California's "Trade Secret" Exception Depends on Contract Language (Richmond Techs, Inc. v. Aumtech Business Solutions)

California courts have long been hostile to restraints on trade. This strong public policy is embodied in Section 16600 of the Business and Professions Code. Most attorneys agree that general non-competition covenants (outside a sale of business or partnership agreement) are generally unenforceable.

In Edwards v. Arthur Andersen, LLP, the California Supreme Court rejected a "narrow restraint" rule which would have exempted restrictions that did not totally foreclose an employee from working in his chosen profession. Put another way (and more simply), customer non-solicitation covenants aren't enforceable.

The more difficult, lingering issue California courts have not squarely addressed has to do with another narrow class of covenants: the "trade secrets" exception. California hasn't exactly been clear whether a covenant designed to protect trade secrets can be enforced. A recent federal district court case seems to suggest there is some continuing vitality to this doctrine.

But here is the key. Unlike other states where access to trade secrets can be the protectable interest supporting the covenant, California puts a premium on how the covenant is drafted. To walk the fine line between protecting trade secrets and honoring the letter of Section 16600, the courts which have invoked the trade secrets exception require that the covenant, as drafted, only prohibit competition that requires the use of trade secret material.

The Richmond Technologies case is illustrative of this somewhat esoteric principle. The dispute in that case centered on a vendor's alleged misuse of source code to supply competing enterprise resource planning software. The non-compete was broken down into three parts: a general non-solicitation of the plaintiff's employees, a similar non-solicitation of the plaintiff's customers, and a more general non-competition clause barring competition with the plaintiff "using its technology."

Paradoxically, the court held that the two non-solicitation clauses - which usually are more limited - were likely invalid under Section 16600. But because the non-competition clause prohibited the vendor from offering a similar ERP software product using the technology it agreed to provide to the plaintiff, the clause was actually quite narrowly drafted to protect trade secrets. Had the clause barred the vendor from providing a similar product or service generally to the marketplace (without reference to the specific technology it developed for the plaintiff), then the court likely would have found that the "trade secrets" exception could not apply.

Again, in California, when considering this exception, it is imperative to focus on the contract language used. California (in many ways) is not like other states. The fact that the interest to be protected by a non-compete is trade secrets is not relevant. The covenant itself must only prohibit competitive activity requiring the use of trade secrets.

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Court: United States District Court for the Northern District of California
Opinion Date: 7/1/11
Cite: Richmond Technologies, Inc. v. Aumtech Business Solutions, 2011 U.S. Dist. LEXIS 71269 (N.D. Cal. July 1, 2011)
Favors: N/A
Law: California

A Summary of Georgia's New (Employer-Friendly) Non-Compete Statute

Loyal readers of my blog (yes, there are quite a few!) surely know that there are a handful of red-flag states out there which have unique non-compete rules. Georgia, historically, has been such a jurisdiction. Employees have met with a high degree of success in challenging non-compete obligations, often succeeding because covenants are facially overbroad and capture too much competitive activity.

All that changed with the passage of a new statute in Georgia, which recently went into effect. The new statute is decidedly more employer-friendly. Because the new law only affects covenants entered into after its effective date, employers now have a strong incentive to redraft agreements and bind key employees to new covenants.

The changes are fairly extensive, so I will summarize some of the main points that I would expect to come up frequently.

(1) Class of employees: non-competition agreements can be enforced against employees who regularly solicit customers, regularly engage in sales, perform the duties of a "key employee", or supervise others.

(2) A term will be presumed reasonable if it is (a) 2 years for employees, (b) 3 years for arms-length business transactions (such as a license or franchise agreement), and (c) 5 years for a sale of business.

(3) Non-solicitation covenants need not have an express geographic territory tied to them.

(4) Burden of proof: the employer will need to establish that the covenant protects a legitimate business interest, which is expansively defined and includes goodwill, confidential information, customer relationships, and specialized training. If the employer demonstrates the covenant meets the statutory terms, the burden shifts to the employee to show it is unreasonable.

(5) Blue-pencil rule: the impetus behind the statute was Georgia's strict rule prohibiting any modification for overbreadth, which also generally resulted in an entire covenant being struck down as void. Courts are now empowered to modify overbroad restraints.

