Supreme Court of Illinois To Rule in Reliable Fire Equipment on Thursday

The Supreme Court of Illinois will issue its ruling Thursday morning in the important case of Reliable Fire Equipment v. Arredondo.

Last year, I wrote extensively on the Second District's opinion in this case, which effectively caused a three-way split among the Appellate District courts in how employment non-competes are analyzed. Though I have not noticed any great controversies or debates in the non-compete cases I currently have, the fractured opinion in Reliable Fire Equipment highlighted a lingering issue over the scope of the legitimate business interests that can support non-compete agreements in Illinois.

My prediction is the Court will adopt (or reaffirm) a three-part test for assessing whether employment non-compete agreements are enforceable. That is, the covenant must: (1) be no greater than necessary to protect a legitimate business interest of the employer; (2) not impose an undue hardship on the employee; and (3) not harm the public interest.

The Court, in my judgment, will not adopt the categorical rule the appellate courts have long advocated for what types of protectable interests can support a non-compete. In other words, I expect the Court to vest trial courts with flexibility to assess whether an employer has articulated a protectable interest under the unique facts and circumstances of each case. I would be surprised if the Court holds that the only two protectable interests are near-permanent customer relationships and trade secret or confidential information.

This will be the Court's first ruling on a non-compete case since 2006. In that case, the Court offered little guidance on the issues in Reliable Fire Equipment and did not discuss the types of interests that can support a non-compete.

Non-Compete Clauses in Franchise Agreements

Generally, non-competition clauses are governed by one of two standards: the strict scrutiny test applied most commonly to employment agreements, and the reasonableness test applied in the context of a sale of business.

The tests are different in degree, not kind. Both tests require a showing of reasonableness, but in the employment context, the employer must articulate a legitimate interest worthy of protection. Courts often scrutinize the asserted interest carefully and find that the covenant does not support something the law protects. In the sale of business context, the courts employ are more straightforward time, territory and scope analysis, and generally presume a protectable interest exists - usually goodwill.

In many states, the tests are colloquially known as the employment test and the sale of business test. But many covenants do not fall neatly within these two buckets. A common example is the covenant incidental to a franchise agreement.

I have had many clients come to me with these issues, and there is not a ton of case law assessing whether a franchisor/franchisee non-compete should be judged according to the strict scrutiny standard or the more traditional reasonableness standard. Courts in Pennsylvania, Kansas, and Washington have looked at franchise agreements as akin to employment agreements and applied strict scrutiny to the reasonableness analysis. Courts in New Jersey, Wisconsin, Virginia, and Montana have taken the opposite approach. There appears to be no majority rule.

What are the main differences between a franchisee and employee which might lead one to conclude that the sale of business standard should apply? Here are four:

(1) The franchisee usually has a close association with the franchised system's goodwill;

(2) Tradesmarks and trade secrets are more likely to be closely aligned with, and entrusted to, the franchisee;

(3) Franchisees lose their capital investment upon termination, where an employee's job simply ends;

(4) Competition by ex-franchisees impacts the economic interests of other franchisees.

Additionally, some courts have concluded that failing to enforce covenants in franchise agreements undermines the franchise systems entirely, where that is not at all the case in the employment arena.

There also are, however, some differences between franchisees and sellers of a business. Here are two big ones:

(1) The franchisor retains a significant amount of control over a franchisee;

(2) Franchisees typically are not compensated for the value of the business upon termination.

In my mind, this is a close call. From my review of cases, it seems as though franchise covenants are drafted better than those found in employment agreements and have more reasonable time and territory restrictions. I don't know why this is, but I think there is less adhesion up front. Potential franchisees always have more choices than potential employees.

I also disagree with the idea that covenants automatically should be characterized as employment or sale of business. I think courts should recast them as either arms-length transactions or contracts of adhesion. For instance, executive employees may be in a far superior bargaining position to change or narrow up their non-competes than even a seller of a business or a franchisee.

The Cost of Litigating Competition Cases

One of the inescapable facts about non-compete and trade secrets cases is that the cost of legal services often far outweighs the monetary value of the case itself.

Courts note, rightly so, that a business may justifiably spend a great deal of money to protect trade secret information (of course, that information better be a capital asset of the firm). So a large expenditure of fees even without a significant monetary recovery may still be worth the effort.

Still, clients need to be aware of how much a lawsuit can cost. Three examples from the past year stick out. In Johnson v. Simonton Building Products, Inc., 2011 U.S. Dist. LEXIS 36056 (D. Kan. Mar. 31, 2011), the defendants spent $1.8 million on a trade secrets case and were unable to recover their fees. Conversely, in ICE Corp. v. Hamilton Sundstrand Corp., 2010 U.S. Dist. LEXIS 120500 (D. Kan. Nov. 12, 2010), the plaintiff spent $1.138 million - recovering most of this on a post-judgment fee petition. I point out these two cases because the prevailing market rates in Kansas are not terribly high - $300 or so an hour is market for experienced partners. The third case, from Chicago, is SKF USA, Inc. v. Bjerkness, 2011 U.S. Dist. LEXIS 110275 (N.D. Ill. Sept. 27, 2011), where Locke Lord's fees totaled $1.3 million.

