There Is No End to Creative "Non-Compete" Arguments (Lindskov v. Lindskov)

As a disclaimer, I am not commenting on this case because it breaks any new ground legally. However, it does demonstrate the ends to which litigants will go to try and stop what they claim is a competitive injury.

From the State of South Dakota (home to the Badlands, Custer State Park and - of course - Wall Drug) comes a family dispute in the business of selling farm implement equipment. Two cousins, Dennis and Les Lindskov, were apparently very successful sellers of New Holland farm equipment and obtained dealerships in Isabel and Mobridge. After an apparent falling out (and after New Holland refused to allow them to "split" the dealerships), Dennis bought out Les.

Problem. Dennis did not secure a non-compete at the time of closing. The closest the sale documents came to a restrictive covenant was a mutual non-disparagement clause, which generally makes a contractual obligation out of the common law of defamation or commercial disparagement.

After Dennis bought out Les, Les started a new business with his son selling the same New Holland equipment in the same areas of Isabel and Mobridge. Dennis filed suit, claiming that the non-disparagement clause prohibited such competition. Not surprisingly, the courts disagreed and refused to interpret the covenant against disparagement as a broad non-compete.

Suits like this tend to arise during a bitter divorce or (as here) an acrimonious family business break-up. Their intent is often not to prevail, but to cause the defendant to become distracted or have his or her reputation harmed with suppliers and customers. Courts need to ferret out strike suits that facially lack merit, particularly when sophisticated parties engage counsel and come to a negotiated resolution. Unfortunately, the court system is not quick or efficient in most cases, and a party can prolong a meritless suit for quite a while. That may have the intended effect of litigation. Not to win necessarily, but to inflict some competitive pain through the lawsuit's mere filing.

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Court: Supreme Court of South Dakota

Opinion Date: 7/6/11

Cite: Lindskov v. Lindskov, 800 N.W.2d 715 (S.D. 2011)

Favors: Not applicable

Law: South Dakota

Supreme Court of Texas Revamps Non-Compete Test...Again (Marsh USA v. Cook)

The Supreme Court of Texas continued a trend we've seen in 2011 - substantial change by states to substantive non-compete law. Earlier this year, Georgia reformed its state law by enacting a new statute designed to allow for easier enforcement of non-compete contracts, particularly in the employment context.

Recently, Colorado has made it easier for employers to enforce non-compete agreements against at-will employees. And Illinois will have its Supreme Court decide, finally, the appropriate test for determining the enforceability of a non-compete agreement in the employment context.

While state supreme court opinions on non-compete issues are few and far between each year, that's not the case in Texas. Over the past several years, the Supreme Court of Texas has made several significant rulings and has chipped away at a 1994 decision that was perceived, correctly so, as creating a difficult enforcement landscape.

The latest ruling in Marsh USA v. Cook returns Texas back to the fold in determining the enforceability of a covenant under the "reasonableness" standard. Prior to this time, courts struggled over a technical, confusing inquiry concerning "ancillarity." Put simply, the Supreme Court of Texas had grafted onto its statute the requirement that promises made by an employer to an employee must "give rise" to a legitimate interest in restraining competition. Essentially, this meant that the employer had to promise to provide an employee with confidential business information. Otherwise, no promise made by the employer bore any rational nexus to enforcing the non-compete.

The Cook decision eliminates this judicially created rule and interprets Texas' Covenants Not to Compete Act according to the letter. As long as there is another agreement supporting the non-compete, trial courts must proceed to a reasonableness analysis. In Cook, the other agreement was providing stock options to a key employee - not providing him confidential information. The lower courts had held that this was not the type of consideration (money) that "gives rise to" an interest in preventing competition. Basically, the lower courts said an employer could not buy a non-compete. The Supreme Court of Texas found that an employer's interest in building goodwill and incenting employees' performance was a legitimate interest worthy of protection.

The interesting part of this ruling is Justice Willett's concurring opinion, which basically makes one important point as it relates to the Court's holding: it is not enough to mouth goodwill. An employer has to demonstrate it through a clear record. The Court makes the valid point that any type of employment incentive - a raise, a bonus, a promotion, or "a better parking space" - can motivate an employee to strengthen client relationships and contribute towards goodwill.

