When starting a company, many entrepreneurs believe that the end justifies the means, and may be lax about fulfilling obligations to former employers. However, the fastest way to put a startup out of business is to sue it for violating duties to a former employer. Even if no duties were breached, such a lawsuit could result in over $100,000 in legal fees.
There are two types of duties to former employers, those that arise from tort law and those that arise from contract law.
Under agency law (tort law) there are three duties that an employee owes the employer:
- Duty of loyalty – the obligation to act only in the interest of one’s employer and not to compete with one’s employer. Even if one is working on one’s own project at home in the evening using one’s own computer and equipment, the project may constitute a breech of loyalty if it competes in the same line of business as that of the employer.
- Duty of obedience – the obligation to obey all reasonable orders of one’s employer. An act of insubordination is a violation of this duty.
- Duty of care – lack of performance is a violation of this duty.
Under contract law, there are confidentiality agreements and restrictive covenants.
- Confidentiality agreements – two restrictions are non-use and non-disclosure. A thorough agreement should have both. An example of a confidentiality breach might be disclosing the identity of the former employer’s customers to the new employer. There are three levels of confidentiality. The lowest level is public domain information, followed by confidential information, and finally by trade secrets, the highest of the three.
- Restrictive covenants – four types of restrictive covenants are non-competition, non-disparagement, non-interference, and non-solicitation.
The following outlines the four types restrictive covenants:
A. Non-Competition agreements – can center on geography, customers, or knowledge. A firm cannot stop another firm from competing with it without a valid non-competition agreement. Two types of circumstances when non-compete agreements arise are transactional settings and employer-employee situations.
i. transactional settings – such as sale of a business.
For example, is a physician sells his/her practice,
a non-competition agreement might prevent the same physician from opening a new practice within a five mile radius.
Courts will consider four factors when enforcing non-competition agreements in the sale of a business:
a) type of business
b) client base, size, and geography
c) impact if the non-competition agreement were extended
d) how long the agreement is to be enforced
ii. employer-employee situations – this is different from transactional settings in that the
employer and employee are not on a level playing field.
Non-competition agreements are blatant restrictions on trade and are therefore difficult to enforce.
However, courts are more willing to enforce those associated with transactional settings than those associated with employer-employee relationships.
However, even if an employer knows that an agreement is overly restrictive and unenforceable,
he/she may have employees sign it in order to make them think twice before trying to compete.
A court will look at the following points when deciding whether to enforce a non-competition agreement:
a) that the agreement is reasonably limited in scope such as duration, geography, client base, and technology.
b) that the agreement is narrowly tailored to the interests of the employer, such as customer lists, trade secrets, goodwill, or extraordinary skills.
c) that the agreement is supported by valid consideration. The agreement must be the product of some bargain.
When people do not give something up in exchange for something else, there is unlikely to be intention to enforce it.
If a company requests that present employees sign a non-compete, the employer is giving nothing in exchange for it.
This situation also applies to employees who show up the first day on the job and are requested to sign a non-compete.
In order to make it enforceable,
employers may specify in the offer letter that the employment is contingent on the signing of the non-competition agreement,
in which case there is valid consideration.
d) that the agreement is not harmful to the public or the employee.
For example, in an area that has a shortage of providers of an essential service,
a court is much less likely to enforce a non-competition agreement related to that service.
A court may change an item in a non-competition agreement to a value that is more reasonable.
For example, the court may shorten the duration of the agreement.
Such changes are referred to a “blue penciling”.
The court must balance the interests of employers, such as protection against damage caused by competition, with the interests of the employees,
such as the ability to earn a living.
Some states have statutes specifying things that are not enforceable.
But an injunction in one state does not necessarily prevent one from competing in another state.
B. Non-Disparagement agreement – prevents the employee from talking negatively about the employer.
C. Non-Interference agreement – prevents the employee from interfering with certain relationships:
- vendor/supplier
- referral patterns
- customers
D. Non-solicitation agreement
Non-solicitation agreements may prevent:
- solicitation of employees to attempt to steal them (but the employee may seek out your firm unless otherwise prevented)
- solicitation of customers
Under general tort claims, there are:
- wrongful conversion (theft) of trade secrets – there have been cases in which even though non-competes had not been signed,
companies have been able to get a TRO against employees who were going to a competing firm when it was inevitable that trade secrets would have
been disclosed. Under the inevitable disclosure doctrine,
an employee may be prevented from performing work in competition with a former employer if a court decides that he will inevitably disclose trade
secrets belonging to the former employer.
When starting a company, many entrepreneurs believe that the end justifies the means, and may be lax about fulfilling obligations to former employers. However, the fastest way to put a startup out of business is to sue it for violating duties to a former employer. Even if no duties were breached, such a lawsuit could result in over $100,000 in legal fees.
There are two types of duties to former employers, those that arise from tort law and those that arise from contract law.
Under agency law (tort law) there are three duties that an employee owes the employer:
- Duty of loyalty – the obligation to act only in the interest of one’s employer and not to compete with one’s employer. Even if one is working on one’s own project at home in the evening using one’s own computer and equipment, the project may constitute a breech of loyalty if it competes in the same line of business as that of the employer.
