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Delaware Choice-of-Law Clauses for Covenants Not to Compete—Does Delaware Have an Interest?

By Richard L. Renck
March 1, 2023
Delaware Business Court Insider

Delaware Choice-of-Law Clauses for Covenants Not to Compete—Does Delaware Have an Interest?

By Richard L. Renck
March 1, 2023
Delaware Business Court Insider

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It is difficult to ignore the ongoing national debate—within the federal and certain state governments—over the use and enforcement of post-employment restrictive covenants. It is within that landscape that Delaware’s Court of Chancery recently issued its memorandum opinion in Hightower Holding v. Gibson, C.A. No. 2022-0089-LWW (February 9, 2023) addressing the applicability of a Delaware choice-of-law clause in certain agreements that contained restrictive covenants, including a covenant not to compete (the covenant).

In denying plaintiff’s motion for a preliminary injunction, Vice Chancellor Lori Will found that the plaintiff had not established a reasonable probability of success on the merits of the claim (that the defendant was in breach of the covenant) after holding that Alabama law, rather than Delaware law applied, and that the covenant was likely void under Alabama law. In so ruling, the vice chancellor found that “Alabama’s strong interests against enforcing the covenants outweigh Delaware’s contractarian policies.”

Delaware courts have recognized that Delaware is a jurisdiction where sophisticated parties are free to enter into any number of contractual relationships, secure in the knowledge that their agreements will be upheld and applied as drafted. See NACCO Industries v. Applica, 997 A.2d 1, 35 (Del. 2009) (“Delaware upholds the freedom of contract and enforces as a matter of fundamental public policy the voluntary agreements of sophisticated parties.”) and Nemec v. Shrader, 991 A.2d 1120, 1125 (Del. 2010) (“Parties have a right to enter into good and bad contracts, the law enforces both.”). That history has spurred parties, and their counsel, to seek to tap into Delaware’s substantive law via choice-of-law clauses in their contracts that state the parties’ agreement that the substantive law of Delaware will apply to the interpretation of that contract even where the parties’ or the contract’s ties to the state of Delaware are not immediately obvious. The Hightower decision addresses such a situation.

Factual Background

The defendant is a licensed financial adviser who lives in Alabama. In 2012, he was hired by a financial advisory firm in Huntsville, Alabama, which later became an affiliate of the plaintiff. In 2019, the defendant (and his partners) sold a majority interest in their firm to the plaintiff and, as part of that corporate transaction, entered into certain agreements, including a protection agreement and an LLC agreement, both of which contained certain restrictive covenants, including the covenant at issue in the litigation.

In December 2020, the defendant resigned his employment with Hightower with the expressed intent of starting his own hedge fund. The preliminary injunction record showed that in furtherance of that intent, in March 2020, the plaintiff formed a new limited liability company under Alabama law and a new fund entity, a limited partnership, under Delaware law. He also formed a third entity, to be the investment adviser firm with the SEC, as an Alabama entity. All such entities (including the Delaware entity) had Alabama addresses listed as their principal places of business.

Plaintiff Hightower sued in Delaware, accusing the defendant of breaching the covenant by establishing a competing venture under various theories. At issue in this decision, however, were Hightower’s request for expedited consideration of its two claims related to the breach of the covenant and the request that the defendant be preliminarily enjoined from engaging in the alleged competing behavior.

The Court’s Ruling

As the court notes, “Delaware follows the Restatement (Second) of Conflicts of Laws, which provides that a contractual choice of law will generally control.” That general rule, however, is subject to exception, and in certain circumstances, the law of the default jurisdiction (that is, the law that would apply absent such a choice-of-law clause) would govern, notwithstanding the express agreement of the parties otherwise. One such exception is where the “enforcement of the covenant would conflict with a fundamental policy of the default state’s law, and the default state has a materially greater interest in the issues—enforcement (or not) of the contract at hand—than Delaware.”

The court held that Alabama would be the default state because it has the “most significant relationship to the transaction and the parties.” This was so because the various agreements were all negotiated and executed in Alabama, the relevant agreements were all performed in Alabama, the alleged competitive conduct centered on Alabama, and the defendant at all relevant times lived in Alabama. As the court noted, Delaware’s ties to the matter are limited to the choice-of-law clauses themselves and the fact that the plaintiff and one entity formed by the defendant were chartered in Delaware.

The court then turned to the question of whether enforcement of the covenant by a Delaware court would subvert a “fundamental policy” of Alabama. The vice chancellor held that it would. “Alabama’s policy against covenants not to compete is a fundamental public policy,” and therefore, “it is well-settled that Alabama law frowns on restrictive covenants.” The court cites to the Code of Alabama that provides that “every contract by which anyone is restrained from exercising a lawful profession” is void unless certain exceptions apply.

One such exemption is for agreements that govern the sale of a business (where restrictive covenants might be enforceable), but such an exception does not apply to the sale of a business involving a professional. Thus, the court first had to determine whether the defendant, an investment adviser, would likely be considered a “professional” under Alabama law. After looking at factors such as professional training and skill, the nature of the services offered, and  “the ability and need to make instantaneous decisions,” the vice chancellor found that the defendant was likely considered a “professional” and, therefore, the enforcement of the covenant against the defendant would likely offend the expressed, fundamental policy of Alabama. The court also noted that even if it had not found defendant to be a “professional,” she would have found that the covenant was overly broad and unenforceable under Alabama law.

Finally, the vice chancellor found that Alabama’s interests in this arena and these circumstances outweighed those of Delaware, and as such, “applying Delaware law in these circumstances would undermine the legislatively expressed interests” of Alabama. Having found no likelihood of success on the merits of the plaintiff’s claims, the court denied the request for preliminary injunction.

As the Hightower decision shows, absent an overarching federal law addressing the matter of restrictive covenants, Delaware’s courts will respect the comity of her sister states as they adopt and express public policies related to the use and enforcement of restrictive covenants in employment relationships. Parties will not, however, be able to contract around such policies by adopting Delaware choice-of-law provisions to govern relationships with tenuous ties to Delaware.

Richard L. Renck, a partner at Duane Morris, litigates matters in both the state and federal courts in Delaware. His practice focuses on complex corporate and commercial litigationwith a particular emphasis on corporate governance disputes and statutory actions arising under the Delaware General Corporation Law.

Reprinted with permission from Delaware Business Court Insider, © ALM Media Properties LLC. All rights reserved.