Back from Hiatus (Part II): State Law Updates

Last week, I discussed three examples of Illinois courts analyzing similar non-compete issues in very different ways, a post that amply illustrates how difficult it is for lawyers to predict outcomes for clients. It also reminded me of a famous Abraham Lincoln quote: "Discourage litigation. Persuade your neighbors to compromise whenever you can. Point out to them how the nominal winner is often a real loser - in fees, expenses, and waste of time. As a peacemaker the lawyer has a superior opportunity of being a good man. There will still be business enough."

But to be sure, many people ignore Lincoln and litigate anyway - often with profoundly silly reasons motivating them.

So because we have litigation, we have legal developments and I therefore have a blog that continues to chug along. And you continue to read, meaning I must update you with some new rulings over the past several months.

California:

The infamous, long-running case involving ex-Korn/Ferry International executive David Nosal may have reached its end, with the Supreme Court declining a cert petition and the District Court now having finally decided on the scope of Nosal's restitution to KFI. United States v. Nosal is the most notable case under the Computer Fraud and Abuse Act, which generally criminalizes unauthorized access to protected computers. Nosal had its roots as a garden-variety trade secret case, but it was a criminal prosecution and tested the CFAA's limits.

Ultimately, Nosal secured some victories along the way. But still he will serve a year in prison and pay restitution to KFI. As to the scope of restitution, KFI sought about $1,000,000 in legal fees incurred to assist the Department of Justice investigation. After the Ninth Circuit weighed in KFI, will have to settle for less: $164,000. Still a heavy price to pay for Nosal, who probably deserved a civil suit but definitely does not deserve to spend a year in prison.

Connecticut:

The case of Datto, Inc. v. Falk discussed whether a forfeiture-for-competition clause was reasonable and enforceable. A minority of jurisdictions apply the same, or at least a similar, non-compete standard to these clauses, which (as one might expect) enable an employer to clawback certain benefits if an employee leaves to compete.

Forfeiture clauses range in scope, frequently calling for the forfeiture of unvested stock options but sometimes also calling for the employee to pay back income earned from the exercise of a grant within a certain period before the end of employment. Datto involved a dispute as to whether the cancellation of certain stock options were void because Falk (an ex-Chief Revenue Officer) accepted a position with a competitor.

The court was bound to apply Delaware law on the question of reasonableness, and that law in my view is somewhat confusing. Precedent, in effect, equated true non-competes with forfeiture clauses, finding they accomplished the same results. That's not necessarily true. A forfeiture clause may incent future performance, while a non-compete unquestionably tries to protect a separate economic interest beyond employee loyalty.

Datto illustrates the confusion in its analysis, though the district court judge admittedly was bound by controlling law. He noted, for instance, that the forfeiture clause was reasonable because "[t]his is not a case of an employee who is barred altogether from working for the competition anywhere in the world."

In my opinion, courts ought to use varying levels of scrutiny when examining restraints, similar to the current First Amendment jurisprudence. Specifically, I think that for employment-based non-competes, courts should use the strict scrutiny test (which by and large, they say they do), and for sale-of-business non-competes, they should examine them under a rational basis inquiry.

For mid-tier restrictions, like franchise non-competes and forfeiture clauses like that in Datto, I would use intermediate scrutiny. That test would require courts to determine whether the restrictive means used (e.g., the scope of the event triggering the forfeiture) are substantially related to the interest the restraint is designed to protect. This test, though it may not be perfect, would at least provide courts with a flexible, coherent way to analyze less problematic covenants that lack adhesive properties.

New York:

The New York Court of Appeals answered a significant question of damages related to trade secrets claims in the case of E.J. Brooks v. Cambridge Security Seals. The Court held that a plaintiff's damages cannot be measured by the costs the defendant avoided due to unlawful activity.

If a principal goal of trade secret law is to encourage innovation, then a cost-avoidance theory of damages seems to be a logical means to further that goal. Stated another way, if the misappropriation shortens a product-development cycle and enables X to bring a product to market more efficiently, then X is unjustly enriched by not incurring research-and-development expenses.

In the Court's view, cost-avoidance is inconsistent with a compensatory theory of damages. And under New York law, only the plaintiff's losses count. Cost-avoidance theory resembles unjust enrichment, but because New York has not adopted some variation of the Uniform Trade Secrets Act -- which specifically allows for unjust enrichment-type damages -- the theory is not viable.

