Supreme Court of Hawaii Takes Expansive View of Trade Secrets Preemption (BlueEarth Biofuels v. Hawaiian Electric)

Warning: This post touches upon the incredibly dry subject of trade secrets preemption.

If you are still reading and you're not a lawyer, I am really impressed. The concept of trade secrets preemption is formalistic, but not difficult to understand. A few decades ago, it was generally thought the law concerning trade secrets was not particularly well-developed and somewhat confusing. When a uniform law was finally drafted (and subsequently enacted in many states), the idea was to coalesce trade secrets law so that lawyers and judges actually had some idea what to do. (Note: This is an extremely truncated, unsophisticated history of why the uniform law ever came to pass.)

Part of the problem with trade secrets law was that a plaintiff could pursue a number of different legal theories arising out of the same set of trade secrets facts - conversion, unjust enrichment to name a few. The commissioners who drafted the uniform law saw this as a problem and wanted to limit the potential claims based on trade secrets theft to just one - statutory misappropriation. Accordingly, the uniform law contains a strong displacement, or preemption, clause that indicates a clear intent that other common law, non-contract remedies are displaced.

The Supreme Court of Hawaii recently had occasion to answer several certified questions concerning the preemption clause in its version of the Uniform Trade Secrets Act. The Court took the majority view and adopted the "same proof" test. In essence, a claim will be displaced if it depends on whether the defendant is found to have misappropriated trade secrets. The most common claims that will be preempted include conversion, conspiracy to misappropriate trade secrets, and (in some states) common law or statutory unfair competition claims. The Court rejected a more narrow "elements" test that some jurisdictions have adopted, which holds that preemption applies if the same legal elements must be proven to the displaced claims. If a plaintiff needs to prove just one other element (such as an agreement in a trade secrets conspiracy claim), then preemption does not apply. This "elements" test makes no sense.

The more interesting question the Court addressed was whether preemption under the Uniform Act applies to non-contract claims based upon "confidential information" that does not rise to the level of a trade secret. Again, the Court followed the majority and held that such claims were in fact preempted (which is interesting, since the statute does not define or even mention these claims). This question, from my perspective, is a very difficult one to address, but the Court answered it the right way.

To allow non-contract claims to proceed when no trade secret is at issue actually would undermine the purposes of the uniform law and lead to a whole host of vague, potentially frivolous lawsuits. A party who diligently invests and protects truly secret information would fare no better than a party who takes only perfunctory steps towards protection (and presumably incurs fewer security measures costs). As a result, the incentive to develop secret information that yields a competitive advantage would be compromised.

Of course, if a party has an enforceable non-disclosure or confidentiality agreement and can establish a breach, then preemption has no impact on this analysis and the court proceeds to a straight contract claim. But to permit common-law, non-contract claims on the theory of misuse of confidential information is a clear invitation for abuse. Those claims should be preempted, for that is the clear intent of the Act's displacement provision.

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Court: Supreme Court of Hawaii
Opinion Date: 7/20/10
Cite: BlueEarth Biofuels, LLC v. Hawaii Electric Co., Inc., 235 P. 3d 310 (Haw. 2010)
Favors: N/A
Law: Hawaii

Non-Compete Agreement's Geographic Restriction Too Specific To Be Enforced (Wright Medical Group v. Darr)

In a state that refuses to employ the blue-pencil rule, sometimes a non-compete that is too specific can render it unenforceable.

This may sound absurd, but the entire premise of the blue-pencil rule is that courts will not rewrite agreements that may suffer from overbreadth. It is relatively easy to specify too much in a geographic restriction, and that was exactly what occurred in an Arkansas dispute recently. In Wright Medical Group v. Darr, the court invalidated a non-compete that restricted an employee from engaging in a competitive business in five named northeast Arkansas counties. The problem was that the employer conducted no business in two of the counties.

The employer tried to save the covenant by contending that its "trade area" was northeast Arkansas, and that it could not be limited on a county-wide basis. However, the non-compete did not define the geographical boundaries by a term like "trade area" or "area in which the employee had selling responsibility." Instead, it listed the five specific counties.

