Sunbelt Rentals Redux: The Same Argument Was Just Made In Michigan (Teachout Security v. Thomas)

Pardon my continued discussion of Sunbelt Rentals, but it's kind of important.

As readers know, the Appellate Courts in Illinois are in flux as to what an employer must prove to enforce a non-compete. To recap, the law in four appellate districts requires an employer to prove:

(a) that the covenant is reasonable in time, territory and scope; and
(b) that the covenant supports a recognized legitimate business information of either: (i) near-permanent customer relationships the employee would not have had access to but for his employment; or (ii) use of confidential business information.

The other appellate district dispenses with requirement (b). My point all along is that it is almost impossible to assess the notion of reasonableness without asking the employer to articulate what it is trying to protect. I think, as do many lawyers, that the legitimate business interest test is dated and incomplete. And I am fine with reformulating the test entirely, but at some point, an employer has to show what the protectable interest is for anyone to assess whether it's reasonable.

Illinois, it turns out, is not the only state to run into this precise issue. Michigan has the same dispute, though it doesn't appear to have been discussed much.

The case of Teachout Security Svcs., Inc. v. Thomas notes that Michigan courts have struggled to define the role of a legitimate business interest in the non-compete analysis. In that case, a security firm sought to enforce a non-compete agreement against its ex-employees. The employees prevailed on summary judgment, as the trial court found that the employer was trying to limit its employees' general skill and knowledge, not the use of anything proprietary.

The employer argued the trial court did not have to do anything more than analyze whether the covenants were reasonable. In support, the employer cited another Michigan court that bought into this argument - effectively the identical argument that the court in Sunbelt Rentals accepted. The Court of Appeals of Michigan, though, disagreed and held the trial court was correct in considering whether the employer had a "reasonable competitive business interest justifying the non-compete agreement."

The statutory framework in Michigan had to influence the court's decision and renders a Sunbelt Rentals-like analysis hard to fathom. For instance, Michigan's statute specifically states that "[a]n employer may obtain from an employee an agreement or covenant which protects an employer's reasonable competitive business interests..." Accordingly, the Legislature has conditioned enforcement on an affirmative showing of what the employer is trying to protect through a non-compete.

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Court: Court of Appeals of Michigan
Opinion Date: 10/19/10
Cite: Teachout Security Services, Inc. v. Thomas, 2010 Mich. App. LEXIS 2011 (Mich. Ct. App. Oct. 19, 2010)
Favors: Employee
Law: Michigan

Seventh Circuit Reaffirms Complete Salary Forfeiture Principle (Gross v. Town of Cicero)

The most powerful remedy for a breach of fiduciary duty claim is that of salary forfeiture. The Seventh Circuit reaffirmed the availability of this remedy in a long-running municipal dispute involving the Town of Cicero. While the facts of that case don't shed any light at all on salary forfeiture in the context of unfair competition cases, the Court cited a number of past precedents.

In particular, the Court stated that "[t]he salary subject to forfeiture is not limited based on the ratio of injurious to legitimate work performed, since an agent who breaches his fiduciary duty has no right to any compensation while acting adverse to the principal's interests." Put differently, there really is no proportionality defense available though my experience is that courts (and juries) effectively consider how serious the fiduciary's transgressions actually were.

The key to salary forfeiture is determining when the fiduciary breach began. For any plaintiff pursuing this remedy against a disloyal employee, it is critical to tailor discovery to find out when precisely an agent started acting in a manner directly adverse to his or her principal.

Often times, this is not easy because of the preliminary stages doctrine. Agents can "prepare to compete", and there is no real bright-line between preliminary competitive activities that are acceptable and actual competition that is not. Each case, of course, turns on its own facts in this regard.