The holding, predictably, spurred a long and persuasive dissent. It summarized the pragmatism and utility of cost-avoidance damages, noting that they are "generally much simpler than, and less subject to challenge than, lost-profit damages, which makes them an attractive alternative for plaintiffs who are willing to forego a potentially larger recovery in favor of a smaller, more certain one." (The assumption of a "smaller" recovery reasonably invokes the principle that a developer does not spend X to recover X. Normally, a rational economic actor would spend X to recover some multiple of X.)

A link to E.J. Brooks is available here. I emphasize again that I view this as a distinctly New York rule of law, and not one likely to be adopted across jurisdictions that have embraced a more flexible approach to damages.

South Carolina:

In Hartsock v. Goodyear Dunlop Tires North America, Ltd., the Supreme Court of South Carolina recognized an evidentiary privilege for trade secrets, but held the privilege was "qualified." That means it is different than, say, an attorney-client privilege or one barring self-incrimination. By "qualified," the Court held that a party seeking the disclosure of trade-secret material must show a "substantial need" for it that is relevant to the specific issues involved in the litigation. If a proponent makes that showing, the trade-secret holder still can gain the benefit of a protective order over the compelled disclosure.

The decision is, to be certain, a weird one. This is not really a privilege rule, but rather a rule of discovery that calls upon courts to make a balancing decision. If anything, this rule will create confusion where none should exist.

Texas:

Everything is bigger in Texas, including damages and attorneys' fee judgments. In the long-running case of Quantlab Technologies v. Godlevsky, a federal district court awarded the plaintiff its attorneys' fees in a trade secrets suit for what the court called defense behavior that was "so acrimonious, vexatious, and indefensible that...[it] exceeds any that this judge has seen in his nineteen years on the bench." The case involved stolen technology in the high-frequency trading industry, and the court at various times had sanctioned the defendants for destroying or failing to preserve evidence.

The price for that behavior was a fee judgment of $3,220,205 against each individual defendant.

The plaintiff didn't fare so well in GE Betz v. Moffitt-Johnston. There, the Fifth Circuit held that under Texas law, a company failed prove than ex-employee breached a customer non-solicitation covenant. The employee succeeded despite "highly suspicious" computer activity, including the mass download of data to an external device. But the company couldn't prove that any contacts with customers amounted to solicitation of business, rendering the contract claim unsupportable.

The Fifth Circuit did, however, vacate a large fee award for the ex-employee. Texas law allows an employee sued on a non-compete violation to obtain fees if the employer knows the agreement is overbroad and sues to enforce the agreement to an extent greater than necessary to protect the employer's interests. That's a hard standard to meet, absent some damaging admission or a truly terrible agreement. And the employee here didn't do so. 

Much Overdue Case Law Update, Part II

This week, I offer my second case-law update, highlighting a variety of cases from around the company on topics of interest.

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Indiana Court Affirms Nationwide Non-Compete Agreement

Last Friday, the Court of Appeals of Indiana addressed the enforceability of a nationwide non-compete agreement for an engineer in the glass container business. The facts follow a typical pattern and deal generally with a senior-level engineer's move from Ardagh Glass Containers to Owens-Illinois. (As an aside, my paternal grandfather worked at Owens-Illinois for something like 35 years, during which time he consumed approximately 364,000 unfiltered Camel cigarettes working the assembly line, kind of a poor man's Don Draper in this respect.)

The employee's non-compete barred his work anywhere in North America and covered products over which the employee contributed development knowledge. The Court of Appeals, applying Pennsylvania law, enforced the non-compete, reasoning that both Ardagh and Owens competed nationally for the same type of customers. The court also remarked on a few typical facts in enforcing the preliminary injunction: (1) the employee's lack of candor on a few important facts that pertained to consideration and his "paid-leave" status at Owens-Illinois; and (2) the employee's lack of urgency in contesting the preliminary injunction and the appeal.

Of greater concern was the court's breezy trade-secrets analysis, which seemed to excuse an improper trade secrets identification at trial. The court all but found the injunction order was too broad in finding that Ardagh Glass identified 16 categories of trade secrets that were at risk. And it found Ardagh Glass would need to do better at a permanent injunction hearing. But the court was not engaged at all in assessing whether the at-risk secrets were actually "threatened" from misappropriation.