The court actually hinted at the possibility that a more general definition - "northeast Arkansas" - would not have helped much, since "there would be no way of knowing exactly what geographic areas are and are not encompassed" by that description. In states that do not blue-pencil, any technically overbroad aspect of the non-compete can render the entire agreement invalid. It is a far preferable practice to tie the geographic restriction to something more self-executing, such as "any county in which the employee had actual sales responsibilities during the 18-month period prior to termination of employment." This type of restriction likely would avoid a finding of overbreadth on technical grounds.

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Court: United States District Court for the Eastern District of Arkansas
Opinion Date: 8/6/10
Cite: Wright Medical Group, Inc. v. Darr, 2010 U.S. Dist. LEXIS 82682 (E.D. Ark. Aug. 6, 2010)
Favors: Employee
Law: Arkansas

Gross Billings for Accounting Clients Proper Measure of Liquidated Damages (Mayer Hoffman v. Barton)

Most shareholder agreements between partners in accounting firms contain strict client non-solicitation clauses, and agreements of this kind normally are looked at under the more lenient standard of reasonableness analysis common to sale-of-business contracts. In fact, accountants more than any other profession seem to use liquidated damages calculations to put an express, pre-determined price on competition.

There is a definite cost-benefit to this. On the upside, a liquidated damages clause provides certainty - particularly among partners who pool in equity and trust as consideration for agreeing not to compete directly for firm clients when they leave. As a potential risk, liquidated damages clauses tend to be difficult to enforce, if for no other reason than lawyers seem to have a tough time drafting them in compliance with governing legal standards. Also, if not properly thought through, the damages clause can actually underestimate potential damages arising out of a breach.

Accounting firms have been ahead of the game on non-solicitation clauses, and there are a number of firms that even allow competition as long as the departing employee or partner purchases the book of business. (Some agreements even allow just the right to buy specific clients, as opposed to the entire book). This "forced purchase" mechanism is still a restriction, but one that courts tend to examine more favorably than outright prohibitions on client work.

As the recent appellate opinion in Mayer Hoffman McCann v. Barton shows, the most commonly upheld liquidated damages formula is tied to a historical look-back of client billings over a set period of time. So for instance, if an accounting firm bills a tax or audit client $40,000 over the past two years, that amount may be pre-determined as the price for taking that client. Courts have even upheld multiples of billings over a period of time, though presumably the look-back period would have to be relatively short if a multiple were used.

Other industries in which these types of revenue-based liquidated damages clauses are common include executive recruiting and retail insurance brokerage.

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Court: United States Court of Appeals for the Eighth Circuit
Opinion Date: 8/11/10
Cite: Mayer Hoffman McCann, P.C. v. Barton, 614 F.3d 893 (8th Cir. 2010)
Favors: Employer
Law: Missouri

High Profile Non-Compete Disputes Turn Out Poorly for Departing Employees

Two of the more high-profile non-compete disputes in the last couple of years have not worked out well for employees challenging their restrictive covenants. The cases involving Matt Baldwin's departure from IMG Worldwide and Mark Papermaster's defection from IBM to Apple have resulted in both employees losing their new jobs, though neither termination resulted from a court order.

The Papermaster case was one of the more significant non-compete decisions to come down in the last several years. Papermaster left IBM to join Apple and head-up its iPhone 4 hardware division. The release of the iPhone 4 has been controversial given myriad problems with its antenna technology. Papermaster appears to be the fall-guy for problems with the iPhone 4 release, and there are reports that he never quite fit into the culture at Apple or was able to navigate around Steve Jobs' hands-on management style. Though the litigation between IBM and Papermaster appeared to have had a satisfactory resolution for the executive (a settlement was reached after a preliminary injunction order), his new employment - over which the parties no doubt spent hundreds of thousands of dollars fighting - never flourished.

The Baldwin case is of more recent vintage. That dispute involved an ex-employee's transfer from the IMG Coaches' Division in Cleveland to Creative Artists Agency in Los Angeles. The suit garnered some attention because of CAA's aggressive efforts to lure sports talent away from IMG, and due to the heavy losses IMG has suffered in recent years from sports client defections. From a legal perspective, the case was interesting in that Baldwin filed a strike suit after moving from Minnesota to California, which has a very strong public policy against enforcement of non-compete contracts.

