In 2017, an ABA Business Law Section task force completed a landmark report titled “Defining Key Competencies for Business Lawyers” that was published in The Business Lawyer. The report, directed towards law firms and law schools, drew on the framework of the influential ABA MacCrate Report (“Legal Education and Professional Development—An Educational Continuum”).

Both reports identify negotiation as a key lawyering skill. As the MacCrate report notes, negotiation is a skill that is “essential throughout a wide range of kinds of legal practice….” The reports discuss specific analytical skills that lawyers should employ when participating in negotiations. The MacCrate report specifically advocates four specific skills that lawyers should utilize in negotiations: (1) determine the bottom line; (2) evaluate alternatives; (3) analyze whether the negotiation is zero-sum, non-zero-sum, or a mixture of the two; and (4) identify outcomes from the negotiation.

This article elaborates on these four analytical skills and includes a link to a free exercise that you can use to develop these skills among members of your negotiating teams.

The Analytical Skills that Lawyers Should Possess

 1. Determine the Bottom Line

The MacCrate report correctly emphasizes the importance of determining the bottom line, which in negotiation terminology is also called the reservation price. But other information is also important when analyzing a negotiation.

• Your stretch goal. Negotiators who have the largest stretch goals are most successful over time. Your challenge is to select a stretch goal that is well beyond your reservation price, but that is not so unreasonable that you lose credibility when presenting it to the other side.
• This is your ultimate goal in a negotiation. Targets lie somewhere between your stretch goal and your reservation price.
• Zone of potential agreement. Great negotiators look at negotiations from the perspective of the other side. This enables them to estimate the zone of potential agreement, which is the range between their reservation price and the reservation price of the other side. If successful, the deal will take place within this zone.

2. Evaluate Alternatives

Your most important task when preparing for a negotiation is to evaluate your best alternative if the negotiation is not successful. In negotiating language, this is your BATNA (“Best Alternative to a Negotiated Agreement”). Determining your BATNA is important because it is a key source of power. The better your alternative, the more leverage you have to walk away from a negotiation. 

Your BATNA strategy should include three elements: find, weaken, and improve. First, you should try to find the other side’s BATNA so that you can determine how powerful they are. Second, you should attempt to weaken their BATNA. For example, if you are involved in negotiating the sale of your client’s company to a buyer who is considering an alternative purchase, you should emphasize problems with the alternative. Third, you should try to improve your BATNA. In negotiating the company sale, for instance, try to find other potential buyers so that you can develop a strong alternative for your client. 

3. Analyze Whether the Negotiation is Zero Sum

Determining whether a negotiation is zero sum is important because your negotiation tactics might be more competitive when fighting over a fixed pie. But don’t be trapped by what researchers call the “Mythical Fixed Pie Assumption.” The assumption that every negotiation is zero sum, while prevalent in settlement negotiations, also arises during transactional negotiations. To avoid the assumption, you should ask questions designed to identify the interests of the other side and match those interests with those of your client to develop opportunities that benefit both sides.

4. Identify Outcomes from the Negotiation

The decision tree is an especially useful tool when identifying outcomes from a negotiation. For example, when you are involved in settlement negotiations, you can use a decision tree to calculate the expected value of the litigation, which is often your BATNA if the negotiation is not successful. Decision trees are also useful during transactional negotiations, such as helping your client decide which of two companies to purchase. Creating a decision tree involves a three-step process: (1) depict the decision in a tree form, (2) add probabilities and financial values, and (3) calculate the expected value of the litigation or a business transaction. I discuss decision trees and the other analytical skills in greater detail in Negotiating for Success, Chapter 3, “Conduct a Negotiation Analysis” (Van Rye Publishing, 2014).

A Negotiation Exercise to Teach the Analytical Skills

To help you and the colleagues on your negotiating teams develop a common understanding of these skills, I have prepared a teaching package that you can use without charge (and no permission is necessary). The package includes a negotiation exercise with two roles, a Teaching Note, and PowerPoint slides. There is a twist to the exercise, known to only one of the parties, that will raise ethical concerns and challenge their negotiating skills.

