Wholesale Insurance Broker Dispute Highlights Potential for Reputational Injury (Allison v. CRC)

Crain's had an excellent article yesterday about the dispute concerning Patrick Ryan's re-emergence in the wholesale insurance brokerage industry. Ryan, the founder of AON Corporation, is one of the most high-profile business and philanthropic figures in the area. He invested a substantial amount of money - $275 million - to create and fund Ryan Specialty Group, a wholesale insurance brokerage.

The controversial aspect of Ryan's maneuver was his plan to outfit RSG: he engaged in a mass recruitment effort that resulted in the defection of more than 100 employees from rival CRC Insurance Services, an Alabama-based broker. Wholesale brokers like CRC and RSG compete to provide insurance proposals to retail brokers. Those retail brokers deal directly with prospective insureds. It can be a fragmented, specialized market, but the gist is that a wholesale broker's key relationships often are with retail brokers - not end-user insureds.

Not all retail brokers were happy with Ryan's plan to ramp up RSG's business through the hiring of CRC's employees. In the insurance industry, non-compete arrangements and client relationships are critical corporate assets. Certain retail brokers saw Ryan's move as less than respectful of those assets. It is not a stretch to think CRC has been decimated in its ability to service clients. The Crain's article contains some illuminating quotes.

Last month, Judge Zagel in Chicago denied CRC's motion to preliminarily enjoin its ex-employees from violating the non-competition/non-solicitation obligations in their employment contracts. What was interesting about Judge Zagel's opinion is the degree to which he analyzed the balance of harms arising out of CRC's injunction request. He assumed the agreements were valid - a ruling that is not a final judgment on those contracts - but spent the bulk of his opinion assessing the harm to the employees if he were to enjoin them from working for RSG, and the harm to CRC if he were to deny the motion.

Ultimately, after struggling with the issue, Judge Zagel found that the harm to the ex-CRC employees - potentially losing their jobs for two years - outweighed corresponding harm to CRC itself. The court found that an injunction would not stem the tide of lost business, holding essentially that there was no guarantee that CRC's clients would come rushing back if the employees were barred from working with RSG.

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Court: United States District Court for the Northern District of Illinois
Opinion Date: 6/21/10
Cite: Allison v. CRC Insurance Services, Inc., 2010 U.S. Dist. LEXIS 61015 (N.D. Ill. June 21, 2010)
Favors: Employee
Law: Illinois

Restrictive Covenants Tied to Stock Option Grant Subject to Lower Scrutiny (The Selmer Co. v. Rinn)

Traditionally, courts will analyze restrictive covenants under two tiers of scrutiny. Those covenants incidental to the sale of a business are subject to a common law rule of reason, while those tied to employment are governed by a stricter standard of scrutiny requiring the courts to examine certain other factors (which vary state-by-state).

But not all employment-related covenants merit strict scrutiny. For instance, an employment contract given to the seller of a business who stays on to assist the buyer likely will be judged under the rule of reason since it was given in connection with the underlying transaction. And even some higher level executives will have their covenants examined with a less exacting standard of review in some states given their pervasive exposure to confidential information.

Another example is one I have written about before: covenants extended in the context of a stock option grant. The law is not uniform on this, but the prevailing sentiment is that covenants which are part of a stock option award agreement will be adjudicated under the less stringent rule of reason rather than the traditional employment standard.

The Wisconsin Court of Appeals held as such in a recent case and articulated the reason behind why courts traditionally are not as likely to invalidate such covenants:

"...[U]nlike typical restrictive covenants, upon which a prospective employee's position may depend, there were no consequences attached to [the employee]'s refusal to accept the agreement. The circuit court found [the employee] was not pressured to sign the stock option agreement, nor was his employment conditioned upon his doing so. Indeed, the circuit court found [the employee]'s refusal would not have affected his employment in any way." In fact, the evidence in the Wisconsin court's case revealed the employee quadrupled his investment in company stock by accepting the agreement's benefits.

The Wisconsin court obviously reached the right result, as covenants executed in exchange for participation in an incentive program are not compulsory and are intended to align the employee's goals with the long-term best interest of the company. In fact, that case did not even deal with a traditional non-compete agreement, but rather applied only if the employee solicited firm clients or disclosed confidential information of the employer.

