Advancement Rights Percolate Beneath Delaware Trade Secrets Lawsuits

Assume you represent a company and suspect a departed executive is competing unfairly by using the company's trade secret information. Further assume you have a case with, at least at first blush, a strong set of facts and a motivated client which wants to move quickly. But like most trade secrets cases, the suit is going to cost a lot of money and take a great deal of discovery to resolve.

How do you feel about advising your client that it may need to pay the ex-employee's legal fees as the case proceeds?

This is the reality of trade secrets lawsuits, particularly against former officers and directors of Delaware corporations. Delaware has a broad public policy that encourages individuals to serve in officer and director roles. To entice that service, Delaware corporate law allows, and virtually all company bylaws adopt, broad advancement rights.

So what is "advancement"?

The concept simply refers to a corporation's obligation to front (or, advance) legal expenses that an officer or director incurs by reason of her service to the company. Unlike indemnification, advancement means that an officer or director may have a right to receive regular payments to defray legal expense as the proceeding develops over time.

Importantly, this advancement right even can apply when the officer or director sits in an adversarial position to the company, as the officer or director would in a trade secrets misappropriation case. I have highlighted above the phrase "by reason of" because it is central to many disputes over whether an individual is properly entitled to advancement of legal fees.

Delaware courts have provided a helpful definition for this key phrase: it simply means there must be a "causal connection" between the underlying proceedings and one's official corporate capacity. See Homestore, Inc. v. Tafeen, 888 A.2d 204, 214 (Del. 2005).

There are a growing number of cases that apply the official capacity test to trade secrets cases. The courts finding advancement rights in these cases reason that where a claim is based on misuse of confidential information learned in an individual's official corporate capacity, that claim is one that qualifies as being brought "by reason of" her service to the company. There are several cases that address this, and most look at the nature of the allegations found in the underlying complaint. An example for practitioners comes from Pontone v. Milso Indus. Corp., 2014 Del. Ch. LEXIS 152 (Aug. 22, 2014), a fairly common dispute between a company and a former officer, who competed after his non-compete agreement ended. The core allegation dealt with the officer's purported misuse of trade secrets to lure away customers and employees of the former employer.

The overarching rationale that allows for advancement is that a corporate officer would not have had access to confidential information but for her service to the company. This, courts reason, provides the essential link between the challenged conduct and the official capacity needed to meet the "by reason of" language that virtually all Delaware corporations have in their bylaws.

The advancement rights that are likely available may be limited to officers and directors, as opposed to employees. But it is essential to parse carefully the language of the state's enabling statute and the corporate charter and bylaws to see who qualifies for advancement and what the precise conditions are for receiving advancement. Though many states will follow Delaware case law, there is variation among the statutory provisions and a high likelihood that a non-Delaware entity will not provide for broad advancement rights.

So for those attorneys who are filing trade secrets cases, it is essential to evaluate the potential for advancing your adversary's costs along the way. In effect, this could double your client's litigation expense.

A Fool's Errand: Seizing Instrumentalities of Trade Secrets Theft

There is much debate about the companion pieces of legislation introduced in Congress that relate to trade secrets law.

Those two proposed laws are known as the Defend Trade Secrets Act of 2014 (the Senate version) and the Trade Secrets Protection Act of 2014 (the House version). The debate often centers around whether it is sensible for Congress to federalize a branch of law traditionally reserved to the States, under which a well-established body of case law already exists. There also is the perception that federal courts provide muscle that state courts cannot, and that in certain states overly taxed judges do not have the resources to handle complicated discovery disputes and the sheer pace of trade secrets litigation.

One area of friction that is starting to gain some attention concerns the federal proposal to allow for ex parte seizure orders in trade secrets cases - something that commands almost no attention at the state level. Seizure orders are common in copyright and trademark cases because the infringing good (a pirated movie, for instance) is itself a reflection of the wrong. In trade secrets cases, however, the device used to store a stolen secret - a hard-drive or a server - may have (indeed, likely has) a mostly legitimate, non-infringing purpose. The DTSA attempts to incorporate the provisions of the Trademark Act in regards to seizure order, but this fails to recognize the vast difference in the type of intellectual property which trademark law is intended to protect compared with trade secrets law.

The TSPA is, to be certain, more mindful of the problems associated with the ex parte seizure order. But in trying to be more balanced (ostensibly), the TSPA deploys a weird seven-part test that an applicant must show on an ex parte basis. As if district court judges need more seven-part tests to apply.

Part one of the test specifically requires an applicant to show that a temporary restraining order would be ineffective because the responding party would evade it. Yet, the law clearly allows federal courts to issue orders directed at parties to preserve relevant evidence. And the destruction of evidence not only leads to sanctions, but it's also a criminal act. The built-in deterrent from the common law is so strong that part one of the test is almost self-defeating. Then, there's part six of the test, which separately requires an applicant to show that the responding part would "destroy, move, or hide the property" subject to the seizure order. I have thought about this too much and still cannot see how this is any different than the part one, but I suppose someone will come up with a reason. The only "benefit" I can see is that it gives an associate three more pages of briefing to come up with in the ex parte motion.