I have used this exercise in training lawyers and judges. Organizations in the public and private sectors (for example, the World Bank and one of the five largest U.S. companies) have used the exercise for negotiation training led by their in-house staff. Thank you to the University of Michigan for support in the development of this package and encouragement to make it available for free distribution outside the university. My only request is that if you decide to use the exercise, I would appreciate your comments and recommendations for improvement. 

During a speech in San Francisco on June 14, 2018, at the Yahoo! Finance All Markets Summit, William Hinman, director of the Division of Corporation Finance of the Securities and Exchange Commission (SEC), provided some welcome clarity regarding the applicability of the federal securities laws to digital assets and tokens projects (Hinman speech). Hinman’s speech, titled “Digital Asset Transactions: When Howey Met Gary (Plastic),” focused on whether a digital asset offered as a security can, over time, become something other than a security. According to Hinman, the answer to this question is a qualified “yes” when a digital asset is sold only to be used to purchase a good or service available through a network. Hinman also expressed his view that Ether—the cryptocurrency of the Ethereum network—is not a security[1] and therefore is not subject to the U.S. federal securities laws. Hinman said that, in his view, Bitcoin is not a security either, reinforcing what SEC Chairman Jay Clayton stated in his remarks recently on CNBC and what many who follow virtual currency developments thought was a foregone conclusion. On June 21, 2018, as discussed below, SEC Chairman Jay Clayton gave congressional testimony that provided further support for the SEC staff’s approach as outlined by Hinman.

Hinman’s speech was even more significant to the universe of those who pay close attention to regulators’ views on digital assets, in particular when a digital asset is deemed to be a security.[2] Hinman suggested that in limited circumstances, the SEC believes that blockchain startups can raise money by selling tokens (or agreements for future tokens) as securities before a network is launched (i.e., before it has functionality or utility), but then further sales of these same tokens can be made as nonsecurities once the circumstances surrounding that sale transaction have changed in a manner that no longer constitutes an investment contract.

Hinman discussed certain factors to be considered in assessing whether a digital asset is offered as an investment contract in a securities transaction. In particular, Hinman focused on the fourth prong of the Howey investment contract test (as explained below) and whether the efforts of an identifiable third party—be it a person, an entity, or a coordinated group of actors—drives the expectation of a return. Also noteworthy was Hinman’s comment that the SEC is “happy to help promoters and their counsel work through . . . issues . . . [and] . . . stand[s] prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use.” As in the cases Hinman discussed, this summary focuses on an analysis under the Securities Act of 1933 and the Securities Exchange Act of 1934. Note that based on context, an analysis under the Investment Company Act of 1940 and the Investment Advisers Act of 1940 may have different results, as may analysis under state laws, due to different definitions or interpretations.

Key Components of Hinman’s Speech

Digital Asset: Product vs. Security. Hinman began by describing promoters selling tokens or coins to raise money to develop networks on which the digital assets will operate, rather than selling shares, issuing notes, or obtaining bank financing. In many cases, the economic substance is the same as a conventional securities offering—funds are raised with the expectation that the promoters will build their system, and investors can earn a return on the instrument. In such cases, Hinman said that it would be “easy to apply” the longstanding “investment contract” test from the 1946 U.S. Supreme Court’s decision in SEC v. W.J. Howey Co.[3] (Howey test): (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profits, (4) to be derived from the entrepreneurial or managerial efforts of others.