As can be seen, fees on either the plaintiff or defense side easily can reach seven figures. From my own personal experience, I just finished litigating a case to a favorable defense judgment where our fees were about $115,000. However, the plaintiff put little effort into the case and could not to seek injunctive relief. Further, there were few discovery disputes and very little in the way of motion practice. It seems unlikely that I could ever litigate a competition case to final judgment for less than $100,000. In past cases, my defense fees have exceeded $400,000 for similar cases - an amount clients consider high, but courts likely would not bat an eyelash at.

Clients need to be aware that litigating competition cases can be extremely costly. Numerous variables arise, from unreasonable (or, frequently, uninformed) attorneys on the other side to unforeseen developments with a client's business during the litigation. The "X" factors normally involve discovery disputes, e-discovery, and involvement of third-parties (by way of subpoena or depositions). It is extremely difficult to budget for competition cases, and often times the best an attorney can do is budget for discrete events along the way.

Uniform Trade Secrets Act Not Uniform When It Comes to Fee-Shifting

Trade secrets cases raise the specter of fee-shifting. Like many prevailing party statutes, fee-shifting is not automatic in trade secrets cases. Rather, a party must meet a prescribed standard and count on a court to exercise discretion to award fees.

The Uniform Trade Secrets Act has been adopted in all but a handful of states (New York, New Jersey, Massachusetts and Texas). The Act's fee-shifting provision generally has three components. A party can recover attorneys fees in the following situation:

(1) If a claim of misappropriation is made in bad faith;

(2) If willful and malicious misappropriation exists; and

(3) A motion to terminate an injunction is made or resisted in bad faith.

I have no experience at all with the third prong of this statutory provision. My hunch is that the drafters of the UTSA intended it to apply when a defendant moves to terminate an injunction on the grounds that secret material has entered the public domain, and the plaintiff continues to assert protection over the information. I could be wrong, though.

The first two prongs are mirror images of each other. A claim made in bad faith is essentially the flip side of a defendant's intentional stealing of secrets. The analysis is basically the same - was there some intent to harm, either through misappropriating legitimate secrets or advancing a meritless claim?

Some of the states that adopted the UTSA do not have fee provisions. Those states are Alaska, Idaho, Missouri, and Vermont. (Interestingly, Alaska also has no provision for recovery of royalty damages in the event of misappropriation.) Virginia has a fee provision but excludes the clause concerning termination of an injunction.

Keep in mind too that to recover fees, a party must be "prevailing." There are not a lot of cases out there which apply the prevailing party standard to UTSA fee-shifting claims. Many times it is obvious. One question which is likely to arise concerns the interplay of injunctive relief and damages. For instance, if a plaintiff obtains a preliminary injunction, but later fails to obtain any permanent relief or damages at trial, is it "prevailing"?

I don't think there are hard-and-fast rules on this. Nor should there be. Courts should adopt a flexible approach to see whether the plaintiff has practically succeeded. The preliminary relief in trade secrets cases is often the most valuable, and a quick stop to any misappropriation may prevent a plaintiff from showing damages.

California Court Holds Trade Secrets Preemption Issue Premature for Ruling (Amron Int'l Diving Supply v. Hydrolinx Diving)

The preemption provision of the Uniform Trade Secrets Act is a topic on which I write quite frequently. The idea is that the UTSA is supposed to displace conflicting tort claims based on trade secrets misappropriation.

States which have adopted the UTSA are varied in how they approach key principles of preemption. One of those concerns whether a court can determine if preemption applies when no definitive ruling has been made on whether something alleged to be a trade secret actually qualifies as such.

A California court has joined the reasoning of states holding that a court cannot adjudicate preemption on the basis of an allegation alone. It joins Virginia, Wisconsin and other courts holding that motions on the pleadings, claiming preemption under the UTSA, are premature.

Ohio is among a group of states (the majority) reaching the opposite conclusion. In such states, it is routine to see ancillary tort claims (such as conspiracy, conversion, and tortious interference) dismissed because the underlying conduct is alleged to be based on misappropriation of a trade secret.

UPDATE X1: A commenter has astutely pointed out that this ruling likely is inconsistent with California state court precedent (which would be binding, as opposed to this memorandum opinion). It appears California adopts a broad view of preemption under K.C. Multimedia, Inc. v. Bank of America Technology & Operations, Inc., 171 Cal. App. 4th 939 (6th Dist. 2009). From reading that case, it appears that courts are empowered to dismiss ancillary tort claims prior to a finding of trade secrets misappropriation. This is the far more sensible rule and is more consistent with California's policy towards non-compete and trade secrets claims.

