The Reading List (2017, No. 8): An Example of How Differently Courts Treat Non-Competes

Non-Compete and Trade Secret News for the week ended February 24, 2017

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Overbroad Non-Competes in Virginia

This week's first two updates could be called a Tale of Two Non-Competes.

A federal district court in Virginia ruled that an employee's non-compete agreement, ancillary to a stock option award, was unenforceable because of its overly broad geographic scope. This case illustrates the perils of linking a restrictive covenant to customers or markets about which an employee has "confidential information." For starters, that may require a court to assess how the agreement treats that defined term - a notorious plot of unruly thatch.

But additionally, a restrictive covenant that is drafted this way often lacks objective parameters. In NVR, Inc. v. Nelson, the covenant's geographic term extended to areas "from which [the employee] received...Confidential Information." Because he received information digitally and since there was no way to tell from where the information originated, the non-compete was overbroad. A copy of the opinion denying the employer's temporary restraining order motion is available here.

Preliminary Injunction in New Jersey

The employer fared better with pursuing injunctive relief in Menasha Packaging Co. v. Pratt Industries, a New Jersey case in which the district court applied Illinois law. This dispute stems from the movement of three ex-Menasha employees to Pratt Industries during the period in which Menasha's client, Mondelez, had put up a packaging contract for bid. Unlike the NVR case, the competition and the immediate threat to Menasha were more tangible and apparent from the record. Menasha also sought very limited enforcement of the restrictive covenant, despite some dispute about whether the contract was facially overbroad. The court enjoined the employees' work with Mondelez, on Pratt's behalf, for the 18-month non-solicit term. The case illustrates the wisdom of narrowing the dispute and seeking relief that is directly tailored to the conduct in question. A copy of the New Jersey' court's preliminary injunction opinion is available here.

Non-Competes in Bankruptcy

The United States Bankruptcy Court for the Northern District of Illinois held in United Providers, Inc. v. Pagan that a claim for intentional breach of contract is dischargeable in bankruptcy. The breach arose from the debtor's alleged violation of an employee no-hire agreement in the medical billing field.

The nondischargeability provision of the Bankruptcy Code for "willful and malicious" injuries, Section 523(a)(6), requires that the breach of contract also give rise to an independent tort claim (e.g., breach of fiduciary duty, trade secrets misappropriation). And even then, a court's finding of nondischargeability is not guaranteed. The court's opinion makes sense because many breach-of-contract scenarios give rise to an economically efficient result, regardless of whether the employer likes it or feels as if it has been the victim of a maliciously designed plot. Only if the underlying conduct is intended to produce a harmful result will a viable nondischargeability argument arise. The opinion is available here.

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One of the more interesting trade-secret filings in a long time comes from the Central District of California, where Songkick has amended its suit against Live Nation Entertainment and Ticketmaster to allege trade secrets theft. The 91-page Complaint is quite a read, but the pertinent allegations of trade-secret theft appear to rest on a departed executive's misappropriation of thousands of documents in order to benefit Ticketmaster's "Artist Services" division, which is now known as OnTour. Consumers may be familiar with this type of service, since it promotes ticket pre-sales, fan clubs, and more direct fan engagement. Songkick's trade-secret theft allegations bolster a more robust antitrust claim against Live Nation, which vigorously has disputed the veracity of the accusations.

For those interested in exploring the data concerning non-competes' impact on wages and mobility, please see the University of Michigan Working Paper entitled Locked In? The Enforceability of Covenants not to Compete and the Careers of High-Tech Workers. The paper details a number of interesting conclusions, including that technology workers in higher enforcement states (think Florida) earn lower wages than their counterparts in lower enforcement states (think California). This at least seems to support the notion that employers do not share the marginal gains from non-compete regimes with their existing employees, a theoretical justification many on the pro-enforcement side frequently offer.

When Bankruptcy Law Collides with Non-Compete Obligations

Non-compete proceedings for most employees are daunting undertakings. For that reason, most non-compete disputes get litigated in the "shadows," outside of reported court decisions.

