End of the Year Post: Why I Support the Defend Trade Secrets Act

This year, I am taking a different approach for my end of the year post. Instead of recapping the year's highlights, I would like to give my perspective on the most significant development in the law of trade secrets and non-competes we're likely to see in some time: the likely passage of the Defend Trade Secrets Act of 2015. Here's my take:

***

On December 1, 2015, I added my name to a Trade Secrets Practitioners' Letter, which was sent to the U.S. House and Senate sponsors of the Defend Trade Secrets Act of 2015 (a copy of the proposed legislation can be found here).

The legislation, which is likely to pass with robust bi-partisan support, creates a federal civil cause of action for trade secrets misappropriation. If passed, federal law will protect all four branches of intellectual property rights - trade secrets, patents, trademarks, and copyright. It is no secret that trade secrets are an increasingly important component of our knowledge economy, and federal courts already are adept at handling these cases under their diversity jurisdiction call or as part of a case featuring a federal claim.

I was at first reluctant at supporting the DTSA, and I believed that state courts' traditional role at handling trade secrets and non-compete litigation was one that we lawyers should continue to honor. However, proponents of the DTSA have persuaded me to the merits of a federal cause of action. My rationale is different, though, than my counterparts. And although my specific reasons for supporting the bill are not contained in the Practitioners' Letter (my background is far to modest to even suggest offering changes), that's not essential to my endorsement of this potential new law.

So why do I support the DTSA? My reasons are two-fold. First, I believe federal courts have the muscle to parse out spurious claims of misappropriation and hold plaintiffs accountable for bad-faith filings. To this end, I think the existence of a federal cause of action will deter counsel from filing claims with a questionable factual basis, since federal district courts have a strong record of imposing fees for claims filed in bad-faith. State courts simply don't have this interest or capacity. The bench is often very close to the bar in state courts, meaning that judges understandably are reluctant to impose sanctions for frivolous claims. State judges also do not have the support of law clerks to conduct the necessary legal and factual research. They do not have the bandwidth to watch cases closely and are unable to engage in the type of analysis that is required to determine whether defense fee-shifting is appropriate.

Second, the changes to the Federal Rules of Civil Procedure (which went into effect today) are likely to reduce the cost of litigation and bring suits to trial more quickly than in state court. Federal courts, particularly with engaged and knowledgeable magistrates, have much greater capacity to monitor discovery for proportionality. The new rules are designed to achieve this end and should allow smaller litigants to defend cases more efficiently. State courts largely count on the cooperation of counsel to self-police discovery. Teeing up discovery disputes rarely leads to positive outcomes in state court, absent active judicial engagement. And unfortunately, many state courts lack this capacity. Therefore, I believe that the federal rules changes will cause counsel to try cases through the discovery phase more efficiently.

***

On November 15, a group of law professors wrote a lengthy letter opposing the DTSA. I do not believe their concerns are sufficient to override the DTSA's benefits at reducing litigation cost and remediating bad-faith claims. These are the concerns:

1. The DTSA's Ex Parte Seizure Provision May Harm Small Businesses, Startups and Other Innovators.

The DTSA contains a controversial provision that allows for the seizure (on an ex parte basis) of the instrumentalities of trade secrets theft. This is not the law's most outstanding feature, to be sure. But it's not an independent reason to defeat the law. For starters, I have a hard time believing that federal courts will warm to the idea of this remedy. It will be deployed sparingly. And the professors give judges short shrift. Judges are competent enough to snuff out abuses and impose damages for an wrongful seizure of property. This remedy potentially is a paper tiger, and it will work itself out in practice.

2. The DTSA Appears to Implicitly Recognize the Inevitable Disclosure Doctrine.

This argument stems from the provision of the DTSA that says a court may impose injunctive relief to prevent actual or threatened misappropriation, "provided the order does not prevent a person from accepting an offer of employment under conditions that avoid actual or threatened misappropriation."

How the professors conclude this endorses the "inevitable disclosure" rule is simply beyond me. No canons of statutory construction allow for this rather extraordinary position. Given the robust debate around the "inevitable disclosure" doctrine, the DTSA easily could have expanded the rights associated with seeking injunctive relief to bring the doctrine within the statutory language. It does not do so. To read some implicit endorsement of the doctrine is simply unreasonable.

