Back from Hiatus (Part II): State Law Updates

Last week, I discussed three examples of Illinois courts analyzing similar non-compete issues in very different ways, a post that amply illustrates how difficult it is for lawyers to predict outcomes for clients. It also reminded me of a famous Abraham Lincoln quote: "Discourage litigation. Persuade your neighbors to compromise whenever you can. Point out to them how the nominal winner is often a real loser - in fees, expenses, and waste of time. As a peacemaker the lawyer has a superior opportunity of being a good man. There will still be business enough."

But to be sure, many people ignore Lincoln and litigate anyway - often with profoundly silly reasons motivating them.

So because we have litigation, we have legal developments and I therefore have a blog that continues to chug along. And you continue to read, meaning I must update you with some new rulings over the past several months.

California:

The infamous, long-running case involving ex-Korn/Ferry International executive David Nosal may have reached its end, with the Supreme Court declining a cert petition and the District Court now having finally decided on the scope of Nosal's restitution to KFI. United States v. Nosal is the most notable case under the Computer Fraud and Abuse Act, which generally criminalizes unauthorized access to protected computers. Nosal had its roots as a garden-variety trade secret case, but it was a criminal prosecution and tested the CFAA's limits.

Ultimately, Nosal secured some victories along the way. But still he will serve a year in prison and pay restitution to KFI. As to the scope of restitution, KFI sought about $1,000,000 in legal fees incurred to assist the Department of Justice investigation. After the Ninth Circuit weighed in KFI, will have to settle for less: $164,000. Still a heavy price to pay for Nosal, who probably deserved a civil suit but definitely does not deserve to spend a year in prison.

Connecticut:

The case of Datto, Inc. v. Falk discussed whether a forfeiture-for-competition clause was reasonable and enforceable. A minority of jurisdictions apply the same, or at least a similar, non-compete standard to these clauses, which (as one might expect) enable an employer to clawback certain benefits if an employee leaves to compete.

Forfeiture clauses range in scope, frequently calling for the forfeiture of unvested stock options but sometimes also calling for the employee to pay back income earned from the exercise of a grant within a certain period before the end of employment. Datto involved a dispute as to whether the cancellation of certain stock options were void because Falk (an ex-Chief Revenue Officer) accepted a position with a competitor.

The court was bound to apply Delaware law on the question of reasonableness, and that law in my view is somewhat confusing. Precedent, in effect, equated true non-competes with forfeiture clauses, finding they accomplished the same results. That's not necessarily true. A forfeiture clause may incent future performance, while a non-compete unquestionably tries to protect a separate economic interest beyond employee loyalty.

Datto illustrates the confusion in its analysis, though the district court judge admittedly was bound by controlling law. He noted, for instance, that the forfeiture clause was reasonable because "[t]his is not a case of an employee who is barred altogether from working for the competition anywhere in the world."

In my opinion, courts ought to use varying levels of scrutiny when examining restraints, similar to the current First Amendment jurisprudence. Specifically, I think that for employment-based non-competes, courts should use the strict scrutiny test (which by and large, they say they do), and for sale-of-business non-competes, they should examine them under a rational basis inquiry.

For mid-tier restrictions, like franchise non-competes and forfeiture clauses like that in Datto, I would use intermediate scrutiny. That test would require courts to determine whether the restrictive means used (e.g., the scope of the event triggering the forfeiture) are substantially related to the interest the restraint is designed to protect. This test, though it may not be perfect, would at least provide courts with a flexible, coherent way to analyze less problematic covenants that lack adhesive properties.

New York:

The New York Court of Appeals answered a significant question of damages related to trade secrets claims in the case of E.J. Brooks v. Cambridge Security Seals. The Court held that a plaintiff's damages cannot be measured by the costs the defendant avoided due to unlawful activity.

If a principal goal of trade secret law is to encourage innovation, then a cost-avoidance theory of damages seems to be a logical means to further that goal. Stated another way, if the misappropriation shortens a product-development cycle and enables X to bring a product to market more efficiently, then X is unjustly enriched by not incurring research-and-development expenses.