The concurring opinion also contains a very scholarly and interesting discussion of non-compete law in the knowledge-based economy. It reads like a summary of law review articles and provides many compelling arguments for strong judicial oversight of employment contracts in the 21st century. There are some great quotes in this opinion for lawyers to use.

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Court: Supreme Court of Texas
Opinion Date: 6/24/11
Cite: Marsh USA Inc v. Cook, 2011 Tex. LEXIS 465 (Tex. June 24, 2011)
Favors: Employer
Law: Texas

Illinois Courts Still Struggling Over "Continued Employment" As Consideration

If you could chart out all the cases in Illinois that discuss the "continued employment" rule, you can reach only one conclusion.

The law is a muddled, hopeless mess.

Two recent decisions just weeks apart confirm that this area of the law is in need of clarification. By now, the concept should be familiar to anyone who reads this blog. For at-will employees, continued employment can provide sufficient consideration for signing a non-compete agreement. This arises when an employer determines an existing at-will employee needs to be bound by a restrictive covenant.

Courts in Illinois, as they are apt to do, have grafted onto this principle a rule that the continued employment must be for a "substantial period." They have not formulated any bright-line rule as to what that means. Some cases suggest it's two years, while others say a shorter period of time. And then other courts say you need to look at other factors beyond just the length of the continued employment. The most important of those factors would be the method of termination - involuntary or a resignation.

The rationale for this factor is obvious. As Judge Castillo recently stated, the "substantial period" rule "protects employees from employers who hire workers, have them sign post-employment covenants, then fire them soon thereafter." He even called the method of termination a "critical distinction in determining that one year's employment was sufficient consideration when the employee quit.

However, the Illinois Appellate Courts may be more employee-friendly. A recent ruling by the Fifth District in Diederich Ins. Agency, LLC v. Smith found that three months' continued employment was not sufficient consideration even though the employee resigned voluntarily to compete. The more significant aspect of the case, though, addressed a novel issue I have not seen an Illinois court examine. The employee, an insurance agent, had signed a 2-year covenant at the start of employment. Less than a year later, the employer modified it to reduce the scope to 1-year. Nothing was provided to the employee for this second agreement, which was clearly more narrow in scope.

The court found that the modification was a new agreement which needed fresh consideration, not supplied by continued employment. This is a curious result (to put it mildly), since the employer's generosity in reducing the scope of the non-compete agreement resulted in a windfall for the employee.

The court's ruling results in kind of a perverse incentive to keep overbroad agreements in place at the risk of running into a consideration problem. Courts should be encouraging employers to do what the agency in Diederich Ins. Agency did and pare back covenants when business circumstances call for it. Arguably, this type of reasoning could extend to modifications of covenants when an employer, for instance, takes out a geographic territory it no longer services or a list of "restricted clients" that may have been identified with specificity.

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Court: United States District Court for the Northern District of Illinois
Opinion Date: 5/23/11
Cite: LKQ Corp. v. Thrasher, 2011 U.S. Dist. LEXIS 54852 (N.D. Ill. May 23, 2011)
Favors: Employer
Law: Illinois

Court: Appellate Court of Illinois, Fifth District
Opinion Date: 6/7/11
Cite: Diederich Ins. Agency, LLC v. Smith, 2011 Ill. App. LEXIS 599 (Ill. App. Ct. 5th Dist. June 7, 2011)
Favors: Employee
Law: Illinois

Supreme Court of Maine Upholds $100,000 Liquidated Damages Clause Against Physicians (Sisters of Charity Health v. Farrago)

Liquidated damages clauses are kind of like the Miami Heat.

They look powerful, but it's hard to tell whether they will ever come through. Courts frequently find such clauses unenforceable. In the non-compete context, they are quite common and can take a variety of different forms. A common type of clause is one that puts a flat-fee price on competition or solicitation of customers.

I am not crazy about flat-fee clauses, because they have been struck down on many occasions as arbitrary. But not always. The Supreme Court of Maine just upheld such a clause in three physicians' employment contracts, set at $100,000 for a non-competition violation. The evidence the court used to uphold the reasonableness of the clause was fairly compelling: over 1,300 patients requested a transfer of their medical records when the doctors left for another institution. At an annual gross revenue per patient level, the (arguable) actual damages far exceeded the liquidated sum.

