Fourth Circuit Addresses Commercial Speech Issue

In 2017, the Fourth Circuit Court of Appeals considered a decision by Judge James Cacheris of the Eastern District of Virginia that is an important addition to the jurisprudence of Lanham Act claims.  The case, Handsome Brook Farm, LLC v. Humane Farm Animal Care, Inc. 2017 WL 3601506 dealt with the requirements to state a claim for a violation of the Lanham Act.

According to the Complaint, Humane Farm Animal Care (“Humane”) is a non-profit organization that certifies certain egg producers for humane treatment of their laying hens.

Handsome Farm Animal Care (“Handsome”) is an egg producer that Humane does not certify.

 

In 2016, Humane sent an email to thirty-six grocery retailers, including some of the largest grocery chains in the nation.  The email alleged that Handsome either did not certify or lacked up to date certifications to support its representations that its eggs are organic and pasture raised.  The email also included the following language.  “I hope you will reconsider changing suppliers."

As a result, Handsome lost existing and potential customers and ultimately  brought a false advertising claim against Humane.  Contrary to the email’s statements, Handsome’s organic certifications were up to date.  The District court issued a preliminary injunction prohibiting Humane from circulating the emails and directed Humane to publish a retraction email.  Humane appealed to the Fourth Circuit to lift the preliminary injunction.

The question before the court was whether the email was commercial speech.  Notably, neither the Supreme Court nor the Fourth Circuit define “commercial advertising or promotion.” The court cited an opinion out of the Southern District of New York in Gordon and Breach Sci. publishers v. Am. Inst.of Physics, 859 F. Supp. 1521, (S.D.N.Y.) which was the leading opinion on the issue.  While most circuits have adopted the Gordon & Breach  factors, the Fourth Circuit had not done so and in particular the second part of the test, that the plaintiff must be “a defendant in commercial competition with the plaintiff.”  That notwithstanding, the Fourth Circuit analyzed the issue and agreed that the evidence should show a competitive relationship, particularly with regard to standing. As it noted, “a competitive relationship, therefore, is necessary inasmuch as it gate-keeps who may appropriately bring suit. This is especially true for realizing Congress’s intent that the Lanham Act ‘protect persons engaged in [interstate] commerce against unfair competition.”

Among the arguments addressed was (1) where a non-profit organization has a direct economic stake in the provision and structures its message in the hopes of realizing an economic gain rather than merely informing the public, may it reasonably be viewed as economically motivated; (2) whether the Humane email promoted a good; (3) whether Humane’s email was focused on the provision of a service rather than on the advocacy of its ideology; (4) whether the message of Humane’s email was focused on economic and legal concerns; and (5) whether Humane’s email appealed to the grocery stores (recipients) economic and commercial motivations, and was directed at offering a service – the reliability of its certification – rather than an idea. The court resolved all of these issues in Handsome’s favor.

  

At the end, the court found that the email was commercial advertising or promotion and upheld the preliminary injunction, including the requirement that Humane issue a retraction email.

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Tortious Interference with Contract or Business Expectancy May Serve as Predicate Acts for Alleged Violation of the Virginia Business Conspiracy Statute, According to the Virginia Supreme Court. Such Claims Carry a 5 Year Statute of Limitations.

For over 30 years, James Dunlap operated two AAMCO franchises in tidewater Virginia.  In 2006 a company that owned a controlling interest in Cottman Transmissions, a competitor, acquired a controlling interest in AAMCO.  The new owner wanted to convert all Cottman centers into ones displaying the AAMCO  banner.  To do so, however, certain AAMCO centers had to close.  Those slated for closure included both of Dunlap’s centers. 

Dunlap filed suit against Cottman Transmission Systems, LLC, its former President, Todd Leff, who became President of AAMCO after the acquisition, and two local Cottman dealers alleging unfair business practices in the form of claims for tortious interference with contract and business expectancy and a violation of the Virginia business conspiracy statute, Va. Code, §18.2- 499 and 500.

The case was originally filed in a Virginia state court, but was removed to the Eastern District of Virginia.  On Cottman’s motion to dismiss, the district court held that (1) tortious interference with contract and business expectancy could not serve as predicate acts to support a claim for violation of the Virginia business conspiracy statute; and (2) the statute of limitations for tortious interference with contract and business expectancy was two years under Virginia law, thus barring Dunlap’s claims.

Dunlap appealed to the Fourth Circuit Court of Appeals which certified two questions of law to the Virginia Supreme Court.  Those issues were:

1. May a plaintiff use tortious interference with contract or tortious interference with business expectancy as the predicate unlawful act for a claim under the Virginia business conspiracy statute, Va. Code §18.2-499 and 18.2-500; and
2. Does a two-year or five-year statute of limitations apply to claims of tortious interference with contract and tortious interference with business expectancy under Va. Code § 8.01.-243?
   The issues were matters of first impression in Virginia.
   The Virginia Supreme Court’s well-reasoned opinion appears at Dunlap v. CottmanTransmission Systems, LLC, 287 Va.207, 754 S.E.2d 313 (2014). 
   Question 1 turned on the proper interpretation of the Supreme Court’s decision in Station # 2, LLC v, Lynch.  280 Va. 166, 695 S.E.2d 537 (2010) upon which the district court relied in dismissing the case.  In Station # 2, the Court held that a “conspiracy merely to breach a contract that does not involve an independent duty arising outside the contract is insufficient to establish a civil claim under § 18.2-500.”  Id at 174, 695 S.E.2d at 541.(italics in original)  That is, the analysis is dependent upon the source of the duty violated. 
   In Dunlap, the Supreme Court noted that “both tortious interference with contract and tortious interference with business expectancy are intentional torts predicated on the common law duty to refrain from interfering with another’s contractual and business relationships.  That duty does not arise from the contract itself but is, instead, a common law corollary of the contract. [citation omitted]  The duty arises outside the contract even though the intentional interference must induce or cause a breach or termination of the contractual relationship or business expectancy.”  Id. at 219, 754 S.E.2d at 319.  Accordingly, the Court held that those intentional torts could serve as a basis for a conspiracy claim under the statute.
   Question 2 involved a determination of whether claims for tortious interference with contract or business expectancy allege personal injuries or injuries to property.  Personal injury claims must be brought within two years, while those alleging injuries to property are covered by a five year statute of limitations.  The Court noted that Virginia had long held that the right to performance of a contract and the right to reap its profits are property interests.  Id. at 220, 754 S.E.2d at 320.  Consequently, the acts supporting tortious interference with contract or business expectancy are directed toward and injure property rights.  Therefore, the Court held the five-year statute of limitations applies to such claims.  Va. Code § 8.01-243(B).
   Based upon the Supreme Court’s answers to the certified questions, the Fourth Circuit vacated the district judge’s judgment and remanded the case for further proceedings.  Dunlap v. Cottman Transmissions Systems, LLC, 576 Fed. Appx.225 (2014).

Oppressive Conduct By Majority Shareholders Warrants Judical Dissolution of a Closely Held Virginia Corporation

A recent decision by Judge Jane Marum Roush of the Fairfax Circuit Court in Virginia is a must read for shareholders in closely held Virginia corporations.  The case, Colgate, et al. v. The Disthere Group, Inc.,(August 30, 2012, Case No. CL-11-117, Buckingham County, Virginia) arose when minority shareholders sued under Section 13.1-747 of the Code of Virginia seeking dissolution of the defendant corporation as a result of oppressive and fraudulent conduct by the majority shareholders.  Virginia law allows judicial dissolution where a minority shareholder proves that "the directors or those in control of the corporation have acted, are acting, or will act in a manner that is illegal, oppressive or fraudulent; or ... the corporate assets are being misapplied or wasted..."   Where a director has a personal interest in the transaction at issue, the burden of proving that the transaction was fair and reasonable to the corporation shifts to the director whose conduct is challenged.

After a lengthy trial, Judge Roush issued a 41 page opinion, Click Here, finding that the corporation should be dissolved based upon the majority shareholders' conduct.  Preliminarily, she noted that the business judgment rule does not apply where it is shown that a director "has acted on his or her own account, and contrary to the interests of the corporation."  She concluded that, in this case, the directors were motivated by their personal best interests and that "dissolution is the appropriate remedy in that the corporation is controlled by a domineering shareholder who is unlikely ever to treat the minority shareholders fairly."

So what did the majority shareholders/ directors do wrong?  Well, they suppressed dividends to retaliate against the minority shareholders who had instituted earlier litigation alleging that a majority shareholder had looted a marital trust. At the same time, the majority shareholders gave themselves pay raises and bonuses nearly equal to the amount by which the dividends had been cut.  In addition,  they consistently redeemed minority shares based upon "'misrepresentations and half-truths' as to the true value of the company," which the court found violated the standards of fair dealing and fair play. 

The court also found that the majority shareholders' compensation was excessive when compared to the company's net income.  And the senior majority shareholder provided employment at significant salaries to a number of members of his own immediate family while either terminating or refusing to hire his sister's children, the minority shareholder plaintiffs.

In addition, the defendants used corporate assets for personal purposes prompting a finding that they had misapplied and wasted corporate assets.  And, the company paid over $6.5 million in life insurance premiums that the court found was intended to provide liquidity to the estate of the insureds so that the company stock could be kept in the majority shareholders' immediate family.  The payments also depleted corporate assets to keep share prices low and to move money to the majority shareholders' families without declaring dividends that would have benefitted the minority shareholders. 

At the end, the court held these facts supported findings of oppression, waste and misapplication of corporate resources that merited the dissolution of the company.  The opinion should be a cautionary tale to majority shareholders of Virginia corporations.  When coupled with Judge Roush's prior opinion in Greenfeld v. Stitley, et al., 2007 Va. Cir. LEXIS 7 (January 5, 2007)(See blog post of March 2, 2009) involving a partnership divorce that resulted in successful claims involving business conspiracy, breach of fiduciary duty, and intentional interference with contract and business expectancy, there are now two lengthy opinions in Virginia that analyze, in detail, the types of conduct that can support oppression type claims in the corporate and partnership settings.

The plaintiffs in the Colgate matter were represented at trial by several of my partners in LeClairRyan.  The matter is now on appeal.

Va. Supreme Court Overturned a Multi-Million Dollar Goodwill Damages Award

Recently in the case of 21st Century Systems, Inc. v. Perot Systems Government Services, Inc. ("Perot Systems") (available here), the Virginia Supreme Court overturned a multi-million dollar goodwill damages award. On appeal, the Virginia Supreme Court found that Perot Systems did not present adequate proof of the value of its lost goodwill.