A link to the Court of Appeals' decision in Vickery v. Ardagh Glass Inc. is available here.

Forfeiture-on-Termination Clause Found Unenforceable

This one is crazy.

Kelley Rieves took a job as an assistant manager at Buc-ee's - a convenience store chain in Texas. It was at that point that Buc-ee's and its cadre of lawyers foisted upon her a historically stupid agreement. Rieves had the ability to decide how she was going to get paid - but it had to be a split between hourly wages and a flat monthly amount.

The catch? The flat amount had to be repaid to Buc-ee's if Rieves (at at-will employee) left within 5 years and didn't give 6 months' notice. This is known (by me) as the stick-without-the-carrot approach. Rieves and Buc-ee's re-upped a year later with a similar arrangement. Rieves, of course, left before the 5-year period ended and filed suit to declare the repayment provision unenforceable. Somehow, Buc-ee's convinced a state court judge to enter an award for payment of the entire amount owed (less taxes) under the contract's repayment clause.

Rieves appealed and, mercifully, won. Common sense prevailed. The reason? A repayment clause inhibits employee mobility. And unless the contract is consistent with non-compete law, it's unenforceable. The salary disgorgement provision, here, was totally unlike a prototypical forfeiture clause that would, for instance, cancel unvested stock options if the employee leaves to compete. Instead, it had no connection to incentivizing the employee's future performance, imposing an illogical and disproportionate penalty on an at-will employee's election to find a better job.

Buc-ee's should be publicly shamed for requiring Rieves to sign such a manifestly stupid agreement. For now, at least we have a public opinion - available here - that will prevent any sort of spurious litigation like this in the future.

Federal Circuit Affirms $91 Million Trade Secrets Verdict

In an unpublished ruling, the Court of Appeals for the Federal Circuit affirmed a $91 million trade-secrets verdict arising out of a business transaction gone wrong in the mitral-valve implant market. The particular invention at issue in that case arose after Neovasc sought to collaborate with CardiAQ and provide CardiAQ with ancillary products. During the course of their relationship, Neovasc apparently designed a competing transcatheter mitral valve implant that was similar to the one CardiAQ had developed. Neovasc learned of the TMVI device after signing a non-disclosure agreement.

The Federal Circuit approved the district court's award of $70 million in compensatory damages and $21 million in enhanced damages (along with an 18-month head-start injunction). The court rejected several claims Neovasc had made concerning the trade secret instructions given to the jury. And it further found CariaAQ's royalty damages testimony was supported by the evidence. This is yet another in a series of high-damage trade secrets judgments we've seen over the past several years.

A copy of the unpublished disposition is available here.

Rule 5.6 and the Indirect Restraint

We lawyers love to make rules for ourselves.

As a regulated profession, lawyers are bound by their state's Code of Ethics. And while many of those provisions have nothing to do with competition, one rule in particular stands out. Model Rule 5.6 is the most widely known public-policy exception that invalidates non-competes. Through its text, Rule 5.6 prohibits a lawyer from entering into an agreement that "restricts the rights of a lawyer to practice after termination of the relationship, except an agreement concerning benefits upon retirement." Clients that come to me with a non-compete just love to hear that, legally, I can't even have one.

Despite the relatively clear nature of the rule, courts have not treated it uniformly and its bounds are not well-defined. Without fail, pure non-competition agreements are invalid. Therefore, lawyers cannot be bound by agreements that restrict their practice area or ability to service specific clients.

The more vexing question concerns the indirect restraint, known commonly as forfeiture-for-competition clauses. A typical forfeiture clause provides that an attorney who withdraws from the firm (normally an equity partner) suffers a reduction of what she otherwise is owed if she takes her clients with her. The contract, therefore, does not prohibit competition but amounts to an indirect restraint. It places a financial disincentive on competing directly for firm clients.

Is such an indirect restraint an impermissible restriction on the lawyer's right to practice. New York courts, for instance, have said "yes," that such clauses are unenforceable and against public policy. The state's Court of Appeals has said that a forfeiture-for-competition provision "would functionally and realistically discourages and foreclose a withdrawing partner from serving clients who might wish to continue to be represented by the withdrawing lawyer and would thus interfere with the client's choice of counsel."