- Duty of obedience – the obligation to obey all reasonable orders of one’s employer. An act of insubordination is a violation of this duty.
- Duty of care – lack of performance is a violation of this duty.
Under contract law, there are confidentiality agreements and restrictive covenants.
- Confidentiality agreements – two restrictions are non-use and non-disclosure. A thorough agreement should have both. An example of a confidentiality breach might be disclosing the identity of the former employer’s customers to the new employer. There are three levels of confidentiality. The lowest level is public domain information, followed by confidential information, and finally by trade secrets, the highest of the three.
- Restrictive covenants – four types of restrictive covenants are non-competition, non-disparagement, non-interference, and non-solicitation.
The following outlines the four types restrictive covenants:
A. Non-Competition agreements – can center on geography, customers, or knowledge. A firm cannot stop another firm from competing with it without a valid non-competition agreement. Two types of circumstances when non-compete agreements arise are transactional settings and employer-employee situations.
i. transactional settings – such as sale of a business.
For example, is a physician sells his/her practice,
a non-competition agreement might prevent the same physician from opening a new practice within a five mile radius.
Courts will consider four factors when enforcing non-competition agreements in the sale of a business:
a) type of business
b) client base, size, and geography
c) impact if the non-competition agreement were extended
d) how long the agreement is to be enforced
ii. employer-employee situations – this is different from transactional settings in that the
employer and employee are not on a level playing field.
Non-competition agreements are blatant restrictions on trade and are therefore difficult to enforce.
However, courts are more willing to enforce those associated with transactional settings than those associated with employer-employee relationships.
However, even if an employer knows that an agreement is overly restrictive and unenforceable,
he/she may have employees sign it in order to make them think twice before trying to compete.
A court will look at the following points when deciding whether to enforce a non-competition agreement:
a) that the agreement is reasonably limited in scope such as duration, geography, client base, and technology.
b) that the agreement is narrowly tailored to the interests of the employer, such as customer lists, trade secrets, goodwill, or extraordinary skills.
c) that the agreement is supported by valid consideration. The agreement must be the product of some bargain.
When people do not give something up in exchange for something else, there is unlikely to be intention to enforce it.
If a company requests that present employees sign a non-compete, the employer is giving nothing in exchange for it.
This situation also applies to employees who show up the first day on the job and are requested to sign a non-compete.
In order to make it enforceable,
employers may specify in the offer letter that the employment is contingent on the signing of the non-competition agreement,
in which case there is valid consideration.
d) that the agreement is not harmful to the public or the employee.
For example, in an area that has a shortage of providers of an essential service,
a court is much less likely to enforce a non-competition agreement related to that service.
A court may change an item in a non-competition agreement to a value that is more reasonable.
For example, the court may shorten the duration of the agreement.
Such changes are referred to a “blue penciling”.
The court must balance the interests of employers, such as protection against damage caused by competition, with the interests of the employees,
such as the ability to earn a living.
Some states have statutes specifying things that are not enforceable.
But an injunction in one state does not necessarily prevent one from competing in another state.
B. Non-Disparagement agreement – prevents the employee from talking negatively about the employer.
C. Non-Interference agreement – prevents the employee from interfering with certain relationships:
- vendor/supplier
- referral patterns
- customers
D. Non-solicitation agreement
Non-solicitation agreements may prevent:
- solicitation of employees to attempt to steal them (but the employee may seek out your firm unless otherwise prevented)
- solicitation of customers
Under general tort claims, there are:
- wrongful conversion (theft) of trade secrets – there have been cases in which even though non-competes had not been signed,
companies have been able to get a TRO against employees who were going to a competing firm when it was inevitable that trade secrets would have
been disclosed. Under the inevitable disclosure doctrine,
an employee may be prevented from performing work in competition with a former employer if a court decides that he will inevitably disclose trade
secrets belonging to the former employer.
Ten issues to consider when hiring a competitor’s employees:
- What the employee had been doing at the former employer – are there some potential activities in the new role that should be off limits?
- The nature of the business – how crucial it is to be first to market, is the market in a particularly highly competitive phase, etc.
- Whether the companies really are competing – even though they may be in the same industry, if there is little product overlap then the risk of transferring trade secrets is lower.
- The degree of competition – even if there is product overlap, a move from a weak player to a strong player may not be a problem, unless the weaker player has just made some sort of a breakthrough.
- Whether the employee had an in-depth knowledge of trade secrets or just general exposure.
- Whether the former employer has been able to achieve something that the new employer has tried unsuccessfully to achieve.
- Whether the former employer took adequate precautions to protect the trade secrets in question – otherwise they might not actually be trade secrets.
- The amount of discretion that the employee will have – if he or she simply is implementing a pre-existing plan with little ability to change it, there may be little risk of doing damage.
- Whether the employee will be working with former colleagues at the new employer – if an entire team is assembled and this team once had knowledge of trade secrets at the former employer, there is greater risk of disclosure of those secrets.
- Whether the employee will receive a substantial increase in salary at the new employer – if so, this could be viewed as a premium for the trade secrets.
