Monday, April 29, 2013

Settlements Redux: A Brief Follow-Up From My Bankruptcy Post

I received a number of e-mails on my three-part series on settlements, which ran over the past few weeks.

Of those e-mails, several dealt with a topic I raised in Part 3 - accounting for the possibility of a settling defendant's bankruptcy. So I felt it was appropriate to answer those questions in a follow-up post.

As I noted in Part 3, a plaintiff settling a competition dispute may be able to litigate, or relitigate, a claim during the course of an adversary proceeding if the defendant files for bankruptcy.

An exception to the general rule of dischargeability is the "fiduciary defalcation" provision contained in Section 523(a)(4) of the Bankruptcy Code. That generally holds that a debt is non-dischargeable when a debtor breaches a duty while acting in a fiduciary capacity.

Because all adversary claims are governed by the Bankruptcy Code, federal law will apply. And federal courts' interpretation of what qualifies for the "fiduciary defalcation" exception to dischargeability is not on all-fours with state law concepts familiar to many readers, such as the common law fiduciary duty of loyalty, rectitute, candor, and good faith.

Let's take a hypothetical and assume a fact pattern we've discussed on this blog before. If a corporate officer sets up a competing business while still employed, this almost certainly would constitute a breach of fiduciary duty under state law. That does not mean that debts arising out of that breach automatically are non-dischargeable under Section 523(a)(4).

Bankruptcy courts generally provide that the debt is non-dischargeable only if the debtor is acting in a fiduciary capacity with respect to the particular conduct giving rise to the debt.

So under the hypothetical I just outlined, the corporate officer may or may not have his debt discharged.

If, for instance, he simply starts a new business, moonlights, and then funnels new customers to his separate entity, any damages for which he's liable under the common law likely would be dischargeable. (I say "likely" because court decisions aren't totally consistent.)

However, if the officer swaps out an order intended for his current employer and runs that through a competing business - essentially the equivalent of a conversion or civil theft - then the company stands a much better chance of claiming that the debt is non-dischargeable.

This is a fine distinction to make, and courts do come out different ways on this.

The 523(a)(4) exception really is intended to provide a remedy for embezzlement or insider corporate theft, such as when a controller - say, in Dixon, Illinois - loots the company till.

Applying the exception to a garden-variety competition case founded on breach of fiduciary duty often yields few clear answers.

Thursday, April 25, 2013

When a Restriction on Soliciting "Prospective" Customers Is Unreasonable (and How to Fix It)

One of the most common drafting errors in non-solicitation covenants - clauses that limit customers to whom competitive services may be offered - is the reach to whom it applies.
In concept, the idea of a customer non-solicitation covenant is not that offensive to most judges. Companies often make convincing, successful arguments that covenants of this kind are narrowly crafted to protect their interest in maintaining business relationships with accounts that generate an ongoing stream of revenue. And, generally speaking, they reflect a careful balance between a company's interest and that which an individual has in maintaining the right to earn a living.

But companies run into trouble when the covenant stretches too far in protecting both former clients and prospective clients. Courts correctly reason that such covenants go beyond what is necessary to protect companies from unfair competition, principally because past and prospective customers aren't contributing to existing goodwill.

Cases reflecting this principal are widely available, with one of the most recent being Newport Capital Group, LLC v. Loehwing, 2013 U.S. Dist. LEXIS 44479 (D.N.J. Mar. 28, 2013). That New Jersey case appears to be the first in that state to take a relatively bright-line approach to barring restrictions on an ex-employee's ability to service prospective customers.

What are the common problems associated with broad, customer-based restrictions? Here are the two most common:

1. The definition of "prospective" customer is perverse. Sometimes agreements define customer in such a way that it's impossible for the employee to even know who is off-limits. If, for instance, "prospective customer" includes any "individual identified by the company's employees as a potential client," it would be impossible to subject this restriction to verification.

2. "Prospective" customers is not defined at all. Most well-drafted non-solicitation covenants contain a definition of the key, triggering term - such as "Restricted Customer" or "Active Account." But many don't, and these agreements often cause judges to scratch their heads. If the term "prospective customer" is entirely undefined, it could mean that particular employee's prospect, another employee's prospect, or some prospect generally available to the market as a whole. Such a shifting, malleable definition causes the parties to interpret the agreement in such a way as to favor their position. Generally, ambiguities go in favor oft the party being restricted.