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Court: United States Court of Appeals for the Seventh Circuit
Opinion Date: 8/27/10
Cite: Gross v. Town of Cicero, 2010 U.S. App. LEXIS 17911 (7th Cir. Aug. 27, 2010)
Favors: Employer
Law: Illinois

"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

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

An Illinois Court Finally Address Sunbelt Rentals (Steam Sales v. Summers)

It took a while...but we finally have a follow-up to the important Sunbelt Rentals case that the Appellate Court of Illinois issued in 2009. As readers may recall, that decision by the Fourth District held that employers need not demonstrate that a restrictive covenant be supported by a "legitimate business interest". Rather, the employer only needed to establish the reasonableness of the covenant in terms of time, territory and scope.

In the intervening months, commentators - including this one - had a lot to say about Sunbelt Rentals, but few courts even addressed the decision. The few that did were federal district court opinions that dealt with Sunbelt Rentals in an oblique way - acknowledging its existence, but treating it as an interesting anomaly.

My take on Sunbelt Rentals was, I think, fairly reasonable. I indicated that I was not sure how a court could assess the "reasonableness" of a non-compete restriction without identifying what it is the employer sought to protect - that is, the so-called "legitimate business interest." Here is a fragment of what I wrote when Sunbelt Rentals was decided:

"It's hard to see, though, how a court can determine whether a covenant is "no greater than is necessary for its protection" without analyzing what business interest it seeks to protect in the first place. The legitimate business interest test fills that vacuum and allows a court to fashion an appropriate restraint, or strike one entirely if the employer can't articulate the need for a restriction."

In that sense, I thought Sunbelt Rentals was interesting and somewhat well-reasoned - I still do - but perhaps a bit narrow and incomplete. I was looking for some acknowledgment that a court can't entirely divorce the reason for the covenant from its terms.

The Second District case of Steam Sales Corp. v. Summers discusses Sunbelt Rentals but is careful not to adopt or reject the rationale of that case. It leaves us wanting a bit more clarification, but the gist of what the Second District held is right in line with the issue I noted after Sunbelt Rentals came out.

Steam Sales acknowledges a tension that exists in that if an employer does not satisfy Illinois' wounded "legitimate business interest" test by showing that the covenant protects either near-permanent customer relationships or confidential business information, then the employer cannot enforce a perfectly drafted covenant. To try and resolve the tension, Steam Sales states that the "reasonableness of time and territory should still be evaluated in relation to a protectable interest." Note the court did not use the term "legitimate business interest", but rather a broader term - "protectable interest." The court does not adopt or reject Sunbelt Rentals, but it tries to build upon its strengths and correct its limitations.

The court does not come out and say what I would like it to - that there are other protectable interests out there (think goodwill and special training for starters) which can support a covenant. But it comes quite close and certainly hints at it. By suggesting that reasonableness must be examined in light of what it is the employer is trying to protect, the court seems open to a more modern, malleable definition of "protectable interest" that can fit the facts of a particular covenant case.

In my opinion, courts here are ready to dispatch the legitimate business interest test that was created out of whole cloth by the appellate courts and just adopted wholesale throughout the state for decades. I think it is almost inevitable that courts build upon Steam Sales and hold that reasonableness must be examined in light of an asserted protectable interest. That there is no particular limitation on what that means seems inevitable.

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Court: Appellate Court of Illinois, Second District
Opinion Date: 10/4/10
Cite: Steam Sales Corp. v. Summers, 405 Ill. App. 3d 442 (1st Dist. 2010)
Favors: Employer
Law: Illinois

Post-Employment Compensation Can Provide Consideration for Afterthought Covenant (Thiesing v. Denstply Int'l)

Minnesota is one of a number of states that prohibit an employer from binding an employee to an afterthought non-compete agreement - one signed after the beginning of employment - absent independent consideration. The most common types of consideration are special training, the opportunity to participate in incentive programs, payment of one-time bonuses, or a promotion.

But another, frequently overlooked type of consideration that is not as immediately recognizable is "post-employment compensation."

How does this work, and how can it provide the requisite consideration to support a covenant?