In the Court's view, cost-avoidance is inconsistent with a compensatory theory of damages. And under New York law, only the plaintiff's losses count. Cost-avoidance theory resembles unjust enrichment, but because New York has not adopted some variation of the Uniform Trade Secrets Act -- which specifically allows for unjust enrichment-type damages -- the theory is not viable.

The holding, predictably, spurred a long and persuasive dissent. It summarized the pragmatism and utility of cost-avoidance damages, noting that they are "generally much simpler than, and less subject to challenge than, lost-profit damages, which makes them an attractive alternative for plaintiffs who are willing to forego a potentially larger recovery in favor of a smaller, more certain one." (The assumption of a "smaller" recovery reasonably invokes the principle that a developer does not spend X to recover X. Normally, a rational economic actor would spend X to recover some multiple of X.)

A link to E.J. Brooks is available here. I emphasize again that I view this as a distinctly New York rule of law, and not one likely to be adopted across jurisdictions that have embraced a more flexible approach to damages.

South Carolina:

In Hartsock v. Goodyear Dunlop Tires North America, Ltd., the Supreme Court of South Carolina recognized an evidentiary privilege for trade secrets, but held the privilege was "qualified." That means it is different than, say, an attorney-client privilege or one barring self-incrimination. By "qualified," the Court held that a party seeking the disclosure of trade-secret material must show a "substantial need" for it that is relevant to the specific issues involved in the litigation. If a proponent makes that showing, the trade-secret holder still can gain the benefit of a protective order over the compelled disclosure.

The decision is, to be certain, a weird one. This is not really a privilege rule, but rather a rule of discovery that calls upon courts to make a balancing decision. If anything, this rule will create confusion where none should exist.

Texas:

Everything is bigger in Texas, including damages and attorneys' fee judgments. In the long-running case of Quantlab Technologies v. Godlevsky, a federal district court awarded the plaintiff its attorneys' fees in a trade secrets suit for what the court called defense behavior that was "so acrimonious, vexatious, and indefensible that...[it] exceeds any that this judge has seen in his nineteen years on the bench." The case involved stolen technology in the high-frequency trading industry, and the court at various times had sanctioned the defendants for destroying or failing to preserve evidence.

The price for that behavior was a fee judgment of $3,220,205 against each individual defendant.

The plaintiff didn't fare so well in GE Betz v. Moffitt-Johnston. There, the Fifth Circuit held that under Texas law, a company failed prove than ex-employee breached a customer non-solicitation covenant. The employee succeeded despite "highly suspicious" computer activity, including the mass download of data to an external device. But the company couldn't prove that any contacts with customers amounted to solicitation of business, rendering the contract claim unsupportable.

The Fifth Circuit did, however, vacate a large fee award for the ex-employee. Texas law allows an employee sued on a non-compete violation to obtain fees if the employer knows the agreement is overbroad and sues to enforce the agreement to an extent greater than necessary to protect the employer's interests. That's a hard standard to meet, absent some damaging admission or a truly terrible agreement. And the employee here didn't do so. 

Back from Hiatus (Part I): Illinois Case Law Update

I've been uncharacteristically quiet about the subject of restrictive covenants, consumed (somewhat mercifully) by other cases in other areas of the law.

But the flow of non-compete decisions does not stop for those who venture astray, and so it appears I have some catchin' up to do.

I'll start with my home State (for now) of Illinois, where we have high taxes and a high output of non-compete cases. The federal district courts in Illinois churn out a lot of interesting non-compete cases. Those decisions, too, tend to be influential. For instance, most Illinois courts have decided to break from appellate case law on the employee at-will consideration rule that has generated some buzz (and some appellate work for yours truly).

Non-Competition Covenants and Motions to Dismiss

One example of this independence from the federal bench is the case of Medix Staffing Solutions Inc. v. Dumrauf. Judge Sara Ellis granted a motion to dismiss a non-compete claim that Medix brought again a former Director of Business Operations. The decision was notable - and fairly bold - since Illinois courts have suggested that enforceability and overbreadth questions generally are unsuitable for motions to dismiss. True, you see these teed up more often at summary judgment or even through preliminary injunction rulings. But infrequently, the propriety of a motion to dismiss in the context of non-competes appears in the case law.