3. The DTSA Likely Will Increase the Length and Cost of Trade Secret Litigation.

As discussed above, the opposite will occur - particularly given the change to the Federal Rules of Civil Procedure.

Separately, the Professors rely on a study showing that the cost of IP litigation ranges from $250,000 (for cases worth less than $1 million) to $1.6 million (for cases where over $25 million is at stake). However, this statistical evidence does not necessarily mean that trade secrets cases in federal court are more expensive. For starters, many of those cases are high-stakes patent cases. A lot of trade secrets claims are in the mold of employment (as opposed to IP disputes). Too, the Professors' reliance on this study assumes that the cost is lower in state court. I am not so sure about this, since state courts are more apt to grant continuances - the biggest cause of increased legal fees. With federal courts, you have some assurance that judges will enforce deadlines strictly.

4. The DTSA Will Likely Result in Less Uniformity in Trade Secret Law.

This justification also seems insufficient. The states have developed rules under the Uniform Trade Secrets Act, and with some exceptions, the law is indeed predictable. There are some differences in the Uniform Act concerning attorneys' fees availability and the statute of limitations. To this end, a federal law certainly will help bridge any differences.

It will take time for courts to resolve some areas of the law - like the "inevitable disclosure" doctrine - but it is very likely that courts will look to the laws in their states until such time as the circuit courts step in. That is a fairly long process that must play out, but it won't hurt parties and won't confuse lawyers. The permutations in trade secrets law among the states simply aren't that great that we will need to worry about having to cite to new law and new cases.

***

I realize that the arguments on both sides of this debate are well thought-out and well-intentioned. But having absorbed this debate now for a couple of years, I remain convinced that trade secrets lawsuit in federal court will weed-out weak, spurious claims and will result in a quicker disposition of cases by judges who have the staff to handle them.

Second Circuit Adopts Narrow View of Computer Fraud and Abuse Act

As the Second Circuit wades into the long-simmering fray over the Computer Fraud and Abuse Act, I am starting to wonder if this is all worth the trouble. In other words, do we have reason to be concerned about the CFAA reaching seemingly innocuous conduct, or is the statute working as intended?

For those unfamiliar with the dispute over this once-obscure law, the statutory language "exceeds authorized access" has divided federal courts for more than ten years. The CFAA imposes both civil and criminal liability for those who exceed authorized access from a protected computer and obtain certain types of information. The term "exceeds authorized access" means to access a computer with authorization and to use such access to obtain or alter information in the computer that the accesser is not entitled to obtain or alter.

The dispute in employment contexts almost always arises when an employee, before leaving to compete, accesses a company database and digitally copies proprietary files (they do not have to be trade secrets under the CFAA). The employee's access is technically authorized, but if the employee acquires information contrary to his duty of loyalty and then misuses company data, some courts have held that this improper purpose qualifies as "exceeding" authorized access. Other courts take the opposite view.

An interesting (and very disturbing) case from the Second Circuit has fueled this split in authority. The case is not an employment case and involves a disgusting set of facts that I won't repeat. The case of United States v. Valle arose when a New York City police officer accessed a computer program called Omnixx Force Mobile, which allowed him to search restricted databases like the federal National Crime Information Center database, to gain sensitive personal information about an individual. The purpose of his access was to learn details about a woman the officer knew from high school, and whom he and a co-conspirator intended to kidnap. As such, the officer had no valid law enforcement purpose for accessing the database.

Reversing a conviction under the CFAA, the Second Circuit waded into the fray over the meaning of "exceeds authorized access" and the application of that statutory term to the officer's conduct. The court acknowledged a deep circuit split over the term's meaning and then took a deep, even nauseating dive, into the CFAA's legislative history. After going through that exercise, the court ultimately found that both the narrow and broad view found some support. And because of that, the court determined that a criminal statute had to be construed narrowly (the so-called rule of lenity).

The Second Circuit then adopted the "parade of horribles" approach, articulated by Judge Kozinski in United States v. Nosal. In that case, Judge Kozinski described the potential reach of the CFAA if the court had authorized a broad definition of "exceeds authorized access," a reach that would in his view criminalize a wide range of innocuous, everyday behavior. The examples include an employee using a computer to check Facebook, in violation of a corporate computer policy and similar conduct qualitatively different than that before the court.