One of the law's great anomalies is that the opposite view comes from the Supreme Court of California, where as a matter of policy non-competes are unenforceable in all lines of work. The Court in that case upheld a partnership provision that caused a withdrawing partner to forfeit withdrawal benefits if he practiced insurance defense work in a particular locale. The Court upheld the agreement, focusing on the changing nature of the law practice. In the Court's view, "these agreements address important business interests of law firms that can no longer be ignored." In fairness to this California decision and its seeming incongruity from the rest of non-compete law, the state's broad public policy restriction on non-competes does not apply to partnership contracts. So to this end, the state statute known as Section 16600 cannot provide a collateral source of rights for attorneys to attack forfeiture-for-competition clauses.

For its part, Maine goes further than California and declined to adopt an ethics rule similar to Rule 5.6. Lawyers, therefore, are free to sign non-competes without running afoul of that state's code of conduct. Just recently, a federal court in the District of Columbia - which had not addressed the scope of Rule 5.6 - predicted that it would follow New York's majority rule and bar indirect restraints.

Like many areas of non-compete law, this one is relatively unclear and varies from state to state. However, if lawyers are confused about the types of agreements to which they can be bound, they shouldn't expect sympathy from their clients in the real world. The landscape there is even more unsettled.

South Carolina Appellate Court: Physicians' Liquidated Damages Clauses Enforceable

I have written frequently on this blog concerning the subject of liquidated damages. A pre-determined formula or amount of damages is particularly appropriate for non-compete disputes for three primary reasons.

First, proving lost profits can be difficult and requires a company to develop a sustainable, sensible damages model (in my experience, too many plaintiffs never think about this until it's too late).

Second, it eliminates the transaction costs associated with proving lost profits. This requires company time and effort, and often the retention of an expert in the field.

And third, liquidated damages helps solve the time-tested riddle of whether pursuing non-compete litigation is an economically viable outcome for a company. By pre-setting damages, a plaintiff can eliminate some inherent risk and uncertainty surrounding a traditional damages presentation.

Of course, there's a downside. Liquidated damages clauses aren't easy to uphold and are frequently struck down by courts as penalties.

The Court of Appeals of South Carolina just upheld a liquidated damages provision in a physician shareholder agreement that was unlike any I've ever seen. It had several components:

If the physician violated a 20-mile non-compete tied to his or her interventional cardiology practice, then the physician:

(1) forfeited $60,000 in deferred compensation (the payment meant to provide fresh consideration for the new contract);

(2) owed 100 % of the physician's prior year's income with the medical practice;

(3) was divested of a defined share of accounts receivable owed the medical practice; and

(4) was divested of earned but unpaid salary.

If the physician paid the amounts, then he or she was free to compete.

The amounts subject to the liquidated damages clause, as might be expected for the profession, were several hundred thousand dollars per physician. But the Court of Appeals upheld the contract, reasoning that the economic impact from competing in violation of the contract was inherently difficult to calculate and further reasoning that the formulas were tied to what the practice could have expected to receive had the physicians complied with the terms of the agreement.

The kicker for the Court of Appeals seemed to be the impetus behind the non-compete in the first place. The medical practice took out a $5 million loan to finance construction of a new medical office. After the physicians left to compete, the office was not fiscally sustainable - and closed.

The lesson to be learned for corporate counsel is that it is worth considering a robust liquidated damages clause and - more importantly - developing a rationale for why the formula approximates lost profits upon competition. Well thought-out clauses can add a great deal of value to actual or threatened litigation and mitigate the risk associated with developing a damages model.

The case is Baugh v. Columbia Heart Clinic, P.A., 2013 S.C. App. LEXIS 5 (S.C. Ct. App. Jan. 16, 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.

Illinois Court Approves Forfeiture Provision in Management Incentive Plan (Viad Corp. v. Houghton)

A federal district court in Chicago recently granted summary judgment in favor of an employer on a forfeiture-for-competition claim against a Senior Vice-President in the trade show design business.

Typically, forfeiture-for-competition clauses are not viewed with the same degree of skepticism and scrutiny as garden-variety non-compete restrictions. Though the effect may be deter someone from jumping ship, courts have noted that the problem of depriving someone of his or her livelihood is absent in a forfeiture case.

Still, courts struggle. Some jurisdictions - a minority, to be sure - will examine forfeiture clauses under the same analytical rubric as non-compete clauses. Others clearly do not.