As it turns out, Baldwin's planned migration to CAA didn't work out very well either. The central problem appears to have involved Baldwin's misappropriation of confidential IMG information via, yes you guessed it, a USB memory stick. Following the commencement of litigation both by Baldwin in California and by IMG in Ohio, CAA fired Baldwin - apparently for misappropriating IMG's information.

Parties often never consider impact of litigation can have on an employee's ability to perform to an anticipated level in their new position. The costs of litigation, unforeseen facts (such as misuse of data), client dissatisfaction, distraction, and adverse publicity can ruin a new employment relationship regardless of whether a judge tells an employee he can't engage in certain conduct. Decisions to compete are frequently made on an expedited basis, and this fact alone naturally results in poor decision-making.

Papermaster's resignation from Apple likely resulted from him simply being the wrong fit at the company, and that relationship might have ended sooner than expected whether a suit had been filed or not. But Baldwin's problems were compounded by a poorly planned transition and, in all likelihood, a new employer who disapproved of what Baldwin did on his way out the door at IBM.

There is simply no substitute for extensive advance planning when making a decision to compete. Employees who challenge non-compete agreements ought to consider not just whether they can win a suit, but also whether they can be successful in their new position.

Over Half of Departing Employees Compromise Proprietary Data, Study Finds

Does that statistic surprise you? Research conducted by the Ponemon Institute, which was compiled in June of 2009, indicates that, in fact, over half of all employees compromise their employers' confidential information when leaving. The most surprising part of this study was that the data was compiled by interviewing the employees themselves.

Over two-thirds of survey respondents admitted to transferring confidential business information on to a USB memory stick. Almost 90% of those respondents admit that their company forbids such a practice. Over half of respondents admit to accessing web-based e-mail from workplace computers, but most employees don't believe that company policy prohibits that conduct.

My experience is that in larger, more sophisticated organizations, corporate policies concerning transfer of data to portable media, and access to web-based mail, are much more clear and widely disseminated among the employee ranks. In smaller organizations, security measures still have not caught up. It is routine for companies to allow, either implicity or explicity, documents to be shuffled around via USB drives or to be sent via web-based e-mail.

The advent of new technology, and evolving means by which it is moved, means employers need to start revising non-disclosure agreements and trade secrets policies. If certain security measures are not explicitly outlined, employees often will claim ignorance (sometimes rightfully so) about migration of data.

From an employee's perspective, little more needs to be said than what has not already been written about 100 times here. If you transfer documents to a USB stick or e-mail lists to your Gmail account, it will be traced and discovered.

Tennessee Court Expands Geographic Reach of Non-Compete Agreement (J.T. Shannon Lumber v. Barrett)

Regular readers of this blog know that a court's application of the blue-pencil or equitable modification rule can be outcome-determinative in a non-compete dispute. Normally, this rule is applied to pare back or narrow an otherwise overbroad non-compete agreement.

But what about using the rule to expand the geographic scope of a covenant?

That is what a recent federal court in Tennessee did in a non-compete dispute, though it is not clear the court utilized the blue-pencil rule per se.

In J.T. Shannon Lumber v. Barrett, an executive vice-president signed a non-compete agreement that prohibited him from working for "any company which competes directly or indirectly with [J.T. Shannon] anywhere within the United States of America, or such area as a court in enforcing this Paragraph shall determine is reasonable under the circumstances."

The court interpreted the non-compete provision in such a way as to restrict the executive's ability to work in the Asian lumber market, given his prior involvement in expanding the company's office in Shanghai. In particular, the court noted that "the parties' expectations under the contract" allowed it to alter the geographic scope both to shrink the territorial region within the United States or to extend it internationally. Therefore, the court looked more to the contract language than the blue-pencil rule itself.

The result certainly seems equitable, but this is a case we don't see come down very often. I highly doubt the parties "expectations" included expanding the geographic reach of the non-compete, and I am sure the employee's attorney advised his client that the language in the contract likely was inserted to allow a court to reduce - rather than expand - the covenant.

Despite the employer-friendly ruling, I would not recommend that companies deploy language like that quoted above. There are much better ways to provide for flexibility in the geographic reach of a non-compete agreement than relying on extremely general language that likely was not meant to address the situation presented in J.T. Shannon Lumber.