And as any attorney representing an employee knows, the possibility of bankruptcy looms should litigation go poorly. Many employees are generally aware that a bankruptcy suit stays (or puts a stop to) other litigation. Although this can alleviate pressure in debt-collection suits, a stay is by no means a safe harbor when it comes to non-compete disputes.

That is because a creditor can file a lift-stay motion in bankruptcy court, which would allow it proceed against an employee for enforcement of the restrictive covenant. Like many other areas of non-compete law, this one too is somewhat opaque and not governed by a clear, bright-line rule. Generally, a bankruptcy court must balance the hardship to a creditor (i.e., employer) if it is not allowed to proceed with the lawsuit against the debtor. It also must consider prejudice to the debtor, the debtor's other creditors, and the bankruptcy estate itself.

A seminal case from 1984, In re Curtis, sets out twelve separate factors that bankruptcy judges must consider when ruling on a lift-stay motion. Those factors are:

(1) Whether relief would result in a partial or complete resolution of the issues;

(2) Lack of any connection with or interference with the bankruptcy case;

(3) Whether the other proceeding involves the debtor as a fiduciary;

(4) Whether a specialized tribunal with the necessary expertise has been established to hear the cause;

(5) Whether the debtor's insurer has assumed responsibility for defending the case;

(6) Whether the action involves primarily third-parties;

(7) Whether litigation in another forum would prejudice other creditors;

(8) Whether the judgment in another action is subject to equitable subordination (!?!);

(9) Whether the movant's success in the other proceeding would result in a judicial lien avoidable by the debtor;

(10) Judicial economy;

(11) Whether the parties in the other proceeding are ready for trial; and

(12) The impact of the stay on the parties and the balance of harms.

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It is important to remember that ongoing compliance with a non-compete is not dischargeable in and of itself, even if defending against the injunction would be costly. But still, an employer must show "cause" under Curtis to lift the stay and seek an injunction. The best argument for relief is that a denial of relief will moot any contract rights the employer has, because non-competes only last a short period of time (usually 6 months to 2 years). Conversely, an employee normally contends that the enforcement will hamper his ability to perform under a plan of reorganization (assuming a Chapter 13 case).

These are difficult interests to reconcile, and for that reason, bankruptcy courts will look to determine the likelihood an employer will prevail in a separate proceeding, and whether a non-compete injunction proceeding was well underway before the bankruptcy filing. Employees should not assume that bankruptcy court provides a safe have to avoid an injunction proceeding, as even that question is so fact-specific that it is difficult to predict accurately how a lift-stay motion will be resolved.

What Happens In Bankruptcy...Does Not Necessarily Stay in Bankruptcy.

The unfortunate reality of many non-compete lawsuits is that the parties face a vast asymmetry in legal resources. While individuals suing companies in court is hardly a novel concept, an individual usually stands something to gain - money - if she wins. A non-compete defendant is in no such similar position.

As a result, bankruptcy looms as a potential "option" for defendants in a good percentage of non-compete cases. Most defendants don't realize that there's a significant chance that a damages award may not even be dischargeable, though this depends on a host of factors. Blanket statements or conclusions can't be made.

Another vexing issue is a company's ability to pursue injunctive relief to protect customer goodwill or confidential information, even if a non-compete defendant has filed a bankruptcy petition. The most obvious step for companies to take is to file a lift-stay motion. This refers to the fact that all litigation against a debtor is "stayed" (or halted) once he or she files a petition.

Bankruptcy laws serve to relieve an honest debtor from the weight of his financial obligations and give him a fresh start in business life. Injunctive relief, though, is not a matter that impacts the administration of a bankruptcy estate, so courts often confront a company's attempt to lift the stay so that it may seek to pursue an injunction and protect against the loss of customers or trade secrets. Because damages are difficult to prove, injunctive relief still is the preferred remedy for most non-compete plaintiffs.

Since bankruptcy laws do not give a debtor a shield to misappropriate assets or customer relationships, under what circumstances will a court grant an employer's lift-stay motion and allow it to proceed forward with its case outside of bankruptcy?

