
Rutledge argued that the “employee choice” doctrine should only apply to limited partnership agreements that fall within the scope of the Delaware Revised Uniform Limited Partnership Act, and that an expansion of Cantor Fitzgerald would be unfair to employees receiving modest salaries and benefits in contrast to more highly compensated and sophisticated partners.
LKQ argued that the Court should not distinguish forfeiture-for-competition provisions in limited partnership agreements from those in other agreements. LKQ contended that Delaware law supported this understanding of forfeiture-for-competition provisions considering its strong support for freedom of contract. LKQ also argued that it should receive the benefit of the bargain it struck with Rutledge.
The Court’s ruling and reasoning
The Court ruled that forfeiture-for-competition provisions can be enforced beyond the limited partnership agreement context and that the “employee choice” doctrine can apply to other types of agreements, including RSU awards. The Court relied on Delaware law’s support for freedom of contract and the right of sophisticated parties to enter into voluntary agreements. Further, the Court distinguished forfeiture-for-competition provisions from other types of restrictive covenants generally found in employment agreements because forfeiture-for-competition provisions do not restrict the ability of employees to work. The Court also noted that whether compensation remains subject to forfeiture or whether it has already been paid and is subject to repayment or “clawback” does not alter this analysis.
When reviewing certification requests from other courts, the Court noted that it only addresses issues of law based on stipulated facts and that it was not addressing the factual circumstances in this case, so the Court acknowledged that it may be possible that a forfeiture-for-competition provision that requires a clawback may be so extreme in duration and financial hardship that it precludes employee choice by an unsophisticated party. In such a case, a forfeiture-for-competition provision would be reviewed for reasonableness instead.
Takeaways
- Forfeiture-for-competition provisions in Delaware-governed equity compensation award agreements can be enforced against employees in certain contexts, not only partners.
- The Court reinforced Delaware’s long-standing position on freedom of contract by making a clear distinction between restrictive covenants that prevent an employee from working for a competitor versus forfeiture-for-competition provisions that are enforceable as bargained-for provisions struck by sophisticated parties.
- Employers that have been facing increased scrutiny in the implementation of traditional non-compete agreements have often included forfeiture-for-competition provisions in equity incentive grants governed by Delaware law. The LKQ Corp. decision supports this approach and provides an alternative path for employers when considering how to best protect their business interests and trade secrets.
- The LKQ Corp. decision does not alter the standard of review for traditional non-competition provisions in employment and other similar agreements. These agreements continue to be subject to reasonableness review in the context of a potential restraint of trade.
- Non-compete enforceability varies by state and is a continually evolving area of law. Employers should closely monitor developments in non-compete law and tailor agreements with employees who reside in states that do not enforce or significantly restrict non-compete covenants.
Footnotes
[1] LKQ Corp. v. Rutledge, No. 110, 2024 (Del. 2024).
[2] Cantor Fitzgerald, L.P. v. Ainslie, No. 162, 2023 (Del. 2024).
[3] The Court declined to opine on the second question because it found that the Cantor Fitzgerald ruling is not constrained to the limited partnership agreement context.