Protecting Your Business from Competition by Former Employees

Usually, You Can’t . . .

It’s final in California: you can’t prohibit your employee from competing with your business after leaving the job.

In a recently published opinion (Edwards v. Arthur Andersen LLP (2008) 44 Cal.4th 937, 81 Cal.Rptr.3d 282), the California Supreme Court made it clear that except in a few clearly defined situations, once an employee leaves, he or she is free to compete, even if the competition starts immediately and “right across the street” literally or figuratively (such as on the internet).

The main exceptions: When the employee came to work for you as a result of selling her business to you in the first place. This actually occurs in several situations:

• When you purchased the goodwill of the employee’s business
• When you purchased all of the employee’s ownership interest (such as stock) in the business entity (or the entity’s ownership of a subsidiary or division)
• When you purchased all or substantially all of the operating assets of the employee’s business entity (or its subsidiary or division)

In Edwards, the employee did not sell a business. He worked as a tax CPA for Arthur Andersen in Los Angeles. When he was first employed in 1997, he signed an agreement that if he was terminated or resigned, (1) he would not perform professional services of the type he provided for any client for whom he worked during the 18 months before leaving; (2) he would not solicit the business of any client of the firm to perform such services (even if they were not his clients at the firm) for 12 months after leaving; and (3) he would not solicit away from the firm any of its professional personnel for 18 months after leaving.

In 2002, the U.S. government indicted Arthur Andersen in connection with the infamous Enron investigation, and Andersen announced that it would cease its accounting practices in the United States. Andersen announced that HSBC USA, Inc., through a new subsidiary, Wealth and Tax Advisory Services (WTAS), would purchase a portion of Andersen's tax practice, including Edwards’s group.

HSBC offered Edwards employment. Before hiring any of Andersen's employees, HSBC required them to execute a “Termination of Non-compete Agreement” (TONC) in order to obtain employment with HSBC. Among other things, the TONC required employees to release Andersen from “any and all” claims, including “claims that in any way arise from or out of, are based upon or relate to Employee’s employment by, association with or compensation from” Andersen. In exchange, Andersen would agree to accept Edwards’ resignation, agree to Edwards's employment by HSBC, and release Edwards from his noncompetition agreement. If he did not sign the TONC, then his employment by WTAS would violate his agreement with Anderson because he would be working for a competitor of Andersen.

Edwards refused to sign the TONC, because he felt (based on advice of his own counsel) that releasing “any and all” claims he may have against Andersen might free Andersen from the obligation to indemnify him in the event he was later named as a defendant in any Enron-related litigation. Andersen then terminated his employment and WTAS refused to hire him. Edwards sued.

After the trial court denied Edwards’ claims, the appellate court reversed the decision, and the California Supreme Court upheld the main conclusions of the appellate court. (By the way, this illustrates the uncertainties of going to trial in litigation; you never know how long it may take or how much it will cost to decide your case, or whether it will ultimately go your way.)

The Supreme Court held that releasing “any and all” claims did not include releasing a claim based on the employer’s obligation to indemnify an employee against claims made for the employee’s actions within the scope of employment. This obligation is one imposed by statute, the court said, and could not be waived by an employee due to the strong public policy embodied in the statute. So Edwards’ reason for refusing to sign the TONC was not that important. However, the court said, the real reason that the TONC was not enforceable was this: a prohibition on competition by a former employee is illegal unless it is expressly allowed by the exceptions stated in the statutes. Those exceptions are summarized in the bullet points printed above.

. . . However, You Can Protect Trade Secrets

So how do you protect your business when a former employee competes with you, with the knowledge and expertise the employee developed while working for you? By protecting your trade secrets and intellectual property. An employee (current or former) cannot legally use your confidential information or intellectual property (such as patents, trademarks and copyrighted materials) to compete with you. Thus an employee cannot take a confidential customer list and send a flyer out to those customers advertising her new business with prices a tad below yours. The employee cannot copy your publications created in-house or for you (such as marketing materials) or use your house-developed software.