There are several factors courts have examined in the past, though there is no uniform set of rules:

(1) Likelihood of success - This seems rather obvious, but it poses serious challenges for bankruptcy judges. If a bankruptcy judge weighs in on the merits (even if it's not a decision or judgment), then there is a substantial risk that the court hearing the underlying dispute will be influenced by another judge's thoughts. This is a particularly acute concern when the non-compete case is in state court.

(2) Prejudice to debtor - The most obvious hardship is the cost of litigation. However, in the past, bankruptcy courts haven't found that this practical reality is a significant prejudice factor that would justify a denial of relief.

(3) Prejudice to the estate - In a garden-variety employee matter, the bankruptcy estate rarely has an interest in the non-competition covenant. Put another way, the contract is not an estate asset.

(4) Harm to the moving party - In the decisions addressing lift-stay motions, most courts find that the potential harm to the ex-employer (i.e., loss of customers or impairment of trade secret rights) is the most important factor to consider. Courts seem receptive to the notion that it is impermissible to use the bankruptcy laws offensively to continue violating unexpired restrictive covenants.

It also is important to keep in mind that considerations of lifting a stay are different in Chapter 11 or 13 cases when enforcement of a covenant not to compete may affect a debtor's ability to reorganize and earn income. However, in a typical Chapter 7 case, a bankruptcy court is unconcerned with a debtor's ability to generate post-petition earnings because those earnings are not estate property.

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.

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.

Non-Compete Case Law Update: The Mildly Interesting, But Useful, Edition

The new year is off to a pretty big start. We've already seen significant decisions from federal appellate courts on criminal trade secrets prosecutions and the epic Mattel/MGA "Bratz" dolls dispute. We have a looming debate over amendments to the Computer Fraud and Abuse Act, and pending legislation in Massachusetts concerning non-compete agreements.

But there's other activity in the trenches - the sort of routine work that parties and courts continue to crank out that don't necessarily generate headlines. Over the past few weeks, I've noticed some lower court decisions come through that are significant in their own right.

Trade Secrets Preemption in New Jersey

Last year, New Jersey became the latest state to adopt the Uniform Trade Secrets Act. Like all versions, the New Jersey Act displaces conflicting remedies based on claims of trade secrets misappropriation. However, the language of the statute preserves other common law rights and remedies, such that its text is not directly comparable on the issue of preemption in other states. As a result, New Jersey courts have not yet subscribed to the view that other civil claims are not preempted. This is an odd result, and the statute may be in for revision since it's near impossible to reconcile the preemption clause with the savings clause. The case discussing preemption is unreported and not binding on any other New Jersey court, SCS Healthcare Marketing, LLC v. Allergan USA, Inc., 2012 N.J. Super. Unpub. LEXIS 2704 (Sup. Ct. Ch. Div. Dec. 7, 2012).

Injunction Bonds

I have written in the past on the considerations underlying the need for an injunction bond - effectively, security for a preliminary order later deemed wrongfully entered. Federal courts have to consider the amount of security when entering a temporary restraining order or preliminary injunction. The case of Smiths Group, PLC v. Frisbie, 2013 U.S. Dist. LEXIS 9445 (D. Minn. Jan. 24, 2013), looked at a high-level executive's prior year's salary and ordered security in that amount as a condition for enforcing a one-year non-compete covenant.

Dischargeability of Debts Arising Out of Non-Competes

Damages claims against ex-employees often intersect with bankruptcy law. For a defendant found to be in breach of a non-compete, an award of lost profits may greatly exceed the defendant's ability to pay. As such, the specter of bankruptcy is always at the fore. A debt is not dischargeable though if it is a result of a "willful and malicious" injury to another entity or its property. In an adversary proceeding, a hair salon, contending a departed stylist's non-compete debt was non-dischargeable, was unable to show she willfully injured her ex-employer. The court focused on two factors: (a) the employee was terminated and therefore may have breached the agreement not to injure her ex-employer, but rather to pay her bills; and (b) she obtained the names of her customers largely from Facebook, the White Pages, and her memory. Finally, the court determined that the hair salon could not establish that as single customer even left, thereby indicating it suffered no real injury. Though the "willful and malicious injury" test is flexible, this was a clear case where some of the equities strongly favored the employee. The case is In re Rhoades, 2013 Bankr. LEXIS 157 (S.D. Oh. Jan. 11, 2013).

