December 2023
Delaware court declines to enforce restrictive covenants in LLC agreement but grants interlocutory appeal.
In Sunder Energy v. Jackson, et al., a company, Sunder, sued a former employee, Jackson, for breaching a non-compete and employee non-solicit. The covenants were in Sunder’s LLC agreement (the “LLCA”), which had been amended in 2019 and 2021 to include them, and by which Sunder claimed Jackson was bound through his receipt of incentive units. As drafted, the covenants ran while Jackson held the units and for two years thereafter. None of the eight named parties resides in Delaware. The only tie to the state is that Sunder is a Delaware LLC.
On November 22, 2023, Vice Chancellor J. Travis Laster assessed Sunder’s application for a preliminary injunction. The court began by lamenting the growing role of Delaware courts in adjudicating restrictive covenants cases around the world. The court’s two primary concerns were (a) overwhelming Delaware courts and (b) eroding other courts’ willingness to defer to Delaware decisions. The court nonetheless applied Delaware law, and went on to deny a preliminary injunction.
The court denied Sunder’s motion for two primary reasons. First, it held that the LLCA amendments were not validly adopted by the minority members (which included Jackson), and that in fact the majority owners breached their fiduciary duties to the minority members by failing to alert them that the amendments adversely affected their rights. Second, the court found that the non-compete and employee non-solicit were overly broad. The court gave four reasons:
- The non-compete precluded the sale and marketing of products even if they were not similar to Sunder’s.
- The covenants bound not just Jackson, but also his wife and children as “Affiliates.”
- The covenants covered almost the entire country—including 46 states where Sunder claimed it anticipated doing business—which the court found deprived Jackson of his ability to earn a living.
- The covenants were indefinite in time because they were tied to Jackson’s ownership of incentive units that were transferable only if Sunder chose, in its sole discretion, to repurchase them.
Importantly, the court also declined to modify, or “blue pencil,” any of the covenants. Vice Chancellor Laster held that Delaware discourages blue penciling given the “differences in bargaining power between repeat-player businesses and individuals” and because modifying covenants “creates a no-lose situation for employers, because the business can draft the covenant as broadly as possible, confident that the scope of the restriction will chill some individuals from departing.”
Sunder petitioned for interlocutory appeal. On December 22, Vice Chancellor Laster granted the request. Much of the court’s reasoning was steeped in judicial economy, but it also addressed Sunder’s argument that appeal is warranted because the court’s decision conflicted with prior decisions that were less hostile to restrictive covenants and more inclined to blue pencil. The court did not agree that there was conflicting authority, but did concede the following:
“[T]here is a sense in which Delaware decisions over the past decade have paid greater attention to the real-world effects of restrictive covenants, the bargaining dynamics in which they arise, and the incentives employers have to include ever more favorable provisions in their form agreements. There has also been a growing societal understanding regarding the implications of restrictive covenants which has led to more jurisdictions limiting their use, as well as federal initiatives. From a big picture standpoint, it does seem like more recent Delaware decisions have been less likely to enforce the full scope of restrictive covenants and related provisions designed to protect them from challenge (such as stipulations as to reasonableness and blue-penciling requirements). The difference is a matter of degree, because prior decisions considered these factors as well. The difference also may stem from the fact that the provisions have simply become more onerous over time. But at a high level, Sunder’s impression is not unfounded. If the Delaware Supreme Court wants this court to afford less significance to context, defer to provisions designed to protect covenants from challenge, enforce broad restrictive covenants as written, and generally prioritize contract law over equity in this setting, then it would be helpful to know that.”
The appeal is now pending.
S&K Take: Delaware has issued several notable restrictive covenants decisions over the past year. See, e.g., Kodiak Building Partners, LLC v. Adams (Del. Ch. Oct. 6, 2022); Ainslie v. Cantor Fitzgerald, L.P. (Del. Ch. Jan. 4, 2023); Hightower Holding, LLC v. Gibson (Del. Ch. Feb. 9, 2023); Intertek Testing Services NA, Inc., v. Eastman, (Del. Ch. March 16, 2023). As Vice Chancellor Laster’s opinion in Sunder suggests, recent Delaware decisions do seem to evidence a growing hostility towards restrictive covenant and a reluctance to blue pencil. Delaware courts also appear hesitant even to adjudicate covenants disputes involving parties located in other states. Employers should mind this trend and ensure that their covenants—whether in operating agreements, incentive award grants or more traditional employment agreements—are validly adopted, given for adequate consideration, and not overly broad. The days of imposing draconian covenants with the expectation that courts will simply modify rather than strike may be coming to an end.
