United States: Protecting Your Competitive Edge

This newsletter explores important considerations for companies and some uncommon approaches to protecting your company's competitive advantage, customers, confidential information and employees from unfair competition and poaching.

Decades of experience and knowledge of the uneven statutory and common law of the 50 states teaches that a company's defenses to unfair competition must include a coordinated system of protection to be effective. Some states are friendly to efforts to protect competitive advantage, some are unforgiving and some are downright impossible. But whether you are in the best of states or the worst of states, there are some measures that every company should consider keeping in its arsenal to protect its competitive edge.

Top Restrictive Covenant Agreement Considerations for Employers

This article continues our discussion from the last newsletter of important considerations on which companies should focus to create an enforceable array of competitive advantage protections. In this, and in subsequent client communications, we will focus on the most important considerations, not only contractually but also under state and federal common and statutory law.

Employee raiding covenants. Though most state courts will permit reasonable contractual restrictions on not soliciting other company employees, there are some jurisdictions that have refused to enforce such restrictions. Courts are also mixed on the extent to which an employee's duty of loyalty, as opposed to a company officer's fiduciary duty, restricts the employee from encouraging a co-worker to join the employee at a competitor, so you should review the state law that will apply to your situation.

Even in states where courts have not enforced postemployment restrictions on soliciting employees, an in-term restriction will generally be enforced, so you should apply such restrictions both during an employee's employment and after termination. In deciding whether to enforce these restrictions courts look to protectable interests of an employer. They generally review such restrictions to determine whether they are reasonably necessary to protect an employer's confidential information about its employees or justified by an employer's interest in maintaining a stable work environment. Courts in some states have refused to enforce such clauses, concluding that an employer does not have a proprietary interest in its at-will employees or in their skills. In other cases, courts have held that there did not exist confidential information in need of protection. To demonstrate the need for such restrictions, it is often important to document the employer's expenditures on training and maintaining the work force, and the efforts undertaken to keep information about its employees confidential.

The enforceability of post-employment employee non solicitation restrictions will often depend on the scope of the restriction. As with any restriction, they must be reasonable in terms of scope and duration (e.g., if circumstances supporting a protectable interest only justify a limited time period for the restriction, or the employee only works for and has knowledge about employees in one of the company's facilities, the company should not overreach and prohibit solicitation of employees of affiliates or in facilities where there is no chance the employee has any confidential information about employees in other locations, or for a period of time long beyond what is justifiable).

On the other hand, it cannot be emphasized enough that when circumstances justify a post-employment employee non solicitation covenant, a company should not draft the restriction too narrowly. All too often, such restrictions are limited to "shall not solicit." The result is usually that the court will then narrowly enforce the "non solicit" restriction and leaves the employee free to encourage other employees to leave. More inclusive drafting of the restriction will close that loophole.

Do I arbitrate?

In some industries, such as securities, arbitration of non compete and non solicitation issues is the norm and is accomplished efficiently. For most employers, however, arbitration is often not the best forum for resolving disputes stemming from the breach of such restrictions. Proponents of arbitration claim that, in seeking damages, arbitration is often swifter and less expensive. But, unless your industry is committed to and has considerable experience in such arbitrations, a company may better meet its needs in a judicial forum. The decision as to what is best for your company will be guided by the applicable state law and the court in which the restriction would likely be heard.

Even if you agree to arbitration, you may have to seek judicial enforcement or vacation of an arbitration award. Further, arbitration discovery is almost always more limited in scope than in court actions, especially as to non parties, and it is often more difficult to enforce. Therefore, the scope of discovery should be expressly set forth in the agreement. Companies should also carveout an exception for injunctive relief to combat the fact that obtaining injunctive relief from an arbitrator can be complicated and near impossible. Even when there are carve-outs, injunctive reliefs complicates the interplay between an arbitrator's authority and domain over damages, as the court may decide legal questions in the injunction action that could have material consequences for the merits of the damages action before the arbitrator.