Illinois has a mixed bag of cases from which to glean guiding principles. Judge Dow in Viad Corp. v. Houghton examined a forfeiture provision in a management incentive plan. That plan contained a clause that required repayment of incentive income (called "special compensation") received within the year prior to departure if the employee quit to compete.

The court, though stating it did not believe a non-compete analysis applied at all, was nonetheless careful and held the clause reasonable under the admitted facts. Of particular importance was the fact that the special compensation was designed to incent a participant's future performance with the company, was not part of "regular wages", and was an entirely voluntary election. The court did not discuss the recent Kelly Bires case, which looked at a forfeiture provision in a royalty agreement. The court in Bires was likely persuaded by the lengthy forfeiture term - 10 years.

For employers, forfeiture-for-competition provisions are gaining in popularity, due in large part to their ease of enforcement and the fact they can achieve the same goals as a non-compete. Covenants tied to incentive-based income (e.g., stock options) are presumptively reasonable, and courts only will examine whether the employee's post-termination activities fell within the competition provision and whether the employer properly exercised a clawback or forfeiture decision.

One other point is worth noting for practitioners and clients alike. If the forfeiture concerns regularly earned income (such as commissions), not only is a court much more likely to examine the clause under a traditional non-compete test, but also it could be void under state wage payment laws.

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Court: United States District Court for the Northern District of Illinois
Opinion Date: 2/26/10
Cite: Viad Corp. v. Houghton, 2010 U.S. Dist. LEXIS 17447 (N.D. Ill. Feb. 26, 2010)
Favors: Employer
Law: Illinois

Kelly Bires' Deal With TD Racing Held Unfair Restraint of Trade (Bires v. WalTom)

To what extent are compensation forfeiture provisions adjudicated under non-compete standards?

This is a question that has vexed Illinois courts - state and federal - for many years, and the case precedents yield no clear answer. Jurisdictions are split on whether forfeiture-for-competition provisions should be analyzed as a de facto restraint of trade or under ordinary freedom of contract principles.

Recently, a case involving a high-profile athlete has shed new light on how courts view forfeiture clauses. Kelly Bires is a successful NASCAR driver who previously signed a "Driver Agreement" with WalTom (since sold to TD Racing Development). Among other provisions, Bires agreed to pay a 25% royalty on future race-related earnings to WalTom for a period of ten years following the time in which he ceased driving on the WalTom team.

Bires, in a wide-ranging dispute, challenged the royalty provision as an unenforceable restraint of trade under Illinois law. Bires just recently inked a new deal with JR Motorsports, which is managed by the Earnhardt family. A federal court in Chicago agreed with him and granted him a judgment declaring the royalty provision unenforceable.

The court relied on a 1973 precedent from the Appellate Court of Illinois, which involved a true forfeiture-for-competition clause in the insurance industry to conclude that a provision which is not a restraint in the actual sense (that is, WalTom could not prevent or enjoin Bires from competing for another racing team) can be considered one if the intent of the clause is to discourage competition. The court examined WalTom's statement that it expected to earn close to $7 million from the royalty provision and had little trouble concluding that the contract had to be examined under the strict scrutiny standard applicable to non-compete agreements.

Under that analysis, the court's task seemed fairly simple. The royalty provision had no geographic term, but the court rightfully downplayed this as a significant factor. (NASCAR competes everywhere, so a geographic term would have little meaning). However, the ten-year post-affiliation royalty provision was overbroad - as was the definition of "race-related earnings" to which the royalty rate attached. It included virtually any income derived from any entertainment medium, extending well beyond true race earnings.

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Court: United States District Court for the Northern District of Illinois
Opinion Date: 9/23/09
Cite: Bires v. WalTom, LLC, 662 F. Supp. 2d 1019 (N.D. Ill. 2009)
Favors: N/A
Law: Illinois

Forfeiture-for-Competition Clause Held to Be Reasonable Non-Compete (Medtronic v. Hedemark)

I wrote a few weeks ago about forfeiture-for-competition clauses, a different type of restrictive covenant that leaves an employee with a choice to compete at the price of relinquishing deferred compensation or stock option proceeds.

Though there is a divergence of opinion on the issue, the majority of courts hold that forfeiture covenants will not be construed as non-compete agreements and thereby require an overlay of reasonableness. As my prior post indicates, the case authority adopting the minority view, however, is prevalent.