Given the Second Circuit's adoption of a narrow view (and its agreement with the Fourth and Ninth Circuit), the circuit split over the CFAA's reach has become deeper. It is possible that U.S. Attorney Preet Bharara will seek to file a petition for writ of certiorari over this question. Though Congress in the past has entertained amendments to the CFAA, no legislative activity is imminent. In my view, Congress easily could find a middle ground between the two lines of authority to ensure that the CFAA does cover the type of conduct at issue in Valle and even civil cases that resemble some form of insider hacking or sabotage.

But even though I have in the past endorsed the narrow view of the CFAA, I question whether prosecutors are abusing the law. While the result in Valle seems wrong strictly in terms of justice, the Second Circuit's reversal in no way suggests that prosecutors overreached by charging Valle under the CFAA. Nor am I seeing an overuse of the CFAA in the civil context. Cases like Nosal, to be sure, seem more appropriate for a civil remedy. But are they outliers? Is the CFAA actually being used selectively, rather than punitively? If so, then perhaps we need not worry so much about individuals being hailed into court based on a "confused, accidental, or otherwise inappropriate use" of a database (the coin the phrase used by the dissenting judge in Valle). Maybe we have struck the right balance and done our best with an imperfect law that can, at times, be used effectively.

Fifth Circuit Addresses Meaning of "Fundamental Policy" In Choice-of-Law Dispute

Choice-of-law clauses are one of the most important procedural frontiers in non-compete disputes.

State law concerning enforceability of covenants not to compete often contains unique twists and turns. Witness Illinois' rather unique rule on consideration in the at-will employment context. Increasingly, choice-of-law clauses are becoming prevalent in non-compete litigation. This paradigm arises because of our increasingly mobile economy where employees work for companies domiciled in other states, the effect of mergers and acquisitions, and corporate counsel's more informed awareness to selecting a particular state's law when drafting contracts in the first place.

I have written many times on the tensions posed by choice-of-law clauses, and generally courts need to assess several questions, including the connection that the chosen state's law has to the litigants. Choice-of-law clauses pose even more difficult questions when the state with the greater interest in the lawsuit has a strong public policy concerning non-competes.

A stark illustration of these choice-of-law rules comes from the recent Fifth Circuit case of Cardoni v. Prosperity Bank. The case involved a very common set of facts that can give rise to choice-of-law disputes. Prosperity Bank in Texas bought an Oklahoma-based bank called F&M, and in connection with that acquisition had key F&M employees sign new employment contracts governed by Texas law. Those contracts contained typical non-competition, non-solicitation, and non-disclosure covenants. Four bankers, who all were Oklahoma residents, then left to compete against Prosperity.

The Fifth Circuit's analysis of the choice-of-law clause focused on the degree to which Oklahoma's public policy was "fundamental" and whether it was sufficient to override the Texas choice-of-law clause. The court described the notion of a "fundamental policy" as an "elusive concept" but made clear to note that it is not one that focuses on assessing potential outcomes of the case. Put another way, courts do not look to whether the difference in state law changes the result at trial. The "fundamental policy" question must strike deeper than that. (This is not the standard in a minority of other states.)

As applied to the bankers' contracts in Cardoni, the court found that Oklahoma's public policy against enforcement of employment non-compete agreements was "fundamental" on account of its state statute. It is fairly safe to assume that a state's enactment of a statute directly concerning non-competes expresses the will of the people or, less colloquially, a "fundamental policy" for purposes of a choice-of-law analysis. Oklahoma, for its part, is one of a handful of states (along with California and North Dakota) that generally ban non-competes.

The court's analysis was different for the bankers' non-solicitation clauses, which the same Oklahoma statute generally permits. The law in Oklahoma is nuanced as to those clauses' permissive scope, but even the narrower limits of enforceability do not implicate a fundamental policy (at least in the Fifth Circuit's eyes). Therefore, in Cardoni, the court reached a somewhat unusual result that Texas law (the chosen law in the contracts) governed the non-solicitation covenants but not the broader non-competition covenants.