If you decide to use an arbitration clause, you should consider limiting the employee's defenses to enforcement of the restrictive covenants by noting that alleged breaches of the agreement by the company are not defenses to the enforcement of the restrictive covenants. This should be justifiable, since the parties have provided for arbitration to resolve disputes as to the enforcement of the parties' breaches of the agreement and the employee can seek enforcement of the employee's rights more economically and swiftly through arbitration. Depending on the state law, the same limitation on employee defenses to alleged company breaches would likely be enforceable without reference to arbitration.

Can I get an agreement while the employee is walking out the door?

Many employers realize they have left themselves vulnerable when employees are being fired or are resigning and the company cannot locate an agreement signed by the employee. The company may or may not have enforceable trade secret protections that will slow down the employee's competition, but, at that point, employers often will seek to include restrictive covenants in a severance agreement with the employee. Is it enforceable? That depends on the applicable state law and the circumstances. Generally, restrictive covenants are viewed as an exception to state laws protecting competition and, in virtually every state, such restrictive covenants must be ancillary to a valid employment agreement or business sale agreement to be enforceable. However, courts in many states (where restrictive covenants are generally legal) will enforce such severance covenants as being limited to an "employee choice," e.g., compete without the money or take the money and don't compete. Courts in many states will enforce it to that extent, and they may permit an employer to seek "claw-back" of payments already made if the employee is found to have breached the agreement. On the other hand, since a severance restrictive covenant is unlikely to be viewed by a court as ancillary to a valid employment agreement, it is possible that the same court would not grant injunctive relief or damages for its breach beyond requiring the employee to give back the money.

There are tactical reasons that such an agreement may be valuable as well. An action to seek a declaration of rights or claw-back of payments under a severance restriction would likely survive a motion to dismiss and provide a solid count as part of an action seeking to enforce rights under other theories, such as trade secrets laws. A prevailing attorneys' fees provision may also enhance the likelihood of compliance. Even in sates where such severance restrictions are void, an employer might consider use of an ERISA severance plan containing restrictions and claw back terms. Those plans would be enforced under federal rather than state law. Although space is too limited in this newsletter to discuss this further, the use of ERISA plans to provide additional protections will be featured in the next newsletter.

Shoring Up Your Proprietary Safeguards

By Kenneth K. Dort and Jeremiah Posedel

Consider this scenario: Your company is a mid-sized business with significant R&D expenditures. As the result of years of development efforts, your company has garnered a substantial portfolio of valuable formulas and materials processes, all of which are particularly difficult to re-engineer. Bottom line – your company has a portfolio of valuable intellectual property in the form of multiple trade secrets.

Protecting these trade secrets is a series of measures implemented over the years and now embodied in a "confidentiality policy"that includes:

Upon examination, you realize the policy is not only thin, but also that none of these requirements are being rigorously followed. What to do?

The current situation places the company's trade secrets in jeopardy, should it ever attempt to enforce its intellectual property rights against a departing employee intending to use those trade secrets with his or her new employer. Because the laws protecting trade secrets require that the information be "secret" and that reasonable steps be followed to maintain that "secrecy," one of the threshold issues to be addressed will be how "secret" the former employer is treating that information. Therefore, because our example reveals a company that is rather complacent in protecting its trade secrets from disclosure, a court may well rule that the information is not a trade secret and, thus, not protectable.

To avoid possible litigation traps going forward, remedial actions should be implemented immediately. Here are the steps to consider:

Step One — Revise the company's policy to include:

Step Two — Conduct orientation sessions for all employees that:

Step Three — Implement a monitoring program to periodically:

Even though the company's current approach leaves it open to attack in the face of current litigation, its immediate action to remedy those defects and to eliminate them going forward will place it in a stronger position to protect the intellectual property that might be the target of departing employees and the subject of future litigation.