Two significant competing interests collide in trade secret cases: (1) the right of the employee to start a competing businesses or to continue to work in a chosen occupation – even when this includes leaving an employer to accept a position with a competitor; and (2) the right of the existing business to protect the confidential and proprietary information in which it has invested significant resources, not only to develop, but also to protect. So it is critical for you to know how you can protect your trade secrets, and how you can recover damages if its trade secrets are misappropriated by a former employee.

The California Uniform Trade Secrets Act (Civil Code §3426 and following) defines a trade secret as “information, including a formula, pattern, compilation, program, device, method, technique, or process, that: (1) derives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use; and (2) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.” So what, practically speaking, is a trade secret?

Customer Lists: Is a customer list a trade secret? It depends. A customer list will most likely be considered a trade secret if it possesses potential economic value by allowing a competitor to direct sales efforts to those who have already shown a predisposition to purchase the item for sale, or the service being offered. Courts are reluctant to protect customer lists to the extent they embody information which is readily available through public sources such as the yellow pages or business directories and contain mere identities and locations of customers that anyone can easily identify as potential customers. However, if you have expended time and effort identifying customers with particular needs or characteristics, you can probably prohibit a former employee from using this information to capture a share of the market. As a general rule, the more difficult the information is to obtain, and the more time and resources spent by an employer in gathering it, the more likely a court will conclude that such information is a trade secret.

A customer list possesses economic value when the secrecy of that information provides its owner with a substantial business advantage. Therefore, a court will likely find that a customer list has economic value when 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.

Software: Software developed by a company for its own benefit can also be treated as a trade secret. A company is typically able to establish that the software has independent economic value by showing that it invested time and money to develop and benefit from the software. Moreover, since the company is normally able to establish that the software contains unique features for the company’s benefit, the software should be considered a trade secret.

Reasonable Efforts: You must make reasonable efforts to ensure the secrecy of your confidential information. The more the preventative measures you take to ensure its secrecy, the more likely that a court will find you have made the necessary effort.

Patents and Trademarks: A trade secret is not a patent or a trademark. Patents and trademarks are matters of public record, while a trade secret is confidential and proprietary. Patents are issued for the purpose of protecting the rights of inventors, while trade secrets cover information that includes formulas, patterns, compilations, programs, devices, methods, techniques or processes. A formula or program that might not satisfy the strict requirements for obtaining a patent may still be a trade secret if it has characteristics that are not available to the public. A trademark, whether registered or not, can be protected from any competitor’s use if it is sufficiently unique.

Misappropriation of a Trade Secret

The Uniform Trade Secrets Act prohibits the misappropriation of a trade secret. A misappropriation of a trade secret does not occur when a former employee announces a new affiliation, even to clients of a former employer whose identity would be considered a trade secret. Simply announcing a new affiliation is considered basic to an individual’s right to engage in fair competition. However, misappropriation occurs if information from a customer database is used to solicit customers. For example, a former employee (or her new employer) cannot send letters or otherwise contact your actual or potential customers, seeking to obtain their business. Anything more than an announcement of a change of employment will most likely be considered a misappropriation under the Uniform Trade Secrets Act. (See California Civil Code §§ 3426.1 (b) and 3426.2.)

You may be able to get an order from the court preventing the former employee (and her new employer) from doing business with any customer who switched their business from you. Also, you may be able to recover monetary damages for the actual loss caused by the misappropriation. If you can’t prove the actual damages you suffered, a court may order that a reasonable royalty be paid for no longer than the period of time the use of the trade secret could have reasonably been prohibited. (California Civil Code § 3426.3.)

The “Personal Clients” Defense

One of the common defenses to a misappropriation claim is the former employee’s claim that she brought the clients to the company when she was hired. Whether these clients are truly the employee’s “personal clients” depends on the specific circumstances, but it usually comes down to when she began developing the client relationship and how much the employer contributed to the development of the relationship. The defense does not apply when the employee came to work for you as a result of selling her business to you in the first place, as described above. Also, if the employee merely knew a client before you employed her, she may not be able to prove that she had previously established a business relationship. And if you can establish that you provided substantial financial support for the continued relationship (such as travel and entertainment expenses, client discounts, client or employee training or capital expenditures), then you may be able to enforce a claim for misappropriation.