The result illustrates the importance counsel must pay to choice-of-law questions when cross-border disputes arise. It is crucial to examine the nature of the contacts the parties have to the competing states, the relationship of those contacts to the actual dispute, and the permutations of the law between the respective states.

Is the Majority Test for Determining Bad Faith in Trade Secrets Claims Still Good Law?

Recently, I had the opportunity to speak at the American Intellectual Property Law Association's annual Trade Secrets Summit. My topic (along with co-presenter William L. Schaller) was "Bad Faith in Trade Secrets Litigation." I know the topic well, having represented many defendants in specious trade secrets claims, including the prevailing defendants in Tradesman Int'l v. Black, 724 F.3d 1004 (7th Cir. 2013).

Although the Uniform Trade Secrets Act does not define "bad faith," its commentary in Section 4 does indicate that courts should look to the standards of the Patent Act, 35 U.S.C. Sec. 285, That section enables a court to award attorneys' fees to a prevailing party in an exceptional case. Therefore, the UTSA's commentary seems to equate "bad faith" with "exceptionality." (As a side-note, not all states that have adopted the UTSA contain a bad-faith provision on par with Section 4. At last count, four states lack a discretionary fee-shifting provision.)

The case law concerning a Section 4 claim of bad faith is relatively narrow, with few courts outside California formulating much in the way of a test. California, for its part, has long adopted a two-part "objective/subjective" test, which asks:

1. Whether the trade secrets claim is "objectively specious." This means that the plaintiff must lack proof as to one of the essential elements of the case.

2. Whether the facts support a finding of "subjective misconduct." Here, courts examine evidence of harassment, delay, and improper motive.

Lawyers who have experience with bad-faith claims often assume that this California test is generally applicable. However, a Supreme Court case from 2014 may cause attorneys to reconsider if they're examining claims of bad-faith under the appropriate framework.

Pivoting back to the Patent Act, the Court in Octane Fitness, LLC v. ICON Health & Fitness, Inc., 134 S. Ct. 1749 (2014), clarified the standard of "exceptionality" under Section 285. It stated:

"an 'exceptional' case is simply one that stands out from others with respect to the substantive strength of a party's litigating position (considering both the governing law and the facts of the case) or the unreasonable manner in which the case was litigated. District courts may determine whether a case is 'exceptional' in the case-by-case exercise of their discretion, considering the totality of the circumstances."

The standard is remarkably flexible, endorsing a large grant of discretion to a trial judge to consider whether fee-shifting is appropriate. Given the fluid "totality of the circumstances" test, virtually nothing is off-limits in establishing bad faith.

At the Trade Secrets Summit, Bill Schaller and I discussed the importance of "trigger facts" to avert a bad faith claim. Those trigger facts may insulate a plaintiff from fee-shifting, even if the case turns out poorly. Among the most common trigger facts are:

1. Some suspicious computer activity, such as mass downloads or improper use of a personal storage device.

2. Physical retention of corporate records, which could reflect company secrets.

3. Dishonest conduct at the time of departure or failure to participate in an exit interview.

4. The failure of counsel to alert the plaintiff as to erroneous facts assumed by the plaintiff in filing the case (here, most claims of misappropriation must proceed based on inference).

It is possible the Octane Fitness framework is no different than the California test, for the bad-faith determination is inherently fact-specific. However, for defendants, it seems quite clear that they have enormous flexibility in arguing a claim for fees based on the case's inherent weakness, even apart from any evidence that reflects evil motive. That is the way it should be.

Supreme Court Decides Not to Step Into Planned Parenthood's Trade Secrets Fray

The interplay between trade secrets and the public interest has deep roots in the law, but presents a thorny issues for courts to address.

In recent years, trade secrets law has been at the forefront of the public's concern over fracking technology and in particular the chemical composition data that oil and gas providers may have to make available. Recently, The Wall Street Journal ran an article concerning the software known as TrueAllele - described as a high-tech computer program that helps law-enforcement officials sort out complex mixtures of DNA at a crime scene. The scientists behind the program is resisting defense attorneys' requests to see the source code of the program, claiming it is a trade secret.