It's hard to create bright-line rules and there may be situations when companies can define "prospective" customers in a way to make it reasonable. They could limit the definition to:

1. Those prospects with whom the employee, or someone under employee's direct management, had been actively making a proposal at the time of his departure.

2. Those prospects identified on certain confidential lists of customers developed and maintained by the company and to which the employee had regular access.

3. Prospects for which the company's confidential information was used to solicit competitive products or services on behalf of a third-party.

It's entirely possible even these limiting definitions won't do. But they're certainly a good start in extending a non-solicitation covenant into otherwise forbidden terrain.

Monday, April 22, 2013

New Jersey Non-Compete Bill Follows Maryland Lead - And Then Takes It a Step Further

In January, I discussed Maryland's proposed Senate Bill 51, which (if passed) would ban certain non-compete agreements if an employee was deemed eligible to receive unemployment benefits.

I offered my take on why this bill was fatally flawed. This is nothing more than another example of intrusive legislative meddling with absolutely no concern for the unintended consequences likely to result in day-to-day practice.

At least three Assemblymen from New Jersey have taken an even further step, proposing A3970, a bill that would ban a broader range of business protection covenants when an individual is deemed eligible for benefits under the state's unemployment compensation law. Incredibly, the proposed bill is not limited to general market-based non-competes, but also extends to any kind of non-solicitation covenant and even non-disclosure agreements.

New Jersey's unemployment compensation law is very similar to those in other states, in that an employee is generally not eligible to receive UC benefits if she voluntarily quits her job or is terminated for misconduct. Some states - like Maryland - have broader definitions concerning eligibility. "Misconduct" is very fact-specific and could, in many cases, cover the type of pre-termination conduct (e.g., theft of data, solicitation of accounts) that gives rise to competition suits.

For more on A3970, read the fine post from Seyfarth Shaw here and an interesting online article from here. The latter post discusses the exact point that I made in January when discussing the proposed Maryland legislation: the bill encourages companies to fight unemployment claims when they otherwise wouldn't. This is the law of unintended consequences at work.

Wednesday, April 17, 2013

Settlements (Part 3 of 3): Dealing With a Defendant's Bankruptcy in Non-Compete Litigation

This is the third and final installment on my series devoted to settlements in non-compete litigation.

Today's topic is a little different.

This is largely a plaintiff-centric column, offering some practical points to consider when assessing the risk of bankruptcy in connection with non-compete (or other competition) litigation. Though many non-compete suits settle on straight equitable terms (such as injunctions enforcing the terms of an agreement), large-dollar settlements are not that unusual. This is particularly so if the defendant has moved a large volume of customer business in violation of a covenant, or if he has misappropriated valuable commercial data. In these cases, a plaintiff should be able to prove some consequential damages - and that may lead to a settlement comprised in part on the payment of money.

The threat of bankruptcy is a fairly significant lever for a defendant to pull. And even if a case settles on financial terms, it does not extinguish the possibility that a plaintiff will have to deal with the bankruptcy process at some point. Although there is nothing a plaintiff can do to prevent a defendant from filing for bankruptcy (such a promise or covenant would be void), it can take certain protective steps to ensure that it preserves as much of its claim as possible.

Here are some considerations:

1. Be Aware of the Preference Claim. Any time a plaintiff receives a cash payment settlement, there is a possibility it will be clawed back if the defendant files for bankruptcy within 90 days. Although there are defenses to this so-called preference action, the most common - the "ordinary course" defense - is almost certainly not available. A plaintiff can at least mitigate the risk of a preference claim by preserving the full value of a claim. For instance, if a plaintiff has a legitimate damages claim for $100,000, and settles for half of that, it should insist on a consent judgment of the full amount. After the 90 day period expires (following tender of the $50,000), it can release the full judgment. This way, if the defendant does file for bankruptcy in the preference period, the plaintiff has a larger claim to file in the bankruptcy estate and is entitled to a larger share of assets the trustee collects.

