Recognizing a Litigious Reality
Safeguarding Against Unfair Competition and Tortious Interference

By Sandra S. Benson, Patricia S. Wall, and Betty S. Harper

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‘Rule of Reason’ Balancing Test

Employers have used noncompetition clauses (also known as noncompete clauses or covenants not to compete) for more than two centuries. These clauses have a tarnished past, and courts generally do not like to enforce them. As described by Milton Handler and Daniel Lazaroff [“Restraint of Trade and the Restatement (Second) of Contracts,” 57 New York University Law Review 669, 1982], noncompetition covenants in early English law were deemed unenforceable due to the lengthy apprentice process that was customary at the time, as well as the Black Plague, which decimated England’s population. The legal position against these covenants began to fade as the guild system eroded and the free transferability of property and goodwill became an important social goal. In 1711, the landmark English case Mitchel v. Reynolds [1 P. Wms. 181, 24 Eng. Rep. 347 (Q.B. 1711)] developed a rule of reason that was adopted by most states in the United States and roughly remains in force today. In the 19th century, American courts began to circumscribe the broad pro-employer stance, because some employers overreached with dominant bargaining positions and anticompetitive misconduct. Some courts began to limit post-employment restraints to prevent use or disclosure of confidential information and diversion of customers by employees who had close customer contact during the employment relationship (see Handler and Lazaroff, 721–739).

The usual remedy is for an employer to obtain a court order enjoining (prohibiting) a former employee from violating the noncompetition agreement. Before a court will grant such a remedy, an employer must demonstrate that enforcement is necessary to protect its legitimate business interests. This interest is weighed against the harm to the employee and the public. Because the practical effect of enforcement is typically to put the employee out of some line of work for a time, a court must ensure that the restriction is not overbroad in time, scope of service, or geographic area. While courts in some states will modify a noncompetition clause that is too broad, others will not. Today, the outcome of a noncompetition case is hard to predict because it depends on state law and the specific facts and circumstances of each case. A few states have enacted legislation to limit or void the enforcement of post-employment noncompetition clauses (see Serena Kafker, “Golden Handcuffs: Enforceability of Noncompetition Clauses in Professional Partnership Agreements of Accountants, Physicians, and Attorneys,” 31 American Business Law Journal 31, 1993; Vitauts Gulbis, “Validity and Construction of Contractual Restriction on Right of Accountants to Practice, Incident to Sale of Practice or Withdrawal from Accountancy Partnership,” 13 A.L.R. 4th 661, 1982).

Legal Standards

Noncompetition clauses among accountants today are numerous and multifaceted. Typical noncompetition clauses for accountants take one or more of the following forms during employment and a specified period of time following termination: 1) a promise not to practice at all in a geographic area; 2) a promise not to provide competing services; or 3) a promise not to provide services to any of the firm’s clients. Some accounting firms include liquidated damages or a reimbursement clause that establishes a damages formula if the accountant competes and the firm loses clients to the former employee. In the cases reviewed by the authors, the courts generally applied a balancing test to accountants (Exhibit 1) that is basically the same test as applied in other commercial business contexts.

The courts have addressed the following major issues in accountant noncompete cases (Exhibit 2) in the last several decades:

Is the restriction necessary for a legitimate business interest? Most courts agree that an accounting firm has a legitimate business interest in its client base. If an accountant provides services, or brings in a new client while employed, the benefit of those efforts belongs to the employer. From the company’s perspective, it would not be ethical for the employee to simply walk away with clients secured by the firm’s efforts, investment, and goodwill.

While the firm has an interest in protecting its clients, it cannot necessarily protect all of its clients from competition by any one single accountant. Imagine an accounting firm with offices located across the country and internationally. Suppose an accountant, Andrew, provides general accounting services for the Philadelphia office of a national firm for two years. Andrew then quits, moves to Chicago, and solicits the business of several companies in Chicago. Some of these companies happen to be current clients of his former firm’s Chicago office. Unless Andrew used confidential information, many jurisdictions would find that there is no unfair advantage for Andrew to compete for the business of the Chicago clients because he did not develop relationships with these clients in Philadelphia. Many jurisdictions would also find this geographic radius is unreasonably extensive. The question then becomes which clients or services can an accounting firm protect against unfair competition from a specific accountant. To address this, courts consider whether limitations on geography, time, services, and the definitions of clients are reasonable.