Protecting Your Customer List From Poaching

By Joseph C. Faucher and Mark E. Furlane

Aside from the goods or services that it provides, a company's most valuable asset is arguably its customer or client information. Client lists and information, however, are invariably vulnerable to "poaching" by current employees who are considering a move to a competitor or striking out on their own. Therefore, companies should treat their client information just as they treat their product designs and proprietary methods – as a trade secret. Unlike with other tools of enforcement, such as non compete and non solicitation covenants (whose enforcement is generally state specific and often unlawful), virtually every state will enable a company to protect trade secrets and confidential information, if the company has undertaken the necessary prerequisites to enforcement.

History shows that it can be very difficult to prevent employees — particularly senior level employees – from using their employer's customer lists to compete. This is particularly true in states such as California, where the law is notoriously resistant to restrictions on competition. But, even in California, an effective and comprehensive trade secret and confidential information protection program can be developed. This program can then form the basis for a company's protection program in other states.

In California, as in virtually every other state, two conditions must be satisfied for information — including customer information — to enjoy trade secret protection. First, the information must derive independent economic value from not being generally known to the public. Second, the employer must use efforts that are reasonable under the circumstances to maintain the secrecy of the information.

Depending on the nature of a company's business, the first part of the test – that the list has independent economic value from not being publicly known – is relatively easy to meet. Customer information, such as contact information, product usage and pricing, seasonal differences, and virtually every other unique bit of information developed by your company as to your clients and prospective clients combine to drive the economic value calculation. Such information has obvious value. After all, if a competing company were to obtain your company's client list, it may be spared the expensive, arduous and time consuming task of identifying customers who are ready, willing and able to buy what you are selling. As one California case has noted, "a customer list can be found to have economic value because its disclosure would allow a competitor to direct its sales efforts to those customers who have already shown a willingness to use a unique type of service or product as opposed to a list of people who only might be interested."

Therefore, at a minimum, in order to demonstrate why the customer list has value, companies should document the processes they go through to compile their lists along with the costs and expenses associated with doing so. This can be as simple as "brainstorming" the various steps the company takes, and expenses that it incurs, in developing its client base. Memorialize it in writing. The more detail, the better.

To satisfy the second condition, companies must make reasonable efforts to maintain the secrecy of their client list. There is no one way to go about this, but as one court noted, "reasonable efforts to maintain secrecy have been held to include advising employees of the existence of a trade secret, limiting accessing to a trade secret on need to know basis, and controlling plant access." In other words, to protect a customer list and information as a trade secret, one of the first steps is to tell all employees — in writing — that the list of customers is the property of the company and a company trade secret, and to obtain the employees' acknowledgements. It is also a good idea to have in place a formal confidentiality and computer use agreement, which will contractually augment the applicable state trade secret law. Having a confidentiality agreement in place can help establish that the company's employees were aware that the company considers the list to be confidential. The agreement should also specify obligations of the employee with respect to confidential information upon termination of employment.

Companies should also develop a means of restricting access to the customer list and information. This would include preventing employees from accessing files and computer systems that contain customer contact information without an appropriate authorization or a password, and affirmatively instructing employees that they are not to use or divulge any client information to anyone outside the company, except for company purposes. Employers should also limit access to client information on a "need to know" basis.

Under most state laws, former employees may send professional announcements about the employee's new business affiliation. However, if the customer list and information meets the trade secret test, using the customer list for the purpose of sending such a solicitation would constitute trade secret misappropriation, and courts may issue an injunction to prevent further misappropriation of customer lists.

Mid-Term Restrictive Covenants: What is Sufficient Consideration?

By Marion B. Cooper and Jerrold J. Wohlgemuth

To be valid and enforceable, an employment agreement with a restrictive covenant must be agreed to by the employee in exchange for something valuable – "consideration." When the restriction is first imposed at the commencement of employment, consideration is not a problem, because the employee receives a clear and obvious benefit: the job.

However, employers often come to the realization after hiring that certain employees should have executed an employment agreement with a restrictive covenant at the commencement of their employment, but did not. Other times, employers realize a current agreement needs updating. To accomplish this, employers often want to ask employees to sign "mid-term contracts" during their terms of employment. The question then arises as to whether continued employment is sufficient consideration for a mid-term contract. If it is not, what is?

