Restriction on Working With "Potential Customers" Held Invalid (Church Mutual Ins. Co. v. Copenhaver)

It is common for a non-solicitation covenant to extend beyond existing customers and cover prospects or potential accounts. Any territory-based non-compete accomplishes the same thing. If you can't contact customers in a certain defined region, almost by definition this will include both existing and potential customers (unless the employer has a customer monopoly).

But provisions that apply this broadly are not always valid. A recent case out of Arkansas proves this point. In Church Mutual Ins. Co. v. Copenhaver, two insurance company sales representatives were sued for violating a customer non-solicitation covenant which prevented them from selling or soliciting property and casualty insurance to churches or other religious institutions for three years within their assigned geographic territories.

The agents left, joined a competitor, and immediately increased the new employer's premiums attributable churches by a factor of five. The former employer sued to enforce the non-solicitation covenant. The court concluded that the covenant was invalid because it was broader than necessary to protect the employer's legitimate business interest in its church clients.

Specifically, the court found that the covenant extended to all churches and religious institutions in a certain territory, which meant it captured non-customers. That was too restrictive under Arkansas law. Additionally, the court found some vagueness in the term "religious institutions", opining that it could mean faith-based schools or hospitals. This ambiguity rendered it overbroad.

Lawyers drafting non-solicitation covenants must be aware of a particular jurisdiction's laws as it pertains to protectable interests. Many jurisdictions will take a very narrow view of what an employer is entitled to protect. In a state that will not blue-pencil (such as Arkansas), even the slightest drafting mistake can render the enforceable part of the covenants invalid.

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Court: United States District Court for the Eastern District of Arkansas
Opinion Date: 5/24/10
Cite: Church Mutual Ins. Co. v. Copenhaver, 2010 U.S. Dist. LEXIS 51268 (E.D. Ark. May 24, 2010)
Favors: Employee
Law: Arkansas

Geographic Restrictions Require Court to Consider Where Competition Takes Place (Concrete Surface Innovations v. McCarty)

It is less and less common these days for parties to fight over industry non-compete agreements, particularly when client non-solicitation covenants will do the trick. As readers of this blog know, the difference in the type of restriction is important when analyzing the reasonableness standard.

For client non-solicitation agreements, geographic restrictions are not necessary provided there is some discernible limit on the clients that are off-limits to the employee. (By way of example, a restraint prohibiting competition with past clients or prospective clients with whom the employee never developed a relationship are at risk of being struck down). But in the vast majority of industry non-compete arrangements (which limit work altogether), geographic restrictions are necessary and require careful analysis.

Measuring the scope of the geographic restraint requires some actual thought, however. Take for example a covenant that provides that an employee cannot compete within 10 miles of his former employer's office. Does this mean the employee cannot open an office or live within that restriction?

Generally, no. It is where the competition occurs that matters. Of course, if the employee is a doctor or provides services in that office, then the 10-mile restraint would apply and prohibit competition. But if the employee provides services to clients outside the 10-mile radius, then the location of his home or office is irrelevant.

A federal district court in Florida recently said as much, rejecting the employer's argument that the location of the employee's new office was the critical inquiry. Instead, the court looked at where the employee was actually providing services to clients. Since those services were not in the office and instead on-site at a client, the office location was irrelevant.

This analysis from Concrete Surface Innovations v. McCarty is useful for analyzing the scope of covenants when an employee solicits or services clients outside a prohibited geographic scope. It's the location of the client that matters, because that is where the competition is occurring.

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Court: United States District Court for the Middle District of Florida
Opinion Date: 5/13/10
Cite: Concrete Surface Innovations, Inc. v. McCarty, 2010 U.S. Dist. LEXIS 56045 (M.D. Fla. May 13, 2010)
Favors: Employee
Law: Florida

Allocating the Cost of Electronic Discovery In Competition Cases (Genworth Financial v. McMullan)

Electronic discovery is the new frontier in unfair competition cases. Many times, employers will be able to obtain evidence that departing employees e-mailed to themselves clearly proprietary customer lists or downloaded information to a flash drive prior to departing. This conduct raises a host of issues, including potential liability under the Computer Fraud and Abuse Act.