Does the restriction have reasonable limitations? There must be reasonable limitations on the scope of a noncompete clause. One very controversial issue for accountants is the scope of the definition of “clients” in the agreement. If the firm prohibits competition against “any clients of the firm,” the agreement is quite likely too broad because this could include past clients, future clients, or clients with whom the accountant did not have contact during employment. A firm usually cannot protect its entire client base from competition by one accountant. However, an employer should be able to protect itself in situations where the employee shared in the goodwill created and maintained by the employer’s efforts and expenditures. An employer is most at risk when the employee works closely with a client over a long period of time and the employee’s services are a significant part of the total transaction. Some courts are broader in their definition of clients than others. Under the more restrictive New York approach, a firm generally cannot prohibit competition for clients with whom the accountant did not provide direct, substantive accounting services while employed by the firm, unless the accountant used confidential information.

Determinations of reasonableness in time and geography vary greatly depending on the state. Practice time restrictions have spanned from terms of six months to five years. A geographic restriction ranging from 50 miles to five states may be justifiable, depending upon the types of accounting services in the restricted area. Some states set guidelines or maximums in the state legislation. For example, Florida law presumes that a restraint against a former employee of six months or less is reasonable, and any restraint more than two years in duration is unreasonable (FSA section 542.335). Under South Dakota law, an employee may agree not to engage in the same profession or solicit existing customers for a period not to exceed two years within a specified area (SDCL section 53-9-11). If not set by statute, longer time periods and greater geographic restrictions will be heavily contested.

The issue of the liquidated damages for loss of business often arises in cases involving accountants. Accounting firms frequently specify damages or reimbursement based on a formula of the client fees earned before the accountant’s departure or based on the fees earned by the accountant after departure. Reimbursement provisions are favored by the courts because they allow the parties to agree on the client’s value and make it easier for the court to validate. The Kansas Supreme Court [Varney Business Services, Inc. v. Pottroff, 275 Kan. 20, 40 (2002)] stated there is a “strong public policy in favor of recognizing provisions that compensate individuals and entities for the loss of a client’s business as valid rather than in finding such provisions unenforceable.” Firms that base their fees on objective evidence of the value of the client are in the most defensible position. Another reason for favorable treatment is that the reimbursement restriction is less burdensome on the employee and the public. An accountant can continue to practice and to appropriate the business by paying for the firm’s loss while, at the same time, the public still has a choice. These fees must be reasonable under the general reasonableness balancing test, and, in many states, must not be so out of line with actual damages that they impose an excessive penalty.

Was there a valid exchange and lack of employer misconduct? For a noncompete clause to be enforceable, there must be a valid, bargained-for exchange. In general business cases, many courts find that the exchange is valid when the employee signs a contract to obtain initial employment or to obtain a promotion. Signing a noncompete clause just to continue employment is less likely to be enforced in some states, unless it is accompanied by a salary increase or other benefit. Bad faith or overreaching on the part of the employer weighs against enforcing a noncompetition clause and may prevent the court from reforming an overbroad covenant.

Is the covenant opposed to public policy or unethical? Model Rule 5.6(a) of the Model Rules of Professional Conduct adopted by the American Bar Association prohibits noncompete clauses among lawyers. The American Medical Association has issued an ethical code for physicians that discourages, but does not prohibit, unreasonable noncompete clauses (EC 9.02). The AICPA Code of Professional Ethics, however, does not address the issue for accounting professionals. Accountants in a few reported cases have raised the ethics issue by arguing that the practice of accounting is like the practice of law; yet, the accounting profession does not have an ethical rule comparable to the rule for attorneys.

Covenants that are impermissible under a state law are considered void and unenforceable. For example, in Alabama, noncompetition clauses are not enforceable against professionals under any circumstances [see Gant v. Warr, 286 Ala. 387 (1970)].

Which law applies? It is not sufficient to be concerned with the law of only one state. Many accounting firms include “choice of law” provisions because they have offices in multiple states. Sometimes firms want to “forum-shop” to pick a state with laws more favorable to the employer. Under the Restatement (Second) of Conflict of Laws Section 187(2) (a)-(b) (1989), parties may include clauses regarding forum selection, but courts may ignore this choice in two instances: 1) when the selected state does not have a substantial relationship to the parties or a reasonable basis for their application; or 2) when the law of choice violates a fundamental policy of the state with a materially greater interest. A state with a strong policy against noncompete clauses that has an interest in the transaction will not honor the parties’ choice of law. In Cherry, Bekaert & Holland v. Brown [582 So. 2d 502 (1991)], Brown was a manager in Mobile, Ala., and worked for CB&H, headquartered in North Carolina. CB&H knew that Alabama would not enforce noncompete clauses, and the partnership agreement provided that North Carolina law would govern. Upon Brown’s departure, CB&H filed suit in North Carolina, but while this suit was pending, Brown filed suit in Alabama seeking to declare the covenant void. The Alabama Supreme Court held that Alabama had a materially greater interest than North Carolina in the determination of the issues, so the provision in the partnership agreement designating North Carolina law would not be given effect against an Alabama resident.