Hinman next focused on the specific facts of the Howey case, which involved a hotel operator, Howey, selling interests in a nearby citrus grove coupled with a service contract obligating the hotel operator to harvest and market the oranges on the purchaser’s behalf. Howey unsuccessfully claimed it was selling real estate rather than securities. Hinman highlighted that although the transaction in Howey was recorded as a real estate sale, it also included a service contract to cultivate and harvest the oranges, which meant that the investors were relying on the efforts of Howey for a return. Hinman emphasized that regardless of whether something is called a “token” or a “coin,” the analysis turns on how an asset is sold, which may cause investors to have a reasonable expectation of profits based on the efforts of others.

Just as in Howey, Hinman stressed, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value to be sold later at a profit.[4] In addition, as in Howey—where interests in the grove were sold to hotel guests who were passive investors, not farmers—tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network.

Gary Plastic. As the title of his speech signals, Hinman analogized certain sales of tokens to the facts in Gary Plastic Packaging v. Merrill Lynch,[5] in which the court held that a transaction may be subject to the securities laws, even if the underlying instrument would not be a security, based on the manner of their sale and the promises associated with such sale. In Gary Plastic, the court found that despite the fact that conventional certificates of deposit (CD) issued by a bank are not securities, they were securities in that instance because they were sold in a manner that satisfied the Howey test. The CDs were sold through a program organized by Merrill Lynch that promised retail investors it would maintain a secondary market for the CDs. The court found that the CDs represented a joint effort by the issuers of the CDs and Merrill Lynch, and that the CDs were investment contracts because investors expected to receive profits through the extra services provided by Merrill Lynch.

Applying the same reasoning to tokens, Hinman stated that although tokens themselves (which are, after all, “simply code”) may not be securities, “how [tokens are] being sold and the reasonable expectations of purchasers” are central to the securities law determination. Therefore, in the context of a token sale that resembles the sale of a security, the application of the securities laws is appropriate because such laws’ disclosure requirements (among other protections) are necessary to mitigate the information asymmetry between promoters and investors.

Mutability: From Security to Utility Tokens. Hinman explained that a digital asset transaction may no longer represent a security offering, i.e., an investment contract, if, in addition to the token or coin lacking other security-like features, the network on which the token or coin is to function is sufficiently decentralized—where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts. Moreover, Hinman added, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede, and as a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult and less meaningful.

Ether and Bitcoin. Hinman expressed his view that sales of Ether are not securities transactions, stating: “Based on my understanding of the present state of Ether, the Ethereum network, and its decentralized structure, current offers and sales of Ether are not securities transactions.” Hinman also said that, in his view, Bitcoin also is not a security because network participants are not reliant upon the efforts of a central third party. Hinman stated:

I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.

Hinman cautioned that the analysis of whether something is a security is not static and does not strictly inhere to the instrument, specifically noting that even digital assets with utility that function solely as a medium of exchange in a decentralized network could be packaged and sold as an investment strategy that can be a security.[6]

Director Hinman reiterated that although the token or coin by itself is not a security, the packaging and sale of such token or coin could bring it within the purview of the securities laws.

Token Sales. Hinman provided additional context to Chairman Clayton’s prior remarks in which the chairman noted that an overwhelming number of the token sales he has seen likely qualify as securities offerings under the Howey test. Hinman reiterated that merely calling the token a “utility token” does not give it the substance needed to avoid being a security. He focused on the concepts of full decentralization and consumptive intent of the purchasers as two important factors, but noted that a broader facts-and-circumstances analysis is required.

In what appears to be the SEC’s nod to token pre-sale agreements, such as the SAFT (simple agreement for future tokens) or SAFE-T (simple agreement for equity or tokens), where tokens are issued as securities to accredited investors pursuant to the private offering regime of Regulation D, Hinman noted the possibility of structuring a blockchain-based enterprise with funding through token pre-sale agreements without necessarily affecting the ability of the token to be sold later as a nonsecurity.[7]

Facts-and-Circumstances Assessment

Ultimately, the question of whether the offering of a token qualifies as a security will turn on a facts-and-circumstances analysis. Hinman provided the following illustrative (but not exhaustive) list of considerations:

1. Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, whose efforts play a significant role in the development and maintenance of the asset and its potential increase in value?
2. Has this person or group retained a stake or other interest in the digital asset such that the person or group would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
3. Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
4. Are purchasers “investing”—that is, seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
5. Does application of the Securities Act protections make sense? Is there a person or entity on which others are relying and that plays a key role in the profit-making of the enterprise such that disclosure of the person’s or entity’s activities and plans would be important to investors? Do informational asymmetries exist among the promoters and potential purchasers/investors in the digital asset?
6. Do persons or entities other than the promoter exercise governance rights or meaningful influence?