The employee's agreement specifically provides that if an employee is unable to obtain work reasonably commensurate with his or her education and experience as a result of a covenant, then the employer must make the employee whole in terms of compensation for a the shorter of the period of unemployment or the expiration date of the covenant.

The agreement also should contain a make-whole provision so that if an employee finds a lower-paying job, the employer must pay the difference between the new wage and that the employee earned at the time of termination.

Not every post-employment compensation provision will satisfy contract formation requirements. For instance, some provisions place a subjective standard on the employee to diligently or conscientiously look for work and document efforts to the ex-employer. As should be apparent, there is wide latitude for the employer to deny compensation under such clauses. Courts in Minnesota have held that when an employer chooses to enforce a non-compete, a conditional promise to pay - that is, upon the employer's finding that the employee diligently searched for work - is illusory. An unconditional promise, however, will provide consideration.

In contract provisions calling for post-employment compensation, an employee must examine whether the employer retains discretion to pay or to impose conditions on pay. This ordinarily will determine whether the consideration element can be met.

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Court: United States District Court for the Eastern District of Wisconsin
Opinion Date: 9/28/10
Cite: Thiesing v. Dentsply Int'l, Inc., 2010 U.S. Dist. LEXIS 102373 (E.D. Wis. Sept. 28, 2010)
Favors: Employer
Law: Minnesota

Franchise Non-Compete Agreement Enforceable By Sylvan Learning Center (Sylvan Learning v. Gulf Coast Ed.)

It has been a while since I've written on non-compete covenants in the context of franchise agreements. The overriding protectable interest that franchisors assert to justify such covenants is "goodwill" - which is the notion that a business's value as a whole is greater than the sum of its parts.

Other common protectable interests - confidential information, long-term clients - may not directly apply to franchise operations. What a franchisor seeks to protect against is the ability of a franchisee to learn its system and simply replicate a business model under a different name.

I've been an advocate of employing non-solicitation clauses, rather than non-compete agreements, for sales employees. The opposite is true with many retail franchise operators. Non-solicitation covenants probably don't protect the franchisor enough. Given the nature of consumer-driven retail businesses, location, advertising and a unified system of operations often bring in business more than direct solicitation of customers. In this sense, it is very common to see non-compete agreements against terminated franchisees enforced regularly.

A good example of this concerned a recent dispute over the operation of a Sylvan Learning Center. Joe Jezewski's franchise and license agreement with Sylvan Learning was terminated, and he immediately began operating a competing educational center in the same store location with the same phone number and same method of conducting business. A district court in Alabama, applying Maryland law, had little trouble issuing a preliminary injunction against Jezewski and enforcing a 20-mile non-compete agreement.

Of interest was the way Sylvan presented the non-compete. It was very careful to point out what Jezewski could do and it emphasized how limited in scope the restriction actually was. Because courts always will consider the potential hardship to one bound by a covenant, plaintiffs - whether employers or franchisors - should always make as part of their case an affirmative showing that they are not seeking to restrict too much.

Also, the court was careful to note that failing to enforce a non-compete against Jezewski would undermine the franchise system, which is built on permitting franchisees to exploit someone else's investment in branding, advertising, and development of goodwill. In this respect, it is much more difficult for franchisees to claim that restrictions are overbroad on hypertechnical grounds or to assert that the covenants do not protect a legitimate interest.

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Court: United States District Court for the Middle District of Alabama
Opinion Date: 10/6/10
Cite: Sylvan Learning, Inc. v. Gulf Coast Education, Inc., 2010 U.S. Dist. LEXIS 107160 (M.D. Ala. Oct. 6, 2010)
Favors: Franchisor
Law: Maryland

Fee Agreements and Time Sheets Discoverable In Non-Compete Dispute (OfficeMax Inc. v. Sousa)

Key employees who leave one firm to join a rival often have their attorneys' fees paid for by the new employer. Agreements to indemnify an employee for fees are sometimes contained in a negotiated new employment contract as a material inducement for the employee to defect and join a competitor. Indeed, many employees on the fence may not leave without some security that litigation will be financed by the new employer, which - to be sure - is in a better position to provide for and fund a legal defense.