Last year, the intersection of trade secrets law and the public interest reached the headlines when the First Circuit held that Planned Parenthood need not release its Manual of Medical Standards and Guidelines based on Exemption 4 to the federal Freedom of Information Act. The suit arose when New Hampshire Right to Life issued a FOIA request to the Department of Health and Human Services after Planned Parenthood received a federal grant. The suit was partly a reverse-FOIA action, whereby Planned Parenthood sought to prevent HHS from releasing portions of documents that HHS had determined were not exempt from disclosure.

The First Circuit had held the Manual (and related pricing information) was subject to Exemption 4. Under the circuit's applicable test, Planned Parenthood did not need to demonstrate actual competitive harm. Instead, it only had to show "actual competition and a likelihood of substantial competitive injury in order" to bring the information within Exemption 4. Further, courts need not conducted a "sophisticated economic analysis of the likely disclosure."

The Supreme Court declined to weigh in and interpret the First Circuit's test concerning Exemption 4, but this denial of certiorari was not without its own headline. Justice Thomas and Justice Scalia dissented from the denial of the cert petition, with Justice Thomas stating that "Courts of Appeal have embraced varying versions of a convoluted test that rests on judicial speculation about whether disclosure will cause competitive harm to the entity from which the information was obtained."

Justice Thomas' statements are somewhat curious, because trade secrets law does not demand an actual demonstration of harm before protection ensues. Indeed, the very test associated with preliminary injunctions necessitates some degree of "judicial speculation" concerning disclosure. But that speculation must be grounded in factual support. It is unclear whether he advocates a very narrow application of Exemption 4 that would call for some broad assessment of actual, as opposed to likely, harm. Regardless, the circuit courts' apparent inconsistency in applying Exemption 4 is the focus of Justice Thomas' dissent and serves as a microcosm of the conflicting interests often at stake in trade secrets disputes.

Illinois Revitalizes "Old" Rule Concerning Limits on Confidentiality Agreements

Attorneys in Illinois have assumed for many years that non-disclosure agreements do not need a time limit on them.

That assumption is now conclusively incorrect.

The genesis of the problem comes from the Illinois Trade Secrets Act, which provides as follows:

...a contractual or other duty to maintain secrecy or limit use of a trade secret shall not be deemed to be void or unenforceable solely for lack of durational or geographical limitation on the duty.

The ITSA passed the General Assembly in 1985, and after that point in time, a smattering of cases dealt with the reasonableness of non-disclosure covenants and seemed to endorse them without much analysis as to scope.

But in 1985, around the time the ITSA went into effect, a case called Cincinnati Tool Steel Co. v. Breed held that durational and geographic limitations are required for a confidentiality agreement. A few subsequent cases followed Cincinnati Tool Steel, but not many and the issue was rarely litigated.

(As a potentially interesting aside, "Cincinnati Tool Steel" was not some company based in Cincinnati, Ohio but simply took its name of the president, Ronald Cincinnati. Pardon me for being somewhat of an onomastic snob, but whenever I think of this case, I cannot help but be reminded of James Spader's portrayal of Robert California in The Office, a fantastically geographic-oriented surname.)

Two recent cases, though, have revitalized Cincinnati Tool Steel. In the Appellate Court of Illinois, the case of AssuredPartners, Inc. v. Schmitt (from October 26) held that an unlimited non-disclosure covenant, both in terms of its duration and in terms of the information that fell within the terms of the covenant, was unenforceable. In particular, the court warned that such a broad covenant drastically limited the employee's ability to work in the relevant industry because it prevented him from using any knowledge he gained while employed with AssuredPartners, despite his prior work experience in the industry and regardless of whether he gained that knowledge because of his employment.

The second case, Fleetwood Packaging v. Hein, comes from the Northern District of Illinois, where Judge Tharp invoked the rationale of Cincinnati Tool Steel to conclude a non-disclosure agreement that lacked a temporal and geographic scope was unenforceable. Responding to the argument concerning the ITSA clause cited above, Judge Tharp found that it only applied to contractual restrictions that limited the use of trade secrets - not confidential information.

The reasons for demanding limitations on non-disclosure covenants are sound and generally hinge on two policy rationales.

