Rolando Diaz of the Lewis Brisbois Delaware office prepared this post.
The Court of Chancery refused to enforce a restrictive covenant in Sunder Energy, LLC v. Jackson, 2023 Del. Ch. LEXIS 580 (Del. Ch. Nov. 22, 2023). Chancery subsequently approved, with thorough reasoning, an interlocutory appeal to the Supreme Court–which makes its own determination whether to accept the interlocutory appeal.
BRIEF FACTUAL BACKGROUND
Sunder Energy, LLC (“Sunder”), a Delaware LLC headquartered in the State of Utah, a purveyor of residential solar power systems, had an exclusive dealer agreement with Freedom Forever LLC (“Freedom”), one of the nation’s largest installers. In the summer of 2023, Freedom encouraged Tyler Jackson, the head of sales for Sunder, who lived and worked in the State of Texas, to join Solar Pros LLC (“Solar Pros”), another solar power system dealer that referred installations to Freedom. This led to a mass exodus of Sunder’s workforce. Nine of the twelve regional managers that reported to Jackson, as well as over three hundred sales personnel, joined Solar Pros. On September 25, 2023, Solar Pros announced that Jackson had joined as its new President.
Sunder asserted that Jackson—as a holder of Incentive Units—was bound by certain restrictive covenants (the “Covenants”) provided for in Sunder’s 2019 and 2021 LLC operating agreements (the “OA”) that applied to any Incentive Unit holder (the “Holder”). The co-founders formed Sunder by filing a certificate of formation with the Delaware Secretary of State but did not execute a written operating agreement.
In the fall of 2019, the two co-founders that together owned 60% of the membership interest of Sunder engaged a law firm to draft an LLC agreement that dramatically changed the ownership structure of the LLC; it imposed the Covenants, emasculated the minority members rights as owners, and reduced them to purely economic beneficiaries with very little rights. Communications from the majority co-founders to the minority rights holders did not explain that the two co-founders received common units with full rights while the minority holders received incentive units with little to no ownership rights.
In a concerted effort to obfuscate reality, the majority co-founders referred to the Holders as “partners,” implying that there was some semblance of equal footing aside from the difference in percentage of interests. For the subsequent adoption of the 2021 operating agreement, the majority co-founders did not even bother to circulate a copy of the new operating agreement. Instead they only circulated the signature page and indicated to the Holders that there were no substantive changes to the operating agreement and that the only change was the addition of a member. This was not true. The geographical scope of the restrictive covenant was also expanded.
In addition to broad restriction on the use of Sunder’s confidential information, the Covenants in the OA prohibited a Holder from: (i) engaging in any competitive activity (the “Non-Compete”); (ii) soliciting Sunder’s employees and independent contractors (the “Worker Non-Solicit”); (iii) soliciting, selling to, accepting any business from, or engaging in any business relationship with any of Sunder’s customers; and (iv) inducing, influencing, advising, or encouraging any Sunder stakeholder to terminate its relationship with Sunder. Furthermore, each Covenant bound not only the Holder, but also Holder’s affiliates, defined in the OA as a Holder’s spouse, parents, siblings, and descendants, both natural and adopted. The Covenants applied while a person held incentive units and for two years thereafter. However, a Holder had no right to transfer or divest themselves of the Incentive Units. In contrast, Sunder had the option, but not the obligation, to repurchase the Incentive Units for zero dollars upon either Sunder’s termination of Holder’s employment or if the Holder left the company without good reason.
On September 29, 2023, Sunder terminated the dealer-installation agreement with Freedom and filed an arbitration to enforce their rights against Freedom. Sunder also filed an action in the Court of Chancery against Jackson and its competitors. Sunder sought a preliminary injunction enjoining Jackson and any party acting in concert with Jackson from taking any action in breach of the Covenants. The Court denied the preliminary injunction because Sunder could not establish a reasonable likelihood of success on the merits. The Court found (i) the restrictive covenants unenforceable under general principles of law and (ii) the competition and solicitation restrictive covenants unreasonable in their scope and effect.