Lessons from Two New York Cases

Because the enforcement of a covenant is unpredictable, many employers rely on the court to reform a covenant that was determined to be overbroad. This is not an advisable strategy in many states, because the court will often decide that the employer exhibited bad faith in trying to implement an overly broad restriction. A comparison of BDO Seidman v. Hirshberg [93 N.Y.2d 382 (1999)] to Scott, Stackrow & Co., C.P.A.’s, P.C. v. Skavina [9 A.D.3d 805; cert. denied, 3 N.Y.3d 612 (2004)] shows how bad faith can make a difference.

In BDO, Hirshberg, an accountant, became an employee of BDO Seidman as a result of a merger. Several years after the merger, as a condition to promotion, Hirshberg expressly acknowledged his fiduciary relationship and signed a manager’s agreement that if he served any former client of BDO’s Buffalo office during an 18-month period following termination, he would compensate for the loss and damages suffered in the amount of 1 Qs times the last fiscal-year fees BDO had charged the client. The clause did not require Hirshberg to stop practicing after termination. Hirshberg resigned, and BDO alleged that he serviced 100 clients and billed $138,000 during the first year after he left. Hirshberg countered that some of the clients were personal clients he had recruited or brought with him on his own and that he was not the primary representative on some of the accounts. Because this covenant was implemented as part of a promotion to manager, a high level of trust only one step below partnership, and because there was no evidence of employer anticompetitive misconduct, the New York State Court of Appeals allowed partial enforcement of the covenant recognizing clients developed through the efforts and resources of BDO, and for whom Hirshberg had provided substantial accounting services.

In Scott, the appellate court applied the rationale in BDO. Skavina had been a staff accountant for John A. Yager, CPA, for four years when Scott purchased the Yager client list. Scott required Skavina to sign an employment agreement containing a restrictive covenant when she was hired and annually thereafter. The restrictive covenant required Skavina not to solicit or perform accounting services for any of Scott’s clients for a period of two years following termination. After Skavina joined a new firm, she solicited and performed services for clients she had served while employed at the Yager and Scott firms. The New York State Supreme Court, Appellate Division, upheld the lower court’s ruling that the agreement was unenforceable and partial enforcement was not allowed.

What accounts for the different outcome in the Scott case? What can employers that will apply New York law learn that will help them increase the odds of implementing an enforceable noncompetition clause? As shown in Exhibit 3, the enforceable noncompetition clause in BDO was part of an agreement where the employee was promoted to manager, a position of trust; the employee was not prohibited from practicing, but was required to reimburse the firm for its loss of business from firm clients; and the time period was reasonable. There was no employer misconduct in trying to implement an overbroad covenant or a covenant that was not based on a valid exchange. Considering these factors, the court was willing to reform the covenant from an overbroad definition of clients to a reasonable one.

The unenforceable clause in the Scott case was given to a staff accountant upon initial hire and annually thereafter, with no promotion, salary increase, or other benefit besides continued employment. The clause was an outright ban on practicing and did not have a geographic limit or an option to pay reasonable liquidated damages to the former employer. Furthermore, the employer was put on notice by BDO that its inclusion of the term “any client” was too broad. Thus, not following the BDO guidance resulted in “bad faith” that prevented the enforcement of a noncompete.