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Court: United States District Court for the Southern District of California

Opinion Date: 10/21/11

Cite: Amron Int'l Diving Supply, Inc. v. Hydrolinx Diving Comm., Inc., 2011 U.S. Dist. LEXIS 122420 (S.D. Cal. Oct. 21, 2011)

Opinion Date: 10/21/11

Favors: Employer

Defining "Damages" and "Loss" Under the CFAA

The Computer Fraud and Abuse Act is my least favorite statute. This is partly a result of the way it has been set up - a series of amendments that allow for civil actions, within a criminal statute.

The other fundamental problem with the CFAA is that key terms are either confusing, vague or undefined.

Regardless of which statutory provision is invoked in a CFAA claim, a plaintiff must prove either "loss" or "damages" to obtain compensatory damages (if it sounds redundant, it kind of is). Though the terms sound synonymous, they're not. Here's a brief summary of the difference.

To prove "damages," a plaintiff must show "impairment to the integrity or availability of data." Courts generally hold that this means destruction or deletion of files or hard drives. It does not mean the copying of electronic information from a computer system.

"Loss" is the subject of conflicting court rulings, but generally means costs of responding to an offense, damages from an interruption in service, or costs of conducting a damage assessment.

Disputes often arise whether retention of a forensic expert to examine an ex-employee's computer fit within the idea of "conducting a damage assessment." The general rule is they do not, because such costs are more akin to assisting in the overall litigation.

Also, the loss of business resulting from misuse of confidential information is not properly a "loss" under the CFAA, but is better addressed within the construct of contract damages or trade secret law.

In Alabama, No Implied Covenant Not to Compete In Business Sale (Pinzone v. Papa's Wings, Inc.)

A few months ago I discussed New York's common law rule that in a sale of business, when goodwill is part of transferred assets, the law implies a covenant on the part of the seller not to solicit the patronage of his or her former clients. Under New York law, this is inextricably bound up with goodwill itself, such that even in the absence of an express non-compete in the business sale documents, courts will grant the purchaser one to protect the integrity of the deal.

In Alabama, the opposite is true. The Court of Civil Appeals held that the existence of a covenant not to compete cannot be implied even when the sale agreement includes the transfer of intangible goodwill.

As I have previously noted, even in more protectionist states like New York, it is far preferable to draft clear covenants and include them in the transaction documents. What these cases discuss are gap-filler rules at common law, which should be invoked sparingly. Parties always are free to contract for a wide array of covenants in connection with an arms' length transaction, and courts generally enforce them as long as they are not patently unreasonable.

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Court: Court of Civil Appeals of Alabama

Opinion Date: 7/9/10

Cite: Pinzone v. Papa's Wings, Inc., 2010 Ala. Civ. App. LEXIS 189 (Ala. Ct. Civ. App. July 9, 2010)

Favors: N/A

Law: Alabama

Establishing Value From Being Secret Is the Most Difficult Part of any Trade Secrets Case

I was reading an article by the firm Drinker Biddle today which discussed trade secret protection over customer lists.

One particular comment caught me by surprise. The article suggests that establishing economic value over a trade secret is relatively easy to establish. I respectfully disagree. As my readers know, trade secret laws place a two-part burden on a plaintiff to establish the existence of a trade secret. A plaintiff must show that the information is economically valuable from being secret, and that the information is the subject of reasonable secrecy measures.

If you analyze the case law, it is actually far easier to establish the second prong of the test - secrecy measures. Most employers now are aware that protection of knowledge assets is important and deploy enough secrecy measures to establish that they acted reasonably. (Though of course there are plenty of cases out there where a plaintiff, after the fact, attempts to establish secrecy when information never was intended to be kept out of the public domain.)

The first part of the test, though, can be incredibly difficult to establish. In the case of a customer list (which the Drinker Biddle article discusses), an employer may be able to claim that a list is economically valuable in the sense that it spent money advertising and marketing to the customers on that list.

But is it really that easy to show that the list is economically valuable "from being secret"? I don't think so. A plaintiff may not be able to account for the fact that the details of its list frequently change or evolve, that key parts of the list (say contact information) may be gleaned from public sources, or that major parts of the list can be obtained from commercially available databases. This is particularly the case with a prospect or target list.

At a minimum, a trade secrets plaintiff must identify the witnesses who can establish that information is valuable because of its secrecy. That is to say, those witnesses (likely, experts) must be prepared to testify that comparable information is not known by competitors or being used in the industry, and that such information provides true competitive value in very specific ways.

