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Recognizing
a Litigious Reality
Safeguarding Against Unfair Competition and Tortious
Interference
By
Sandra S. Benson, Patricia S. Wall, and Betty S. Harper
NOVEMBER 2007
- Many accountants have access to confidential information and trade
secrets. Employers, concerned about misappropriation of their prized
assets, commonly include noncompetition clauses in their employment,
stock-purchase, and partnership agreements. To save time and money,
employers may be tempted to use standard broad language to prevent
employees from unfairly pirating relationships and information acquired
during employment. This is a blunder that may cost a company dearly
in the long run. Overbroad covenants are unenforceable, and litigation
is costly. Although state laws vary, several legal standards can
be culled from the cases involving accountants. Two especially interesting
New York cases reveal the pitfalls of drafting and implementing
noncompetition clauses for accountants. Another avenue of protection
may be the resourceful use of a tortious interference claim against
a subsequent employer who induces and benefits from the violation
of a restrictive covenant. The purpose of this article is to make
employers aware of the hurdles in implementing noncompetition clauses
and to provide practical strategies for increasing the odds of enforceability.
‘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.
Sandra
S. Benson, JD, has practiced as an attorney and is currently
an assistant professor of business law; Patricia S. Wall,
JD, MBA, CPA, EdD, is an assistant professor of business
law; and Betty S. Harper is a professor of accounting,
all at Middle Tennessee State University, Murfreesboro, Tenn.
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