In many jurisdictions, the employer's agreement to continue at-will employment can be sufficient consideration. The reasoning applied varies, however. In some cases, courts have relied on the fact that the employee would have been terminated if he had not signed the restrictive covenant agreement. In other cases, courts have found adequate consideration only where the employment continued for a substantial period of time. Whether that period is sufficient is determined by the courts, although employment of a year following execution of the new agreement seems to be a minimum. If the employee leaves, or is terminated before then, courts have deemed there to have been no consideration.

Some courts refuse to enforce mid-term restrictive covenants absent a grant of a new or enhanced benefit to the employee, in addition to continued employment. In many states, courts require as a second precondition for enforceability that the restrictive covenant agreement must be ancillary or incidental to the employment contract, meaning that it must be subordinate to the contract's main purpose, in addition to meeting the consideration requirement.

New consideration must be more than "illusory." For example, in those jurisdictions requiring new consideration, where an employee has a pre-existing employment contract for a definite term, continued employment may not be sufficient because the employee had a prior, existing right to be employed such that his continued employment did not afford him any benefit to which he was not already entitled. Promotions or salary increases given prior to the signing of the restrictive covenant, rather than in exchange for signing, are also insufficient. By contrast, substantial benefits, such as promotions or a salary increase, special training, participation in a stock option plan or an annuity contract, granted contemporaneously with, or in exchange for, executing the mid-term contract, have been recognized as sufficient consideration. The applicable state law and the rulings by courts where the dispute is likely to be heard should be consulted to determine the minimum acceptable consideration.

Given there is little consistency between courts on these enforcement issues, the employer is left in a quandary. To relieve that uncertainty employers desiring to execute mid-term contracts may contemplate the security of offering separate new consideration in exchange for the employee's execution of a mid-term contract as a matter of course, but it might not be necessary. If the mid-term agreement is replacing an existing one, language should be included in the new agreement that preserves any employer protections in the new agreement in the event the new agreement is found to be unenforceable. Given the state specific consideration requirements and importance that sufficient consideration plays in enforcement of these agreements , the advice of counsel who knows about and has experience concerning the requirements of the various state statutes and common law is critical.

Hiring Away the Competition

By Daniel Aiken and Aaron Moyer

Recruiting talented employees is key to the success of any business. Doing so can be tricky, however, particularly when the person you want to hire is working for the competition and is subject to postemployment restrictions, such as non-competition and customer non-solicitation covenants. The following provides some basic guidance for what you and your company should do when faced with such a situation.

Ask the right questions of the prospective employee.

Foremost, it is important to know whether the individual you intend to hire is bound by any post-employment restrictive covenants with a previous employer. Generally, you will be looking for non-competition, nonsolicitation agreements (possibly including restrictions against soliciting the former employer's employees, customers, contractors, suppliers, or vendors), and confidentiality agreements, but all potential restrictions should be explored. In addition to the more traditional employment agreement, post-employment restrictive covenants can exist in many different types of employer documents (e.g., company ethics statements, employee handbooks, invention assignment agreements, confidentiality or technology use agreements), or other documents signed by the employees. So, push the prospective employee to investigate all potential sources of restrictions to which the prospective employee may be subject. It can be disappointing to find out that your potential new star may be bound by post-employment restrictions, but it is best to know such information in advance, so that you can assess the risks in hiring the person and develop an appropriate strategy if you decide to proceed with the person's hiring. Finding out about a prospect's post-employment restrictions is only the beginning of the company's analysis.

Review and analyze the restrictions. If the individual is subject to post-employment restrictions, review them carefully to determine the nature and scope of the restrictions and how they might impact the person's employment with you. The analysis should include the likelihood that a court will enforce the restrictions, which will vary according to the applicable state law and circumstances. The assessment should also include both a legal analysis of the restrictions' enforceability and practical considerations such as past enforcement history of the employer, importance of this person to the former employer, extent to which employment with you differs from prior employment. You should then assess what steps can be taken to minimize as many of the restrictions as possible. This analysis will rely heavily on the nature and scope of the restriction, the applicable law, and the nature of the prospective position.

