Delaware Supreme Court Ruminates on Freedom of Contract

What could be more fitting on this Valentine’s Day than a love letter from the Delaware Supreme  Court to the doctrine of freedom of contract.  Here is how Justice Traynor begins his opinion in Cantor Fitzgerald, L.P. v. Ainslie:

The courts of this State hold freedom of contract in high—some might say, reverential—regard. Only “a strong showing that dishonoring [a] contract is required to vindicate a public policy interest even stronger than freedom of contract” will induce our courts to ignore unambiguous contractual undertakings.

Justice Traynor then proceeds to the nature of the case.  Plaintiffs, as partners at Cantor Fitzgerald (Cantor), entered into a  partnership agreement, which included a forfeiture-for-competition clause (the Clause).  The Clause bound partners for four years after leaving the partnership.  Pursuant to that clause, Cantor demanded forfeitures from six partners, ranging from under $100,000 to over $5 million.  The Chancery Court applied a test akin to those for covenants not to compete.  By that standard, the Chancery Court found the Clause unreasonable and refused to enforce it.

In keeping with its reverence for freedom of contract, the Supreme Court reversed.  The Delaware Partnership Act, the court noted, is expressly designed “to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements.”  These partners went into the agreement with eyes open and enforced it against other departing partners.

The discussion begins with a seven-page summary of the operative provisions of the Limited Partnership agreement.  Basically, if departing partners worked for a competitor, they forfeited the contents of the Capital Accounts that would otherwise be paid out over four years after their departure from the firm.  The departing partners must have thought that the Clause was unenforceable, because when they resigned from Cantor, they notified Cantor that they were taking up employment with a competitor.  

Two findings, one factual/conceptual, one legal, seem to me crucial to the Supreme Court’s ruling in favor of Cantor.  First, the contracts at issue here were among partners, not between an employer and an ordinary employee.  Under Delaware law, restrictive covenants with employees are tested for reasonableness, but when it comes to the Clause, the public policy interests are weighed differently, with principles of freedom of contract counseling more deferential treatment to the parties’ reciprocal agreement.  Freedom of contract is not absolute.  It is constrained by public policy.  But simply attaching economic penalties to a decision to compete does not offend public policy.  The departing partners are free to compete against Cantor.  Having done so, they forfeit their Capital Accounts.

While there might be situations in which a Delaware court would refuse to enforce a provision like the Clause, notwithstanding freedom of contract, this was not such a case: “[T]he plaintiffs voluntarily entered into the partnership and the Agreement, elected to compete with the partnership upon their departure, and thereby assumed the risk of the forfeiture.”

Teaching aside: I use Valley Medical Specialists v. Farber to teach covenants not to compete.  The case similarly involves a departing partner who might well be enforcing the covenant were the stethoscope around another neck.  I like the case because, even if we might not think the equities favor Farber, who presumably went into the agreement with eyes open, public policy disfavors enforcement of a covenant not to compete that stands between a doctor and his patients with specialized needs or between a doctor and potential patients in a region that might lack specialists in the doctor’s area.  It’s a nice illustration of when judges need to intervene in the interests of public policy even in the absence of legislation or regulation.

Hat tip: Eric Chiapinelli