Permanent Injunctions and The Erie Problem

God help us all!

I am discussing the Erie v. Tompkins case from 1938. This was like the fourth most annoying case from law school, and I thought I left it once and for all in Champaign, Illinois in 1997.

But it rears its head - fittingly so, perhaps - in the tragicomedy known as E.I. duPont v. Kolon Industries. The issue, though, is one that is likely to repeat, so if for no other reason than I feel an obligation to get this issue on the table, I have to discuss this. And it's somewhat surprising that I haven't seen it come up much before.

The issue, put simply, is this: does federal or state law apply to determining whether to issue a permanent injunction in a diversity case for violation of the trade secrets act?

Why is this issue important? For injunctions arising under federal law, courts apply the so-called eBay test that requires a court to examine four factors before awarding a permanent injunction: (1) irreparable injury, (2) inadequate remedy at law, (3) balance of hardships favoring the plaintiff, and (4) that the public interest is not disserved by issuing an injunction.

This differs from the state-law approach. In many states, courts have held that if a statute authorizes a court to issue an injunction, then a plaintiff need not prove irreparable harm. Demonstrating success on the merits is enough.

Trade secrets law is governed by state law. And every state that has adopted the Uniform Trade Secrets Act (47 states) allows for injunctions to issue in trade secrets cases.

So in Kolon Industries, the Eastern District of Virginia found that the Erie doctrine applies, and a federal court must apply state substative law to determine whether a permanent injunction remedy is appropriate in a trade secrets case. Erie basically says this: on a matter of substance, a federal court must apply the law of forum state. On procedural issues, federal law applies.

My problem is not so much with the Erie-based holding in Kolon Industries, because it is hard to see a permanent injunction order as anything other than substantive. But state laws that do not apply an eBay-like test, to me, make no sense. It should never follow that because a legislature has authorized an injunction for a violation of a state statute, that the injunction should automatically be entered.

This is particularly the case when the plaintiff has damages remedies available to it. In the Kolon Industries case, DuPoint obtained compensatory damages of $919.9 million. I can see where an injunction should automatically follow if the statutory violation does not allow for the recovery of damages, such as in the case of some deceptive trade practices statutes. Or in the case of a prophylactic law applicable to a regulated industry.

But when a damages remedy is available (and indeed has been awarded), it is short-sighted to rely on the fact that a statute has authorized injunctive relief to award injunctive relief. This is not to say, of course, that Kolon Industries was wrongly decided on DuPont's entitlement to an injunction, which was clearly warranted on the facts.

"Head-Start" Rule Applies to Damages, As Well As Injunctions (Berardi's Fresh Roast v. PMD Enterprises)

The concept of a "head-start" injunction is well-established in unfair competition law. The idea of it is rather simple. In a case involving trade secrets misappropriation, a defendant may be enjoined - or prevented from using the secret - if the plaintiff can show the defendant's efforts to bring a product or service to market were substantially shortened as a result of the misappropriation.

We often see this in cases where the secret is some sort of tool used to develop a product. Take, for instance, an engineering drawing for a complex piece of equipment. A defendant who has misappropriated a proprietary drawing may try to claim he could easily reverse-engineer the drawing from the product itself. However, this may take a long time, depending of course on the complexity of the product. By short-circuiting the process and stealing a drawing, a defendant can reduce his time to market a competing product.

A plaintiff is justified in seeking relief for this head-start the defendant unfairly obtained through misappropriation of the secret product. Courts often will require a defendant to refrain from exploiting the benefits of a secret for a period commensurate with the unfair head-start.

The notion of head-start relief, however, is not limited to equitable relief. As a recent Ohio appellate decision noted, "a trade secret defendant's damages may be limited to the time the defendant saved in getting a product to market by virtue of its misappropriation." The amount of damages will be a factual question. A judge or jury must determine the actual lead-time or head-start the defendant unfairly obtained, a question often requiring detailed fact and expert testimony.

It should be noted, too, that the head-start concept applies outside the trade secrets arena. It is a very common remedy in cases of insider duty of loyalty claims. If a key employee competes unfairly before quitting and seeks to misappropriate a corporate opportunity, courts are more than willing to force the executive to sit on the sidelines for a time equal to his period of disloyalty. In this context, calculating the head-start may be much easier. Rather than figuring out how long the reverse-engineering process might be (as in a trade secrets case), a plaintiff likely need only show when a key emloyee's fiduciary breach began.

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Court: Court of Appeals of Ohio, Eighth Appellate District
Opinion Date: 10/21/10
Cite: Berard's Fresh Roast, Inc. v. PMD Enterprises, Inc., 2010 Ohio App. LEXIS 4314 (Ohio Ct. App. Oct. 21, 2010)
Favors: Employer
Law: Ohio

Equitable Extension Remedy Approved Under Maryland Law (TEKsystems, Inc v. Bolton)

The equitable extension remedy is a device that allows a court to give an employer the full benefit of the bargain if an employee is found to violate a valid restrictive covenant. In many non-compete cases, particularly those where no immediate restraining order is sought, an employee may continue to violate the non-compete covenant while the litigation is pending.

Employers seeking to enforce the agreement therefore will usually have to live with some actual competition until a court orders the employee not to work in a certain capacity or not to cultivate certain accounts. The extension remedy is a means to correct the period of time during which an employee is in actual breach.

In many states, like Illinois, the extension remedy must appear in the contract. From the employer's perspective, it is far more preferable to have a bargained-for remedy that gives it the ability to extend the non-compete for any period of time in which the employee is in breach. However, in the absence of a contractual clause specifically empowering the courts to extend the non-compete term, employers often argue for such an extension under the courts' inherent power to achieve equity.