Keep in mind there really is no downside to using a liquidated damages clause in a contract. Even if they are unenforceable, the fallback position is actual damages - which is where you'd be without including the clause in the first place. I still believe that some formula based on the number of clients lost, rather than a flat fee for breach itself, has a better chance of being validated by a court. But as the Maine case shows, the decisions on these types of provisions come out both ways with no real distinguishing factors.

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Court: Supreme Judicial Court of Maine
Opinion Date: May 26, 2011
Cite: Sisters of Charity Health System, Inc. v. Farrago, 2011 Me. LEXIS 62 (Maine May 26, 2011)
Favors: Employer
Law: Maine

Supreme Court of Colorado: Continued Employment Does Constitute Sufficient Consideration for Non-Compete (Lucht's Concrete Plumbing v. Horner)

Colorado was one of a handful of states - along with South Carolina, Washington and a few others - which held that continued employment was not sufficient consideration for an at-will employee's agreement to a non-competition covenant. I have written often on this subject before. The issue arises in a fairly common fact pattern. If an employer requires an existing at-will employee to sign a non-compete under threat of termination, is this ability to fire enough legal "consideration" to form a valid non-compete contract?

Colorado has now decided "yes."

In Lucht's Concrete Plumbing, Inc. v. Horner, the Supreme Court of Colorado joined the majority of states and held that continued employment does provide sufficient consideration to form a valid non-compete agreement. This reverses last year's appellate decision, a summary of which can be found here.

The Court quite simply held that since an employer may terminate an at-will employee at any time, its agreement not to discharge the employee once he or she signs a non-compete agreement is legal consideration to form a contract which is not illusory. The Court alluded to, but did not really discuss, the problematic situation of involuntary termination shortly after signing. Courts have recognized that there may be a consideration problem if the employer extracts a non-compete agreement from an existing at-will employee and then terminates him or her shortly thereafter. The Supreme Court of Colorado seemed to suggest this was not so much a consideration issue, but would bear on the agreement's overall reasonableness.

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Court: Supreme Court of Colorado

Opinion Date: 5/31/11

Cite: Lucht's Concrete Plumbing, Inc. v. Horner, 2011 Colo. LEXIS 436 (Col. May 31, 2011)

Favors: Employer

Law: Colorado

Expedited Discovery In Non-Compete Cases Is Not Guaranteed

By now, most of my readers know that non-compete disputes often arise very quickly. The preferred - and in most cases - only true remedy is injunctive relief preventing certain competitive activity from occurring.

Employers seeking to enforce non-compete agreements by way of injunctive relief almost always seek expedited discovery. In emergency injunction proceedings, expedited discovery frequently is necessary for an employer to be able to prove its case at the time of hearing. Remember that in many non-compete disputes, an employer knows only a fraction of what competitive activity has occurred, or which is about to occur.

Expedited discovery is just what it sounds like: production of documents and deposition testimony on a truncated schedule, sometimes in a matter of days - not weeks. This is a marked, even drastic, departure from a typical discovery schedule. In non-injunction cases where damages are sought, discovery can take the better part of a year. In complex litigation, it often exceeds two years.

But there is no guarantee a court will even order expedited discovery. To be sure, an employer must establish why it needs such discovery and why courts should depart from the typical (and lengthy) discovery protocol. In the federal system, courts use one of two standards for evaluating a request to expedite discovery.

The first standard is the minority rule and is called the "preliminary injunction" standard. Specifically, the party seeking expedited discovery has to show that irreparable injury would result without resort to a quick discovery process. It also must show some likelihood of success on the merits, which typically is accomplished through a detailed initial complaint and injunction moving papers. Finally, an employer will need to show that the burden to the responding employee in producing information is outweighed by the harm to the requesting party from not obtaining such discovery.

Parties who state convincing cases for expedited discovery, in fact, often establish in their moving papers as much of the case as they ultimately can prove on their own. It is not uncommon to see detailed affidavits from likely witnesses, along with supporting business documents like e-mails or customer contracts. A prepared employer will tell the court it has done what it can and needs expedited discovery to fill in the gaps, which it cannot be expected to know from firsthand knowledge.

The second standard is more prevalent and is generally known as the "good cause" standard. A court will evaluate whether an employer has demonstrated good cause to depart from the normal discovery schedule. The test is certainly more flexible. Under either test, however, an employer (or enforcing party) needs to demonstrate some specific reason why expedited discovery is sought. In non-compete cases, this reason often is evidence that an employee is soliciting or servicing a specific group of customers or using sensitive business information unfairly.