It is somewhat of a mistake to call the two tests used by courts as the "employment test" and the "sale of business" test. They are not limited to such confining topics. It is more appropriate to say generally that covenants that are part of an adhesive agreement are subject to strict scrutiny, while those which are the product of a bargained-for-exchange are governed by a rule of reason.

Covenants in the latter group almost certainly include those in a franchise agreement, operating or shareholder agreement, settlement agreement, or incentive plan award agreement. It might even include covenants tied to long-term employment contracts for high-level executives, though the law on this is not particularly well-developed. The former group normally will be found in most employment or independent contractor agreements.

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Court: Court of Appeals of Wisconsin, District Three
Opinion Date: 7/13/10
Cite: The Selmer Co. v. Rinn, 789 N.W.2d 621 (Wisc. Ct. App. 2010)
Favors: Employer
Law: Wisconsin

Revised Federal Pleading Standard Heightens Plaintiff's Duty to State Claim (US Bank v. Parker)

Lawyers are accustomed to lax pleading standards available to them in federal court. While discovery and pre-trial obligations are far more exacting, getting a claim to survive the initial pleading stage has never been perceived as that difficult.

However, after the recent Supreme Court decisions in Twombly and Iqbal, that perception is changing.

Those decisions held that simply reciting bare elements of a cause of action and surrounding them with mere labels and conclusions would not allow a plaintiff to survive a motion to dismiss a complaint. Instead, the complaint had to plead enough facts to make a claim factually plausible.

This standard can impact non-compete cases, particularly when the plaintiff may have a reasonable suspicion that a departed employee is violating a post-employment obligation but little in the way of actual evidence.

In a recent case out of Missouri, a federal district court held that Twombly and Iqbal require allegations beyond those qualified as "upon information and belief." The court in US Bank v. Parker found that the plaintiff's sole allegations of breach were all made upon information and belief and contained no facts that would render them plausible.

The case highlights the problem employers often face when deciding whether to pursue a claim for unfair competition: the information gap. For employees who have left no paper (or digital) trail of their post-competitive plans, an employer must have some means to discover wrongdoing. Particularly when there is only a non-disclosure or non-solicit covenant at issue, the employer will need evidence, not just belief, that documents have been taken or are missing, or that protected accounts have been solicited.

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Court: United States District Court for the Eastern District of Missouri
Opinion Date: 7/9/10
Cite: US Bank Nat'l Ass'n v. Parker, 2010 U.S. Dist. LEXIS 68324 (E.D. Mo. July 9, 2010)
Favors: Employee
Law: Federal Rules of Civil Procedure

Poignant Lyrics and Lessons From the LeBron Fiasco

You take the pieces of the dreams that you have
cause you don't like the way they seem to be going
You cut them up and spread them out on the floor
You're full of hope as you begin rearranging
Put it all back together
but anyway you look at things and try
The lovers are losing

-- "The Lovers Are Losing" (Keane, 2009)

What do the lyrics from a (great) song by British alt-rock group Keane and the ridiculous LeBron James fiasco of last week have to do with non-compete law?

Well, it all has to do with hope, expectations and loyalty.

When an employee departs from one firm and jumps ship to a competitor, the motivations for doing so are almost always noble and altruistic - at least from that employee's perspective. She may be trying to raise her pay, service her clients better, or provide for long-term security. No shame, that. Along the way, she may make mistakes, but it is rare that such mistakes are the product of anything more than negligence.

However, from the perspective of the jilted employer, the feelings are always more personal. Perhaps it has to do with the training and investment made in employees, the lack of respect an employer has for its competitor, or an inflated sense of the employer's importance.

Witness the comments from Cleveland Cavaliers majority owner Dan Gilbert after LeBron James left to take his talents to South Beach:

"This shocking act of disloyalty from our home grown chosen one sends the exact opposite of the lesson we would want our children to learn. And who we would want them to grow up to become."

Gilbert peppered his open letter to Cavs fans with other inflammatory screed, calling James' move a "cowardly betrayal" and describing his decision (or perhaps the presentation of it) as "heartless and callous."

Clearly, Gilbert felt like he, his fellow owners, co-workers and fans were personally scorned. As over-the-top as his letter was, this is not at all unlike what occurs during litigation between competitors. Under the pressure to save clients or protect proprietary information, employers have to make fast decisions - and sometimes the decisions made in the heat of the moment are emotional and not particularly well-considered.