The facts in Perot Systems are forthright, Perot Systems alleged that Defendants, former Perot Systems employees, conspired to "destroy [Perot Systems] and steal away tens of millions of dollars a year of [Perot Systems] business by unfairly and improperly using [Perot Systems'] confidential and proprietary information." The case centered on a group of ex-Perot Systems' employees who left the company to join 21st Century Systems, a rival government contracting firm. Perot Systems filed suit, alleging violation of Virginia's business conspiracy act, violation of Virginia's Uniform Trade Secret Act, breach of fiduciary duty, breach of non-disclosure agreements, and breach of non-compete and non-solicitation agreements. After the employees left but before the trial, Perot Systems was sold to Dell for $3.878 billion. As part of the sale Dell assigned $1.6 billion in goodwill to Perot Systems. Perot Systems' valuation expert used the Dell sale as a benchmark for assessment purposes when calculating the total loss of goodwill resulting from the defendants' actions. The jury ultimately accepted this assessment in awarding Perot Systems damages.

When dealing with tangible assets the valuation of a company is often more easily understood; firm values can be assessed to real estate, machinery and equipment, inventory and receivables. But businesses are not valued solely based upon tangible assets. Goodwill is a non-tangible asset that a business can earn over time. It is the benefit and advantage of the good name, reputation and connection of a business, the attractive force which brings in customers. Goodwill has been defined as "the excess of the sales price of a business over the fair market value of the business’ identifiable assets." Advanced Marine Enters. v. PRC Inc., 256 Va. 106, 501 S.E.2d 148 (1998). Valuation of this asset is subjective and difficult to clearly calculate. When a business is sold, goodwill can greatly enhance the sales price.

On appeal the Virginia Supreme Court overturned the jury's award of lost goodwill damages. The Court held that Perot Systems failed to use any data concerning the sales of comparable business. It also faulted Perot Systems from failing to demonstrate that the sale price was negatively affected as a result of the defendants' actions. And merely taking the later sales price attributed to goodwill and applying that amount to the defendants' prior conduct is insufficient to support a claim for loss of goodwill.

The court did acknowledge, however, that "damages for loss of goodwill may be recovered if proven" even if it is "impossible of valuing with mathematical precision . . . ." Like many things in life, proving loss of goodwill can be done- you just have to do it the right way.

Virginia Clarifies Test for Judicial Dissolution of Corporations and Partnerships

Last month the Virginia Supreme Court issued two significant opinions relating to the judicial dissolution of partnerships and closely held corporations. Both cases addressed issues of first impression. The opinion addressing the corporate issues also considered the propriety of a shareholder not only seeking a judicial dissolution but also pursuing a derivative suit under Va. Code § 13.1-672.1 at the same time.

Russell Realty Associates v. C. Edward Russell, Jr. involved the standard for judicial dissolution of general partnerships under § 50-73.117(5) of the Virginia Uniform Partnership Act. Here are the facts. In 1978, Charles E. Russell, Sr. created an irrevocable trust dividing his estate into two separate trust shares, one for the benefit of his son, Eddie, and the other for the benefit of his daughter, Nina, and her children. The partnership was created to fund the trust. Its purpose was to acquire, hold, invest in, lease and sell investment properties. As Charles Russell withdrew from the partnership his son took over its active management. After Charles’ death the management of the partnership and the trust became acrimonious, specifically as to the future of the partnership and trust distributions. Those disagreements prevented the sale of certain partnership assets. The two partners and their counsel unsuccessfully tried to resolve the issues for years. Over that period, Nina began to insert herself in the management and operations of the partnership to a significant degree.

Ultimately, Eddie filed suit seeking a judicial dissolution of the partnership. He alleged (1) serious and irreconcilable conflicts with his sister and her son; and (2) that those conflicts had frustrated the partnership’s economic purpose and made management of its assets and affairs not reasonably practicable. Nina responded seeking an accounting and alleging that Eddie had violated his fiduciary duties. She also sought aid, guidance and a declaration regarding her son’s rights to distributions from the trust as well as Eddie’s removal as co-trustee. After trial, the Court found in Eddie’s favor and granted dissolution of the partnership. Nina appealed.

The sole issue on appeal was whether Eddie met the strict standards for judicial dissolution of a partnership under the Virginia Code. The Code provides, inter alia, that a court may dissolve a partnership where “(a) the economic purpose of the partnership is likely to be unreasonably frustrated; (b) another partner has engaged in conduct relating to the partnership business which makes it not reasonably practicable to carry on the business and partnership with that partner; or (c) it is not otherwise reasonably practicable to carry on the partnership business in conformity with the partnership agreement.” Va. Code § 50-73.117(5). A court may dissolve a partnership where it finds that any of those three conditions have been satisfied.

In Russell, the trial court granted dissolution based upon (a) and (c) above, the economic purpose and business operations tests, respectively. Because the Supreme Court had never addressed the legal standard for dissolution in the partnership context, it adopted the test applicable to dissolution actions that involve limited liability companies. See The Dunbar Group, LLC v. Tignor, 267 Va. 361, 593 S.E.2d 216 (2004).

On appeal, Nina argued that dissolution under the economic purpose prong of the statute required a showing of “truly poor financial performance” and that the trial court’s conclusion that the partnership was not run as a “model of business efficiency” was insufficient justification for dissolution of a profitable business. The Court rejected Nina’s argument noting: “[T]he purpose of the change [in the Revised Uniform Partnership Act] was to allow continuation of a partnership that was not financially profitable based on an inquiry into the partners’ expectations in determining the economic purpose of the partnership.” It concluded that a partnership need not be a financial failure to support a judicial dissolution under the economic purpose prong of the statute.

In Russell, the Supreme Court found evidence in the record that: (1) the relationship between the siblings frustrated the ability of the partnership to take advantage of economically favorable offers to sell certain properties; (2) the “disruptive relationship between the partners had resulted in the partnership incurring substantial added costs” including the need for attorney intervention to facilitate communications and decision making; and (3) despite the provisions of the Partnership Agreement that vested decision-making authority in Eddie, the parties’ relationship imposed unnecessary economic costs “preventing the partnership from taking advantage of and conducting its business in a timely and efficient manner.” According to the Supreme Court those facts were sufficient to satisfy the economic purpose test and warrant the judicial dissolution ordered by the trial court.