Tortious Interference

Intentional interference with contractual relations is a business tort that is especially prevalent in the field of intellectual property. A third party may be liable for this tort by inducing an employee to breach a contract (restrictive covenant) with an employer and encouraging the use of confidential information, such as customer lists. Since customer lists have been held to be trade secrets in some jurisdictions, the third party could also face liability for misappropriation of trade secrets.
In some jurisdictions, such as Tennessee, a third party can be held liable for treble damages for inducing an employee to breach a restrictive covenant (T.C.A. 47-50-109). However, New York has limited the use of punitive damages in these types of cases. In Garrity v. Lyle Stuart, Inc., [40 N.Y.2d 354 (1976)], the court, quoting Walker v. Sheldon [10 N.Y.2d 401 (1961)] stated: “[P]unitive damages are available only in a limited number of instances … [For example,] ‘in cases where the wrong [doer] complained of is morally culpable, or is actuated by evil and reprehensible motives, not only to punish the defendant but to deter him, as well as others who might otherwise be so prompted, from indulging in similar conduct in the future.’ It is a social exemplary ‘remedy,’ not a private compensatory remedy” (page 358). In Lockheed Martin Corp. v. Aatlas Commerce, Inc. [283 A.D. 2d 801, 3d Dept. (2001)], the New York Supreme Court, citing Murray v. Sysco Corp. [273 A.D. 2d 760, 1st Dept. (1989)], determined that the plaintiff must show the following elements for procurement of breach of contract: “1) the existence of a valid contract between plaintiff and its employees; 2) defendants’ knowledge of that contract; 3) defendants’ intentional inducement of employees to breach that contract; and 4) damages.”

Restrictive covenants are held to be unenforceable in many jurisdictions if unreasonable in geographic or temporal scope. Thus, the issue of intentional interference with contractual relations is never litigated because the first element of the above test is missing. The litigating party may find it more feasible to sue the third party under misappropriation of trade secrets (e.g., customer lists).

If a new employer knows of a restrictive covenant before hiring, that employer should make it clear to the new employee that the new position will not involve the use of any trade secrets or confidential information belonging to a former employer. This was not the case in Ticor Title Insurance Co. v. Cohen [173 F.3d 63, 2d. Cir. (1999)]. As the New York Court of Appeals had in BDO Seidman v. Hirshberg, the U.S. Court of Appeals for the Second Circuit emphasized that an employee’s relationship with an employer’s clients may be so exceptional that the enforcement of a restrictive covenant is justified (Thomas G. Eron, “Employment Law: 1998–99 Survey of New York Law,” 50 Syracuse Law Review 563, 2000). The defendant, Kenneth Cohen, was a sales manager for Ticor Title Insurance Company and Chicago Title Insurance Company. Upon advice of counsel, Cohen signed a restrictive covenant which provided that upon quitting, he would not work in the title insurance business in the state of New York for six months. His normal minimum annual pay of $600,000 included a base salary of $200,000 and commissions. During 1998, Cohen went to work for TitleServ, a direct competitor of Ticor. Having notice of the restrictive covenant, TitleServ offered to pay Cohen his salary for the six-month period if he was prohibited from working.

The U.S. Court of Appeals found the facts in this case on point with the facts in Maltby v. Harlow Meyer Savage, Inc. [166 Misc. 2d 481, 633 N.Y.S. 2d 926 (Sup. Ct. 1995); aff’d 223 A.D. 2d 516, 637 N.Y.S.2d 110 (1996)]. In Maltby, the court enforced a restrictive covenant when stockbrokers (who were earning more than $100,000 per year plus bonuses) breached their restrictive covenants and went directly to work for a direct competitor of their former employer. They had agreed to a six-month noncompete clause, during which time they were to receive their base salary. The court found the geographic and time restrictions reasonable, emphasized the “unique personal services,” and found that a broker’s ability to earn a living would not be substantially impaired by this restriction.

Similarly, in Ticor, Cohen’s clients were developed during his tenure at the company; about half had previously been clients of another Ticor salesman who had left the company. Because New York fixes the price and terms of title insurance, personal relationships with clients separate salesmen from the competition. During 1997, Cohen spent $170,000 entertaining clients, and spent $138,000 during part of 1998. The U.S. Court of Appeals found that it would be inequitable to allow a competitor to take Ticor’s investment by hiring its employees (Eron, 2000).

In Cherry, Bekaert & Holland v. Brown, the Alabama Supreme Court found that the provision of a partnership agreement was not a noncompete agreement, but instead found that “the requirements of the paragraph are tantamount to a covenant not to compete and operate in the same manner.” The provision required that a withdrawing accountant or partner who served the former firm’s clients within three years of leaving had to pay the firm 150% of the fees charged by the firm to the client during the last 12-month period when the firm served the client. The court held that the requirements were “so harsh and punitive in nature that they virtually operate to prevent the practice of accounting by the withdrawing partner totally.” The departing partner in this case brought suit for interference with contractual business against Cherry, Bekaert & Holland. The trial court entered a judgment for the employer on this issue, finding that Brown had offered no proof of any intentional interference with his business. The decision was upheld by the Alabama Supreme Court.

