Delaware Supreme Court Upholds Forfeiture-for-Competition Provision in Limited Partnership Agreement

On January 29, 2024, in Cantor Fitzgerald, L.P. v. Ainslie, the Delaware Supreme Court reversed a Chancery Court holding that a forfeiture-for-competition provision in a limited partnership agreement was unenforceable as an unreasonable restraint of trade. Applying the Delaware Revised Uniform Limited Partnership Act (“DRULPA”), the Supreme Court held that (i) the forfeiture-for-competition provision was not a liquidated damages provision or a noncompete covenant subject to scrutiny for reasonableness; and (ii) in light of public policy considerations regarding freedom of contract and enforceability of partnership agreements, and absent extraordinary circumstances, such forfeiture-for-competition provisions should be enforced.

Background

The plaintiffs were six former limited partners of Cantor Fitzgerald, L.P. (“Cantor”), who voluntarily resigned from their employment with an affiliate of Cantor and withdrew from their positions as partners at Cantor between 2010 and 2011. As Cantor partners, the plaintiffs were parties to Cantor’s limited partnership agreement, which contained a mechanism pursuant to which former partners were cashed out of their capital accounts and paid for certain equity units in installments over a four-year period following the partner’s withdrawal (the “Conditioned Amounts”). However, the limited partnership agreement also contained a forfeiture-for-competition provision,¹ which provided that any former partner who competed with Cantor during such four-year period forfeited the right to receive any Conditioned Amounts that remained to be paid. As such, the limited partnership agreement did not prohibit former partners from competing with Cantor, but disincentivized them from doing so for four years by tying an economic cost to their decision to compete.

Following their withdrawal from Cantor, the plaintiffs joined competing firms, prompting Cantor’s determination that such partners had engaged in competitive activity within the four-year period and, consequently, were not entitled to the Conditioned Amounts, which ranged from approximately $100,000 to over $5 million (nearly $9 million in total). Plaintiffs filed suit against Cantor and both parties moved for summary judgment.

The Chancery Court found that the forfeiture-for-competition provision was a condition precedent to Cantor’s obligation to pay the Conditioned Amounts, and that it was subject to the same reasonableness review that Delaware courts use to analyze noncompete and nonsolicit agreements. As a result of its reasonableness review, the Chancery Court ruled that the forfeiture-for-competition provision was unenforceable because it was an unreasonable restraint of trade, largely due to its four-year duration.

The Supreme Court’s Decision

On appeal, the Supreme Court, sitting en banc, rejected the Chancery Court’s conclusion that the forfeiture-for-competition provision was a restraint of trade subject to review for reasonableness and unanimously reversed the Chancery Court’s judgment. The Court held that the forfeiture-for-competition provision should be enforced as written, “absent unconscionability, bad faith, or other extraordinary circumstances.” The Court came to its conclusion for three main reasons.

First, the Court observed that an express policy of DRULPA is “to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements.” Favoring deference to sophisticated parties’ bargained-for terms, the Court noted that the common law’s distaste for forfeitures did not generally extend to limited partnership agreements, and that the forfeiture provision should enjoy deference on “equal footing with any other bargained-for-term in a limited partnership agreement.”² Because the plaintiffs voluntarily became party to the limited partnership agreement and then voluntarily withdrew and competed with Cantor, public policy considerations weigh in favor of enforcing that agreement.

Second, in distinguishing forfeiture-for-competition provisions from customary non-competes in employment agreements, the Court explained that forfeiture-for-competition provisions do not prohibit competition, but instead attach an economic cost to a withdrawing partner’s decision to compete. As such, forfeiture-for-competition provisions are distinct from non-competes that bar former employees from earning a living in their chosen field. The Court found that non-competes implicate a strong policy interest that justifies scrutiny for reasonableness and a balancing of equities, while forfeiture-for-competition provisions do not raise the same concerns because they offer former employees a choice—they are free to compete, but should they choose to do so, they forfeit certain deferred payments.

Third, the Court rejected the Chancery Court’s approach of treating the forfeiture-for-competition provision as if it were a liquidated damages provision. In doing so, the Court distinguished cases where former employers sought to enforce liquidated damages provisions in employment agreements against former employees as penalties for breaches of restrictive covenants from the current circumstances, where former limited partners sue a partnership seeking to invalidate a forfeiture-for-competition provision that is a condition precedent to the partnership’s obligation to pay deferred financial benefits to the former partners.