The second suit, Cattano v. Bragg, involved a tempest between the only two partners/shareholders in a law firm structured as a corporation. Among other complaints, after discovering that checks had been written on the firm’s escrow/trust account to Cattano’s wife and children, Bragg sought inspection of all corporate records. Cattano responded by firing Bragg and attempting to remove her as director at a special meeting of the shareholders.

Bragg filed suit seeking a judicial dissolution and an accounting and division of assets. She later amended the Complaint adding derivative claims against Cattano for breach of fiduciary duty and conversion.

The Circuit Court appointed a Receiver and directed that the Receiver perform a complete accounting of the books and records of the firm.

At trial, the jury found in Bragg’s favor on the derivative conversion count and awarded the firm $234,412.18. It also awarded Bragg monetary damages for breach of contract and judicial dissolution. It did not find in Bragg’s favor, however, on the claim for breach of fiduciary duty. In a separate trial the Circuit Court awarded Bragg $269,813.00 in attorneys’ fees, plus costs and expenses of $19,415.71, finding that the conversion claim had “yielded a substantial benefit to the corporation.”

Cattano appealed raising a number of corporate issues.

First, Cattano objected that Bragg did not have standing under Va. Code § 13.1-672.1(A) to bring the derivative claim on the basis that she did not “fairly and adequately represent the interests of the corporation in enforcing the right of the corporation.” Noting that in Virginia there is no exception to the rule that actions for injuries to a corporation must be brought derivatively rather than directly by a shareholder, the court found that a single shareholder could pursue a derivative claim on behalf of the corporation. Because it had never addressed the standard to apply in determining whether a plaintiff fairly and adequately represented the interests of the corporation in a corporate derivative claim, the Court adopted the factors it had used in Jennings v. Kay Jennings Family Limited Partnership, 275 Va. 594, 659 S.E.2d 283 (2008) which it borrowed from Davis v. Co-Med, Inc., 619 F.2d 588, 593-94 (6th Cir. 1980). Those factors are:

“ (1) economic antagonisms between the representative and members of the class;
  (2) the remedy sought by the plaintiff in the derivative action;
  (3) indications that the named plaintiff is not the driving force behind the litigation;
  (4) plaintiff’s unfamiliarity with the litigation;
  (5) other litigation pending between the plaintiff and defendant;
  (6) the relative magnitude of plaintiff’s personal interests as compared to his interests in the derivative action itself;
  (7) plaintiff’s vindictiveness toward the defendant; and
  (8) the degree of support plaintiff is receiving from the shareholders he purports to represent.”

Jennings, 659 S.E.2d at 288

The Court noted that these factors “are not exclusive and must be considered in the totality of circumstances found in each case.” (quoting Jennings, 659 S.E.2d at 288.)

Significantly, the Cattano court noted:

"While the present case contains economic antagonism as well as apparent animosity between the firm’s only two shareholders, we do not find this to be a determinative factor when evaluating a closely held corporation; nor do we find it determinative that the sole other shareholder does not support the derivative suit. To so hold would be to enact a de facto bar on derivative suits in two shareholder corporations. . . . In closely held corporations, we must look beyond the mere presence of economic and emotional conflict, placing more emphasis on whether the totality of the circumstances suggest that the plaintiff will vigorously pursue the suit and that the remedy sought is in the interest of the corporation."

Applying the appropriate factors, the Supreme Court held that Bragg fairly represented the interests of the corporation in that she sought a return of funds that had been misappropriated by an officer. Such a claim was highly appropriate for a derivative action. Given that she would be entitled a portion of the funds returned to the corporation suggested that her interests were aligned with the corporation and she would vigorously pursue the claim.

Second, Cattano argued that Bragg was pursuing her own interest given the possibility of an award of attorneys’ fees and costs, whereas with pure judicial dissolution no such fee shifting mechanism was available. The Court rejected the argument finding that, because the fee shifting mechanism in the context of a derivative claim was a deliberate policy choice on the part of the General Assembly, the claim should not be barred.

Third, Cattano asserted that Bragg could not act in the firm’s interest in pursing a derivative claim at the same time she was seeking to dissolve the corporation. That argument, too, was unpersuasive. Instead, the Court held that, not only was it in the interest of the corporation to have the misappropriated funds returned, but “judicial dissolution is a remedial mechanism that exists in addition to, rather than as a substitute for, shareholder’s rights.” It is not a per se bar to a derivative claim.

Finally, the court examined the appropriateness of awarding attorneys’ fees to Bragg as a result of her prevailing on the derivative claim. Va. Code § 13.1-672.5(1) provides that: on termination of a derivative proceeding, the court shall: (1) order the corporation to pay the plaintiff’s reasonable expenses (including counsel fees) incurred in the proceeding if it finds that the proceeding has resulted in a substantial benefit to the corporation. . .” Prior to this opinion, no Virginia court had interpreted that provision of the Code. Because there was no Virginia precedent as to the standard to be applied, the Court borrowed from the United State Supreme Court’s decision in Mills v. Electric Auto-Lite Company, 396 U.S. 375 (1970) where that Court held:

"[A] substantial benefit must be something more than technical in its consequence and be one that accomplishes a result which corrects or prevents an abuse which would be prejudicial to the rights and interests of the corporation or affect the enjoyment or protection of an essential right to the stockholder’s interest."