The court in Dumrauf found that the employer's non-compete was extreme and facially unenforceable when it barred the employee from working within 50 miles of any Medix office for any business that competed with Medix or that offered a product or service in competition with Medix. Of central concern to the court was the non-compete's prohibition on Dumrauf's work in any capacity for a competing enterprise. The case demonstrates the importance of drafting non-competition agreements with a reasonable scope limitation that is roughly commensurate with the type of job the employee performed at the company (or perhaps one that, if not comparable, would threaten the same type of legitimate business interest).

Judge Ellis lastly declined to modify, or blue-pencil, the non-compete, as is typical of most (but not all) Illinois courts. The deciding factor is usually how close the employer came to being reasonable. But here, the non-compete failed terribly so Judge Ellis said no to rewriting it.

Non-Solicitation Covenants and Motions for Summary Judgment

The employer didn't fare a whole lot better in Call One, Inc. v. Anzine, but the case does show that blue-penciling is not always a pipe dream.

The non-solicitation covenant in Anzine had all the hallmarks of a crapshow. It was (a) not limited to the employee's particular accounts, and (b) included something called "prospective" customers, which unhelpfully covered accounts the company solicited or "had plans to solicit."

Judge Matthew Kennelly found the covenant unenforceable, noting along the way that Illinois precedents in the non-compete field are of "less than usual value." This could mean either that the cases are too fact-specific to be helpful in a subsequent case, or that Illinois state appellate courts are not helpful as a general proposition. Or both.

But Judge Kennelly looked to a reformation clause in the underlying agreement, which contemplated that a court could make an invalid clause valid. Many changes skim over that clause for reasons that are obvious. As a result, he fixed some (but in my opinion not all) of the problems in the non-solicitation clause, such that Anzine was still barred from soliciting company customers (and active prospects as of the date she was terminated) and customers for which she had sales responsibility.

One other observation on this case. Anzine sent a couple of work spreadsheets to her personal email account, but Judge Kennelly found that no jury could find that this rose to the level of "misappropriation" of a trade secret. The self-emailing phenomenon is not new, but in and of itself it is no panacea for a trade secrets claim. Here, Anzine appeared to have plausible reasons for what she did, and the e-mailing didn't occur under suspicious circumstances (like, for instance, a forwarding of documents after notice and before departure). The court's discussion of this is worth a read for practitioners who've dealt with this set of facts before.

Non-Competition Covenants, Non-Solicitation Covenants, and Motions to Dismiss (Redux)

And on the opposite end of the spectrum (somewhat), we have American Transport Group v. Power. There, the court denied the defendant's motion to dismiss a restrictive covenants claim even when problems with those covenants were clearly apparent. The theme running through this case was nearly the opposite of Dumrauf, as Judge Virginia Kendall repeatedly noted that the employer must have the opportunity to develop the record on the question of reasonableness.

The non-compete precluded a freight broker's salesman from working for any competitor for three months, regardless of geographic location. I have a lot to say about the freight brokerage business, but that's beyond the scope of this. It is true, however, that geography seems to matter very little for sales people who work the phones contacting shippers (that is, customers) and arranging carriers. So I wasn't terribly bothered by the three-month clause or the lack of a geographical limit, as much as I am bothered by the use of non-competes in this industry entirely.

The non-solicitation clause though was a problem, and I think Judge Kendall should have found it unenforceable. It barred Power, for one year, from soliciting or diverting any customer or carrier of his employer. The court provided little analysis here, but I am uncertain how ATG ever could restrict the employee's use of a carrier (in effect, a supplier) when freight brokers all deal with the same carriers. Seems gratuitous.

***

So what lessons did we learn today? Judges reach different holdings on similar facts. Companies still have a lot to learn when drafting agreements. Lawyers will keep getting business because this stuff ain't going away. And your author can't take a month off again, because the cases keep piling up.