2. Obtain Personal Guaranties and a Pledge of Stock (Where Applicable). When there are corporate and individual defendants settling a non-compete case, special issues pertaining to guaranties and pledges of stock arise. Assume, for instance, that an ex-employee left to start her own company. If she is sued on a non-compete or related claim, the plaintiff may sue not only the individual, but also her new company. If the company commits to pay the settlement amount (which it would want to do to take advantage of a tax deduction), then the individual defendants should guaranty payment. A corporate bankruptcy won't affect the guaranty. Similarly, the plaintiff may want to take a pledge of the individual's stock in the defendant-company as further insurance against default on the payment obligation.

3. Obtain Admissions Where Possible. As discussed in points (4) and (5), some debts in bankruptcy are not dischargeable. Bankruptcy law contains limited exceptions to a debtor's goal of discharging her debts. Those suits - called "adversary" proceedings - are like trials, but courts will consider and give preclusive effect to admissions in related litigation. It's critical, therefore, to use admissions of the defendant where possible. If the defendant is willing to settle litigation, and bankruptcy is a real threat, a plaintiff should consider requiring the defendant to either: (a) concede in the settlement agreement that she violated her fiduciary duty of loyalty, or willfully stole confidential information; or (b) execute a consent judgment (often times in connection with an agreed injunction order) that contains similar admissions that a judge then signs off on. These can be used offensively in a later adversary proceeding.

4. Consider the "Fraud in a Fiduciary" Capacity Exception for an Adversary Proceeding. The Bankruptcy Code provides that a debt is not dischargeable if a defendant obtains property by way of fraud in a fiduciary capacity. This doesn't necessarily mean that every fiduciary defalcation is non-dischargeable. But if a plaintiff has a cognizable fiduciary duty claim and obtains strong admissions in the underlying suit (or in connection with settling the underlying suit), it may be able to pursue an adversary claim in the bankruptcy court.

5. Determine If There's a Willful or Malicious Injury. This is similar to the fraud exception, but it's far broader and captures fiduciary conduct that the previous exception might not. If a defendant commits a willful injury in tort, she can't discharge that debt. Simple as that. The common paradigm in competition cases for a non-dischargeable debt is the willful taking of a trade secret, since that is essentially a tort and would likely qualify for a strong adversary claim. A non-compete violation presents a tougher, closer question. I wrote back in February about an Ohio case where the bankruptcy court found that a straight non-compete breach did not amount to a willful injury, and the associated debt was dischargeable. But you can find cases to the contrary, such as In re Ketaner, 149 B.R. 395 (Bankr. E.D. Va. 1992). Likely, a plaintiff will need to couple a simple breach with some pre-termination conduct that smacks of unfair competition or misappropriation of company data. A simple breach of contract probably won't do, and there must be some evidence of an intent to injure and not just an intent to act. This is a terribly fine line to walk, since every breach of contract contemplates some financial gain to the detriment of others.

Monday, April 15, 2013

Episode 6 of Fairly Competing: Practical Considerations When Seeking Injunctive Relief

The sixth Fairly Competing podcast, Practical Considerations When Seeking Injunctive Relief, is now available for listeners and subscribers.

In this episode, John MarshRussell Beck, and I debate injunction practice in competition cases. We talk about the differences between seeking emergency temporary restraining orders, preliminary injunctions, and how to gather enough facts in discovery to seek or oppose such relief.

We also examine some of the nuances in injunction practice in our home states of Ohio, Massachusetts, and Illinois, and broadly discuss litigating injunctions in federal court.

You can listen to the podcast by clicking on the link below, visiting the official podcast website, or subscribing to Fairly Competing on iTunes.

Listen to this episode

Friday, April 12, 2013

Settlements (Part 2 of 3): 5 Reasons Non-Compete Cases Should (and Do) Settle

This is the second in a three-part series on settlements in non-compete litigation.

On Monday, I offered several reasons why non-compete cases don't settle. Today I flip this concept around.

It is true most non-compete cases do settle, a reflection that business cases get resolved for pure economic reasons. But, in the context of non-compete suits, what are the motivations that drive parties to compromise their claims and defenses? Again, I offer five:

1. Non-Compete Disputes Yield Uncertain Outcomes. There are a few overriding reasons why this is so. First, resolution of a case often depends on the rule of reasonableness, which I and others have discussed so often. By definition, courts can reach different outcomes on similar facts under this flexible, case-specific approach. Second, many jurisdictions employ a blue-pencil, or modification, rule that enables a court to award some relief even if it finds the agreement is unreasonable. Third, judges have personal views on this subject, a reflection that there is an inherent tension between the freedom to contract and the freedom to compete. Uncertain outcomes naturally drive parties to settle for fear of a loss.