First, as AssuredPartners recognizes, the presence of a non-disclosure covenant that is unlimited in scope can have a drastic chilling effect and can raise the possibility that an employer will attempt to bootstrap what should be a narrow restriction into a much broader non-compete that the parties never signed. Just as problematically, the relatively undefined nature of confidential information (which by definition is at least partly subjective) can leave an employee twisting in the wind if she stays in the same industry as her prior employer (which most employees do).

Second, it is awfully difficult (if not impossible) for an employee to know what remains confidential after she has left. Much ephemeral business information can lose value quickly. If corporate strategies shift, then a strategic plan that is a few years old may be of no use to anyone. Only insiders should know what remains confidential. Those who no longer are providing services to a company have no reason to know whether certain information retains some confidentiality. Therefore, it makes sense to require some reasonable limit on scope so that an employee is not left uncertain as to what she can disclose about her past work.

Allowing unlimited agreements to protect trade secrets, while certainly a fine distinction, is consistent with public policy. The challenge, of course, is to parse viable trade secrets (which should be more specific and more obvious) from general confidential information  (which likely is categorical and less obvious).

Pennsylvania Follows Trend in "Consideration" Cases

The subject of consideration is the new frontier of non-compete disputes.

Although Illinois is at the forefront of this burgeoning consideration debate, other states increasingly have begun exploring the concept of what exactly an at-will employee receives in exchange for agreeing to a non-compete agreement. This "exchange" is the fulcrum of consideration, a legal term that ensures the enforceability of a contract obligation.

Pennsylvania, like other state supreme courts, has waded into the arena, albeit with an arcane and interesting twist to the legal problem. Yesterday, the Supreme Court of Pennsylvania in Socko v. Mid-Atlantic Systems of CPA, Inc. held that an employee can challenge a restrictive covenant agreement signed after the start of employment on the grounds that it lacks consideration, even if the agreement contains specific language that the employee "intends to be legally bound."

Why does that intent-to-be-bound language matter?

Pennsylvania is the only state to adopt something called the "Uniform Written Obligations Act." Consider, for a second, whether a statute can be uniform if 1 out of 50 states has enacted it. The Act provides that a written promise:

shall not be invalid or unenforceable for lack of consideration if the writing also contains an additional express statement, in any form of language, that the signer intends to be legally bound.

The challenge for the Supreme Court of Pennsylvania was to harmonize this very old statute with the general common-law principle that says an employee who signs a restrictive covenant after the inception of employment must receive new consideration beyond employment itself. This rule generally requires an employer to provide something tangible such as a promotion, a bump in pay, or some severance benefit. Continued employment never suffices in Pennsylvania.

The Court, facing a somewhat daunting challenge, did its best to reach what it felt was the right result, consonant with years of legal decisions in the restrictive covenants area. It concluded that, despite the plain language of the Act, extending it to contracts in restraint of trade would be "unreasonable." The Court considered the "historic background regarding" non-competes, as well as their "unique treatment in the law." Therefore, even if non-compete contracts include the mandated "intends to be legally bound" language, an employee still can challenge the agreement on the grounds that it lacks consideration.

The main canon of statutory interpretation that the Court had going for it was the strict construction rule. That rule generally states a statute in derogation of the common law must be strictly construed. Applied to non-competes, the Court traced the history of these "unique" agreements and the special issues pertaining to consideration that the law had afforded them.

The case is perhaps not a model of how to resolve questions of statutory construction. Nevertheless, it continues a clear and definite trend. In the last several years, courts seem to be pivoting away from examining whether an employer has a legitimate business interest to protect through a non-compete and towards looking at whether there even is consideration at all. To be sure, questions of reasonableness and protectable interest are vitally important in cases like this. But the consideration issue is fundamental to the issue of contract formation in the first place and often results in a rapid disposition of the suit.

Lost Profits and No-Hire Clauses

A common feature of employment contracts these days is the no-hire clause. This is a form of a non-solicitation covenant and specifically precludes an employee from encouraging other employees to leave the firm.

I estimate that 9 out of 10 employee clients of mine are unconcerned with this type of covenant. They simply don't care to recruit fellow co-workers to join them at a new job. For the ten percent of clients that do care, they tend to be upper-level managers or lead a sales team. Their value to a new employer may depend on replicating that sales team.

