In Cantor Fitzgerald, L.P. v. Ainslie, the Delaware Supreme Court announced, as a matter of first impression, that “forfeiture for competition” provisions in limited partnership agreements are generally enforceable and do not constitute restraints on trade subject to review for reasonableness. The ruling reversed a Court of Chancery decision that invalidated a forfeiture for competition under the reasonableness standard applicable to restrictive employment covenants.
The plaintiffs in Ainslie were former Cantor Fitzgerald limited partners and employees of a Cantor Fitzgerald affiliate in Hong Kong. Upon admission as a Cantor Fitzgerald limited partner, each plaintiff signed a limited partnership agreement. Among other things, the limited partnership agreement contemplated that Cantor Fitzgerald would maintain a capital account for each partner and that each partner would receive the amount of their respective capital account in annual installment payments over a four-year period following that partner’s withdrawal. More specifically, Cantor Fitzgerald would be required to make an initial “Base Amount” payment within 90 days of the partner’s withdrawal, with the difference between the Base Amount and the amount of the partner’s adjusted capital account paid out annually on the anniversary of the Base Amount payment date.
The limited partnership agreement contained two interrelated mechanisms designed to discourage former Cantor Fitzgerald partners from competing with the partnership after their departure. The first mechanism required former partners to not breach certain restrictive covenants for a two-year period following the partner’s withdrawal, including, among other things, to refrain from engaging in “Competitive Activity” as specified in a separate provision. The determination of whether a limited partner was engaging in Competitive Activity was to be made “in good faith by the Managing General Partner in its sole and absolute discretion[.]” If a former partner was in breach of restrictive covenants, including by engaging in Competitive Activity, Cantor Fitzgerald was authorized to seek injunctive relief to prevent an ongoing breach.
Separately, the limited partnership agreement contained a “Conditioned Payment Device” that operated regardless of the reason a partner ceased to be a partner and allowed Cantor Fitzgerald to withhold remaining amounts of a former partner’s adjusted capital account if the former partner breached certain partner obligations or engaged in Competitive Activity. To remain eligible to receive the full amount of their capital account, the former partner was obligated to refrain from engaging in Competitive Activity “prior to the date such payment is due.” In other words, in order to avoid the Conditioned Payment Device and to receive their full adjusted capital account amount, the former partner could not engage in Competitive Activity for the four-year period during which the former partner was eligible to receive capital account payments from the partnership.
Following the plaintiffs’ withdrawal as limited partners, Cantor Fitzgerald determined that each was ineligible to receive amounts beyond the Base Amount because each had engaged in Competitive Activity within one year of withdrawing from the partnership. Approximately three years following their withdrawal, the plaintiffs filed suit. The plaintiffs argued at summary judgment that the Conditioned Payment Device operated as a four-year noncompete that should be reviewed for reasonableness and was unenforceable because it was not appropriately limited in time or space and failed to protect a legitimate interest of Cantor Fitzgerald. Cantor Fitzgerald asserted in defense that the Conditioned Payment Device was a mere condition precedent to its paying additional amounts of a partner’s adjusted capital account, and that therefore the court should apply the “employee choice” doctrine, under which courts do not review forfeiture for competition provisions for reasonableness so long as the employee voluntarily terminated their employment.
The Court of Chancery invalidated the restrictive covenants in the limited partnership because they were facially overbroad against public policy. Turning to the Competitive Activity condition of the Conditioned Payment Device, which is a common “forfeiture for competition” provision, the Court of Chancery noted a split among jurisdictions on the “employee choice” issue before choosing not to apply it. The Court of Chancery instead subjected the Competitive Activity condition to a reasonableness review. Largely due to the four-year duration, the Court of Chancery invalidated the Conditioned Payment Device as an unreasonable restraint of trade.
The Delaware Supreme Court reversed the Court of Chancery decision, holding, as a matter of first impression, that forfeiture-for-competition provisions in partnership agreements are not restraints of trade subject to review for reasonableness. Relying on public policy considerations, including Delaware’s strong regard for freedom of contract, in particular in the limited partnership context, the Delaware Supreme Court distinguished forfeiture for competition provisions from restrictive employment covenants. Restrictive covenants are reviewed for reasonableness and a balancing of equities because they are enforceable through injunctive relief and could preclude an employee’s employment altogether in a chosen profession and thus expose the employee to risk of serious financial hardship. Conversely, forfeiture for competition provisions are not enforceable through injunctive relief and do not prohibit employees from competing or obtaining gainful employment. Policy concerns are diminished in the forfeiture for competition context and are therefore insufficient to override Delaware’s contractarian approach.
As applied to the facts in Ainslie, the Competitive Activity condition did not limit a former partner’s ability to compete or otherwise obtain employment in the context of the Conditioned Payment Device. The former partner simply forfeited the benefit of receiving its full capital account. Moreover, the forfeiture contemplated by the Conditioned Payment Device was consistent with Delaware’s limited partnership statute, in particular 6 Del. C. § 17-306, which permits partnership agreements to contain a consequence that would otherwise be unavailable in a standard commercial contract, most notably penalties and forfeitures.
The Cantor Fitzgerald v. Ainslie decision comes at a time when restrictive covenants are under fire in Delaware and beyond. Delaware has no statute or law that renders restrictive employment covenants per se invalid; however, over the past several years the Court of Chancery has employed an exacting reasonableness standard to invalidate, and not blue pencil (i.e., rewrite), restrictive covenants in several cases. By categorizing forfeiture for competition provisions as distinct from restrictive covenants, the Delaware Supreme Court helped define, at least in part, the contours of Delaware’s restrictive covenant jurisprudence. Indeed, the Ainslie decision provides greater certainty around the validity and enforcement of forfeiture for competition provisions contained in Delaware alternative entity agreements, even where the scope of competitive activity that triggers a forfeiture for competition provision is otherwise invalidated as an unreasonable restraint of trade. Moreover, although Ainslie was decided in the limited partnership context, it is reasonable to expect that forfeiture for competition provisions in LLC agreements will be treated the same given that the freedom of contract principles embodied in Delaware’s limited partnership statute are also embodied in Delaware’s LLC statute.