2. Business Solutions Abound. Imagine a personal injury case. The lone satisfactory outcome for the plaintiff is pretty straightforward - it needs cash. A business competition case is more dynamic. Potential solutions include not only payment of cash or injunctive relief, but also the acquisition of all or part of a competitor's business. A plaintiff even may be satisfied by a lengthy "earn-out" related to certain customer business or a license fee for intellectual property in dispute. An employer may waive a non-compete so long as an employee simply stays out of a very narrow business segment, or away from a certain customer, for a period of time. In short, even contentious cases are amenable to creative business solutions not apparent in a large class of civil lawsuits.

3. Legal Fees Can Mount Quickly. Most non-compete and trade secrets are positioned for a quick injunction hearing so that the parties see a judge's initial conclusions on the merits of the case. Although this can have the effect of creating leverage for the party that achieves a favorable outcome, it also forces the parties to think settlement for fear of running up large legal bills in a compressed timeframe.

4. There's Usually An Asymmetry In Resources. In most employee non-compete cases, the defendant simply won't have the financial muscle to litigate. While this dynamic is less prevalent in trade secrets cases, competition litigation is often characterized by a vast disparity in the legal resources that the parties bring to bear. Start-ups and individual defendants are at a huge disadvantage, and there is almost never insurance coverage to backstop a defense.

5. The Attorneys Think Like Businesspeople. Compound an attorney's natural inclination to fight with the coarse feelings attending non-compete cases, and you have a toxic brew. But sometimes the attorneys can temper their clients' personal animoisities and encourage the parties to reach a sensible business result. This is when attorneys need to act as counselors - to become, in effect, part of the management team - and craft a solution that will avoid litigation and unnecessary legal expense. My experience is that, in non-compete suits, if the attorneys have a full and complete understanding of the larger business dynamics, they often can bring a fresh perspective and creative ideas to help settle cases.

Next week, I will post the final installment on this series devoted to settlements: some brief thoughts on bankruptcy considerations in the context of settlements.

Monday, April 8, 2013

Settlements (Part 1 of 3): 5 Reasons Non-Compete Cases Shouldn't (and Don't) Settle

This is the first in a three-part series on settlements in non-compete litigation.

Every judge, lawyer, and litigant is probably familiar with the maxim that most civil cases settle. That's undoubtedly true. But some classes of suits are better positioned to settle than others. In non-compete and other competition litigation, there are many reasons why cases do settle. I'll be talking about those in my next post.

But today's post looks at settlement from the opposite perspective. What are the reasons why non-compete cases don't settle? And, to explore this further, are these reasons justifiable? For now, I'll focus on five reasons:

1. Each side thinks it will prevail. The most apparent reason that non-compete suits don't settle is that each side believes strongly in its case. This may seem obvious and intuitive, but in a large percentage of civil litigation, a determination of liability is pretty clear. Non-compete disputes are different because contracts are governed by a flexible rule of reason, meaning that courts will take a fresh look at the facts and circumstances to determine enforcement in every case. Precedent only gets you so far. In this regard, the closest parallel to non-compete litigation is in the copyright context, where the contours of the "fair use" doctrine are ill-defined and subject to a multi-factor balancing test. The rule of reason in non-compete cases is a close analogue, with parties often justifiably believing the facts will fit within their view of the rule of reason.

2. The case involves unusual facts. Cases involving strange fact patterns are hard to settle because prior results or other cases don't influence the parties as much. Non-compete disputes have their share of weird fact patterns, with the case of IBM v. Johnson perhaps the best and most notable. They also frequently involve a misunderstanding among the parties as to what level of competition actually is occurring or whether the companies offer different products or services.