There are two pitfalls I often see when parties move for expedited discovery.

First, employers often do not narrowly tailor their discovery requests to the issues likely to be at issue during an injunction hearing. If the discovery proposed to be served is too broad, a court almost certainly will deny expedited discovery - or in some cases, indicate which requests for information need to be answered on an expedited basis.

Second, employers sometimes don't make a specific showing of an emergency at all. Vague complaints that sweep too broadly or do not identify for the court why injunctive relief should issue often doom expedited discovery motions. For employers seeking to obtain expedited discovery, it's critical to introduce affidavits early on in the case to demonstrate some likelihood of actually getting injunctive relief.

If a judge sees the potential for a fishing expedition, with only vague conclusory allegations, he or she will deny a request for early, expedited discovery. No judge wants to be burdened with repeated emergency motions for a case that is crawling out of the gate.

Supreme Court of Illinois Grants Leave to Appeal in Reliable Fire Equipment

Today the Supreme Court of Illinois granted an employer's leave to appeal in Reliable Fire Equipment v. Arredondo, the Second District case last year which added new confusion to non-compete law in Illinois.

Following Reliable Fire Equipment, the five appellate courts in Illinois were left to apply three different "protectable interest" tests. The Court had little choice but to resolve this conflict among the appellate districts.

The case represents the Court's first true opportunity to enunciate a standard by which employment-based non-compete agreements will be judged. I believe the Court will adopt some variant of the traditional test widely used across many jurisdictions, which allows enforcement of non-compete agreements if: (a) the covenant is reasonable and not greater than is required for the protection of the employer; (b) the covenant does not impose an undue hardship on the employee; and (c) the covenant is not injurious to the public interest.

Element (a) is almost always an issue in litigation and encompasses traditional hot-button issues like a covenant that is too long, too extensive in geographic reach, or too broad in scope. It also would require a court to analyze the breadth of the covenant in relation to the interest an employer seeks to protect.

Also, it is element (a) where Illinois courts have gotten lost on a detour for the last, oh, 70 years or so. The Court is unlikely to issue an opinion in Reliable Fire Equipment until early 2012.

Hair Stylists Subject to Enforceable Non-Compete Agreement (Jon Scott Salon v. Garcia)

Clients mistakenly believe that non-competes are limited to a narrow range of "sophisticated" industries. In fact, non-compete agreements are common in a wide range of disciplines, from so-called professions (accounting services) to business-to-business relationships (wholesale insurance brokerage) to retail services (personal training).

I presented at a seminar a few weeks back, and a judge remarked to me that his experience with non-compete cases "usually involved hair stylists." Though he was joking, it's not unheard of to see such cases. Stylists develop a personal connection with their clients and provide a service that is hard to replicate. Many personal services providers have sales employees or technicians who develop intimate relationships with clients and who get to know their clients very well. It is this kind of interest a business can protect legitimately through a non-compete agreement.

Employers ought to consider using the least restrictive means possible to prevent competition by personal services providers. A customer non-solicitation agreement for a hair stylist, for instance, would narrowly match the restriction with the protected interest. A stylist presents a risk only if she takes her clients. She is unlikely, for instance, to develop some proprietary program or process that has independent value.

Don't be surprised, though, when courts misapply the law if the non-compete defendant is a retail service provider like a stylist. A lot of judges who don't hear but a few non-compete disputes a year think covenants should be limited to a narrow set of circumstances - the high-paid CEO, the rainmaking insurance producer, or the partner at an accounting firm. A recent Texas judge misapplied the law and dismissed a proceeding against a stylist, holding that because she was an "at-will" employee, she could not be restrained by a non-compete at all.

This was a ruling that was contrary to existing precedent. The mistake may have been made due to courts' hostility to non-compete agreements, particularly as to employees who line Main St. USA. Non-compete litigation always has a cost; mistakes made by courts are one of those costs that are hard to predict.

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Court: Court of Appeals of Texas, Fifth District
Opinion Date: 5/19/11
Cite: Jon Scott Salon, Inc. v. Garcia, 2011 Tex. App. LEXIS 3790 (Tex. Ct. App. May 19, 2011)
Favors: Employer
Law: Texas

Non-Compete In Post-Employment Settlement Agreement Judged With Less Scrutiny (McClain & Co. v. Carucci)

Not all non-competition covenants are judged with the same degree of scrutiny.