Mills, 396 U.S. at 396. In Cattano, the Court found, as did the Circuit Court, that the recovery of over $234,000 of misappropriated funds was a substantial benefit to the firm.

These opinions are welcomed additions to the limited case law in Virginia addressing judicial dissolution and derivative actions. In particular, they suggest that both partners and 50% shareholders in closely held corporations have significant remedies they can use to protect against abuses by other owners. They should serve as cautionary tales.

Wider Latitiude Given to Noncompetes in Business Sales and Settlement Agreements than to Noncompetes in Traditional Employer/Employee Agreements

A noncompete entered into as part of a settlement agreement to end litigation between an employer and former employee receives more latitude than a traditional noncompete signed before or during the employment period.

In a recent case, Plaintiff McClain & Co. Inc. sued a former employee for breach of an agreement not to compete that was included in a post-employment settlement and release contract to which the two parties agreed.

McClain accused the former employee of misappropriating $285,793 of McClain’s funds while he was an employee by submitting false payroll records for employee services that the employees did not actually perform. The parties then entered into a Settlement Release and Agreement a few months after the former employee was no longer employed by McClain where McClain released him from claims relating to his supposed misconduct in exchange for a payment of $250,000, and his compliance with a noncompete restrictive covenant, among other things.

The covenant provides:

The former employee agrees that for a period of thirty (30) months immediately following the Termination Date . . . , he shall not provide perform or undertake any Competing Services anywhere in the territory . . . (ii) instruct, hire, engage, or contract with any other person or entity to provide, perform, or undertake any Competing Services anywhere in the Territory; and (iii) own . . . , serve as director, officer or manager of, or control . . . any entity or business that provides, performs or undertake Competing Services anywhere in the Territory.

McClain accused the former employee of establishing a competing business, MPT, just six days after signing the settlement agreement. As a result, McClain sued for breach of contract against the former employee for violation of the non-competition covenant in the contract as well as conversion and tortious interference with contract.

The former employee moved to dismiss on the ground of failure to state a claim for which relief can be granted because the noncompete is unenforceable as a matter of law. His motion was denied as to the breach of contract and conversion counts.

The court decided that McClain’s allegation that the former employee established a business on a certain date that competed with McClain’s business is sufficiently specific and factual in nature to pass muster under Federal Rule of Civil Procedure 8. The court also held that the phrase “upon information and belief” can be used when the factual basis supporting a pleading is only available to the defendant at the time of the pleading.

The former employee’s other attack on the breach of contract is a claim that the non-competition clause is unenforceable. “In considering the enforceability of restraints on trade, Virginia courts focus on the reasonableness of the restraint because the law looks with favor upon the making of contracts between competent parties upon valid consideration and for lawful purposes and therefore courts are averse to holding contracts unenforceable on the ground of public policy.” Opinion at 7 (internal citations omitted).

The court held that agreements not to compete in the employer/employee context as part of an employment contract are subject to more careful scrutiny. The test is whether the contract is narrowly drawn to protect the employer’s legitimate business interest, and is not unduly burdensome on the employee’s ability to earn a living, and is not against public policy. Id., quoting Omniplex World Servs. Corp. v. U.S. Investigations Servs., 270 Va. 246, 249 (2005).

The court noted that a noncompete like the one in this case which is part of a post-employment agreement has yet to be reviewed in Virginia. The court stated that greater latitude is allowed in determining a convenant’s reasonableness when it’s a covenant not to compete between a vendor and buyer than when it’s related to an employment contract.

Restraints are given more leeway for being acceptable when the noncompete is between a buyer and seller than between an employer and employee because “employees often have comparatively little bargaining power and less leverage for negotiating a fair deal, while the sale of a business more typically involves sophisticated parties coming to an agreement after an arms-length negotiation process.” Op. at 9, citing Centennial Broad., LLC v. Burns, 2006 U.S. Dist. LEXIS 70974, at *27-29 (W.D. Va. Sept. 29, 2006). “Restrictions on an employee’s means of procuring a livelihood for himself and his family” are more likely to threaten public policy interests than restrictions on a seller . . . .” Op. at 9, citing Centennial Broad., 2006 U.S. Dist. LEXIS 70974, at *28-29. The court noted that this same reasoning applies with the noncompete is between partners in a professional firm. Op. at 9.

In the instant case, the court held refused to hold the noncompete to the more restrictive standard applicable in employment cases because the former employee was not an employee when it was made and it was negotiated at arm’s length while the former employee was represented by counsel. There was consideration for both parties and it was not a “take it or leave it” situation where the former employee was concerned with securing a job. The court concluded that bargaining power was more equally distributed and reasonable in general. Therefore the noncompete was sufficiently circumscribed to survive the former employee’s facial attack on a motion to dismiss.

As we begin to see more categorization of noncompete agreements, Virginia courts are giving wider discretion to noncompetes in business sales and settlement agreements than to traditional noncompetes in employer/employment agreements. This raises the question whether a different standard may be applied to even more potential categories of noncompetition agreements.

Expedited Discovery requires “Unusual Circumstances”

A recent opinion out of the Eastern District of Virginia states that “unusual circumstances” must be shown to grant a party expedited discovery. And the court adopted two prongs of the prior test for granting a preliminary injunction to determine when sufficient unusual circumstances exist: a strong showing on the merits and a showing that irreparable harm is likely.

