What to Do When Your Client’s COO Becomes Your Competitor’s BFF
Apr 9, 2014 | Raleigh, NC, United States
Jeremy M. Falcone
James M. Weiss
One of your most important clients just called. She reports that one of her senior sales people quit a few months ago, and she just learned that the sales person has joined a large competitor. Panicking, your client wants to know what she can do. This article will give you a roadmap to responding when a client has lost a key employee, whether a sales person or an executive, and the client wants to take legal action to remedy the situation.
Start by asking about your client’s goals. Does she want injunctive relief as soon as possible? Does she accept losing the employee but think that she might build a damages case against the new employer? Is she worried about losing valuable trade secrets or customers in the very near future? What other concerns does she have following the departure as a key employee? Once you have a sense of your client’s goals, you can start evaluating whether you can achieve those goals, and if not, start evaluating your client’s options for dealing with the departed employee.
First, ask your client if the company had contracts with the departed employee. Did the employee have any kind of employment agreement at all or was he an at-will employee? Did the employee have a non-compete agreement, a non-solicit agreement, a confidentiality agreement, and/or another type of contractual arrangement?
Next, identify the information that your client wants to protect, such as trade secrets, customer information, or other potentially protectable intellectual property. You also should ask about the former employee’s access to that information, both while he was employed and after he left. Ask the client what precautions it takes to protect that information. Find out about the computing devices that the former employee used and whether your client can run forensics on them to identify electronic malfeasance.
All of these questions will help you chart a plan of attack that best addresses your client’s goals while remaining realistic about the relief that your client can reasonably secure, both in the short term and the long term.
Does the Departed Employee Have a Non-Compete Agreement?
The first line of defense that your client may have is a covenant not to compete with the former employee. An enforceable non-competition agreement is the best bulwark against employees going to work for competitors in the same field. The law generally does not view non-competition agreements favorably because they can deprive someone of his or her ability to earn a living. However, many states will enforce a covenant not to compete if its terms are reasonable. On the other side, in some states, non-competes are virtually unenforceable. For example, in California, covenants not to compete are generally unenforceable by statute. See Cal. Bus. & Prof. Code § 16600 (permitting exceptions for limited situations, usually involving the sale of a business or dissolution of a partnership). See also Fillpoint, Inc. v. Maas, 208 Cal. App. 4th 1170, 1177 (2012). Although states generally take similar approaches, check the law in your state to determine how courts generally evaluate non-competition agreements.
In states where such agreements can be enforced, courts consider whether such a covenant is reasonable. What terms are reasonable is often established through case law, but some jurisdictions have codified their restrictive-covenant law. E.g., Fla. Stat. § 542.335; Tex. Bus. & Com. Code § 15.50. When evaluating reasonableness, courts typically evaluate several specific factors. One threshold issue that several states consider is whether a non-compete agreement is necessary to protect the legitimate interests of an employer. E.g., Techworks, LLC v. Wille, 770 N.W.2d 727, 734 (Wis. Ct. App. 2009); Whelan Sec. Co. v. Kennebrew, 379 S.W.3d 835, 841–42 (Mo. 2012). These states typically balance the employer’s interests, the employee’s interests, and the public’s interests in some fashion. Illinois, for example, enforces covenants that (1) are no greater than necessary to protect the employer’s legitimate business interest, (2) do not impose undue hardship on the employee, and (3) do not injure the public. Reliable Fire Equip. v. Arrendondo, 965 N.E.2d 393, 396 (Ill. 2011).
In other states the courts go straight to the three issues that are usually at the core of enforceability: time, scope, and range. While the specifics vary from state to state, precedent generally guides courts in determining whether time, scope, and range restrictions are reasonable. Underpinning courts’ decisions—and precedents guiding them—is the reluctance to enforce agreements that leave a former employee without a meaningful way to earn a living. Restrictions that are tailored to an employer’s true needs and that leave an employee room to earn a living when he or she moves on are more likely to be enforced.
Although there is no hard and fast line, courts generally deem a term of one to two years as a reasonable period to agree not to compete. Courts also want to see agreements that limit the non-compete to the industry or profession in which an employee is engaged. And courts tend to treat skeptically covenants without any geographical restrictions or that exceed a former employer’s geographic reach.