In addition, the director set forth the following seven nonexhaustive questions that help market participants evaluate whether a digital asset functions more like a consumer item and less like a security:

1. Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
2. Are independent actors setting the price, or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
3. Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
4. Are the tokens distributed in ways that meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
5. Is the asset marketed and distributed to potential users or the general public?
6. Are the assets dispersed across a diverse user base or concentrated in the hands of a few users who can exert influence over the application?
7. Is the application fully functioning or in early stages of development?

Growing Consensus Among SEC Officials

On the very same day as Hinman’s speech in San Francisco, Valerie Szczepanik, the SEC’s new Senior Advisor for Digital Assets and Innovation,[8] and Gary Goldsholle, Senior Advisor to the Director of Trading and Markets, corroborated Director Hinman’s remarks while speaking at a panel event on Capitol Hill.[9] Specifically, Goldsholle reiterated Hinman’s position that something can transform from a security to a nonsecurity. Goldsholle made sure to also add that the same instrument could transform back into a security if the facts and circumstances changed yet again. Relatedly, Szczepanik acknowledged that there is a spectrum for tokens, stretching from those that are intended purely for fundraising (i.e., securities) to those that are purely consumptive (i.e., not securities). Both Goldsholle’s and Szczepanik’s comments indicate a building consensus among the SEC staff on these issues.

On June 21, 2018, SEC Chairman Clayton provided further confirmation that the framework outlined in Hinman’s speech is the “approach [SEC] staff takes to evaluate whether a digital asset is a security” in testimony to the U.S. House of Representatives Financial Services Committee.[10] Clayton emphasized that the SEC will consider the facts and circumstances of a given token sale and utilize a principles-based framework to reach a conclusion on whether the token sale constitutes a securities offering. Under such a framework, persons “attempting to fund a project—whether it be opening a new manufacturing plant or creating an application on a distributed network—by inviting others to invest in the enterprise based on the expectation that they will profit from other people’s efforts” must register their offerings with the SEC or rely on an appropriate exemption from registration.

Canadian Securities Administrators Weigh In on Tokens

In the same week, the Canadian Securities Administrators (CSA) separately released a staff notice that addressed the question of when an offering of tokens may or may not involve an offering of securities. Although the CSA did not explicitly address the concept of mutability, it did provide an illustrative list of situations where tokens implicate securities law concerns under Canadian law. Although the SEC and the CSA operate in different jurisdictions, Canada and the United States share similar legal tests for determining an “investment contract,” so the Canadian examples may also provide some persuasive instruction.[11]

Conclusion

Hinman’s speech offers support to software developers, technologists, inventors, and supporters of innovation in applying a framework for evaluating token sales under the Howey test. It is a helpful guide for developers of distributed networks and tokenized products, for enterprises looking to raise money by offering a security that will later become a decentralized token, and exchange platforms seeking to determine when compliance with the securities laws and regulations related to token distribution and secondary trading is necessary.

Importantly, it clarifies the legal standard and factual details that the SEC is likely to consider when evaluating a token sale. Given the significant penalties for violations of the federal securities laws and regulations by those who, among other things, publicly offer unregistered securities, operate a securities exchange that should be registered, or act as a broker-dealer or investment adviser without registration or relying on an exemption, this clarification of the SEC staff’s position will be very well received.