Georgia court enforces—but modifies—sale-of-business non-compete.
In Baldwin v. Express Oil Change, the owners of a group of automotive repair shops (“Sellers”) sold their interests to a larger entity (“Purchaser”). The plaintiff, Baldwin, was an employee of Sellers, who at one point received a profits interest and phantom equity that had value only on a change in control. However, Baldwin did not agree to any restrictive covenants when he received these grants. Purchaser, accordingly, required Baldwin to sign a restrictive covenants agreement as a condition of the sale. Baldwin balked, but eventually signed after Purchaser offered Baldwin more than he otherwise would have received on the change in control. The covenants included a four-year post-closing non-compete that applied, among other things, to a five-mile radius of each of Purchaser’s 1100 locations across 29 states. Baldwin had been responsible for only 18 stores, all of which were in Georgia.
After the sale, Baldwin sued to invalidate the non-compete under the Georgia Restrictive Covenants Act (“GCRA”). The case was removed to federal court. The district court upheld the non-compete but “blue penciled” it. First, the court reduced the geographic scope to cover only locations within five miles of the 18 stores Baldwin managed. Second, the court reduced the duration of the non-compete from four years to two.
The defendant appealed. On appeal, an 11th circuit panel agreed that the covenants were overbroad geographically. While Purchaser had a legitimate interest in preventing Baldwin from soliciting clients and employees, that interest did not extend to locations where Baldwin had no relationships with customers or employees. However, the appellate court reversed the district court’s temporal reduction of the non-compete. The district court had assessed the non-compete in the ordinary employment context, where non-competes are presumptively unreasonable if they are longer than two years post-employment. The appellate court held that the district court should have assessed the covenant in the M&A context, which carries a rebuttable presumption that non-competes up to five years are reasonable. Under the GCRA, said the court, Baldwin was an “executive employee” who received consideration in connection with the sale of all or a material part of the business, and thus a five-year presumption applied.
S&K Take: This case arises under a specific Georgia statute, but is important in several respects. First, it is a reminder that employers offering equity or change in control benefits should use that opportunity to have recipients sign restrictive covenants at that time. Otherwise, the employee may have more leverage than is preferable in connection with a later transaction. Second, Baldwin reminds that restrictive covenants signed in connection with an equity stake are likely to be enforced for longer than one in the ordinary employment context. Third, we’ve seen more frequently individuals suing to invalidate covenants before the company sues to enforce it; employers should be mindful of this. Finally, in view of the affirmed holding that the non-compete was at least partially overbroad, purchasers in the M&A context should consider whether it is appropriate for individuals to sign covenants that go beyond the portion of the business in which they were or will be engaged.
Washington court primed to address pleading standards in pay transparency claim.
Atkinson v. Herc Rentals involves a plaintiff who applied for a job with equipment rental company Herc in Washington only to then file a class action complaint on the grounds that the job posting did not include salary ranges under applicable state law. Herc moved to dismiss, asserting among other things that the plaintiff did not apply for the job in good faith. The role was in sales but the plaintiff did not have any relevant experience, and the plaintiff lived in California while the job was in Washington. The plaintiff also had filed approximately 16 other lawsuits with the same or similar allegations for dissimilar positions with other entities. Herc argued that the plaintiff was attempting to recast Washington’s pay transparency statute as “a strict liability statute under which Washington employers would automatically be liable to any applicant who submits a job application, without regard to their qualification, genuine interest, and the like” and that such a reading would lead to absurd results. The motion is pending.
S&K Take: It is not uncommon for repeat plaintiffs to sue for technical violations of statutes concerning job applications and hiring—a cottage industry for plaintiffs’ lawyers. We see them in the pay transparency context, in cases involving disability discrimination statutes, and in matters involving applicants with criminal records. It will be interesting to see how courts frame the pleading standards that apply to these types of cases. Though outside the employment context, the U.S. Supreme Court recently took up a claim involving “tester” standing for a plaintiff who sued a hotel she did not plan to visit for having a website that was inaccessible to her as a disabled person. The Court, however, vacated the appeal as moot without addressing the question presented.