On the pro-enforcement side is the "sale-of-business" covenant, under which the restrictions normally are examined only for their reasonableness as to time, territory and scope. On the anti-enforcement side is the traditional employment-based covenant, which usually requires an enforcing party to show not only that the covenant is reasonable, but also tied to a legitimate business interest. The burdens on an employee's ability to earn a living, and the public interest are usually considered as well under an exacting "reasonableness" analysis.

The history of covenants not to compete is quite interesting (to me), and many would argue that the old justifications and presumptions that courts used long ago do not apply in a more modern economy. Sale-of-business covenants were the first types of covenants to be enforced by courts, and for the most part, they pose few enforcement problems. Employment covenants are a different story.

In the past on this blog, I have been critical of the sale-of-business nomenclature, because it is underinclusive and suggests to courts, lawyers, and (most importantly) clients that the test only applies to a covenant signed in connection with a business sale. Sounds logical.

But it's not right.

In point of fact, courts analyze a wide range of covenants under this more relaxed standard. Among these are covenants in franchise agreements and shareholder agreements. Last week, a Virginia court - in a matter of first impression - added another type of agreement to this list: settlement agreements.

This makes sense. Many settlement agreements are the product of arms-length negotiations and pose few problems in terms of being adhesive. That is not always the case, though. For many terminated employees, a severance agreement may not be negotiable at all and may be presented as a take-it-or-leave-it offer. A lot depends on the employee's position within the company, and pre-existing contracts he or she has which may impact the terms of any release.

In McClain & Co., Inc. v. Carucci, the employer and employee reached a post-employment settlement agreement after Carucci apparently embezzled nearly $300,000. The agreement called for him to pay the employer $250,000, grant it a 30-month non-compete, and exchange releases. The court examined the few other cases on point and concluded that the "sale-of-business" test applied to the settlement agreement, at least in Carucci's case.

The court did not lay down a per se rule on this, nor should it have. A court when confronting a non-compete in a release agreement likely will examine a number of factors, including the degree to which it was negotiated, the benefits the employee received (such as garden-leave), the circumstances of the employee's termination, and other unique circumstances.

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Court: United States District Court for the Western District of Virginia

Opinion Date: 5/4/11

Cite: McClain & Co., Inc. v. Carucci, 2011 U.S. Dist. LEXIS 48404 (W.D. Va. May 4, 2011)

Favors: Employer

Law: Virginia

Flat-Fee Liquidated Damages Award Upheld in Staffing Dispute (ProTherapy Assocs. v. AFS of Bastian)

Staffing agreements almost always have some sort of non-compete or (more commonly) non-solicitation covenant. Courts recognize that without such protections staffing companies could become an involuntary employment agency for their clients.

In recognition of this, many agreements don't prohibit solicitation but rather tie a monetary price to it. These arrangements are called "liquidated damages" clauses, and they basically set a pre-determined formula for solicitation or hiring of an employee. Liquidated damages clauses can be enforceable, but several procedural requirements must be met. Most commonly, the damages must not be readily ascertainable at the time of contracting. Additionally, the formula or pre-determined sum must not be grossly disproportionate to damages that might be expected to result from a breach.

A recent dispute in the skilled nursing staffing industry upheld a clause that provided for $10,000 per wrongfully solicited or hired employee. The case followed a familiar storyline. The staffing company was terminated in favor of a replacement. The nursing homes used the replacement company to hire the workers the homes could not themselves hire without paying the liquidated damages.

The court found the $10,000 sum to be reasonable and enforceable. The plaintiff introduced evidence showing that the replacement cost of skilled nurses was relatively close to the $10,000 figure and that nurses frequently received signing bonuses of $10,000. Employers who choose to utilize liquidated damages clauses should be prepared to justify them with actual figures showing why the preset number was reasonable and proportionate to likely harm. The number need not be perfect, but also it can't just be random and certainly can't be punitive.

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Court: United States District Court for the Western District of Virginia
Opinion Date: 5/3/11
Cite: ProTherapy Associates, LLC v. AFS of Bastian, Inc., 2011 U.S. Dist. LEXIS 47161 (W.D. Va. May 3, 2011)
Favors: N/A
Law: Florida