The seventh part of the test is downright bizarre, as it states that the applicant cannot have publicized the requested seizure. This raises the obvious question of what constitutes a publication. If a company needs to reassure investors, lenders, or clients that it is taking steps to remedy trade secrets theft that includes the application for a seizure order, it seems unusual to penalize the company for such a practice and remove an otherwise viable remedy the statute provides. There's no policy rationale to discourage publication.

In opposing the new federal legislation, a group of 31 law school professors stated that they were "concerned the TSPA requires a level of secrecy about court rulings that is unprecedented." I don't believe that's the case at all, since nothing in the TSPA requires the impoundment of court orders relating to ex parte seizure applications. My concern is that existing law covers any concerns Congress may have. And the new law may stand in the way of applying that time-tested law relating to preservation of relevant evidence, expedited discovery, and the use of court-appointed neutrals to image and copy digital storage media.

I have been relatively ambivalent when it comes to federalizing trade secret law. But any law that allows for the use of ex parte seizure orders is pushing me towards favoring the current state law regime. This is simply a poor fit for a branch of intellectual property law that is qualitatively different than trademark and copyright.

A Non-Compete Damages Overview

Companies that enforce restrictive covenants against ex-employees often face an uphill battle in proving damages resulting from a breach. It is for this reason that in the vast majority of cases a plaintiff focuses primarily on securing an injunction right away. It also is fairly clear that unless a new employer has aided the breach in some respect (for which it could be liable to an equal extent as the breaching employee) that an individual likely does not have the ability to pay a monetary judgment.

Still, it is important for plaintiff's counsel to understand the damages landscape and how to value a case. In this regard, the following damages theories might be available in a non-compete dispute:

1. Lost profits - The conventional method of proving contract damages is through a showing of lost profits. By definition, lost profits are speculative to a degree because they seek to project a model of economic activity in a counter-factual world. Put another way, but for the breach of the restrictive covenant, what profits would the employer have earned? Lost profits claims are delimited by the "reasonable certainty" rule, which means that a plaintiff must establish loss to a reasonable degree of certainty. Many courts confuse this rule's application. Generally speaking, it applies to the fact of damage. And once a plaintiff shows some damage, it is entitled to greater latitude in quantifying the harm - particularly where the employee's conduct has impeded quantification. In non-compete cases, a party may attempt to prove lost profits by projecting a picture of future sales from diverted or impaired customers.
2. Restitution - Although lost profits is likely the preferred route to establish damages, the concept of restitution also may apply in non-compete suits. Many courts hold that if a plaintiff's lost profits (or reliance) damages are unavailable due to the uncertainty in measuring the loss, a plaintiff can recover in restitution. The term simply refers to the plaintiff's interest in having restored to it any benefit the defendant achieves. Non-compete cases present an obvious case for restitution damages when a new employer has benefited from an employee's breach. The damages simply may be the new employer's own profits that are tied to the employee's breach, not those the ex-employer would have earned absent the breach.
3. Liquidated Damages - I have written extensively, both in this blog and in published journals, regarding the benefits of using liquidated damages clauses in non-compete agreements. The idea is that an employer can predetermine its damages by setting forth a formula in a contract. That formula then would apply if (a) it's a reasonable measure of damages, (b) the potential loss is difficult to quantify, and (c) it is not intended as a penalty to coerce contractual performance. Many cases find that non-compete contracts are well-suited to liquidated damages clauses. The reason is that the interest a non-compete protects is largely intangible. Therefore, proving specific, monetary loss always will be difficult. Drafting is essential, with the employer bearing a significant burden to show that its damages formula is reasonable. Employers would be well-advised to create a working damages model based on objective criteria that will stand up in court to the inevitable defense challenge.
4. Goodwill Impairment - The concept of "goodwill" is intrinsically tied to non-compete cases because many times the contract protects this intangible business interest. Goodwill is nothing more than a company's expectation that its customers will remain with the firm. Since a non-compete violation can result in a permanent loss of customers beyond the covenant's duration, a damages analysis relying on goodwill impairment is another possible means of recovery. In some respect, it overlaps with a projection of future profits so the two analyses shouldn't result in a duplicate damages claim. Although expert testimony is not needed to prove lost profits, it likely would be required if a plaintiff sought to prove goodwill impairment. The reason is that any goodwill impairment analysis should incorporate some sort of regression analysis to explore the relationships among variables that may affect a business's going-concern value.

Assessing damage in a non-compete case frequently is an afterthought. Counsel for both plaintiff and defendant should examine exposure as quickly as possible, even if the facts concerning liability will be the initial focus in the case.