The enforceability of no-hire clauses is not something that is widely litigated. One certainly can argue with exactly what kind of legitimate business interest the clauses protect. But for the most part, I've been content to assume that an employer at least can demonstrate some kind of an interest, even if it seems to vague and ephemeral.

The question of damages, though, presents a much more confounding problem. If one employee solicits another to leave - in violation of a covenant prohibiting that solicitation - what is the employee's monetary exposure?

A couple of possible damage theories immediately come to mind:

1. The employer's cost to replace the wrongfully solicited employee. These costs might include recruitment expenses, headhunter fees, signing bonuses, and incremental pay differentials between the former and replacement employee.
2. Liquidated damages, if provided for by contact. Some employment agreements attempt to define the agreed-upon damages for breach of a no-hire covenant. I have seen these clauses expressed as a percentage of the solicited employee's last-prevailing rate of pay.
3. Lost profits. The conventional form of contract damages, this would measure the loss to the employer associated with the breach of the no-hire covenant.

But as to this last category, how would one prove that? Assume that the employee who was wrongfully solicited then began contacting or soliciting customers of the former employer. Is any lost income properly attributable to the no-hire violation? This would seem to be a step removed from the underlying breach, particularly if the employee who solicited the customer had no restrictive covenant agreement prohibiting that sales activity.

This is roughly the fact-pattern of Acadia Healthcare Co. v. Horizon Health Corp., 2015 Tex. App. LEXIS 7683 (Tex. Ct. App. July 23, 2015). To be sure, the case involved a great deal of facts that supported more serious charges of conversion, trade secret theft, and breach of contract against other employees. But the case is certainly crucial for how the plaintiff was unable to use expert testimony to render a lost-profits opinion arising from a no-hire breach.

The plaintiff's expert looked at two sets of facts and gave separate damages opinions on each. As to the first, he identified a specific prospect that a former Horizon employee solicited for Acadia (the new employer). The employee himself had signed no employment agreement, but his superiors solicited him to join Acadia in violation of their own no-hire covenants. The court found that the expert's opinion on lost profits concerning the solicited account was too speculative, in that the expert assumed that Horizon would have retained the account for 15 years. The expert's inability to identify specific information supporting a 15-year contract duration was fatal to this opinion.

The other fact concerned the solicited employee's "lost production," In essence, Horizon had claimed damages from the wrongful solicitation of this employee under the assumption that, but for the solicitation, he would have produced profit for Horizon into the future. The problem with Horizon's theory was that Horizon assumed the employee, who was at-will, would have remained with Horizon, would have been offered a new sales position, and would have accepted it. And the expert again assumed that the employee would have signed hypothetical contracts with 15-year contract terms.

Acadia Healthcare illustrates how difficult it is to prove damages in competition cases. As it relates to no-hire clauses, the damages analysis becomes attenuated because the recruitment usually precedes the proximate cause of any loss. And even assuming a plaintiff can tie those causes together, the assumptions underlying any future damages projection inherently become problematic and attenuated.

The Inevitable Disclosure Rule and Commercial Transactions

Claims for trade secrets misappropriation normally arise out two types of transactions: a fractured employment relationship or a failed business strategic transaction (such as a merger or joint venture).

One way to prove threatened misappropriation (and therefore secure injunctive relief) is to claim that improper use or disclosure of a secret is "inevitable." This inevitability theory is disfavored and not even viable in some jurisdictions. However, it continues to spur litigation and debate.

In the employment context, claims of inevitable disclosure normally must meet a certain standard, though the standard is necessarily flexible and case-specific:

1. The old and new employer must be direct competitors.
2. The employee's new position must overlap with the old one.
3. The new employer must fail to take some reasonable step to guard against the employee's use or disclosure of trade secrets.
4. The employee's departure conduct must suggest the possibility of misuse (e.g., misleading the employer as to plans, suspiciously accessing proprietary data).

If the inevitability theory works in employment cases, it does so because the employee's objectively perceived value to the new employer tends to derive from her prior work experience. Put another way, the employee normally does not bring some unrelated, free-standing value apart from this job history. So (again, in theory) it's at least plausible that even well-intentioned employees will disclose something that they shouldn't.