A software development company, ForceX, Inc., sued its former vice president for allegedly forming a competing company that violated a noncompete agreement. ForceX’s complaint alleged (1) beach of duty of loyalty and fiduciary duty, (2) breach of contract, (3) violation of the Virginia uniform trade secrets act, and (4) intentional interference with contract. ForceX filed a Motion for Expedited Discovery seeking discovery in the form of requests for production of documents and a deposition to determine the extent of competitive activities. Plaintiff argued for two standards of review: one for an expedited deposition and another for expedited document requests, but the court found that “all requests for expedited discovery should be governed by the same standard....”

“Courts have found that immediate discovery ‘should be granted when some unusual circumstances or conditions exist that would likely prejudice the party if he were required to wait the normal time.’” Opinion at 5-6, quoting Fimab-Finanziaria Maglificio Biellese Fratelli Fila, S.p.A. v. Helio Import/Export, Inc., 601 F. Supp. 1, 3 (S.D. Fla. 1983).

It is not clear when these “unusual circumstances” exist. The court looked to a history of cases for guidance. Before 2008, the first two prongs of the Blackwelder test for a preliminary injunction—(1) the likelihood of irreparable harm to the plaintiff if the preliminary injunction is denied and (2) the likelihood of harm to the defendant if the preliminary injunction is granted—were weighed against the third prong—the likelihood that the plaintiff will succeed on the merits—to determine whether “unusual circumstances” existed. Opinion at 6. This test was a sliding scale so that as the plaintiff’s showing of a likelihood of irreparable harm grew weaker, their showing of success on the merits would need to be stronger to gain a preliminary injunction.

But after the Supreme Court decision in Winter v. Natural Resources Defenses Council, Inc., 555 U.S. 7 (2008), the Fourth Circuit determined that the Blackwelder test was replaced with the Winter test but did not say which portions of the Winter test a court should use when deciding a motion for expedited discovery. As a result, courts have considered two different standards in evaluating expedited discovery motions: (1) a modified preliminary injunction factors test and (2) a reasonableness or good cause test. The court in this instance rejected the reasonableness test, saying it is most logical to treat the motion for expedited discovery under a standard similar to the preliminary injunction standard.

Finding no clear answer as to when “unusual circumstances” exist, the court in the instant case used a variation of Blackwelder and considered two elements that were emphasized by the Fourth Circuit and the Supreme Court: a strong showing of the merits and a showing that irreparable harm to plaintiff is “likely” and not simply “possible.”

The court ultimately found that the ForceX was not entitled for expedited discovery. Plaintiff did not show it was likely to suffer irreparable harm in the absence of the expedited discovery. Despite Plaintiff’s argument that expedited discovery was necessary to find out about defendants’ products and potential customers in order to prevent loss of customers and business before it occurred through improper means, the court held that a potential loss of customers causing a decrease in revenue is not an unusual type of harm.

In many business litigation cases, lost profits can be a critical component of damages. Damaged companies may also be required to take steps that would mitigate their damages. But it can be difficult to take mitigating steps before discovering information about which clients were impacted by the defendant’s tortious conduct. This factor, however, must be balanced to protect a potentially innocent company from being bombarded by litigation pressure. So plaintiff companies in fast action cases, such as those involving business conspiracies, tortious inference and trade secrets, must be prepared in some courts to explain why their particular case is unusual in needing expedited discovery.

Copyright Infringement: Repeat Willful Violations Result in Permanent Injunction and High Damages

In a recent opinion, Seoul Broadcasting System Intl. v. Ro, an Alexandria U.S. district court granted Plaintiffs a permanent injunction and ordered steep damages against the defendants who were repeat copyright infringers and willfully ignored cease and desist letters, signifying a focus on deterrence to protect copyrights of businesses.

Plaintiffs Seoul Broadcasting Corporation, Mun Hwa Broadcasting Corporation, and KBS America, Inc., profit from the sale and licensing of DVDs and videotapes of their proprietary programming and distribute Korean-language television programming in the United States.

Plaintiff accused Defendants, Daewood Video, Inc. and owner Young Min Ro., Korean Korner, Inc., Sun Yop Yoo, of illegally distributing television programming. All Defendants are or were previously in the business of renting or selling videos and had past licensing agreements with Plaintiffs which had expired or were not renewed.

The current opinion is a result of a bench trial held on the issue of damages and other relief. The court previously granted summary judgment of copyright infringement in favor of Plaintiffs.

In copyright actions, courts traditionally grant permanent injunctions if liability is established and there is a continuing threat to the copyright. Opinion at 14, quoting Dea Han Video Prod., Inc. v. Chun, et al., No. 89-1470-A, 1990 WL 265976 at *1311 (E.D. Va. June 18, 1990). The court decided to issue a permanent injunction in this case because the Daewood defendants, with assistance from Korean Korner and Yoo, infringed Plaintiffs’ copyrights continuously over a period of more than a year. And Defendants, save one, all had a history of unlawful copying and selling Korean video programming. Moreover, the ease of making the copies made it more likely Defendants would infringe in the future if a permanent injunction was not entered.

The court considered in depth the damages award. Statutory damages in copyright infringement cases, according to 17 U.S.C. § 504, are significantly higher if the court finds the infringement was done willfully. The damages imposed may be up to $150,000 per act of infringement. Opinion at 16.

“Willfulness may be inferred where there is evidence that infringements continued after warnings or cease and desist letters from the plaintiff.” Opinion at 16, citing Masterfile Corp. v. Dev. Partners, Inc., No. 1:10cv134, 2010 U.S. Dist. LEXIS 100857, 14-15 (E.D. Va. Aug. 16, 2010). All Plaintiffs had sent cease and desist letters to Young Min Ro, owner of Daewood Video.