On remand, the Chancery Court will determine whether there is a genuine issue of material fact regarding whether the plaintiffs engaged in prohibited competitive activity under the limited partnership agreement.

The Seventh Circuit’s Certified Questions

Not surprisingly, the implications of the Court’s decision and its application to other circumstances remain to be developed. The US Court of Appeals for the Seventh Circuit recognized this fact in LKQ Corp. v. Robert Rutledge (March 15, 2024). That case concerned a forfeiture-for-competition provision in the company’s restricted stock program and whether the company could claw back proceeds received by the former mid-level manager “from multiple stock sales over many years” when he resigned and went to work for a competitor. The district court concluded, and the Seventh Circuit concurred, that the provision was overbroad and unreasonable. However, the Seventh Circuit was uncertain on the scope of the Cantor Fitzgerald decision and whether that decision precludes, as a matter of Delaware law, review of forfeiture-for-competition provisions for reasonableness. As a result of the “far reaching impacts on corporations and their employees,” the Seventh Circuit certified the following questions to the Delaware Supreme Court:

• Whether Cantor Fitzgerald precludes reviewing forfeiture-for-competition provisions for reasonableness in circumstances outside the limited partnership context; and
• If Cantor Fitzgerald does not apply in all other circumstances, what factors inform its application? For example, does it matter what type of agreement the forfeiture provision appears in, how sophisticated the parties are, whether the parties retained counsel to review the provision, whether the forfeiture involves a contingent payment or claw back, how far backward a claw back reaches, whether the employee quit or was involuntarily terminated, or whether the provision also entitled the company to injunctive relief?

Although the Delaware Supreme Court is not required to provide the requested legal guidance, the Seventh Circuit stressed its importance “to us and all other courts sure to grapple with how best to read Cantor Fitzgerald.” Such additional guidance would provide welcome clarity to companies and employees.

Key Takeaways

• The Court reaffirmed Delaware’s strong interest in freedom of contract in ruling that forfeiture-for-competition provisions in limited partnership agreements do not violate public policy and, absent extraordinary circumstances, should be enforced.
• Forfeiture-for-competition provisions in limited partnership agreements are valid devices for discouraging former partners from competing. Because the provisions of the Delaware Limited Liability Company Act (the “DLLCA”) are substantially similar to DRULPA, it is likely that the Court’s rationale would also apply to a similar case under the DLLCA, where a forfeiture-for-competition provision would likely be found to be a valid device for discouraging former members of a limited liability company from competing.
• The Court recognized that forfeiture for competition is distinct from enjoining competition through a restrictive covenant. This analysis may extend beyond the limited partnership and limited liability company contexts (e.g., employment or equity agreements governed by Delaware law). The Court, citing the Restatement (Second) of Contracts, notes that forfeiture is not disfavored where “the event is within the obligee’s control, or the circumstances indicate that he has assumed the risk.”
• The Court’s rationale for treating forfeiture-for-competition provisions as conditions precedent for additional payments, and not as penalties or liquidated damages provisions, provides a reasonable basis for enforcement of such provisions in M&A transactions as alternatives to traditional noncompete provisions.
• The Court also observed that forfeiture for competition may be achieved by a provision to claw back previous payments, although the permissible scope of such provisions are uncertain.
• The Court did not preclude all public policy arguments for invalidating forfeiture-for-competition provisions. The Court noted that it is “conceivable that a public-policy interest or inequitable outcome could, under some circumstances, outweigh the interest in freedom of contract.”

¹ The partnership agreement also contained restrictive covenants, such as a non-compete, that apply after a partner’s withdrawal, which if not complied with by a former partner would provide independent grounds for Cantor to be relieved of paying the Conditioned Amounts and entitle Cantor to seek other remedies, such as injunctive relief. The Supreme Court’s decision did not address the enforceability of the restrictive covenants.

² The Court also recognized that DRULPA permits partnership agreements to provide for consequences that would be “unavailable in a standard commercial contract, most notably penalties and forfeitures.”