In Schott v. Beussink [950 S.W. 2d 621 (1997)], an employer sued departing employees for interference with contractual relations. Additionally, the employer sued for: 1) breach of a restrictive covenant prohibiting termination of the contract prior to June 30; 2) breach of a restrictive covenant prohibiting departing employees from soliciting the employer’s clients for two years; and 3) civil conspiracy. The trial court sustained the employees’ motion to dismiss and found that the restrictive covenant was against public policy. The appellate court reversed and found that an accounting firm has an interest in protecting its clients. It reasoned that there were no geographic limitations in the covenants and employees should be able to make a living, thus there was no violation of public policy. The appellate court also found that the employer had failed to provide sufficient facts to support a claim of interference with contract.

Practical Strategies

Banning employees from practicing for a post-employment period may be enforceable in certain states, but there are caveats. There are many ways noncompete clauses can be attacked in terms of reasonableness, unless state law is unambiguous. Firms must be prepared to defend their covenants through litigation. Pushing the envelope in terms of time, geography, or the entire client base will invite a lawsuit and may appear to be overreaching. A court may see this as bad faith by the employer and may not be willing to rewrite the covenant into a reasonable one. To increase the odds of enforceability, employers should stay within reasonable bounds of time, geography, and damages based on the cases in the state of the applicable law. Be careful to give the written noncompetition terms to prospective employees and partners in advance so they clearly understand the terms. Do not engage in underhanded conduct in presenting the noncompete clause.

Accounting firms should study the state laws carefully and narrowly tailor their noncompete clauses to an employee’s activities within their organization. Firms should take several factors into consideration:

• The specific language of the clause is very important, and thus a specialized attorney should draft the contract.
• Restrictions must be reasonable and no broader than necessary to protect legitimate interests of the firm. Be specific as to which clients are covered. In states like New York, make sure the noncompete specifies clients with whom the accountant is given direct, substantive work.
• Require recruitment efforts to be firm-driven and consider implementing a client development plan that includes paying employees’ membership dues in community organizations where business may be developed.
• Consult state law for reasonable limitations in time, geography, clients, and scope of activities, and stay within these limits.
• Practice bans are more onerous than reimbursement provisions. It is appropriate to limit the enforcement of these covenants to very narrowly defined time frames, classes of clients, or activities.
• Reasonable-reimbursement clauses based on formulas related to the anticipated loss have greater public policy support than practice bans. An unbiased objective formula commonly used for practice sales to third parties is advisable.
• The employer should exercise good faith in implementing and enforcing covenants.
• It is advisable with existing employees to tie a noncompetition agreement to a raise or promotion.
• Do not require all employees to sign noncompete clauses. Instead, select only those employees who will have the opportunity or ability to unfairly compete.
• Avoid requiring employees or partners to sign noncompetition agreements without allowing time to review them.

Taken together, these steps will show a court that an employer is attempting to protect only the firm’s legitimate interests, while keeping the burden on the employee and the clients to a minimum.

Proctecting Client Relationships

The tortious interference cases illustrate the importance of an employee’s relationship with the firm’s clients. They emphasize the importance of protecting this interest with a restrictive covenant and the pursuit of claims against the new employer when there is sufficient evidence of tortious interference with contractual relations. When an employee leaves for a competitor, the firm should always stress to the departing employee and the new employer the terms of any existing noncompete and nondisclosure agreements. These matters can be discussed in an exit interview with the employee and in a letter (including the noncompete agreement) to the new employer. Some employers even include a clause in the noncompete and nondisclosure agreements requiring that the departing employee show such agreements to the new employer.

A new employer must be careful not to induce an employee to breach a restrictive covenant. If a new employer knows of a restrictive covenant before hiring, it should be made clear that the new position must not involve the use of any trade secrets or confidential information belonging to the former employer. A new employer can defuse concerns by providing a letter of assurance to the former employer that the noncompete and nondisclosure agreements will be honored.

Despite the widespread use of defective covenants, many accounting firms continue to execute such agreements. The key to enforcement is to prepare a document that is reasonable to all parties. With a careful eye on tightening up contractual language and an awareness of the peculiarities of state law, employers should be able to increase the chance that the covenant to prevent unfair competition will work in their favor.

©2009 The New York State Society of CPAs. Legal Notices