Gilbert spoke of "disloyalty", which is a word often invoked against employees when they leave to compete. LeBron, for all his self-indulgence, was not disloyal - at least from a lawyer's perspective. He didn't breach any contract, demand to be traded, or renege on a promise.

But competitives decisions - like the Decision - frequently inflame passions and evoke feelings that Gilbert expressed so inartfully.

I have written before about cease-and-desist letters gone haywire. Letters that employers would like to claw back. There are a small number of cases where those letters, clearly not thought out at all, actually result in substantial liability for interference or defamation.

Emotions run high - understandably so - when employees leave to compete. Often times, lawsuits are not thought out particularly well. We see this often when filing a complaint seems like the right thing to do, but it ends up alienating the very customers who have to testify in court. This is a hidden cost of litigation that usually is considered after the first shot has been fired.

This is just a guess, but I highly doubt LeBron James thought of the poignant lyrics Tom Chaplin wrote when he decided to ponder his basketball future. What seemed like the right decision may still turn out to be just that. Those hard feelings that Dan Gilbert has probably will subside over time and other emotions will settle in.

This evolution of emotion is extremely common in unfair competition suits, and employees who find themselves making the jump across the street will have to deal with the confrontation and discomfort that we all saw on TV last week. Individuals who are sales-driven, type-A personalities tend to do better in dealing with litigation and the confrontation that comes with it.

But it is not for everyone. It may be very difficult to deal with inflammatory rhetoric that is tossed around in non-compete or fiduciary litigation, and it can be so distracting that the employee who is sued simply is unable to perform the very skills that made her a valued asset to begin with.

The comforting thought for most of us, though, is that we don't have to go to work and get booed - like LeBron certainly will.

Liquidated Damages Clauses in the Professional Services Context and General Drafting Considerations (Palekar v. Batra)

Liquidated damages clauses are common in restrictive covenant agreements, particularly in those for accountants, physicians and other professionals. One reason for their prevalence is the view some courts and legislatures have taken with regard to restraining professionals' ability to compete. It is highly disfavored and impacts the public interest to a much greater degree than ordinary sales businesses, so by substituting a liquidated damages clause for an actual prohibition on competition, employers can mitigate compelling arguments against enforcement.

Delaware is no exception. It has a statute in place that prohibits any agreements restricting the right of a physician to practice medicine in a particular locale. However, it does not prohibit agreements that put a price on such competition. Courts in Delaware have held that a liquidated damages clause in a physician's contract which may discourage competition, but which does not prevent it, are consistent with the statute.

Of course, the clause itself must still be legally compliant. The standards of enforceability are fairly uniform from state to state. As the Superior Court of Delaware recently noted, however, liquidated damages clauses are presumptively valid and the burden rests on the party challenging it to show it is unenforceable. (This is not true everywhere - some states flip the burden of proof).

Drafting liquidated damages clauses requires attorneys to take into account a number of different considerations:

(1) It is important to have a number of recitals to show that the parties intend to fix damages ahead of time in the event of a breach.
(2) Those recitals should include an acknowledgment that the parties agree damages in the event of breach would be difficult to calculate.
(3) The clause cannot, in most jurisdictions, allow for the simultaneous recovery of actual damages - or else it is not a true liquidation at all.
(4) The liquidated damages clause must provide some clear or readily ascertainable amount accruing on breach. If the amount cannot be determined, it won't be enforced.
(5) If the clause applies to multiple covenants, attorneys ought to consider whether the clause makes any sense at all by applying hypotheticals. For instance, it would seem unreasonable to apply the same damages to a breach of a major covenant (i.e., a client non-solicitation covenant) as it would to a relatively minor one.

My experience has shown that courts are often receptive to liquidated damages clauses in non-compete arrangements, particularly if the agreement is well-drafted, contains proper recitals and appears to be designed to compensate the employer rather than to punish the employee. In addition, if the clause is a proxy for an actual restriction, then courts seem more inclined to view them as enforceable.

On the other hand, I have also had success in invalidating covenants that were hopelessly vague, cumulative of other remedies, and which appeared designed to forfeit previously-earned benefits. It is a very difficult area of the law and demands that attorneys have an intimate understanding of the law governing the agreement.

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Court: Superior Court of Delaware, New Castle
Opinion Date: 5/18/10
Cite: Bhaskar S. Palekar, M.D., P.A. v. Batra, 2010 Del. Super. LEXIS 257 (Del. Super. Ct. May 18, 2010)
Favors: Employer
Law: Delaware

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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