In a failed business transaction, this rationale is absent. Businesses may combine because of synergies that are unrelated to their status as market competitors. Therefore, it is dangerous to presume that erstwhile joint venture partners, for instance, will will have any incentive to incorporate the others' trade secrets.

The Appellate Court of Illinois' decision in Destiny Health, Inc. v. Cigna Corp., 2015 IL App (1st) 142530, notes this important distinction in applying the inevitable disclosure theory and rejecting it to a failed joint venture. Destiny Health discusses the leading case involving a failed acquisition and the attempted use of the inevitability theory, Omnitech Int'l v. Clorox Co., 11 F.3d 1316 (5th Cir. 1994). Both cases expound upon the difficulty in establishing trade secrets misappropriation through the inevitable disclosure theory.

Omnitech and Destiny Health both emphasize the danger associated with inferring trade secret misappropriation after a failed transaction. This leads to one of two perverse results: (1) if a company evaluates one potential target, and then declines to acquire it, the company effectively would be precluded from evaluating other targets; or (2) the company would have to evaluate potential targets without evaluating their trade secrets. 

Ultimately, I believe that contracts should set the parameters for the inevitable disclosure rule. In commercial transactions, a simple non-disclosure agreement (signed as a condition of evaluating a business transaction) should determine any future restrictions. If, as in Destiny Health, the agreement is silent on a party's ability to develop certain products, explore certain targets, or contracting with certain vendors, then the "inevitable disclosure" theory should be unavailable.

Similarly, in the employment context, I believe that the inevitable disclosure rule only should be applied to demonstrate the employer's protectable interest in enforcing a non-compete agreement. In other words, the employer should not have to wait for the ex-employee to disclose something before seeking enforcement. As long as the employer can show extensive access to company secrets, then this should support enforcement of a non-compete - assuming of course, the terms are reasonable and the agreement carries proper consideration.

The Destiny Health case illustrates the potential misuse and overapplication of the inevitable disclosure rule. Right now, it's operating as an uncontrolled extension of trade secrets law. The rule needs standards, but few courts seem willing to apply them with regularity.

Hawaii Goes Deep on Non-Compete Law

The mentions that the State of Hawaii gets on this blog are, predictably, few and far between. However, in the span of just a few weeks, we have two significant legislative and judicial updates.

The first concerns Act 158, which Governor David Ige signed into law in June. The law is limited in scope and is industry-specific. The main thrust of the law is that it bans enforcement of non-compete agreements for employees of technology businesses. A technology business is defined as one which derives more than half of its gross sales from "sales or licensing of products or services resulting from software development or information technology development." The law further defines those terms.

The law also prohibits the use of non-solicitation covenants, which are defined exclusively as those restrictions that prohibit an employee from soliciting a former co-worker. It does not include any restrictions on contacting, servicing, or soliciting customers or clients of a former employer, meaning Act 158 expressly leaves open the question of whether this type of restrictive covenant in a technology business is prohibited. By omitting it, it is likely that such covenants will continue to be scrutinized for reasonableness under the common law.

Act 158 took effect on July 1, but the law has prospective effect only. For an excellent summary of Act 158, read Robert Milligan's analysis here.

While Act 158 is decidedly pro-employee, a Hawaii federal district court rendered a decidedly pro-employer decision in a non-compete case. The question presented in The Standard Register Co. v. Keala, 2014 U.S. Dist. LEXIS 73695 (D. Haw. June 8, 2015), was whether continued employment constitutes sufficient consideration to enforce a non-compete against an at-will employee. This issue continues to divide courts across the country. In the past year or so, some courts (Wisconsin) have veered towards a pro-enforcement stance when this type of consideration is at issue. Others (Illinois and Kentucky) continue to lean pro-employee and require additional consideration beyond employment itself. And we await a ruling from Pennsylvania on this same issue.

The district court in Standard Register noted that the Supreme Court of Hawaii never had addressed the question, so it surveyed the majority and minority rules across the United States. In following the majority rule, the court also relied on the forthcoming Restatement of Employment Law, Section 8.06, which appears to endorse the majority position - that forbearance of the right to discharge is itself sufficient consideration. The Restatement goes on to criticize the middle-ground approach taken by Illinois courts (as well as a handful of others) which examine whether the employment continues for a substantial period of time.