In Medtronic v. Hedemark, the Court of Appeals of Minnesota examined a forfeiture-for-competition clause in a stock option award agreement as a de facto non-compete agreement. In that case, Hedemark's agreement provided that, if he left to join a competitor within six months of exercising stock options granted to him under Medtronic's plan, he had to pay back those proceeds on demand. The court granted summary judgment in favor of Medtronic but denied the company's request for attorneys' fees.

The case analysis proceeded to examine the forfeiture clause as a restrictive covenant, even though technically Hedemark was free to compete (albeit at a price). The court found that the covenant supported a legitimate business interest in promoting employee loyalty and stable relationships between the sales force and company customers.

The court also found the forfeiture clause reasonable in scope. In particular, the court focused on the degree of control Hedemark retained over the clause's application. All Hedemark had to do was wait six months from the time the options were exercised to leave and join a competitor. The case does not address at what period of time this may become unreasonable. Finally, the court was not troubled by the lack of a territorial limitation on the forfeiture clause. In Minnesota, non-competes without territorial limits are "often held to be unreasonable."

Even if viewed as a non-compete, the issue of reasonableness will tend to favor employers in forfeiture-for-competition clauses unless there is an overbroad definition of "competitive business" or if the clawback period stretches on for several years.

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Court: Court of Appeals of Minnesota
Opinion Date: 3/3/09
Cite: Medtronic, Inc. v. Hedemark, 2009 Minn. App. Unpub. LEXIS 233 (Minn. Ct. App. Mar. 3, 2009)
Favors: Employer
Law: Minnesota

Texas Strictly Construes Forfeiture-for-Competition Clause (Valley Diagnostic Clinic v. Dougherty)

Not all restraints of trade are treated equally. In virtually all jurisdictions, covenants ancillary to an employment contract are subject to strict scrutiny for reasonableness and undue hardship. On the other hand, courts readily enforce sale-of-business covenants. And non-compete clauses which are ancillary to other relationships, such as distributorship agreements, can fall into either category depending on the facts and the bargaining position of the parties involved.

Another category of covenants has received comparatively little judicial scrutiny over the years. Forfeiture-for-competition clauses do not, technically, restrain an employee from working in a particularly industry, but they exact a price for doing so. A typical forfeiture covenant arises when an employer provides an incentive to an employee to stay with the company for a period of time. The incentive typically is some form of deferred compensation or stock options. Agreements are written to grant an employer the ability to not only forfeit unpaid compensation or vested options, but also to clawback income paid out pursuant to the incentive plan for, say, the year preceding termination.

Courts have taken two general approaches to resolving the validity or enforceability of these restraints. The majority view does not view a forfeiture provision as a restrictive covenant, and in jurisdictions adopting this view, the forfeiture clause will not be subject to a reasonableness inquiry. Courts in Missouri, Indiana and New York follow this line of reasoning.

A second, and minority, line of cases will examine the forfeiture clause as a restrictive covenant, reasoning that the intent of the arrangement is to restrain competition - if not in language, then certainly in impact. Nebraska, Wisconsin and Connecticut take a more dim view of forfeiture provisions. In Illinois, the cases cut both ways.

Add Texas to the minority. In Valley Diagnostic Clinic v. Dougherty, the Court of Appeals of Texas held that a forfeiture-for-competition clause within a medical practice's bylaws will be construed under Texas' Covenants Not to Compete Act because the intent was clearly to restrain competition with the medical practice by a departing shareholder. Under the facts of the case, the forfeiture provision was invalid because it was not designed to enforce any return promise on the part of the shareholder. The precise holding was based on an antiquated and confusing line of Texas cases interpreting its ancillarity requirement for non-competes.

The decision holding that a forfeiture clause is subject to strict non-compete scrutiny arguably contravenes a 1975 Texas case, Dollgener v. Robinson Fleet Services. That case clearly held that a forfeiture provision within a non-contributory profit-sharing plan was not subject to a restrictive covenants analysis because it was not a negative employment covenant. Though the court did not discuss Dollgener, it is possible the Texas legislature's enactment of the Covenants Not to Compete Act abrogated the older line of cases. Still, had it done so, the court should have discussed the ruling and clarified the law in this regard.

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Court: Court of Appeals of Texas, Thirteenth District
Opinion Date: 2/12/09
Cite: Valley Diagnostic Clinic, P.A. v. Dougherty, 287 S.W.3d 151 (Tex. App. 2009)
Favors: Employee
Law: Texas