[1] Technically speaking, the token by itself is not a security, so what Hinman pointed out is that sales of Ether currently are not occurring under circumstances that would form an investment contract.

[2] The SEC first officially confirmed its view that tokens sold through initial coin offerings may qualify as securities when it issued a 21(a) report outlining its investigation of The DAO. See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, SEC Release No. 81207 (July 25, 2017).

[3] 328 U.S. 293 (1946).

[4] See Munchee Inc., Securities Act of 1933 Release No. 10445 (Dec. 11, 2017) (Although Munchee’s token was labeled a “utility token” that would allow purchasers to buy goods and services on the Munchee ecosystem, Munchee and other promoters emphasized that investors could expect that efforts by the company would lead to an increase in value of the tokens. The company also emphasized it would take steps to create and support a secondary market for the tokens. Given these and other company activities, the SEC found that the tokens were securities.); see also Perkins Coie Client Alert, SEC Takes Aim at Initial Coin Offerings Again (Jan. 11, 2018).

[5] 756 F.2d 230 (2d Cir. 1985).

[6] Hinman stated, “if a promoter were to place Bitcoin in a fund or trust and sell interests, it would create a new security. Similarly, investment contracts can be made from virtually any asset (including virtual assets), provided the investor is reasonably expecting profits from the promoter’s efforts.”

[7] See Hinman Speech, at n.15 (noting that a token obtained via a SAFT through a securities offering may later be sold in a nonsecurities offering).

[8] Press Release, SEC Names Valerie A. Szczepanik Senior Advisor for Digital Assets and Innovation (June 4, 2018).

[9] Amir Zaidi (Director of Market Oversight, CFTC), Rep. Sean Duffy (House of Representatives), and Jim Newsome (former Chairman, CFTC) also participated.

[10] Jay Clayton, Chairman of Sec. & Exch. Comm’n, Testimony on “Oversight of the U.S. Securities and Exchange Commission” Before the Committee on Financial Services, U.S. House of Representatives (June 21, 2018).

[11] Canadian Securities Administrators Staff Notice 46-308, Securities Law Implications for Offerings of Tokens (June 11, 2018).

The U.S. Securities and Exchange Commission (SEC) approved an amendment to Rule 701(e) under the Securities Act of 1933 on July 18, 2018, increasing from $5 million to $10 million the threshold in excess of which a private company is required to deliver additional disclosures, such as financial statements, to employees in a compensatory securities offering. The change became effective July 23, 2018.

The SEC also approved the issuance of a concept release soliciting public comment on possible ways to update the requirements of Rule 701 and Securities Act Form S-8, which provides a simplified registration form for compensatory offerings by public companies. In so doing, the SEC has signaled its willingness to consider possible ways to modernize its regulation of compensatory securities offerings and sales.

Rule 701(e) Amendment Mandated by Congress

Subject to certain requirements, Rule 701 provides a federal exemption for a nonreporting company from the registration requirements of the Securities Act for offers and sales of securities under compensatory employee benefit plans or written agreements for the company’s employees, officers, directors, partners, trustees, and, under certain circumstances, its consultants and advisors. Rule 701(e) requires the company to deliver to all such offerees, within a reasonable period of time before the date of sale, financial statements and certain other information if the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $5 million ($10 million following the effectiveness of the amendment). In the adopting Release, the SEC clarified that companies that have commenced an offering in the current 12-month period will be able to apply the new $10 million disclosure threshold immediately upon effectiveness of the amendment.

The SEC’s action to amend Rule 701(e) came as no surprise. It was directed to do so by Congress within 60 days after the Economic Growth, Regulatory Relief, and Consumer Protection Act was signed into law on May 24, 2018. The law also requires that every five years the SEC index for inflation the disclosure threshold amount to reflect the change in the Consumer Price Index for All Urban Consumers. In publishing the final Rule 701(e) amendment without engaging in a cost-benefit analysis or seeking public comment, the SEC made clear that Congress itself had undertaken the requisite analysis and that the agency exercised no discretion. By raising the existing $5 million threshold, the SEC explained, Congress intended to address two key concerns: “that additional disclosure makes it more expensive for [private] companies to compensate their employees with . . . stock and that this disclosure puts [these] companies at risk of disclosing confidential financial information.”