First, the Court was faced with determining the Covenants’ governing law. The terms of the Covenants appeared in the OA, which governs the internal affairs of a Delaware LLC. The OA expressly provided that Delaware law governed its terms. Thus, a contractarian basis for the application of Delaware law existed. Under normal circumstances, the combination of the internal affairs doctrine and contract principles would require the application of Delaware law. However, for the Covenants, the drafters were not attempting to govern the internal affairs of a Delaware LLC. Instead, the drafters were attempting to govern an employment relationship. The Court opined:
Delaware follows the Restatement (Second) of Conflict of Laws, and Delaware courts consequently will not enforce choice of law provisions when doing so would circumvent the public policy of another state that has a greater interest in the subject matter. Consequently, when a different state’s law would govern in the absence of a choice of law provision, and if that state has established legal rules reflecting a different policy toward restrictive covenants, than Delaware’s then this court will defer to that state’s laws notwithstanding the presence of a Delaware choice of law provision.
Thus, either Utah, where Sunder is headquartered, or Texas, where Jackson worked and resided would apply in the absence of a choice of a law provision. Under the Court’s analysis, both Texas and Utah approach the enforceability of restrictive covenants only slightly differently than Delaware. Under its conflict of laws analysis, due to the low degree of divergence between laws of the relevant forums, the Court applied Delaware law, finding that the conflict between Delaware and Utah law was a false conflict.
Second, due to the circumstances for ratification of Sunder’s 2019 and 2021 LLC operating agreements, the Court determined that Sunder’s purported majority co-founders breached their fiduciary duty by failing to fully disclose all material information and making misleading partial disclosures to the minority. The 2019 agreement materially and adversely impacted the rights of Sunder’s minority members; legal counsel only represented Sunder and the majority co-founders, but the co-founders made it seem as if counsel represented everyone. For the 2021 agreement, the co-founders told the minority members that the 2021 agreement contained no material changes and did not even bother to circulate a copy of the 2021 agreement to the minority members. Thus, the Court determined that due to the co-founders’ breach of fiduciary duties, the amended operating agreements themselves were invalid, and consequently, so were the restrictive covenants therein.
Assuming, however, for the “sake of argument” that the amended LLC agreements were valid, the Court addressed the enforceability of two of the Covenants, namely, the Non-Compete and Worker Non-Solicit provisions. The Court found the Non-Compete provision extremely overbroad. The prohibited business activity covered a wide swath of the “door to door sales industry, without regard to whether Sunder markets or sells similar products.” The restriction on a Holder’s affiliates (as defined in the OA) was inane; it was not written in a manner that simply thwarts a straw man conferring the benefits to a Holder. But, as written, a Holder’s “daughter cannot go door to door selling girl scout cookies.” Absurdly, the Covenants thus purported to bind a Holder’s wife and children. The geographic scope of the Non-Compete left only Alaska, Montana, North Dakota, and South Dakota available for a Holder as territory not restricted by the Covenants. Perhaps the most appalling factor of the Non-Compete was that since a Holder had no right to divest himself of the Incentive Units under the OA, the temporal component could continue in perpetuity. Similarly, the Court found the Worker Non-Solicit overbroad and unreasonable. It also applied to the same set of affiliates and for the same potentially “forever” time period. It extended not only to any current Sunder employee or independent contractor, but also applied to “any person employed in the past by Sunder for any period of time.” Individually, each overbroad provision was unreasonable. And read together, the Court deemed the Covenants oppressive and refused to enforce them.
Delaware courts will not apply Delaware law under a theory of contract law if another state has a greater public policy interest in an issue when, absent a choice of law provision, another forum’s laws would apply. Circumstances may also dictate abandonment of the internal affairs doctrine when drafters embed employment provisions that have nothing to do with the governance of the entity into a governing agreement. Additionally, Delaware courts apply both general principles of law and a holistic analysis of restrictive covenants to determine reasonableness. This analysis can result in Delaware courts refusing to enforce restrictive covenants.