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Court: United States District Court for the Western District of Tennessee
Opinion Date: 8/4/10
Cite: J.T. Shannon Lumber Co., Inc. v. Barrett, 2010 U.S. Dist. LEXIS 79099 (W.D. Tenn. Aug. 4, 2010)
Favors: Employer
Law: Tennessee

Cut In Salary Usually Does Not Void Non-Compete Clause (Leibowitz v. Aternity, Inc.)

Clients frequently ask whether a cut in salary or commissions will void an existing non-compete obligation. Like most covenant-related questions, the answer largely depends on the contract language itself.

Employers often will address the issue of salary and compensation in an agreement that also contains a non-compete restriction. That agreement ought to contain a clear provision that allows an employer to change or modify a stated salary, benefit, commission rate, or bonus without affecting the validity of other obligations.

As a New York court (applying Massachusetts law) recently found, this is more than enough to answer an employee's claim that a cut in a commission rate somehow invalidates a restrictive covenant.

What is less clear is a contract that contains no language whatsoever allowing the employer the ability to adjust salary up or down without compromising the non-compete covenants.

If the language of the compensation terms can be read as creating an obligation on the employer's part to pay a certain salary (or even allowing for salary to be increased from time to time), then an employee may have a pretty good case that a unilateral reduction amounts to a breach of contract. Again, all depends on the language of each contract, but the employee's argument clearly is strengthened in this situation.

A more difficult case for the employee would be a contract that just says nothing at all about compensation. Of the contracts I am asked to review, well over half deal with covenants or post-termination obligations only and are utterly silent as to compensation and benefits. This presents a much more difficult issue for an employee, and if she seeks to invalidate the covenant, then she almost certainly will need something else in her favor.

Perhaps the salary cut or commission rate decrease can increase the court's sympathy for a departed employee faced with a non-compete restriction, but standing alone it is a weak defense. An employee is going to need some other contributing factor to escape a contractual obligation. It is relatively easy for an employer to justify compensation reductions based on financial performance, new competitors, or some other external market force, and this normally has nothing to do with the interest to be protected through a non-compete agreement.

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Court: United States District Court for the Eastern District of New York
Opinion Date: 7/14/10
Cite: Leibowitz v. Aternity, Inc., 2010 U.S. Dist. LEXIS 70844 (E.D.N.Y. July 14, 2010)
Favors: Employer
Law: Massachusetts

California Court Strengthens Public Policy on Employee Mobility (Silgeuro v. Creteguard, Inc.)

Most everyone is aware that non-compete agreements have been void in California since 1872, when the California legislature rejected the common-law rule of reason and banned non-competes except in very limited circumstances. Courts have routinely enforced and upheld California's long-standing, unequivoical public policy, and just a few years ago rejected the so-called "narrow restraint" exception some courts had attempted to graft onto the applicable California statute.

Given California's long public policy in favor of employee mobility, the latest ruling out of the Court of Appeal of California should come as no surprise. Rosemary Silguero signed an 18-month non-compete agreement with a company called Floor Seal Technology, Inc. (FST) in 2007. She was subsequently terminated from that position and found new work with Creteguard, Inc. After learning of Silguero's new job, FST contacted Creteguard and requested "cooperation and participation" in enforcing its agreement with Silguero. Creteguard complied, informing Silguero (in writing) that although it did not believe FST's non-compete was enforceable, it "would like to keep the same respect and understanding with colleagues in the same industry."

Silguero sued Creteguard, alleging her termination contravened public policy under California's long-enforced prohibition on non-compete agreements. The Court of Appeal found that Silguero had a valid claim, noting that the FST/Creteguard pact was tantamount to the very type of employee no-hire arrangement it previously found to violate California law.

It is certainly true that in the vast majority of states an employer can discharge an employee for refusing to sign a non-compete agreement and an employer can make execution of a non-compete a condition to accepting a job or a promotion.

However, these default rules do not necessarily apply in the few states like California that have clear, time-honored public policies against enforcement of non-compete agreements.

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Court: Court of Appeal of California, Second Appellate District
Opinion Date: 7/30/10
Cite: Silguero v. Creteguard, Inc., 2010 Cal. App. LEXIS 1263 (Cal. Ct. App. 2d Dist. July 30, 2010)
Favors: Employee
Law: California