The court awarded monetary damages, with a significantly higher damages award against Daewood Video, Inc. and owner Young Min Ro due to previous copyright infringement violations and because the court found that they acted willfully by refusing to follow the cease and desist letters. Daewood and Ro, jointly and severally, were ordered to pay $555,000.00. Defendant Yoo, the one defendant without a history of copyright infringement, was ordered to pay a considerably less amount of $16,951. These disparate amounts and steep fines for Daewood and Ro suggest the court’s unyielding desire to deter repeat violators from ignoring laws set up to protect businesses.

A question is whether courts will use refusal to follow cease and desist letters as a justification for high damages awards in suits other than those involving copyright issues.

Spiteful Motives, Lacking Improper Conduct, do not Support Tortious Interference Claim

In a recent opinion, the Supreme Court of Virginia held that actions motivated solely by ill will or personal spite, that don’t include improper conduct, do not support a claim for tortious interference with an at-will contract. The court provided a helpful definition of when conduct is considered improper and decided that it is not enough if the actions were merely spiteful. Click here for the opinion.

The facts of the case involve a Virginia law firm, Dunn, McCormack & Macpherson (“Dunn”), who had an at-will contract with the Fairfax County Redevelopment and Housing Authority (the “Authority”). Dunn had served as legal counsel for the Authority for around thirty years until the Authority terminated the contract in September 2005.

Dunn sued Gerald Connolly (“Connolly”), Chairman of the Fairfax County Board of Supervisors, alleging that Connolly tortiously interfered with Dunn’s contract with the Authority by persuading Authority to break the contract. Dunn claimed that Connolly’s actions were motived solely by his personal spite, ill will and malice, because he didn’t get along with a partner at Dunn.

The circuit court entered an order dismissing the action for Dunn’s failure to provide facts showing Connolly used illegal means or improper methods when he communicated with the Authority. This court reviewed the circuit court’s ruling de novo and came to the same conclusion.

The elements to support a cause of action for tortious interference with contract rights are: (1) the existence of a valid contractual relationship or business expectancy, (2) knowledge of the relationship or expectancy on the part of the interferer, (3) intentional interference inducing or causing a breach or termination of the relationship or expectancy, and (4) resultant damage to the party whose relationship or expectancy has been disrupted. Additionally, when a contract is at-will, an element is added: the defendant must have employed improper methods. Op. at 6, citing Duggin v. Adams, 234 Va. 221, 226-27, 360 S.E.2d 832, 836 (1987).

The court explained that interference is improper if it is illegal, independently tortious, or violates an established standard of trade or profession. The court quoted the Duggin case, stating:

Methods of interference considered improper are those means that are illegal or independently tortious, such as violations of statutes, regulations, or recognized common-law rules. Improper methods may include violence, threats or intimidation, bribery, unfounded litigation, fraud, misrepresentation or deceit, defamation, duress, undue influence, misuse of inside or confidential information, or breach of a fiduciary relationship. . . .

Methods also may be improper because they violate and established standard of a trade or profession, or involve unethical conduct. Sharp dealing, overreaching, or unfair competition may also constitute improper methods.

234 Va. at 227-28, 360 S.E.2d at 836-37.

Dunn’s argument that Connolly improperly interfered with its terminable at-will contract with the Authority because his actions were motived solely by Connolly’s personal spite, ill will and malice was found to be insufficient. The court found that Dunn failed to appreciate the limited nature of what constitutes “improper” interference. The court stated that it “will not extend the scope of the tort to include actions solely motivated by spite, ill will and malice.” Op. at 7. Because there were no facts alleged that showed improper interference, there was no merit to Dunn’s claim and the action was dismissed.

District of Columbia Limits Applicability of Computer Fraud and Abuse Act

In a case of first impression, a federal district court in the District of Columbia has joined those courts that restrict the applicability of the federal Computer Fraud and Abuse Act. Previously, we have written about the growing number of cases that have adopted a broad reading of this Act in a way that permits a claim to be made where an employee has accessed an employer's computer and removed proprietary data after deciding to accept a new job. See posts dated March 27, 2009 and September 7, 2010.

The CFAA protects companies from the misappropriation of proprietary information by someone who does not have authorized access to the computer or who has been authorized to access the computer, but who exceeds that authorization. The cases attempt to define the limits of authorized access.

A number of courts following the 7th Circuit's opinion in Int'l Airport Ctrs., LLC v. Citrin, 440 F.3d 418 (7th Cir. 2006) have held that an employee who has been given access to his employer's computer network, loses that right of access as a matter of law when he has decided to accept a new job and downloads proprietary information from the network to use in his new position. Courts adopting this logic posit that such conduct violates the employee's duty of loyalty owed to his employer because, once he has made the decision to leave and has accepted the new position, the employee's interests become adverse to the interests of his current employer. Those courts find that accessing the computer, and copying proprietary information under such circumstances, exceed the authorization that the current employer has provided and violate the CFAA.

Not so in the District of Columbia according to a recent opinion by Magistrate Judge John Facciola in Lewis-Burke Associates, Ltd. v. Widder, 725 F. Supp.2d 187 (D.D.C. 2010), click here. There, the court relied upon the analysis of the 9th Circuit in LVRC Holdings LLC v. Brekka, 581 F.3d 1127 (9th Cir. 2009), which held that, once an employer has authorized an employee to access the company computer, even if for limited purposes, that access is still authorized even if the employee violates those limitations. Id. at 1133. According to Brekka, whether an employee has authorization to access a computer is dependent upon whether the employer has terminated that authorization.