Recent Decisions of Interest (No. 5)

FINRA and the Protocol for Broker Recruiting

We have not seen many cases addressing the Protocol for Broker Recruiting, which has been adopted by many firms in the financial services industry. One of the cases actually discussing the Protocol is Ameriprise Financial Svcs., Inc. v. Koenig, 2012 U.S. Dist. LEXIS 13864 (D. N.J. Feb. 6, 2012). The court summarizes the intent of the Protocol by stating that registered representatives who are leaving one firm to join another should keep two lists.

The first should identify basic profile information: name, address, phone number, e-mail address, and account title. That is the representative's list to keep. The second should contain account numbers, plus all data on the first list. That is for the firm. When a representative takes information beyond this basic profile data, as Koenig apparently did, then he or she is potentially liable for misappropriating trade secret data or breaching contractual covenants. Finally, despite this potential breach, the Protocol still will permit a representative to service his or her old clients - as long as he or she does not use "excess information."

Attorneys' Fees and a Discharge in Bankruptcy

An increasing number of non-compete issues end up in bankruptcy court. In re Al-Suleiman, 461 B.R. 893 (M.D. Fla. 2011), dealt with one sure to arise and interest employers who prevail in litigation and obtain monetary relief. The court held that an award of attorneys' fees in underlying non-compete litigation was dischargeable in bankruptcy. In so holding, the court rejected the creditor's argument that the debt arose out of the defendant's "larceny" of a patient list. It also held that the debt did not arise out of a willful and malicious injury to the creditor's business. Though the record is not totally clear, the court in the underlying litigation did not make any findings that would support the theory of nondischargeability.

Forfeiture for Competition Clauses

Finally, a decision out of Texas. Usually, cases involving the link between equity incentive awards and competition covenants produce interesting results. This one is no different. The case is Drennen v. Exxon Mobil Corp., 2012 Tex. App. LEXIS 1161 (Ct. App. Feb. 14, 2012), and it deals with a so-called bad boy provision tied to an award of restricted shares. Essentially, the plaintiff - Drennen - received a number of incentive award units through his long employment at Exxon Mobil, but the program which administered the awards provided that the same could be canceled if Drennen (or any plan participant) engaged in "detrimental activity." This, of course, could include competition with Exxon Mobil during or after employment.

Drennen left Exxon Mobil in late 2006. He informed the Company a few months later he would be joining Hess Corporation, which engaged in the exploration, production, and sale of crude oil and natural gas. He received notice that it was likely Exxon Mobil would cancel his incentive units due to the competitive nature of his work. When it followed through, Drennen sued for declaratory relief. He lost, but the Court of Appeals reversed.

The court found that the provisions concerning forfeiture were unenforceable under Texas law. This is one of the rare cases we see in which a choice-of-law clause is outcome-determinative. Though the plan was governed by New York law, the Texas court refused to enforce that choice-of-law clause, finding it contravened a public policy expressed in Texas law. Simply put, New York honors the so-called employee choice doctrine, which generally enforces forfeiture-for-competition clauses. The idea is that an employee can refrain from competing by accepting the benefits, or preserve his right to work in the industry by forfeiting them. Texas, however, holds that such clauses are not enforceable unless they meet the reasonableness criteria.

Here, the terms of the incentive program did not contain any parameters describing what competitive activity would not result in cancellation. Instead, the cancellation provision was unbounded - it was not limited in time - which created a fundamental enforcement problem under Texas law. The choice-of-law discussion ultimately focused on the close connection between Texas and each of the parties. The court ultimately rejected Exxon Mobil's plea to have New York law apply so as to create uniformity. Though this rationale is commonly accepted, Exxon Mobil's own plan undercut the argument: the plan allowed for the application of other laws to accommodate local laws of foreign nationals.