The question courts have struggled with is how to allocate the cost of electronic discovery, as forensic imaging and data recovery expenses can be extraordinary in terms of absolute dollars. There are a number of approaches courts can take, but the presumption under the Federal Rules of Civil Procedure is that the responding party must bear the expense of complying with discovery requests.

Magistrate Judge Grimm has determined that Rule 26 actually guides courts in balancing the factors to determine who should bear the cost of e-discovery. Among the factors to be considered:

(1) whether the discovery sought is cumulative;
(2) whether the discovery sought is obtainable from another reliable source;
(3) whether the requesting party already has had an opportunity to obtain the information;
(4) whether the burden of discovery outweighs its potential benefit.

Several other courts have outlined other factors to consider as well, with some evaluating total costs of production and the importance of the information.

In cases where the departing employees have not preserved evidence or have taken active steps to delete information, courts have the ability to step in and appoint a third-party forensic expert. The question of cost-shifting becomes more nuanced in those situations, and courts again have to weigh factors in assessing which party bears the burden of expense.

A good example of this is the recent case of Genworth Financial v. McMullan. In that case, former employees left Genworth Financial and established a rival entity. The defendants apparently took copies of the plaintiff's ACT database (full of client information) prior to their staggered departures.

After Genworth sued, it noted that certain information it expected to receive in discovery was not provided. Genworth sought some assurances from the defendants that information was being preserved, so that temporary and inactive files were not being deleted or overwritten. The defendants' counsel indicated that they had no intention of imaging the hard-drives. Genworth then filed a motion to have the court appoint a neutral expert to mirror-image the defendants' computers and media devices.

The court granted the motion with relative ease, particularly given the evidence that certain of the defendants in fact transmitted valuable Genworth information to his home computer. Of more importance to the court was one defendant's admission that he discarded the computer hard-drive after receiving a litigation hold letter from Genworth's counsel - clear evidence that he intentionally spoliated evidence. Finally, the court noted that the defendants' transmission of client information to their home computers was not isolated; an overwhelming amount of valuable data was in fact sent.

Accordingly, the court found a sufficient nexus between the trade secrets claim and the computers at issue to justify appointment of a mirror-imaging expert. The protocol for such imaging followed a three-step process. The expert had to (1) image of the computers; (2) recover deleted data and organize the same into a reasonable searchable form; and (3) allow defendants' counsel to examine the data for privilege and responsiveness.

The cost allocation was addressed last. Given defendants' culpability and spoliation of evidence, it had to bear 80 percent of the neutral expert's recovery cost, while the plaintiff had to pay for the remaining 20 percent. The court also awarded the plaintiff recovery of its attorneys' fees.

The takeaways from this case are numerous, but here are three important points to remember:

(1) Spoliation or failure to preserve evidence once under a duty imposed by law can be costly and lead to sanctions;
(2) Courts have discretion to involve neutral experts to manage certain aspects of e-discovery, particularly if the responding party has been obstinate or uncooperative; and
(3) Allocation of the costs of e-discovery, even in the face of clear spoliation, is not subject to any formula and varies widely from case to case, with the requesting party likely to bear some expense regardless of the responding party's culpability.

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Court: United States District Court for the District of Connecticut
Opinion Date: 6/1/10
Cite: Genworth Financial Wealth Mgmt., Inc. v. McMullan, 267 F.R.D. 443 (D. Conn. 2010)
Favors: Employer
Law: Federal Rules of Civil Procedure

The "White-Hat" Effect, Once Again (Peavey Electronics Corp. v. Pinske)

I have written before about the proverbial "white-hat." If you're wearing it in a competition lawsuit, you're likely to win.

A perfect example of this can be found in a recent preliminary injunction proceeding arising out of Mississippi. At issue was an industry-wide non-compete signed by the general manager of an audio products supplier. The agreement prohibited the employee from working for a competitor within any geographic area in which the employer conducted business.

After the employee was terminated, he moved to California and worked for an audio engineering firm as director of sales. The employer waited several months to file suit and could not show that the employee attempted to solicit any former customers. In fact, the employer had to admit that it was unaware of any projects in which it competed with the employee's new company for any customers.