Indemnification arrangements, however, are fully discoverable in litigation. A plaintiff's first discovery request almost always will include a demand for any employment agreements the defendant has signed in connection with his competing job. Also discoverable are facts related to fees paid by the new employer for a new employee. In a case where the employee does not have a written indemnification agreement, a plaintiff may seek and obtain discovery from the new employer about whether it has paid for the employee's legal fees.

This discovery even may extend not just to the fact of payment, but also the amount and the description of legal services performed. As a recent federal district court case held, records revealing "the general nature of legal work performed are not within the attorney-client privilege" because they do not contain confidential communications.

That is not to say all fee sheets are fully discoverable. For attorneys whose time entries are more detailed and may suggest the type of communication between the attorney and the client, a court certainly has the discretion and ability to cloak time entries with a privilege. But it is a mistake for counsel to assume that all fee sheets are privileged. They're not, even if the time entries generally describe the nature of the work performed and suggest what an attorney and a client may be discussing.

Aside from privilege, there is another point attorneys and clients also ought to be aware of regarding indemnity rights. Courts rely on indemnification agreements to support the conclusion that an injunction may issue. In particular, courts reason that if an employee is indemnified by an employer for legal costs, he or she won't suffer tremendous hardship from a temporary restraint on competitive conduct. This finding is more prevalent in cases where the indemnification agreement states that the employee will be paid his or her full salary even if a court-ordered injunction materially limits the prospective job responsibilities that the employee was hired to perform. Though indemnification agreements provide some insurance for competing employees, they also can actually help a plaintiff in seeking equitable relief.

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Court: United States District Court for the District of Maine
Opinion Date: 9/29/10
Cite: OfficeMax Inc. v. Sousa, 2010 U.S. Dist. LEXIS 103736 (D. Me. Sept. 29, 2010)
Favors: Employer
Law: Federal Rules of Civil Procedure

Lost Profits Always Difficult to Prove In Trade Secrets Case (SKF USA v. Bjerkness)

You have established that your ex-employees copied thousands of files on storage devices before quitting.

You have proven they serviced your key customers after quitting.

You have even convinced a judge that those employees used the very purloined documents to service those same diverted accounts.

Slam dunk case on damages, right?

Not so. Damages often times are the tail wagging the dog in trade secrets cases. Even on those occasions when they are not, parties get bogged down in issues of proof.

In SKF USA v. Bjerkness, a federal district court again held that a plaintiff in a strong liability case could not prove lost profits relating to the defendants' use of trade secrets. The rationale has to do with proximate cause: the customers did not leave the plaintiff because the defendants used stolen documents. Rather, they left because of a change in the plaintiff's ownership and their relationship with the defendants. Absent a non-compete, there is "nothing illegal about that", the court said. Proof of lost profits therefore failed.

Of course, this does not mean that a defendant can simply walk without financial liability. It still must account for its unjust enrichment in a trade secrets case - the profits related to those customers taken and for whom secret information was used. Frequently, in start-up businesses, though, this is an exercise in futility. New businesses frequently are unprofitable, and a plaintiff simply cannot apply its gross margin to the defendant's start-up.

This was the defendant's problem in Bjerkness. Rather than counter evidence of an applicable margin rate, the defendant simply contended it was not liable at all. Accordingly, the court used the plaintiff's margin as a substitute and based unjust enrichment by applying that percentage the defendant's gross sales. The court did not have to accept this as an evidentiary basis for damages.

All this makes injunctive relief more critical in trade secrets cases. Damages are notoriously difficult to prove, at least in "soft secrets" cases. What I mean by that is the sort of operational business information that may contain or reference admittedly confidential information but is not the crown jewel of the company. How do you prove damages from someone's disclosure of an outdated financial statement.