Determine the precise scope and duties of the prospective job. Even though the individual may be subject to post-employment restrictive covenants, the job for which you intend to hire the person may not fall within the restrictions. Or, inasmuch as most restrictive covenants will expire — sometimes in a matter of months — you may decide that the company can tailor the scope of the intended position so that the new employee can bide his her time until the restriction period expires, while still adding value, but without violating the individual's obligations to the former employer. Can the person be employed in a different capacity until "real" restrictions lapse? Can the person be employed outside geographic restricted area or assigned to existing customers different from those of the former employer? Finally, once you have determined the scope of the intended new position, talk to legal counsel about what parts of the postemployment restrictions are likely to be enforceable.

In addition to a review of the applicable law, such discussions should include a review of the industry and whether post-employment restrictions are commonplace, a review of the relative competitive positions of your company and the prospect's employer (including whether the two companies compete for the same customers), and a frank review of your company's flexibility in defining the scope of the intended position. This discussion can often be helpful in coming up with a solution that permits the company to bring on the new employee with an eye to the risk and likelihood of a successful challenge by the former employer. The key is to analyze and take available appropriate steps to minimize the risk of being sued, or, if sued, the risk of a lengthy or costly suit, including a possible settlement strategy before suit is even brought. The employee, especially if sophisticated or represented by an attorney, may seek indemnification. You should determine whether you are willing to entertain such a request. You will also want to consider what type of an escape strategy you will want in terms of the employment and/or indemnification, i.e., how can you pull the plug if litigation that ensues is going badly or you find the new employee was not truthful about not taking anything or contacting customers of the former employer.

But, even before an analysis is complete and a decision has been made to hire the person, there are steps you should take from the initial contact to minimize the risk of suit if you proceed with the hiring.

Protect your company from the beginning.

Companies often get into trouble when recruiting a prospective employee long before the actual hire. Employees may pitch their importance by showing you their customer list and sales volume, but these items are likely to be considered confidential by their employer, if not trade secrets. Further, the employee may offer to bring with them a junior colleague and provide you with confidential information about the employee, or start contacting customers about the person's intentions. Those actions may have already violated the person's restrictive covenants. Ground rules for such activity should be established during the interview process, in writing, if possible. Also obtain written confirmation that the interviewee is not under any undisclosed restrictions and communicate, in writing, that the prospective employee must not disclose or use confidential information or trade secrets and must not bring any property or information belonging to the employer. Follow through and make sure the person complies fully with those mandates.

Hire away, but proceed with some caution. There are often many creative approaches to hiring talented employees who are subject to valid post-employment restrictions. Such a plan typically involves taking some risk that parts of the post-employment restrictions are not enforceable, and also reaching a decision that there are some parts of the restrictions that you expect the new employee to follow. It is important that you communicate, in writing, what you expect of the new employee. For instance, you and counsel may reach the conclusion that the prospect's non-competition restrictions are overly broad and will not be enforced under the circumstances, but that a court is likely to enforce a customer non-solicitation covenant. Typically, the company's offer letter is a good place to memorialize such expectations. In our scenario, the offer letter should state, as a condition of employment, that the new employee will not use or possess his former employer's confidential information and that the employee will not solicit former clients (as well as any other restrictions that your company expects to be followed).

The new employee's supervisor should also take steps to ensure that the employee is sticking to the plan. For example, a supervisor should review any new sales or prospects that were not originally on the new employee's customer list to ensure that the new clients are not restricted.

Although there is no way to prevent a suspicious former employer from challenging your company's hiring of one its employees, following the guidance in this article will place your company in a better position in the event of such a challenge.

Finally, if you find that there is an acceptable risk in proceeding with the hiring, don't make the same mistakes the former employer made that allowed you to proceed with the person's hire. Get an enforceable agreement with your new employee from the start — one that will protect the company's confidential information and competitive position by imposing impose valid restrictions on the employee if he or she decides to leave.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.