The court had little trouble concluding that the non-compete was not necessary for protection of any legitimate business interest. It even suggested that if the employee violated the covenant, the employer could seek money damages - a position that may not be entirely correct.

So when does the employee wear the "white-hat"? Well, the ultimate "white-hat" position is to argue successfully that there has been no breach. But, as I have written on numerous occasions, non-compete cases generally turn out favorably for employees when the following facts are absent, even if there is a technical breach:

(1) No direct solicitation of the employee's accounts;
(2) No misuse of company data or information; and
(3) No pre-termination conduct that is suspect, dishonest or shady.

There are always exceptions, and employees do win cases when some combination of those facts is present. But avoiding these three problem areas usually results in an employee-friendly outcome.

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Court: United States District Court for the Southern District of Mississippi
Opinion Date: 6/1/10
Cite: Peavey Electronics Corp. v. Pinske, 2010 U.S. Dist. LEXIS 53616 (S.D. Miss. June 1, 2010)
Favors: Employee
Law: Mississippi

Asset Purchase Agreement Did Not Transfer Right to Enforce Non-Compete (JSC Terminal v. Farris)

The transfer of a business, either by way of stock sale, asset sale or merger, always yields interesting issues concerning existing non-compete arrangements.

In many cases, employees who suddenly find themselves with new ownership may be saddled with unforeseen circumstances, such as reporting to a new manager and facing a cut in incentive pay. Usually, these changes do not allow an employee to break a valid covenant.

However, the issue of whether a covenant has been (or can be) assigned to a new business owner is a much more nuanced question of law. In some states, assignments are prohibited. In others, the employment contract must speak directly to the question and permit assignments. Finally, some states allow implied assignments.

But, as with anything else, contract language still governs. And that includes the underlying sale documents themselves. A perfect illustration arose when JSC Terminal bought the assets of MidWest Terminal. MidWest transferred to JSC all fixed assets and "all other assets, whether tangible or intangible, which are required and necessary to operate the business." Employee Paul Farris was fired by JSC, hired by a competitor, and sought to solicit JSC's accounts.

A federal court in Kentucky held that the language in the Asset Purchase Agreement between MidWest and JSC did not transfer employment agreement obligations. In particular, the court noted that non-compete arrangements, which are certainly valuable and favored in Kentucky, were not necessary to operate a firm's business.

The court may have been helped by two additional facts: Farris' contract permitted assignment only if MidWest's successors were related to the then-owners of the company and the APA indicated JSC had no obligations to MidWest's employees following closing. While the latter fact was certainly not dispositive of the assignment issue, it was suggestive of the clean break in employment relationships envisioned by the parties as of the closing date.

The key factor in the case, though, was the limited language in the APA concerning transfer of assets. What is interesting is how an employee like Farris would learn of the APA's terms before deciding on whether post-employment competition was permitted or prohibited.

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Court: United States District Court for the Western District of Kentucky
Opinion Date: 5/27/10
Cite: JSC Terminal, LLC v. Farris, 2010 U.S. Dist. LEXIS 52481 (W.D. Ky. May 27, 2010)
Favors: Employee
Law: Kentucky

Supreme Court of South Carolina Holds Trial Court Cannot Rewrite Territorial Restriction (Poynter Investments v. Century Builders of Piedmont)

South Carolina is a state with a fairly strict blue-pencil rule, meaning that drafting is at a premium. Because judges cannot rewrite parties' agreements for them, a non-compete will stand or fall on its own, with courts able to strike only certain terms to avoid overbreadth problems.

The Supreme Court of South Carolina issued another ruling illustrating the narrow scope of its blue-pencil rule in a sale-of-business non-compete. The trial court determined that the seller of a business should be enjoined from violating the covenant, but issued a ruling which modified the geographical scope of the contract beyond what South Carolina courts permit.

The non-compete at issue contained a step-down clause (a topic on which I recently wrote), first providing that it would extend to an area of 75 miles from the principal place of business. If that were unenforceable, the covenant would be limited to Greenville County and any county that borders it. If that were unenforceable, the covenant then would be limited to just Greenville County.