The bottom line is that a trade secrets plaintiff carries a necessarily heavy burden. Courts rightly favor the free exchange of ideas and vigorous competition. Allowing a plaintiff to establish trade secret status over information that is merely valuable - as opposed to being valuable because of secrecy - would undermine this critical policy goal.

Attorneys Fees In Competition Disputes Often Disproportionate to Harm (SKF USA v. Bjerkness)

One of the inescapable truths about non-compete and trade secrets cases is the expense associated with litigating them. In many, if not most, cases, the actual legal fees necessary to pursue a claim and mount a defense are disproportionate to actual quantifiable loss.

This is particularly true where injunctive relief has successfully been obtained, and a defendant may have started competing but where he or she has not been able to pirate away key accounts.

On the one hand, the most practical remedy has been obtained, but going the extra mile and obtaining damages would be exceedingly difficult. This is why many disputes settle at or around the time of an injunction hearing.

For cases where injunctive relief is not pursued or obtained, trying to obtain an actual remedy is quite difficult and may be an exercise in futility. This is particularly true when a plaintiff cannot point to actual accounts it lost.

A recent federal district court case in Illinois demonstated just how out of hand attorneys fees can get in competition cases. In SKF USA v. Bjerkness, the plaintiff prevailed on a trade secret misappropriation claim and obtained a judgment of only $81,068. Prior opinions in the case suggested the plaintiff's damages presentation was not very convincing.

But the plaintiff obtained a key finding - that misappropriation was "willful." That finding allowed them to obtain attorneys' fees under the Illinois Trade Secrets Act. The fee petition sought $1.3 million, representing 2,700 billable hours of time (or about a year and a half worth of work for a normal Chicago attorney to bill). The bulk of that fee petition was granted.

Such a result is not that uncommon. Fees generally are high in unfair competition cases for several reasons.

First, there normally a number of legal issues to address, from enforceability arguments to proper trade secrets identification.

Second, these cases ordinarily are document intensive, both from parties and non-parties (such as customers).

Third, they are hotly contested, and sometimes provoke irrational litigation behavior among attorneys. It is a truism that non-compete and trade secrets cases often are fought just to be fought, and to obtain a greater competitive advantage outside the actual scope of litigation.

Any case assessment must begin with planning for these contingencies and advising clients on what other similar disputes actually can cost.

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Court: United States District Court for the Northern District of Illinois

Opinion Date: 9/27/11

Cite: SKF USA Inc. v. Bjerkness, 2011 U.S. Dist. LEXIS 110275 (N.D. Ill. Sept. 27, 2011)

Favors: Employer

Law: Illinois

Ohio Among States Adhering to Dominant View of Trade Secrets Preemption (Office Depot, Inc. v. Impact Office Products, LLC)

The preemptive effect of the trade secrets can be relatively narrow or very broad depending on which state's law applies. As explained in prior posts, preemption is the concept that a state's trade secrets act displaces conflicting state law tort claims based on misappropriation.

There are a number of preemption-related questions that courts must resolve. One of the more significant ones involves whether the trade secrets preemption clause displaces state law tort claims for misappropriation of confidential information not rising to the level of a trade secret.

The dominant view among states is that it does. Preemption would displace any tort claim based not only on trade secret misappropriation (such as conversion or unjust enrichment), but also any similar claim to the extent it is predicated on misuse of confidential, proprietary or other commercially valuable information.

Last week, an Ohio federal district court reaffirmed this principle under the Ohio Uniform Trade Secrets Act. Several Ohio cases previously addressed this issue, and it is a state squarely within the majority class adhering to a broad view of preemption.

There are two general policy rationales supporting this view. First, a narrow view of preemption would enable a party simply to default to other tort claims to avoid having to prove the statutory elements of trade secret misappropriation. If a party can sue for misappropriation of confidential information, why would it ever undertake the burden of pleading and proving the elements of a trade secret case? This would undermine the statute's goal of uniformity among jurisdictions to protect commercially sensitive information.

Second, allowing a party to bring tort claims for misappropriation of confidential information would discourage it from employing the secrecy measures of information that the trade secrets laws require. A party simply could bypass enacting secrecy measures and sue in tort for misusing confidential information that is not widely disseminated or publicly available, but still known by others in the industry. This would lead to less certainty, discourage fair competition, and impede the development of commercial ideas.

States adopting a minority view, which would allow for tort claims based on misappropriation of confidential information, include: Wisconsin, Virginia, Missouri, and South Carolina.

States which adhere to the majority view include: New Hampshire, Ohio, Hawaii, Kentucky, Michigan, and California.

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Court: United States District Court for the Northern District of Ohio

Opinion Date: 9/26/11

Cite: Office Depot, Inc. v. Impact Office Prods., LLC, 2011 U.S. Dist. LEXIS 109420 (N.D. Ohio Sept. 26, 2011)

Favors: Employee

Law: Ohio