ACCOUNTANT'S LIABILITY

January 2000

N.Y. COURT OF APPEALS RULES POSTEMPLOYMENT RESTRICTIVE COVENANTS ENFORCEABLE

By Dan L. Goldwasser, Esq., Vedder, Price, Kaufman & Kammholz

On May 13, 1999, in a unanimous opinion, the New York Court of Appeals held that a client compensation clause contained in a CPA firm manager's agreement was enforceable. This was the first time in over 50 years that the court had addressed the issue of the enforceability of a postemployment restrictive covenant. Although the court found that the clause was enforceable, it nevertheless ruled that certain portions of the clause were unenforceable, sending a clear message that such covenants must be narrowly drawn.

Case Details

The case, BDO Seidman v. Hirshberg, arose out of BDO's effort to enforce a "compensation clause" against a former tax manager who had begun servicing approximately 100 BDO clients shortly after leaving the firm. Under the terms of his manager's agreement, Hirshberg could not service any BDO client within 18 months after the termination of his employment at BDO without compensating BDO. The specified amount was 150% of the revenues derived by BDO from such clients during the 12 months preceding the termination of Hirshberg's employment, payable over a period of five years.

The case had been first heard in the Erie County Supreme Court, which ruled that the clause was unenforceable because "plaintiff is overprotected and defendant is unreasonably limited." On appeal, the Appellate Division, Fourth Department affirmed, making similar findings and without providing any further guidance as to what type of clause, if any, would be deemed enforceable. The Fourth Department's cryptic language concluded, "because the restrictive covenant in this agreement is over broad, it is unreasonable and unenforceable." The Appellate Division also rejected BDO's contention that the court should modify the clause to the extent that it found the restrictions to be overly broad, stating that to do so, "the court would thereby be required to rewrite the entire covenant."

BDO sought leave to appeal from the Court of Appeals, pointing out that the Fourth Department's decision was in conflict with other decisions dealing with restrictive covenants, including one interpreting this very same clause in another BDO agreement. BDO also pointed out that the Court of Appeals had not addressed the issue in over 50 years and that the decision of the Fourth Department provided little or no guidance as to what types of restrictions might be deemed enforceable. The Court of Appeals not only granted leave to appeal but crafted its decision in a manner that provides significant guidance to the lower courts and accounting firms as to what types of postemployment restrictions will be enforced. Equally important, the court established guidelines as to when courts should undertake to reform restrictions that contain unenforceable features.

Because of the importance of the issues on accounting firms, the New York State Society of Certified Public Accountants (the Society) filed an amicus brief, in which it argued in support of the enforcement of the clause. It contended that clients are important assets of any professional organization and permitting employees to take those clients without penalty would not only license the theft of valuable assets but also tend to decrease competition among mid-size accounting firms, thereby adversely affecting the public's interests. In this regard, the Society's brief pointed out that CPA practices are regularly bought and sold and Hirshberg would have had to purchase a practice had he not commandeered those clients that had been entrusted to him by BDO. The Society also argued that if this type of provision was not deemed enforceable, CPA firms would likely restrict client contact by members of their professional staffs and that this, in turn, would have a detrimental impact on the very persons the courts were trying to protect.

It is important to note that the clause utilized in Hirshberg's agreement in no way restricted him from continuing the practice of accountancy, as it did not restrict him from either practicing in the same geographic area or from servicing BDO's clients. These features were noted in the Court of Appeal's decision, which emphasized the relatively limited nature of the restriction in Hirshberg's agreement. Nevertheless, the court did find that the reimbursement covenant was overly broad and not wholly enforceable. In particular, the court found that it was unreasonable to require Hirshberg to compensate BDO for clients that he was servicing at the time he joined BDO. Similarly, the court found that it was unreasonable to require Hirshberg to compensate BDO for any BDO clients for which Hirshberg had not rendered substantial services while in BDO's employ. Thus, the court ruled that Hirshberg was free to solicit and service BDO clients whom he may have met on social occasions, or even at firm functions, so long as he had not been assigned to render substantial professional services to them. The court concluded that even compensation clauses that do not otherwise restrict a former employee's actions must be very narrowly drawn in order to be deemed enforceable.

What Clauses Are Enforceable?

The court indicated that postemployment restrictive covenants would only be enforced if they met the following three tests: The restraint 1) is no greater than is required to protect the legitimate interests of the employer; 2) does not impose a hardship on the employee; and 3) is not injurious to the public. Following these principles, the court found that because accounting firms go to great expense to create and maintain their clientele, they have a legitimate interest in protecting their client base. Even so, the court found that it would place a former employee at an unfair disadvantage to restrict the employee from servicing any client of its former employer, especially if the former employer is a national firm with offices across the country.

The court also held that it is permissible to apply the reimbursement clause to clients solicited by Hirshberg during the course of his employment by BDO so long as Hirshberg's solicitation efforts had been funded by BDO.