Even within the reasonableness framework, courts vary. Some courts strictly scrutinize covenants not to compete between employers and former employees, which generally favors employees. E.g., Freeman v. Brown Hiller, Inc., 281 S.W.3d 749, 754 (Ark. 2008). Others take approaches more favorable to employers. For instance, Ohio courts generally enforce reasonable non-competition agreements and sometimes enforce unreasonable ones “to the extent necessary to protect an employer’s legitimate interests.” Century Bus. Servs., Inc. v. Urban, 900 N.E.2d 1048, 1053 (Ohio Ct. App. 2008).
The reasonableness standard does not govern everywhere. Some states’ non-competition statutes impose unique, often bright-line rules dictating when covenants not to compete are enforceable. For example, Colorado generally prohibits all covenants not to compete except (1) contracts for the purchase and sale of a business, (2) contracts protecting trade secrets, (3) contractual provisions permitting an employer to recover an employee’s education and training expenses if the employee has served less than two years, and (4) “[e]xecutive and management personnel and officers and employees who constitute professional staff to executive and management personnel.” Colo. Rev. Stat. § 8-2-113. Louisiana generally permits covenants not to compete only if they expire after two years and apply to specific Louisiana parishes where a former employer does business. La. Rev. Stat. Ann. § 23:921(C).
One other factor to consider is a departed employee’s profession. Some states analyze non-competes differently based on the specific occupation. For example, New Jersey does not apply the reasonableness standard if an employee is an attorney or a psychologist. See Cmty. Hosp. Group, Inc. v. More, 869 A.2d 884, 895–96 (N.J. 2005). In Tennessee, covenants not to compete involving physicians are generally unenforceable. Murfreesboro Med. Clinic, P.A. v. Udom, 166 S.W.3d 674, 683–84 (Tenn. 2005).
Finally, an agreement signed when employment begins usually provides sufficient consideration to enforce the agreement. If an agreement was signed at some other time, you will need to find out whether your client’s former employee received additional consideration in exchange for the employee’s agreement not to compete with the company. Without this consideration, some states will not enforce a non-compete agreement that an employee signed in the middle of his or her employment. E.g., Access Organics, Inc. v. Hernandez, 175 P.3d 899, 903 (Mont. 2008); but see Central Monitoring Svc., Inc. v. Zakinski, 553 N.W.2d 513, 517-18 (S.D. 1996) (no additional consideration needed for non-compete signed six months after employment relationship began)
Does the Departed Employee Have a Non-Solicitation Agreement?
The next line of defense is a non-solicitation agreement. Even if a departed employee does not have an agreement not to compete, he or she may have an agreement not to solicit your client’s customers, not to solicit your client’s other employees, or both. The law governing non-solicitation agreements is less settled than the law governing covenants not to compete. Each state’s approach varies, and state laws governing non-solicitation clauses continue to evolve.
Generally state laws and state courts are friendlier toward non-solicitation clauses than non-competition clauses because solicitation prohibitions interfere less with an employee’s ability to earn a living. Many courts also recognize that employers have special interests in preserving customer relationships, protecting investments in employees’ education and development, and preserving a stable work force. A non-solicitation clause sensibly protects those interests even if an employee joins a competitor.
Currently, California is the only state to prohibit non-solicitation agreements, subject to narrow exceptions. Edwards v. Arthur Andersen LLP, 189 P.3d 285, 288–90 (Cal. 2008) (extending Cal. Bus. & Prof. Code § 16600 to non-solicitation agreements). Missouri had also invalidated non-solicitation agreements, but the state legislature codified recognition of the agreements as valid. Compare Schmersahl, Treolar & Co., P.C. v. McHugh, 28 S.W.3d 345 (Mo. Ct. App. 2000), with Mo. Rev. Stat. § 431.202.
Some state courts also have treated non-solicitation clauses more generously than non-competition clauses. For example, West Virginia has concluded that “non-piracy provisions, which ordinarily do not include territorial limits, are less restrictive on the employee and the economic forces of the marketplace” than non-competition provisions. Wood v. Acordia of W. Va., Inc., 618 S.E.2d 415, 421–22 (W. Va. 2005). Arizona courts agree that non-solicitation agreements are “less restrictive on the employee (and thus on free market forces) than a covenant not to compete.” Hilb, Rogal & Hamilton Co. of Ariz. v. McKinney, 946 P.2d 464, 467 (Ariz. Ct. App. 1997). Both states, however, still require some proof that a non-solicitation clause is reasonable, Wood, 618 S.E.2d at 422, or “no broader than necessary to protect the employer’s legitimate business interest,” Hilb, 946 P.2d at 467.