The court went with the last step-down clause and enforced the covenant only in Greenville County. Its error was apparently trying to craft some compromise among the various step-down provisions. The court held the seller was enjoined from competing within Greenville County and an area within 15 miles from the principal place of business.

The latter part of the order, the 15-mile restraint, was an addition to the non-compete's geographic term. While it may not seem unfair or unreasonable, the court's modification of the covenant went beyond what South Carolina courts permit. In a state that employs the equitable modification rule, the result likely would have survived appellate scrutiny.

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Court: Supreme Court of South Carolina
Opinion Date: 5/24/10
Cite: Poynter Investments, Inc. v. Century Builders of Piedmont, Inc., 694 S.E.2d 15 (S.C. 2010)
Favors: Employee
Law: South Carolina

What Are the Limits on "Preparing to Compete"?

Most jurisdictions recognize that employees are able to plan, outfit and form a competitor prior to the time they quit without running afoul of their fiduciary duty of loyalty. The law concerning fiduciary duties is best understood as a gap-filler that will prohibit unfair competition, particularly when a non-compete agreement is absent or unenforceable.

This doctrine - allowing an employee to prepare to compete - has its limits, of course, and like much of the law concerning unfair competition, a lot has to do with the equities.

What is permissible? Again, that all depends, but here is a basic list of permissible preparatory activities:

1. Incorporating or organizing a business entity
2. Developing a business plan
3. Negotiating an office lease
4. Establishing a bank account
5. Raising capital
6. Purchasing a competing business (if those intentions are disclosed prior to closing)
7. Identifying potential clients or sources of supply

What is prohibited? The touchstone inquiry will be demonstrable, actual competition, not preliminary steps to compete. Another non-exhaustive list:

1. Using employer information to develop account lists
2. Selling or making sales proposals to customers prior to resignation
3. Downloading ex-employer confidential information for use in the new venture
4. Failing to follow through on sales leads in the hopes of saving that account for future competitive activity
5. Taking a corporate opportunity and failing to tender it to the employer

An employee can certainly plan a competing venture so that on the day following resignation, she is able to start contacting customers and generating sales. Most courts will look at how active an employee was in actually competing - not just preparing to compete - in assessing whether the employee has violated a common law fiduciary duty of loyalty.

Remember: this body of law tends to place limits on competition in the absence of a non-compete. Just because an employee has no post-employment non-compete agreement in place does not mean the preparing to compete doctrine can somehow be extended or rendered inapplicable.

Recently, I have seen a number of employee non-compete agreements that contain not only customer covenants, but also prohibit an employee by contract from preparing to compete. It is not clear to me that this type of restriction has any real teeth, or how a court would analyze such a restriction in light of the common law preparing to compete doctrine. In fact, it is difficult to assess what the remedy would be for such a breach as long as there is no actual competition prior to resignation.

Another Illinois Court Fails to Cite to Sunbelt Rentals (Peckham v. Metal Management, Inc.)

Perhaps the Sunbelt Rentals case will not have the impact in Illinois that many lawyers think.

As many readers know by now, one district of the Illinois Appellate Court last year tried to work a sweeping change to the way non-compete contracts are scrutinized by courts. Prior to last year's decision in Sunbelt Rentals v. Ehlers, courts in Illinois generally followed the majority of jurisdictions in looking at two primary factors to determine whether a non-compete contract was enforceable:

(1) Is it reasonable in terms of time, territory and scope restrictions?

and

(2) Does the covenant support, or protect, a legitimate business interest?

In Sunbelt Rentals, the Fourth District Appellate Court held there was no binding Supreme Court precedent allowing the second inquiry to proceed. Accordingly, in one division of the Illinois Appellate Courts, a non-compete contract is judged solely under the reasonableness criteria.

However, the ruling has not had much impact outside the Fourth District. In several cases, both state and federal, courts have either discounted Sunbelt Rentals as an outlier case of little value, or have ignored it altogether.

And so it happened again.

This time, the case arose in Southern Illinois in a dispute between Robert Peckham and Sims Metal Management. When Peckham was fired from SMM in 2010, he sued to declare his non-compete contract unenforceable. SMM countersued and sought preliminary injunctive relief. In denying the injunction, the court examined whether the non-compete covenant supported a legitimate business interest in customer contacts or access to proprietary information.