Concept Release Signals Future Changes to Rule 701 and Form S-8

Both the Concept Release and remarks made by the commissioners and the staff during the SEC open meeting recognize that since Rule 701 and Form S-8 were last amended, new forms of equity compensation have evolved along with new types of contractual relationships between companies and individuals involving alternative work arrangements. A key question has emerged: what does the term “employee” really mean in the emerging “gig” economy? In light of these developments, as well as the congressionally-mandated change to Rule 701(e), the SEC believes that “this is an appropriate time to revisit the Commission’s regulatory regime for compensatory transactions.”

During the open meeting, several of the commissioners emphasized that compensatory offers and sales of securities to employee-investors present different issues for private companies than capital-raising offerings aimed at other prospective investors. As noted in the Concept Release, “using equity for compensation can align the incentives of employees with the success of the enterprise, facilitate recruitment and retention, and preserve cash for the company’s operations.” It was this important distinction that prompted the SEC many years ago to adopt Rule 701 and a streamlined Form S-8.

The Concept Release poses 56 questions in total (with almost 75 percent of the questions focused on Rule 701) for public comment—many stemming from the new types of contractual relationships arising between companies and individuals due to the Internet, including short-term, part-time, or freelance arrangements. Individuals participating in these arrangements do not enter into traditional employment relationships and therefore may not be “employees” eligible to receive securities under Rule 701(c). Yet, companies may have the same incentive-related motivations to offer equity compensation to these individuals.

Several of the comment requests focus on what activities an individual should need to engage in, in order to be eligible to participate in exempt compensatory offerings, or put another way, who should be considered an “employee” in the current gig economy. The Concept Release also solicits comments on further revising the disclosure content and timing requirements of Rule 701(e), including, among other things, asking whether the rule should continue to require more disclosure for a period that precedes the new $10 million threshold amount being exceeded, clarify what it means to deliver disclosure “a reasonable period of time before the date of sale,” and specify the manner or medium in which disclosure should be delivered.

The SEC is also soliciting comments on Form S-8. For the “continued harmonization” of Form S-8 and Rule 701, the SEC is asking to the extent the scope of eligible individuals, including “consultants and advisors,” is changed under Rule 701, whether the same changes should be reflected in amendments to Form S-8. Among other questions, the SEC asks whether it should adopt a “pay-as-you go” fee structure, where companies pay filing fees on Form S-8 on an as-needed basis rather than when the form is originally filed.

Howard Dicker and Aabha Sharma

Non-compete agreements are contractual restrictions that control employees’ future ability to work for competitors of their current employers, who seek to protect their financial interests and trade secrets. While employers traditionally reserved non-compete agreements, or restrictive covenants, for high-level employees whose departures could present a fiscal impact to the company, non-compete agreements are now common with various levels of employees.

However, not all non-compete agreements are enforceable. Whether a court will enforce a non-compete agreement depends on the subject employee and the imposed restrictions. First, the employer must determine whether the employee poses a risk, and is in possession of trade secrets or confidential information that gives the employer a competitive advantage. If so, the employer must then consider the reasonableness of the restriction as it relates to the duration, scope, and geographical area.[1] For example, the duration of the non-compete restriction should not be excessive compared to the value of confidential information the employee might possess.[2] Further, the scope of duties restricted and the geographical area to which those restrictions apply should be limited to the extent necessary to protect the employer.[3]

Employers should also consider public policy and the laws of applicable jurisdiction, which may weigh heavily on the decision to include a choice of law or forum selection clause. Delaware and California are stark examples of the differing jurisdictional approaches to enforcing non-compete agreements.