CPA firms that wish to maximize the extent to which their postemployment restrictive covenants will be enforceable should adopt and implement policies under which business expenses incurred by their employees are both approved and reimbursed by the firm.

It should be noted that the court's decision only applies in those cases in which the employee's services are not unique. Where the employee's services are unique, the courts will normally enforce postemployment restrictions. On the other hand, the court indicated that clients that had been attracted to the firm by the employee's special skills cannot be covered by such clauses.

While the court was not asked to comment on geographic postemployment restrictions, the criteria relied upon by the court in analyzing the BDO covenant would seem to cast serious doubts on the enforceability of such clauses. Similarly, clauses that simply prohibit a former employee from servicing the firm's clients would probably also be deemed unenforceable.

The court's decision also did not address situations in which a former employee seeks to use the firm's proprietary information following his or her employment by the firm. Although it may be implied from the court's decision that such restrictions continue to be enforceable, what constitutes proprietary information will be closely scrutinized. Such information must be truly unique to the firm before the courts will enforce such covenants. Mere checklists that are similar to those in the public domain would probably not qualify as a basis for enjoining a former employee from servicing a firm client (or others) in a postemployment context. Similarly, client lists would also not likely be deemed to be proprietary information for these purposes.

Another question not addressed by the court's opinion is the extent to which its decision applies to firm owners, as opposed to firm employees.

Reformation

The willingness of a court to reform overly broad clauses leaves the former employee with the uncomfortable decision of whether to expend much time and money in contesting enforcement only to have it enforced to a lesser extent. The result is that employers may be able to capitalize on their superior bargaining power and the possibility of court reformation to obtain restrictions on postemployment activity far greater than those approved by the courts. Because of this, the Court of Appeals set down three conditions for determining whether an overly broad postemployment restriction should be reformed. Those conditions are as follows:

1) The unenforceable portion of the clause is not an essential part of the agreed exchange;
2) the clause does not evidence clear overreaching on the part of the employer; and
3) the clause represents a good faith effort to protect the legitimate business interests of the employer. Although these standards are relatively vague, the court nevertheless decided that the BDO clause did satisfy them.

How the lower courts will view these criteria is anything but clear. In this regard, it should be noted that the Fourth Department had refused to reform the BDO compensation clause, finding that the entire clause would need to be rewritten in order to render it enforceable. While the Court of Appeals rejected this approach, it provided no guidance as to when "the unenforceable portion of the clause is not an essential part of the agreed upon exchange." Presumably, this criterion would be invoked only where the employer would not have reasonably entered into the entire agreement in the absence of the unenforceable clause, in which event the courts would both refuse to enforce the clause and declare the entire agreement void, including postemployment obligations on the part of the employer. This raises the possibility of tying postemployment payment obligations of the firm to the former employee's compliance with the restrictive covenants. Thus, if the restrictions are deemed unenforceable, then the firm's obligations to make such payment would likewise be deemed unenforceable.

The second criterion cited by the court for reforming a postemployment restrictive covenant provides a real catch-22 for employers. This is because any firm that incorporates unenforceable aspects into its form of agreement is subject to the argument that it was "overreaching." This criterion was not invoked with respect to BDO because the law was anything but clear, and BDO's clause was quite conservative in comparison to other clauses that had been both approved and disapproved by the courts. Because the court has now greatly clarified the law, any employer that ventures beyond the guidelines established in this case is likely to be found to have impermissibly used its bargaining power, with the result that its entire covenant will be declared unenforceable.

The last criterion cited by the court focuses on the legitimate interests of the employer. In this case, the court found that BDO had a legitimate interest in protecting its client base from raids by former employees. It seems unlikely that the courts would find that an employer would have a legitimate interest in restricting a former employee from practicing in the same geographic area or from performing the same types of services offered by the employer. In short, this criterion gives the lower courts broad latitude to refuse to enforce a postemployment restrictive covenant if they do not approve of the employer's efforts.

In short, the Court of Appeals' decision stands as a clear warning to employers that they must act fairly and reasonably in drafting their restrictive covenants and that the courts will not assist them in their efforts to unreasonably limit the activities of a former employee.

Amount of Reimbursement

The court ruled that BDO was only entitled to charge an amount that is "a reasonable measure of the anticipated probable harm." BDO had argued that its clause was reasonable because the compensation formula was modeled on one commonly used in buying and selling accounting practices. The court rejected such "nonspecific averments," asserting that they are insufficient to demonstrate that the liquidated damage clause was not "grossly disproportionate." Thus, it is not clear whether the court was saying that the required proof must detail actual uses of such a purchase formula or whether BDO must produce and substantiate calculations as to its likely damages.

Most Will Not Be Enforceable

Based upon the Court of Appeals' decision and guidelines, the restrictive covenants of most CPA firms will not be deemed enforceable and may, in fact, be such an extreme departure from the standards announced by the court that they will not even qualify for reformation. Firm owners should take the opportunity to review the court's decision in detail and revisit any and all restrictive covenants that are currently in place. *