In TEKsystems v. Bolton, a federal district court determined that Maryland law allowed for such an equitable extension, even in the absence of a contract provision granting the employer this remedy. That case, which involved the technology staffing industry, held that an 18-month, 50-mile industry non-compete covenant was valid and enforceable against a Jonathan Bolton, a Director of Strategic Accounts who developed a strong reputation and successful track record with financial services firms in New York.

The court therefore imposed an 18-month injunction against him following entry of summary judgment.

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Court: United States District Court for the District of Maryland
Opinion Date: 2/4/10
Cite: TEKsystems, Inc. v. Bolton, 2010 U.S. Dist. LEXIS 9651 (D. Md. Feb. 4, 2010)
Favors: Employer
Law: Maryland

Royalty Injunction Not Appropriate for Knowing Misappropriation of Trade Secrets (Progressive Products v. Swartz)

The Court of Appeals of Kansas recently rendered an opinion on a somewhat obscure issue of law under the Uniform Trade Secrets Act. The question involved application of a royalty injunction, under which a party found to have misappropriated trade secrets can still utilize them as long as a reasonable royalty is paid to the non-infringing party.

The case arose out of a fairly typical departing employee fact pattern. Progressive Products is engaged in the manufacture and sale of Ceram-Back, a ceramic coating for pipe elbows that lengthens the life of a pipe. Several employees left to form a competitor which manufactured the identical product under a different name. The evidence adduced at trial indicated the defendants took the formula for Ceram-Back, its mixing process, a pricing method related to the sale of Ceram-Back, price lists, and customer lists. The court of appeals was unwilling to overrule the trial court's factual determination that the information taken constituted trade secrets and that Progressive Products demonstrated misappropriation under the uniform act.

The tougher issue concerned the remedy. The trial court did not award Progressive Products any damages and refused to issue a prohibitory injunction against the defendants. Instead, it issued a royalty injunction, which conditioned the defendants' future use of the trade secrets on payment of a 20 percent royalty to Progressive Products for three years.

This remedy is found in the uniform act, which varies slightly from state to state. The court of appeals reversed this aspect of the judgment and remanded for the trial court to determine the extent of a prohibitory injunction. In Kansas, the trade secrets law allows for a royalty injunction to issue under "exceptional circumstances." That has been interpreted to include either: (a) an overriding public interest; or (b) acquisition of a trade secret in good faith, with prejudice resulting to the innocent misappropriator should a prohibitory injunction issue.

In this case, the court found the defendants could not qualify as innocent misappropriators. It disagreed with the trial court's rationale that a royalty injunction was appropriate given the interest in competition, Progressive Products' culpability in failing to protect its secrets, and the need for some trade secret protection. As a matter of law, the trial court's rationale failed to meet the applicable standard.

Had the defendants acquired the formulas and other product information innocently or in good faith, perhaps from a party who had misappropriated them, a royalty injunction might have been appropriate. But it was not in a situation involving knowing misappropriation.

In Illinois, the uniform act is not as broad and only permits a royalty injunction to issue when there is an "overriding public interest."

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Court: Court of Appeals of Kansas
Opinion Date: 4/17/09
Cite: Progressive Products, Inc. v. Swartz, 2009 Kan. App. LEXIS 167 (Kan. Ct. App. Apr. 17, 2009)
Favors: Employer
Law: Kansas

Ohio Decision Demonstrates Vagueness Problem With Trade Secrets Injunctions (Chornyak & Assoc. v. Nadler)

A recent decision out of the Ohio appellate courts demonstrates a common, amateurish mistake many attorneys make in trade secrets litigation.

On appeal, a company in the financial services industry contended the trial court improperly refused to hold its ex-employee in contempt of court for violating a permanent injunction order entered in November 2005. That order restrained defendant from "directly or indirectly, ... disclosing, using, transferring or destroying any Chornyak & Associates, Ltd. trade secret(s) as that term is defined in [Ohio Code Section] 1333.61 in any form whatsoever including originals, copies, other reproductions, derivatives, or computerized information, in any form whatsoever."

The plaintiff filed a contempt citation when its expert determined that the defendant had uploaded and used one Word document and two Excel spreadsheets generated during the course of his employment with Chornyak and which had been in his home office stored on a floppy disk. Eventually, the appellate court affirmed the trial court's determination that none of the documents constituted trade secrets of the former employer, and it upheld the trial court's denial of the contempt citation.

The more central question, though, is why the court even addressed the status of the documents as trade secrets in the first place. The underlying injunction order was patently void.

Illinois law on this issue is particularly exacting, mandating that a party seeking an order of injunctive relief spell out with reasonable specificity the exact trade secrets that are the subject of the restraint. In state court, Tseutaki v. Novicky, 158 Ill. App. 3d 505 (1st Dist. 1983), sets forth the standard, while in federal courts the landmark decision from American Can v. Mansukhani, 742 F. 2d 314 (7th Cir. 1984), delineates the law to be followed.

At bottom, a reasonable person with no legal training must be able to ascertain what documents or categories of information are subject to an order punishable by contempt. Simply incorporating the terms "trade secrets or confidential information of the Plaintiff" is too vague and not enforceable by contempt sanctions.

Poor drafting and lack of judicial oversight of such orders does no one any good. The plaintiff will not be able to rely on the order in the event the defendant uses its information, and the defendant will have to test its conduct through contempt proceedings. Great care must be taken with the drafting of injunction orders. And if the plaintiff is concerned about disclosing its trade secrets in a court order, it can always make reference to an attached schedule kept under seal in the court file.

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Court: Court of Appeals of Ohio, Tenth Appellate District
Opinion Date: 12/18/08
Cite: Chornyak & Assoc., Ltd. v. Nadler, 2008 Ohio App. LEXIS 5569 (Ohio App. Ct. Dec. 18, 2008)
Favors: Employee
Law: Ohio