Be Careful When Drafting Geographic Restriction in Louisiana (In re Gulf Fleet Holdings, Inc.)

Louisiana is one of those special drafting states. Attorneys must proceed with great care when drafting the scope of a non-compete restriction by virtue of a strictly applied statute. Section 23:921(C) of the Louisiana Statutes provides that for a non-compete to be enforceable specific parishes or municipalities must be identified. Even if an employer conducts business throughout the state, a blanket prohibition on competing in Louisiana will be invalid.

It is settled law in Louisiana that an employer cannot enforce a non-compete in a parish where it does not conduct business. For employers that want to restrict post-employment activities, therefore, it is essential to be consistent and include in the non-compete agreement only those parishes where it can show demonstrable business activity.

If an employer chooses to be overinclusive and list, for instance, all parishes in Louisiana, this would not necessarily be fatal or render the covenant overbroad. Several courts, including a recent adversary proceeding in bankruptcy, have allowed an employer to engage in this practice and have blue-penciled the listed parishes where the employer does not engage in business.

Another twist, however: the operative agreement must contain a clause allowing for such severing of the covenant. Finally, if the covenant applies outside Louisiana, the restrictions must also list out the prohibited territories by county. So for instance, if an employer chooses to restrict business in neighboring Texas, it too must list each Texas county it considers off-limits.

Louisiana courts place a strange emphasis on over-technical drafting. It can certainly be argued that the practice of blue-penciling specific parishes or counties creates an incentive for an employer to be overinclusive and overbroad, knowing full well courts can strike specific locations without rendering the entire agreement unenforceable.

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Court: United States Bankruptcy Court for the Western District of Louisiana
Cite: In re Gulf Fleet Holdings, Inc., 2011 Bankr. LEXIS 1396 (W.D. La. Mar. 31, 2011)
Opinion Date: 3/31/11
Favors: Employer
Law: Louisiana

Debts Incurred for Violating Non-Competition Provision Usually Are Dischargeable (In re: O'Connor)

In most competition cases, a defendant's obligation to satisfy a monetary judgment entered against him or her may be impacted by the decision to file for bankruptcy.

As a general matter, contract debts are dischargeable. So, if an employee is found liable for breach of a non-compete contract and found to owe lost profits or liquidated damages to the ex-employer, he may be able to avail himself of bankruptcy law and avoid the obligation. It is likely in such a factual matrix that the debt would be discharged.

There are a few notable exceptions, however. If a damages judgment is rendered on a breach of fiduciary duty claim (which often is added to a non-compete case, depending on the pre-termination conduct), that would not be dischargeable as long as the trust relationship existed prior to the act creating the debt. Note that in some jurisdictions (e.g., New Hampshire) ordinary employees do not automatically owe a fiduciary duty to their employers. The test is usually whether the employee was in a supervisory or managerial capacity, but these are rare exceptions.

Another provision of the bankruptcy code provides for non-dischargeability in the event of a willful or malicious injury. No matter how much an employee intends to violate a non-compete, however, the question of malice in a contract claim is meaningless. There is nothing inherently wrong with breaching a contract, as long as the non-breaching party is made whole.

There is one interesting other exception to the non-dischargeability rule: a judgment of damages following a finding of contempt will not be dischargeable. Say, for instance, that a defendant breaches a non-compete agreement and is enjoined by order of the court (or, even by agreement) from further violating his or her contract. If that defendant subsequently competes in a way that violates the court order, any damages arising from the contempt proceeding are non-dischargeable under Section 523(a)(6). This rule applies to both temporary and permanent injunctions.