The vast majority of states, however, treat non-solicitation agreements similar to any other covenant not to compete, either under statute or case law. Two kinds of analyses generally apply. First and most commonly, non-solicitation clauses must meet some kind of reasonableness analysis similar to non-compete agreements. Second, some states have statutorily or by court decision extended their non-competition statutes to cover non-solicitation agreements.
Non-solicitation agreements, similar to non-competition agreements, generally must meet the other hallmarks of any contract such as consideration. But some concerns specific to non-solicitation agreements are important. In particular, in some states, employers should be careful to tie solicitation prohibitions to customers with which an employee actually interacted. New York courts, for instance, have invalidated covenants that barred an employee from soliciting clients when the former employee did not have a relationship with them. Scott, Stackrow & Co., C.P.A.’s, P.C. v. Skavina, 780 N.Y.S.2d 675, 677 (3d Dep’t 2004).
Did the Departed Employee Have Access to Your Client’s Trade Secrets?
Your client’s former employee may have had access to confidential information that would harm the client if it fell into competitors’ hands. To advise your client on how to handle that situation, you must first determine whether the confidential information could constitute a trade secret.
The idea of a “trade secret” may conjure up an image of the secret recipe to your favorite soda or the chemical formula to the latest blockbuster arthritis drug. But information need not be a manufacturing secret to constitute a trade secret. For instance, internal marketing strategies or customer lists can qualify for protection in certain situations.
While the trade secret analysis varies from state to state, most states have adopted some form of the Uniform Trade Secret Act (UTSA). Only New York continues to rely solely on the common law. Even with a uniform statute, the analysis varies from state to state. Many states slightly amended their enactment of the UTSA. State courts have added to the variance by interpreting similar portions differently.
Differences aside, all jurisdictions require that the information that a company wants to protect have some value to the company and be treated as confidential. A finding of confidentiality requires more than just a company’s belief that the information should not be distributed to third parties. The information also cannot be generally available or able to be easily recreated with public sources. So while most companies would consider their customer lists confidential, only lists that cannot be ascertained from public sources usually qualify for protection as trade secrets.
Courts consider several factors in determining whether information is confidential. First, a court will consider whether your client had a confidentiality agreement with the employee. A court will look for any indication that an employee was on notice that a company viewed the information as confidential. A confidentiality agreement provides this assurance. Unlike non-compete provisions, a confidentiality agreement may be unlimited in time because trade secrets can be unlimited in duration. See Brainware, Inc. v. Mahan, 808 F. Supp. 2d 820, 829 (E.D. Va. 2011) (noting that an indefinite non-disclosure provision is not per se unenforceable). Even if your client did not have a formal standalone confidentiality agreement with the former employee, the employee handbook or manual may contain sufficient provisions regarding confidentiality to have placed the employee on notice. See Morlife, Inc. v. Perry, 56 Cal. App. 4th 1514, 1523 (1997) (providing trade secret protection because the employee handbook “contained an express statement that employees shall not use or disclose [the company’s] secrets or confidential information” and included “lists of present and future customers” as protected information).
Next, a court will consider your client’s actions to maintain confidentiality, including the amount of money that the company spent on maintaining confidentiality. Ask whether your client restricted information to certain employees because this can increase the chance that such information will be protected as a trade secret. Also consider the actions that your client took during the employee’s departure, such as holding an exit interview or reminding the employee about his obligation to treat information as confidential. Exit interviews can be a useful time to discuss confidential information and ongoing duties to preserve confidentiality after an employee departs. Ask your client whether she disabled the employee’s access to confidential information immediately upon the employee’s departure. Generally, the greater the efforts the client made to keep the information confidential, the more likely trade secret protection will apply.
While an employee’s confidentiality agreement and a company’s measures to maintain confidentiality go a long way toward establishing information as a trade secret, they cannot create a trade secret when one would not otherwise exist. When information can easily be recreated, courts are unlikely to find that the information constitutes a trade secret. For instance, in Guy Carpenter & Company, Inc. v. Provenzale, 334 F.3d 459, 467 (5th Cir. 2003), the court did not recognize a customer list as a trade secret because the list could be recreated from information available from other sources. Id. Furthermore, the customer list was “relatively short” so the departed employee “could easily reconstitute” it. Id.
Separately, you will need to determine whether the employee actually has used or has threatened to use the confidential information in the new employment. Your client can meet this test if she has learned through secondary channels that the employee has used the confidential information. For instance, your client may have learned that the employee has contacted customers on the confidential customer list or has told potential customers that the employee can create a competing product previously only manufactured by your client.