How to Protect Your Trade Secrets

Don’t wait for a situation to occur where trade secrets are in jeopardy before taking action. Preventive measures may decrease the likelihood that a former employee (or, indeed, a current employee) may disclose trade secrets. And, if someone does disclose – or attempt to use – a trade secret, then proof that you considered this information to be valuable and confidential and took steps to ensure its confidentiality will be helpful. To help protect your business you should take the following steps:

1. Have all employees, independent contractors and temporary personnel execute confidentiality agreements as a condition of new or continued employment. A confidentiality agreement should contain, among other terms, a definition of trade secrets, limitations of how trade secrets can be utilized, and the types of monetary and injunctive relief that you can recover if the employee breaches the agreement.
2. Conduct regular meetings with employees, independent contractors and temporary personnel to remind them about what information you consider confidential and why you want to protect it.
3. Identify any information you consider confidential as confidential and proprietary by either placing it in a separate file or stamping “confidential and proprietary” on it.
4. Limit access to confidential information to only those persons who absolutely must see it. You can place the information in a separate locked file cabinet or require selected employees to use a password to gain access to it.
5. When establishing a new employment relationship, inquire whether that person’s previous employer required her to sign a confidentiality agreement. This promotes awareness by the new employee that you respect the confidential and proprietary information of her former employer and do not want to deal with the possibility that she will expose you to liability by using protected information.
6. If this is the case, advise other employees, independent contractors and temporary personnel that you are required to enforce a confidentiality agreement.
7. Include confidentiality provisions in personnel manuals.
8. Require vendors, suppliers and potential customers to sign nondisclosure agreements about the confidential and proprietary information made available to them, and make the your employees aware of that policy. A nondisclosure agreement is similar to a confidentiality agreement. They both seek to protect trade secrets. Your employees will develop a better understanding that you value your confidential and proprietary information if they see that third parties are being required to sign nondisclosure agreements.
9. Have your employees, independent contractors and temporary personnel agree (via a “work-for-hire” contract) that any confidential information they create on behalf of your company belongs to the company.
10. Hold thorough exit interviews and require personnel who have terminated their relationship with your company to return all confidential information in their possession, including any information that is on their office or home computer.

You Can Recoup Wages Paid to a Disloyal Employee

Under the “faithless servant doctrine” an employer can recover wages and benefits paid to an employee who secretly competes with the employer while still employed. The recoverable compensation is the amount paid after the competition has begun. One piece of good news for employers is that a California appeals court held in a recent case, S.E.I.U. Local 250 v. Colcord (2008) 160 Cal.App.4th 362, that the employer can recover compensation paid to such a disloyal employee even for work done faithfully after the first act of disloyalty. Since this is only an appeal court case, and not the California Supreme Court, this may not be the final word on that question.

The Take Away

Since competition is a fact of life, one of the few ways you have of maintaining an advantage in the market is by protecting your trade secrets. Your right to protect your company’s trade secrets is not automatic. Instead, affirmative steps must be taken to limit other’s rights to use this confidential and proprietary information. Your attorney can aid you in this by, among other things, providing suitable contracts to protect your trade secrets and educating employees regarding their responsibilities. Then, if you make your current and former employees aware of these trade secrets and they still misappropriate them, you may then be able to obtain relief, including the possibility of an award of damages. And you don’t have to abide by disloyalty. If your employee secretly competes with you while still working for you, you may be able to recover the wages and benefits paid from when the secret competition began.

Your Attorney Can Help

Here’s how your attorney can help you protect your competitive advantage. We can:

• Prepare Employee Policies regarding protection of trade secrets and confidential information
• Prepare Confidentiality and Nondisclosure Agreements for employees, independent contractors, vendors, suppliers, potential customers and others with whom you may consider doing business
• Prepare “Work-for-Hire” Agreements with employees and consultants to ensure that intellectual property created by them belongs to you
• Advise you on in-house measures to ensure protection of confidential information and trade secrets
• Advise you on how to conduct thorough exit interviews with terminated employees
• Apply for and process applications for trademarks and tradenames (a patent attorney is required for patent applications)
• Prosecute misappropriation claims against someone who steals trade secrets

If we can be of assistance in any of these matters, please give us a call at (925) 935-3300 or email rbowles@bowlesverna.com.