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Court: United States Bankruptcy Court for the Western District of Louisiana
Opinion Date: 9/30/10
Cite: In re O'Connor, 2010 Bankr. LEXIS 3475 (W.D. La. Sept. 30, 2010)
Favors: Employee
Law: Federal

Lack of Key Non-Compete Can Hurt Secured Creditors In Chapter 11 Valuation (In re Olio Dental)

In a Chapter 11 proceeding, a secured creditor may file a proof of claim valuing the business well above what the debtor believes is accurate. If the debtor intends to carry on the business in the normal course, the court must not look to liquidation value of the business' assets, but rather must examine the use value or fair market value of secured property.

In a recent bankruptcy case involving dental equipment business, HSBC took a security interest in the debtor's "general intangibles of every kind." When assessing the debtor's objection to the proof of claim it filed, the bankruptcy court noted that "the valuation must take into account the value of the business going forward."

However, the debtor's principal had no employment or non-compete agreement, and in the words of the court, "could walk away from this practice and open a new business across the street taking many of debtor's customers with him." Accordingly, the court had to examine fair market value considering the absence of any non-compete binding the debtor's principal.

The result: HSBC's proof of claim estimated the value of its collateral between $375,000 and $500,000. The court valued the secured collateral at just over $100,000 and held HSBC was unsecured as to the balance of its claim.

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Court: United States Bankruptcy Court for the Southern District of Indiana
Opinion Date: 5/26/09
Cite: In re Olio Dental, Inc., 2009 Bankr. LEXIS 1248 (S.D. Ind. May 26, 2009)
Favors: N/A
Law: Federal

Bankruptcy Court Approves Debtor's Petition to Purchase Non-Competes (In re Pilgrim's Pride)

Prior to 2005, key-employee retention plans were often endemic to a company's recovery during a Chapter 11 bankruptcy. The general thought was management needed to have a vested stake in a distressed company, and without an incentive plan, managers would resign in droves.

In October of 2005, Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act, which placed significant restrictions on such incentive plans offered to key managers. In that legislation, Congress authored key changes to Section 503(c) of the Act.

At issue in the Pilgrim's Pride bankruptcy was which provision of Section 503(c) governed the debtor's motion to essentially buy non-compete agreements from departing executives. By way of background, Section 503(c)(1) governs retention bonuses to insiders. The Trustee argued the company's petition to pay nearly $500,000 to a departed CEO and COO fell within the ambit of (c)(1). However, the court disagreed, finding that the company wanted the CEO and COO gone - not retained. Indeed, the restructuring officer testified the voluntary resignations were given under threat of termination.

The court next determined that the sought-after non-compete payments did not fall within (c)(2), which expressly applied to severance pay. Here, the executives had already been paid severance, so no logical reading of (c)(2) could apply to the debtor's petition.

Finally, the court concluded that the non-compete payments were subject to (c)(3). That provision is a catch-all clause in the Bankruptcy Code governing plans outside the ordinary course of a debtor's business not formally designed to retain insiders.

The key issue for the court was what standard to apply to the petition. Noting that some courts implemented a simple "business judgment rule" test, the court went further and held that a debtor's petition was subject to stricter scrutiny. In particular, the court founds as follows:

"Section 503(c)(3) is intended to give the judge a greater role: even if a good business reason can be articulated for a transaction, the court must still determine that the proposed transfer or obligation is justified in the case before it. The court reads this requirement as meaning that the court must make its own determination that the transaction will serve the interests of creditors and the debtor's estate. Put another way, when a transaction is proposed between a debtor and its insiders, the court cannot simply rely on the debtor's business judgment to ensure creditors and the debtor's estate are being properly cared for."

Despite taking a de novo look at the petition for non-compete payments, the court approved them over the trustee's objection. The court noted the payments were not insubstantial, but that the threat of competition from two departed executives outweighed any cost borne by the estate. The court specifically found each executive had extensive knowledge about the debtor's customers and could divert large accounts, potentially costing the company millions of dollars. The court did not comment why the executives were not subject to pre-existing non-compete obligations, either as part of an executive employment agreement or severance package.

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Court: United States Bankruptcy Court for the Northern District of Texas
Opinion Date: 2/26/09
Cite: In re Pilgrim's Pride, 401 B.R. 229 (N.D. Tex. 2009)
Favors: N/A
Law: Federal