Employment Law Cases
Case: Business Intelligence Services, Inc. v. Carole Hudson
Facts
Carole Hudson was an employee of Business Intelligence Services (BIS).
In August of 1983, Ms. Hudson received an employment offer from Management Technologies, Inc. (MTI), a competing firm.
About one-third of MTI’s employees were former employees of BIS.
Business Intelligence Services (BIS) sought an injunction to prevent Ms. Hudson from working for MTI.
Ms. Hudson believed that she had signed an employment contract with BIS in June 1983, but later could not produce a copy of it.
During the summer of 1983, Ms. Hudson had received a promotion at BIS.
On September 9, 1983, prior to Ms. Hudson’s resignation from BIS, Ms. Hudson’s supervisor at BIS told her
that there was no employment contract on file for her and that such a contract was required.
The secretary of BIS’s president approached Ms. Hudson with a contract that she said she had retyped.
Without reading the contract, Ms. Hudson signed it.
The contract had a non-compete clause in it prohibiting Ms. Hudson from doing business
with any of BIS’s clients for a period 12 months after termination of her employment.
On December 29, 1983, Ms. Hudson resigned from BIS.
BIS noted the non-competition clause, and Ms. Hudson expressed her view that the contract that she had signed in June had no such clause.
There was no evidence that Ms. Hudson would be unable to gain employment for the 12 month non-compete duration.
Issue
The issue in this case is whether the non-competition clause was enforcable.
First, it may have been misrepresented since it had been presented to Ms. Hudson as a retyped version of the original.
Second, since the new contract was presented after the commencement of employment with BIS,
there is a question of whether consideration was given.
Holding
The non-competition clause is enforcable, and its one-year duration is reasonable.
Reasoning
In the presentation of the employment contract on September 9, while it may have been misrepresented, there is no evidence of intention to deceive. When one signs something, one is bound by its terms so one should know what is in it.
While continued employment does not constitute valid consideration, Ms. Hudson’s promotion does.
Furthermore, BIS’s specific knowledge of clients’ systems are protectible as a trade secret.
The remedy in this case was an equitable remedy since BIS would suffer irreparable harm and actual damages would be difficult to quantify.
The court issued a preliminary injunction to prevent Ms. Hudson from commencing employment at MTI.
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Case: Reed, Roberts Associates, Inc., v. John J. Strauman
Facts
Reed, Roberts track the employment laws in 50 states and advises companies doing business in those states.
John Strauman was a vice-president of Reed, Roberts who had signed a restrictive covenant indicating that he would not solicit any of the firm’s clients
for three years after the termination of he employment.
After 11 years with Reed, Roberts, Mr. Strauman resigned and formed a company called Curator Associates, Inc, which was located in the same city as
Reed, Roberts and which was in direct competition with Reed, Roberts.
Issue
Enforceability of non-competition and non-solicitation.
Holding
The initial court ruled that the non-solicitation clause was enforceable but that the non-competition clause was not.
However, the court of appeal ruled that neither was enforceable.
Reasoning
The lower court reasoned that the non-competition clause was not enforceable because it interfered with Mr. Strauman’s right to earn a living,
but that the non-solicitation clause was enforceable because it would be unjust for Mr. Strauman to utilize his knowledge of Reed, Roberts’ internal
operations to solicit its clients.
The court of appeal reasoned that the solicitation of customers usually was done through a public directory such as
Dun and Bradstreet’s Million Dollar Directory, so this information did not constitute trade secrets.
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Case: Structural Dynamics Research Corporation v. Engineering Mechanics Research Corporation
Facts
Structural Dynamics Research Corportation (SDRC) and Engineering Mechanics Research Corporation (EMRC) both are in the business of structural
analysis and testing.
Kothawala, Surana, and Hildebrand were former employees of SDRC, where they had signed confidentiality agreements.
Kothawala and Surana had developed an isoparametric computer program in their roles at SDRC.
Kothawala left SDRC to establish EMRC and the other two followed him shortly thereafter.
While at SDRC, Kothawala and Hildebrand had sent to Ford a letter that criticized SDRC with the intent to transfer the Ford business to their new
company once they left.
Furthermore, parts of EMRC’s computer program code were found to be identical to those of SDRC’s.
Issue
Breach of trust, breach of contractual duty not to use or disclose confidential information, and unfair competion.
Holding
The court did not enforce the non-competition clause.
The former employees were found liable for SDRC’s loss of profits from Ford due to Kothalwala’s and Hildebrand’s disparaging SDRC’s ability to
complete the project.
Due to unauthorized use of SDRC’s confidential information, EMRC was liable to SDRC in the amount of 15% of its sales for the next three years,
and $45,000 in damages were to be paid to SDRC.Reasoning
The contract was entered into in Ohio. The Michigan court declared it enforceable under Ohio law, but since it was contrary to Michigan’s public policy, Michigan refused to enforce it. Surana created the confidential knowledge, so he only had to keep it confidential while employed by SDRC. The case was a close one. What tipped the scale was the breach of trust from the disparagement of SDRC before leaving the company.
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