Not only did the court not cite Sunbelt Rentals, it relied on the case Sunbelt Rentals purported to overrule when finding that the non-compete supported no legitimate business interest.

Also of consequence, the court found no consideration to support the non-compete agreement. The court believed that a six-month term of employment with no payment for the covenant itself rendered the agreement unenforceable. It is not clear whether Peckham worked at SMM prior to signing the covenant or whether it was signed at the inception of his employment. If it was the latter, the court's finding almost certainly would be erroneous.

The court had to be persuaded by the fact that Peckham was terminated involuntarily. This case is another example of a court ruling in favor of the employee wearing the white-hat. It was clear SMM went after Peckham when he posed no real threat to it, and when there was no evidence Peckham competed unfairly with SMM by using misappropriated information. Particularly given the involuntary termination, SMM was swimming upstream from the start on this one.

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Court: United States District Court for the Southern District of Illinois
Opinion Date: 5/5/10
Cite: Peckham v. Metal Management, Inc., 2010 U.S. Dist. LEXIS 43784 (S.D. Ill. May 5, 2010)
Favors: Employee
Law: Illinois

"Nominal Damages" Really Means Nominal (Roberson and Penhall Co. v. C.P. Allen Construction)

Virtually all jurisdictions provide that if a plaintiff cannot prove actual, recoverable damages for a breach of contract claim, it may still be entitled to receive nominal damages. Outside of triggering fee-shifting, there is really no utility to exploring issuesconcerning nominal damages at all.

Except when a court determines that nominal damages imposed against a dispatcher for violating a non-solicitation covenant should be $25,000.

That non-sensical ruling arose out of an Alabama case involving a breach of an employee non-solicitation agreement. James Roberson solicited his ex-employer's customers in violation of a two-year non-solicitation covenant. The employer had a hard time establishing actual damages - perhaps because the plaintiff's corporate representative admitted at trial that he had "no idea" how much business his company had lost on account of the breach. An admission like this usually means your chances of recovery are slim.

So the court, incredibly, awarded "nominal damages" for the contract breach in the amount of $25,000 against Roberson. The appellate court had little trouble concluding that this amount was not nominal and reversed for entry of a new judgment awarding the plaintiff, if you can believe this, "a minimal amount of nominal damages." Apparently, this is different than a substantial amount of nominal damages.

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Court: Court of Civil Appeals of Alabama
Opinion Date: 5/7/10
Cite: Roberson and Penhall Co., Inc. v. C.P. Allen Construction Co., Inc., 50 So. 3d 471 (Ala. Ct. App. 2010)
Favors: Employee
Law: Alabama

Georgia Non-Compete Reform Up To Voters In November

It seems like non-compete reform in Georgia has been a slow marathon, but the finish line appears to be in sight.

As readers of this blog probably have found out, Georgia is one of those employee-friendly states where non-compete agreements are enforced much less frequently than in other jurisdictions. The reason largely has to do with Georgia's strict blue-pencil rule, which ends up invalidating a good percentage of contracts on technicalities. Even the slightest degree of overbreadth can render the entire agreement void and unenforceable.

The Georgia legislature has approved a constitutional amendment that will change non-compete law should voters ratify it in November. A simple majority is required for the constitutional amendment to take effect, which then will make non-competes easier to enforce and yield a lot less handwringing by attorneys who draft them.

There are a number of revisions that will go into effect if the amendment passes, including a grant of authority to Georgia courts to blue-pencil covenants. In addition, non-solicitation clauses can include a prohibition on acceptance of business from clients. This would overturn a line of Georgia cases that ruled such a restraint on so-called "passive" solicitation is overbroad and void against public policy. The law also sets presumptively reasonable non-compete durations: for employment, 2 years; for franchisee or distributors, 3 years; and for a seller of a business, the longer of 5 years or the time during which payments are made for the sale.

Finally, the law only applies to new agreements entered into after the effective date. Agreements existing before the effective date of the law would be examined under the old law. Georgia business attorneys should gain a nice stable of employment contract drafting work over the next year or so, assuming this constitutional amendment passes.