Damages cases are much different when a "hard secret" is at issue. On that score, think of a key engineering drawing, proprietary source code or a product formula as a revenue-enhancing secret for which damages may be eminently more provable. If, for instance, a proprietary drawing is taken and used to engineer a competing product, all profits from sales of that unfairly developed product provide a sound evidentiary basis for damages.

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Court: United States District Court for the Northern District of Illinois
Opinion Date: 8/9/10
Cite: SKF USA Inc. v. Bjerkness, 2010 U.S. Dist. LEXIS 80776 (N.D. Ill. Aug. 9, 2010)
Favors: Employee
Law: Illinois

Broker Recruiting Protocol Provides Industry Standard

The Wall Street Journal today had an excellent overview of the Protocol for Broker Recruiting, an industry response dating back now several years to exploding litigation related to advisors moving from one investment firm to another. The Protocol is a recognition of the impact of broker-dealer restrictions on the public interest. In fact, the first line in the Protocol mentions clients' interest in privacy and "freedom of choice in connection with the movement of their Registered Representatives...between firms."

The Protocol had three founding members - CitiGroup, Merrill Lynch and UBS Financial - and since its inception many years ago the list has exploded as firms have clearly made the decision that the benefits they can obtain from recruiting and hiring registered representatives far outweigh the impact of losing advisors to competing firms.

For its part, the Protocol essentially establishes a set of conduct guidelines that allow advisors to avoid liability for switching firms even if a non-compete or non-solicitation agreement is in place. The idea behind the Protocol really centers on several basic principles:

(1) Certain, non-proprietary client information can be taken with the registered representative. This information includes basic contact information and account titles.
(2) Other, proprietary information is off-limits. This includes, most prominently, account numbers, account statements and notes. Courts routinely require an immediate return of such proprietary information in conjunction with TRO or injunction proceedings.
(3) The representative must tender copies of all client information he or she is taking at the time of resignation.
(4) A representative may not solicit clients prior to resignation.
(5) Upon resignation and compliance with the Protocol, the representative may solicit clients he or she serviced at the former firm.

Nothing in the Protocol would absolve a representative from pre-termination misconduct that could give rise to fiduciary duty liability. Restrictive agreements, mind you, still have relevance. If a representative fails to comply with the Protocol, then the agreement can be enforced. Further, if an advisor's new firm is not a signatory to the Protocol, then the Protocol does not apply and the agreements will still be binding.

In fact, earlier this year, U.S. Trust - a wholly owned subsidiary of Bank of America who was not a signatory to the Protocol - prevailed on a temporary restraining order proceeding when several representatives allegedly took certain client information from U.S. Trust and joined Citi Private Bank. Though the defendants argued their conduct complied with the Protocol, the court found it critical that U.S. Trust was not a signatory in issuing the TRO.

The Protocol exempts from protection so-called "raiding", though that term is not defined at all. Presumably, this means a representative could not raid a team of representatives or solicit a sales assistant prior to departure, but a wholesale raid on a partnership may be considered a "raid" even if the representatives attempt to comply with the terms of the Protocol. There certainly is some ambiguity here.

Representatives seeking to switch investment firms have a tremendous incentive to seek early legal advice. A properly conducted transition can enable an employee to avoid the terms of a non-solicitation agreement, while one that is poorly executed can result in unnecessary liability.

The Protocol also could have the effect of increasing a representative's potential monetary liability if it is not followed. If, for instance, a representative takes client information that is protected, he or she may be subject to a punitive damages award because investment firms have had some success arguing that such information qualifies as a "trade secret" under the law.

The key inquiry for obtaining punitive damages in a secrets case is whether misappropriation of such information was "willful." Arguably, the very existence of the Protocol has put representatives - hardly an unsophisticated bunch - on notice of what they can and cannot do. Failure to comply with the Protocol lends support to the argument that the representative knew what he or she was doing was unlawful.