In Delaware, the court views restrictive covenants through a contractual lens and will generally enforce reasonable non-compete agreements. Delaware’s public policy respects the freedom to contract, with very limited exceptions, as its courts “respect[] the right of parties to freely contract and to be able to rely on the enforceability of their agreements. . . . [O]ur courts will enforce the contractual scheme that the parties have arrived at through their own self-ordering . . . Upholding freedom of contract is a fundamental policy of this State.”[4] If Delaware courts find an agreement to contain unreasonable terms, the court may choose to invoke the “judicial blue-pencil” to modify the agreement, rather than void it altogether.[5] 

In California, public policy prohibits any restraint on employment based on non-compete agreements. Section 16600 of the Business and Professions Code deems void any kind of contract to the extent it restrains anyone “from engaging in a lawful profession, trade or business of any kind.”[6] California does not consider whether the parties had adequate consideration or whether the terms were reasonable. “The interests of the employee in his own mobility and betterment are deemed paramount to the competitive business interests of employers.”[7] Although California is an at-will employment state, courts have found employers liable in tort for terminating employees who refused to sign a non-compete agreement.[8] The public policy concern with non-compete agreements is very strong; California courts have even voided non-compete agreements between out-of-state employers and employees that leave to work in California.[9]

These are just two different states’ approaches to enforcing non-compete agreements. Each state’s laws and the facts of each case will determine the enforceability of each respective non-compete agreement. These are just a few considerations for a lawyer preparing a non-compete agreement.

Regardless of how reasonable or well-drafted the non-compete agreement may be, the employer must have an action plan in the event an employee breaches the non-compete agreement. Cases involving the violation of non-compete agreements rarely proceed to trial. Thus, counsel should inform employers of all available remedies and consider the strategic effect that requests for injunctive and interim relief will have on the ultimate case disposition.

[1] See generally, e.g., Coady v. Harpo, Inc., 719 N.E.2d 244, 250 (Ill. App. Ct. 1999); Norman D. Bishara et al., An Empiracle Analysis of Noncompetition Clauses and Other Restrictive Postemployement Covenants, 68 Vand. L.J. 1, 28-35 (2015) (addressing the reasonableness requirement for restrictive covenant enforcement).

[2] See supra n. 2.

[3] See generally Philips Elecs. N. Am. Corp. v. Hope, 631 F.Supp.2d 705, 715 (M.D.N.C. 2009); Nev. Rev. Stat. § 613.200 (2017) (some states require the non-compete agreement to have valuable consideration and reasonableness pertaining to duration and scope, which is combined with the geographical area).  

[4] Ascension Ins. Hldgs., LLC v. Underwood, No. Civ. 9897-VCG, 2015 WL 356002, at *4 (Del. Ch. Jan. 28, 2015).

[5] See e.g., Del. Exp. Shuttle, Inc. v. Older, No. Civ.A. 19596, 2002 WL 31458243, at *13–14 (Del. Ch. Oct. 23, 2002) (adjusting a three-year time limit to a more reasonable “two-year duration” and imposing a geographical limitation where there was none).

[6] Cal Bus. & Prof. Code § 16600.

[7] Application Group, Inc. v. Hunter Group, 61 Cal. App. 4th 881, 900 (1998).

[8] D’sa v. Playhut, Inc., 85 Cal. App. 4th 927, 929, 934 (2000) (“[A]n employer cannot lawfully make the signing of an employment agreement, which contains an unenforceable covenant not to compete, a condition of continued employment.”)

[9] See Application Group, Inc., 61 Cal. App. 4th at 899-900 (striking down a Maryland employer’s non-compete agreement with a former employee who moved to work for a California employer).

This article is adapted from the Director’s Handbook: A Field Guide to 101 Situations Commonly Encountered in the Boardroom, edited by Frank Placenti, and from The Role of Independent Directors in Corporate Governance, Second Edition, by Bruce Dravis.