3. One party is determined to have its day in court. Settling litigation is almost always an economic decision, with parties balancing litigation costs, potential exposure, and the benefits of certainty. Frequently, however, parties in non-compete cases will take principled stands and avoid the typical cost-assessment that goes with litigating. This is usually so because non-compete disputes evoke visceral reactions among the parties, partly because important societal interests (freedom of contract vs. freedom to compete) sit in tension with one another. The plaintiff feels jilted and scorned; the defendant just wants to ply his or her trade. Raw emotions are difficult to temper even with a rational cost-benefit assessment about continuing the fight.

4. The law is unsettled or unclear. Non-compete cases are heavy on the law - meaning that even if the facts are all out on the table, the impact of those facts is frequently not clear. Some of the legal issues that arise involve choice-of-law, blue-penciling, tolling of the restricted period, and sufficiency of consideration. These rules vary from state-to-state, and many states haven't clearly defined their legal standards. If an unsettled legal issue is the fulcrum of the dispute, the case automatically becomes more difficult to settle and the parties become more entrenched in their positions.

5. A larger strategic issue is at play. Non-compete suits don't settle because of strategic reasons that may not even involve the parties to the suit. One example is when a company wants a court ruling that upholds its agreement. That ruling then can be used offensively in other cases or as a deterrent among employees who are made aware of a company's court victory. Companies that settle non-compete disputes quickly often establish a market rate for breach. Even a supposedly confidential settlement may not keep that rate hidden from third-parties. On the flip side, and unfortunately, a plaintiff sometimes pursues a competition law case - even though it's terribly weak - to slow down the growth of a potential market competitor simply by causing them to spend valuable resources on legal fees.

My next post will look at why non-compete suits should (and do) settle. It will be the mirror-image of this post. And my final installment on settlements will address a very specific issue that is plaintiff-centric: how to assess potential bankruptcy issues when settling competition suits.

Wednesday, April 3, 2013

Practice Tip: Don't Call Your Liquidated Damages Clause a "Penalty" In the Contract

Readers of this blog know that I am an advocate of using liquidated damages clauses in non-compete agreements. Though not for every situation, they can help avoid the knotty problem of proving lost profits damages through extensive discovery and use of expert testimony. And they can provide a true remedy for a breach, because often times an injunction won't recapture a lost customer.

In terms of drafting liquidated damages clauses, I have several general rules companies should do their best to abide by:

1. Think through the actual formula used to ensure it's a sound predictor of actual loss.

2. Run through hypotheticals to see how the formula will play out in a potential suit.

3. Avoid using arbitrary, fixed numbers and come up with a methodology that is tied to an objective financial indicator, such as past sales or earnings.

4. Reserve in the liquidated damages clause the ability to seek injunctive relief.

Here's what not to do: Call your liquidated damages clause a "penalty."

Unfortunately, that's what the plaintiff did in Kehoe Component Sales, Inc. v. Best Lighting Prods., Inc., 2013 U.S. Dist. LEXIS 38816 (S.D. Ohio Mar. 20, 2013). At the tail-end of the non-compete (contained in a supply, not an employment, agreement), the agreement stated that "[p]enalties for violation of the non-compete provision shall be the rate of $500,000 per occurrence."

To the court's credit, it did not strike the liquidated damages clauses solely on the basis of the unfortunate verbiage used. Rather, it determined that the arbitrary fixed sum of $500,000 had no relationship to any past sales practice and was a draconian provision intended to secure contractual performance.

But judges are people too, and it's awfully hard to get around the optics of how such a clause looks on paper. Liquidated damages clauses are not always enforceable and won't be honored if they lack a reasonable relation to potential loss (a so-called contractual "penalty"...verboten in all states). Courts do not "punish" a breach of contract because it's not a wrong; an efficient breach of contract is often times a great business decision. A liquidated damages clause, if not thought through, can have the effect of punishing a breach. And courts will strike them if that's the apparent intent.

Particularly when it says so right in the contract.

Monday, April 1, 2013

Episode 5 of Fairly Competing: The Lessons of v. Powers

The fifth Fairly Competing podcast, The Lessons of v. Powers, is now available for listeners and subscribers.

In this episode, John Marsh, Russell Beck, and I discuss the high-profile litigation involving former executive Daniel Powers and his move to Google in late 2012.

More background on this important non-compete case can be found on previous blog posts authored by John, Russell, and me.

You can listen to the podcast by clicking on the link below, visiting the official podcast website, or subscribing to Fairly Competing on iTunes.

Listen to this episode