The difficulty comes when your client cannot demonstrate that the employee has used or has threatened to use the confidential information. While in many jurisdictions your client may not be able to move forward, some UTSA jurisdictions have adopted the doctrine of inevitable disclosure to plug that gap. The inevitable disclosure doctrine recognizes that in certain limited circumstances a departed employee possesses such critical knowledge of the former company that disclosure to the new employer is inevitable. The former company can then enjoin the departed employee from working for the new employer. A number of UTSA jurisdictions have recognized the inevitable disclosure doctrine as a substitute for actual or threatened use of the confidential information. See PepsiCo, Inc. v. Redmond, 54 F.3d 1262, 1272 (7th Cir. 1995) (recognizing the inevitable disclosure doctrine in Illinois). Others have rejected it. See, e.g., Holton v. Physician Oncology Servs., LP, 742 S.E.2d 702 (Ga. 2013). Many other jurisdictions have yet to rule on its availability.
Where it applies, generally courts narrowly construe the inevitable disclosure doctrine. Among other factors, courts will compare the two employers to determine whether they are direct competitors with similar products or services. Courts will also consider an employee’s role and responsibility at the old and new employers to determine whether the new job will require the employee to rely on confidential information learned in the previous position. Bad faith by an employee or a new employer can also factor into the analysis. For instance, an employee who downloads confidential information shortly before departure or a new employer that encourages disclosure of information could be found to have acted in bad faith.
What Are Your Client’s Remedies?
In addition to the remedies in contract and under the UTSA, your client potentially could assert several tort claims against the former employee and his or her new employer. The new employer’s actions might meet the requirements of tortious interference with contract, provided that you can demonstrate that the new employer was motivated (solely, in some states) by a desire to damage your client’s business. A statutory unfair and deceptive trade practices claim might also provide a remedy against the former employee or the former employee’s new employer.
Once you have identified the particular claims available to your client, you need to decide the proper method for pursuing the claims. Sending a letter to an employee’s new employer detailing the employee’s agreements might seem fruitless. However, in some cases a new employer is unaware of these agreements. A new employer may take appropriate action after learning about your client’s agreements with the employee, obviating the need to take further legal action.
When an opening letter does not do the trick, your client has several options. You may go to court and immediately seek a temporary restraining order. As with any temporary restraining order, you will need to demonstrate a likelihood of success on the merits of your client’s underlying claims. Although you will not have the benefit of full discovery, your client might be able to immediately enjoin the new employee. Explain to your client that the sooner you seek a temporary restraining order the better. Every day of delay works against an argument that your client will suffer irreparable harm unless a court grants immediate injunctive relief.
Once you have a temporary restraining order, you will have to begin preparing for a preliminary injunction hearing. Some courts may allow you to do very limited discovery in the period between issuance of the temporary restraining order and the preliminary injunction hearing, such as doing a one-hour deposition of the departing employee and making limited document requests. This is also a good time to take advantage of any forensic work that you can develop on the former employee’s old computers. You might also consider asking a court to grant you access to the former employee’s current computers and devices to look for your client’s confidential material.
Alternatively, you might consider filing a lawsuit without seeking a temporary injunction and proceeding to full discovery. In certain circumstances, damages can be more valuable to your client than an injunction. Your client needs to be willing, however, to commit significant assets to a lawsuit seeking damages. Moreover, it may be hard to measure the damages that are attributable to one employee going to work for a competitor.
Your client’s decisions will have consequences. Your client may be accused of interfering with the former employee’s relationship with the new employer. You could see counterclaims against your client for tortious interference or for violating your state’s unfair and deceptive trade practices statute. Cautionary tales can be found throughout the case law. Many states recognize, however, that as long as a former employer pursues a lawsuit with a legitimate basis, merely filing those claims does not constitute tortious interference or unfair trade practices. See, e.g., Reichhold Chems., Inc. v. Goel, 555 S.E.2d 281, 290 (N.C. Ct. App. 2001) (finding no tortious interference liability unless the “suit is brought with no sufficient lawful reason”). In Reichhold, the North Carolina court upheld the employee’s counterclaim award of compensatory and punitive damages against the former employer. Id. at 291.
A departed employee can present many problems for a client. At the same time, your client will have a variety of options for pursuing the employee or new employer to protect your client’s business. Start by identifying your client’s objectives. Once you identify those objectives, analyze the factual record and the law in the applicable jurisdiction to identify the best path to recommend. The discussion above is intended to help identify that path.
*This article orginally appeared in the February 2014 Issue of For the Defense.