Even the strongest corporate governance practices cannot guarantee the quality of corporate results.

Governance is about process, not perfection. Governance is a form of corporate risk mitigation, focusing on the decision-making processes within a company to limit the likelihood boards and executives will misuse corporate assets or make ill-considered choices.

Director independence is part of that process and is not a goal in itself. Independence is an imperfect substitute for what investors and policymakers actually want: decision makers who act with integrity and who form judgments on behalf of shareholders after thoughtful and fair consideration of the salient facts, untainted by favoritism.

No rule can predict that an individual will make a virtuous choice at a critical moment. There is no objective test to ensure that a director will think and act on behalf of the best solution for the company, regardless of his or her personal stake in the outcome. Instead, the independence standards in the laws and rules for corporate governance measure potential conflicts of interest, with the assumption that independence from conflicts will produce independence in judgment.

For securities law purposes, the definition of director “independence” is derived in part from the 2002 Sarbanes Oxley Act, in part from the 2010 Dodd-Frank Act, in part from SEC regulations, and substantially from the rules of the NYSE and NASDAQ. In addition, appointment of special committees of the board, or approval of transactions between the company and insiders, can generate state law questions of independence. There are also separate IRS and SEC independence measurements connected to the approval of some executive compensation.

Accordingly, company counsel must consult multiple sources to advise the board on whether a determination of independence falls on the right side or the wrong side of a relevant definition.

Independence is typically considered in terms of a director’s independence from corporate management. Government and exchange independence rules surround corporate managers with individuals both inside and outside the corporation who are in a position to influence management’s decisions and actions, and who not only can form judgments independent of management, but also serve at times as a check on management.

In testing the independence of a director from management, the primary questions relate to whether the director has employment, family, or other significant economic or personal connections to the company, other than serving as a director. A director’s family or economic connections to the company’s outside auditor can also disqualify a director from being independent.

However, independence of directors can also be fact-specific and situational. In litigation, a director who is independent for other purposes could have a stake in the legal issues that renders him or her conflicted.

For that reason, a director who is independent for one purpose may not be independent for all purposes. The board cannot take a “set it and forget it” approach to determination of a director’s independence. If situations change, the determination of independence can change too.

Within the corporate governance process, independence is important at the board level and for committees of the board, many of which are required to be mostly or even entirely comprised of independent directors. Moreover, it is important to measure independence before electing directors or appointing them to critical committees. If a problem arises later, the company may not be able to cure the failure to meet the independence requirement.

The term “independent director” is often used interchangeably with the state corporate law term “disinterested director,” which means a director who does not have an economic or personal interest in a particular transaction or arrangement requiring board approval. The two terms overlap substantially, but they are not identical. Independent directors will be “disinterested directors,” almost as a matter of definition, but not all disinterested directors will be independent. For example, it would be possible for the CEO, as a nonindependent director, to be a “disinterested director” and to vote on a transaction in which another director had a financial or personal interest.

Management knows the day-to-day operations of a company in a way that the board cannot. The board relies on management to present complete and honest assessments of company performance in order to fulfill the board’s oversight duties. The board must ensure that it has processes to ensure that the information it receives is correct and not somehow tainted by honest error, undue optimism, or dishonest manipulation.

Directors who meet the requirements for independence can still make mistakes or misjudgments, and can still wind up being unduly influenced by management. The governance process, however, including director independence, does not promise perfection—just a process to mitigate the risks.

Director’s Handbook demonstrates that while no single legal treatise can hold the answers to all factual situations that clients encounter, one book can hold the important questions that the clients and the lawyers should be asking, offering 10 sample questions across 101 topics to get conversations going within the boardroom and between attorneys and clients. The Role of Independent Directors covers the formal and informal obligations of independent directors, derived from such varied sources as federal securities laws, state corporate and fiduciary laws, stock exchange contractual terms, and investor “best practice” considerations.