Again, keep in mind, the old Georgia law is still relevant because the law is not retroactive. Employers would be well advised to have their agreements audited and redrafted to suit the new law. Prospective employees must now pay careful attention to their agreements and be vigilant about negotiating terms. They can no longer count on courts to save them from a bad deal.

Discovery Requests Can Play Important Role In Determining Reasonableness of Non-Compete (SNS One v. Hage)

Many clients are under the impression that a non-compete agreement can be analyzed strictly by looking at the four corners of the document.

While in some cases this may be true, the vast majority of non-compete issues turn on specific facts that fall outside the terms of the agreement. When a non-compete dispute ripens into a lawsuit, discovery plays a big role in determining whether a covenant is reasonable or overbroad. Counsel for an employee always will need to determine how to frame discovery requests to try to lock in an employer. Conversely, an employer must carefully consider how it responds to a discovery request and assess the implications of its answer.

A recent case out of Maryland illustrates the importance discovery plays in non-compete disputes. In SNS One v. Hage, the employee's non-compete agreement prohibited him from being employed by a competitor for a one-year period after termination. The employee's attorney requested of the employer a list of who those competitors were. The employer repeatedly refused to do so, and on a motion to compel, the court even warned the employer that its refusal to respond may lead to an inference that the covenant was overbroad.

And that's just what the court found at summary judgment. In so holding, the court stated an important maxim for attorneys to remember: "An employee needs firm, solid guidance on what he can and cannot do if he leaves his employer." In that case, the employer provided no such guidance and never really tried.

At a bare minimum, the employer should have provided a preliminary, good faith list of competitors that it considered off-limits. Had it done so, the court might have concluded that the agreement was reasonable. Employers would be well-advised to keep a list of actual or potential competitors so that responding to this type of discovery does not cause a fire drill or result in an incomplete list. The same is true of particular customers that an employer contends falls within a non-solicitation clause.

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Court: United States District Court for the District of Maryland
Opinion Date: 7/11/11
Cite: SNS One, Inc. v. Hage, 2011 U.S. Dist. LEXIS 74718 (D. Md. July 11, 2011)
Favors: Employee
Law: Maryland

Covenant Not to Solicit Clients Implied When Goodwill Sold With Business (Bessemer Trust Co. v. Branin)

Last year, a client called me and described a familiar problem. He had purchased an insurance business from another agent in town, who had worked for a while during the transition but quickly became dissatisfied. When the relationship finally soured, the agent left and started a competing agency, soliciting away his former clients.

The buyer clearly purchased the agency's goodwill and client list, but the covenants in the closing documents were a mess. Still, the buyer believed that the integrity of the transaction depended on the agent not soliciting his former customers away. He's correct, at least under most states' laws.

The Court of Appeals of New York clarified the "implied covenant" rule in Bessemer Trust Co. v. Branin, which dealt basically with the above scenario in the financial services world. The Court clarified that a seller may not actively solicit the patronage of his former clients when the goodwill of an established business is sold.

The Court addressed a related question: what assistance can the seller provide the new employer with respect to those clients? Several factors were addressed.

First, the custom of the industry is always relevant.

Second, a court must assess whether the seller initiated contacted with his old customers, or whether the customers reached out to the seller's new firm.

Third, a seller may advertise generally to the public, but cannot send targeted mailings or make individualized telephone calls to former clients.

Fourth, when a client seeks "factual information" about the seller's new firm, the seller cannot explain why he believes his products or services are superior to that offered by his former firm.

Fifth, a seller cannot convey proprietary information about his former customers to his new employer.

Sixth, a seller can assist his new employer in making a sales pitch to a former client and may be present during such a meeting, but must limit his responses to "factual matters."

Keep in mind that these factors are to be considered when there is no restrictive covenant contained in the business sale documents. When a business purchases a competitor's goodwill, carefully drafted covenants must be included both in the sale documents and in any transition or stay-on employment agreements. Those covenants can, and should, prohibit much broader restrictions that would prohibit the type of activity the Court of Appeals described above. They also should provide a panoply of self-executing remedies for breach, such as extension of the restriction and, when appropriate, liquidated damages.

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Court: Court of Appeals of New York

Opinion Date: 4/28/11

Cite: Bessemer Trust Co. v. Branin, 16 N.Y.3d 549 (Ct. App. 2011)

Favors: N/A

Law: New York

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.