In the District of Columbia case, before he left his job, Widder copied proprietary and confidential electronic files onto a thumb drive that he took with him to his new employer. Some of the copying took place on his last day of work. The court found the Citrin standard to be unworkable and confusing. Instead, it held that Widder did not exceed his authorized access to the system even if he accessed and copied documents he was not entitled to see. Accordingly, the court dismissed the CFAA claim.

Based upon this decision, the CFAA is not an available remedy or a means of creating federal question subject matter jurisdiction in the District of Columbia for the theft of proprietary electronic information, except where the employer has terminated the employee's access rights before the theft occurs.

Publicly Available Software Code Can Be a Trade Secret if Compilation is Not Generally Known

A recent Fourth Circuit opinion analyzed when a software compilation can qualify for protection as a trade secret. The plaintiff company claimed that although its software used publicly-available mathematical formulas, the combination and implementation of these formulas contained in the source code for the software constitutes a trade secret. The Fourth Circuit agreed, holding that a trade secret may be composed of publicly-available information if the method by which that information is compiled is not generally known. Processes that are publicly known can become trade secrets when combined into a source code and the manner and sequence of the processes is unique and unknown to the public. The case is Decision Insights, Inc. v. Sentia Group, Inc., 2011 U.S. App. LEXIS 5151 (4th Cir. Va. March 15, 2011), and can be foundThe case can be found here.

The case arose when Decision Insights, Inc. (“Decision Insights”) filed a complaint against Sentia Group, Inc. (“Sentia”) and individual former employees alleging that Sentia’s development of a competing software application was based on materials obtained from the Sentia’s misappropriation of Decision Insight’s trade secrets. The question considered by the district court was whether Decision Insight’s software application, as a total compilation, could qualify as a trade secret under Virginia law.

Sentia had hired a former consultant for Decision Insights who worked to develop software for Sentia that would compete with Decision Insights’ software. According to Decision Insights, the software developed by Sentia is almost identical to its own. Decision Insights asserted that all the parameters, variables, and sequencing associated with the programs must have been the same as Decision Insights’ software to obtain such identical software.

The criteria for establishing the existence of a trade secret under Va. Code § 59.1-336 includes whether or not the compilation has independent economic value, is generally known or readily ascertainable by proper means, and is subject to reasonable efforts to maintain secrecy.

On appeal, the court considered whether Decision Insights adduced enough evidence at trial for a jury to reach the conclusion that Decision Insights’ software, as a compilation, is not generally known or ascertainable by proper means. At trial, Decision Insights had introduced two experts who testified that part of the source code was unknown to the public and the sequence of the processes was unique and not publicly available. One expert identified 13 proprietary processes in the source code, and stated that “[t]he collection of these processes as a whole and the sequence of these processes also serve as a proprietary aspect of [Decision Insights’ software].” Opinion at 14.

The court held that due to the evidence offered by the two experts, the trial court erred in concluding that Decision Insights had not satisfied its evidentiary burden to show that its software compilation was not generally known or readily ascertainable by proper means. The court noted that a trade secret may be composed of publicly-available information if the method by which that information is compiled is not generally known. The court cited Servo Corp. of America. v. General Electric Co., which held that a trade secret “might consist of several discrete elements, any one of which could have been discovered by study of material available to the public.” 393 F.2d 551, 554 (4th Cir. 1968). The court also found that numerous variables that were part of the Decision Insights software code were not in public literature or known outside the company.

The court remanded and directed the district court to consider other criteria specified by the Virginia Trade Secret Misappropriation Act, including whether Decision Insights’ software code has independent economic value and whether Decision Insights engaged in reasonable efforts to maintain the secrecy of the software code. See Va. Code. Section 59.1-336.

In the past, parties have claimed that a company’s products or process are not trade secrets unless kept strictly and wholly confidential. This case is important because it allows some components of trade secret information to be publicly known in certain circumstances while maintaining their trade secret status so long as other important information, such as the way those public pieces of software code are put together, remains confidential. The question of whether information was adequately kept confidential frequently arises in unfair business practices cases and this opinion helps clarify the issue.

Press Releases Can Cause Waiver of Work Product

Statements made in a press release, if based on attorney work product information, may waive work product as to the subject matter of the statements. In E.I. DuPont de Nemours and Company v. Kolon Industries, Inc. (E.D. Va. July 30, 2010), click here, the court found that the plaintiff, E.I DuPont de Nemours and Company ("DuPont") waived information that was otherwise non-discoverable work product because DuPont relied upon that information to support a statement in its press release.

The case involves allegations by DuPont that the defendant Kolon Industries, Inc. ("Kolon") misappropriated DuPont’s secret processes and technologies for manufacturing Kevlar. In addition to the civil litigation filed by DuPont, the F.B.I. had previously conducted a criminal investigation of a Kolon employee. During that criminal investigation, DuPont's general counsel office had worked closely with government officials. In a previous opinion, the Court held that work product was not waived by Dupont's sharing of documents with law enforcement agencies that were investigating the alleged misconduct. E.I. DuPont de Nemours and Company v. Kolon Industries, Inc., (E.D. Va. Apr. 13, 2010).

However, DuPont's issuance of the press release was another story. The controversial statement read: "FBI investigation has revealed that, in August 2008, three Kolon managers flew to Richmond, the location of our global Kevlar technology and business headquarters, expressly for the purpose of obtaining confidential DuPont process technology." DuPont was distributing the press release to DuPont’s customers, presumably in an attempt to gain a competitive advantage. Press releases are, of course, a common tactic used by companies to protect and bolster public opinion and brand name.

Kolon sought discovery of work product information, contending that DuPont had waived its work product relating to the subject matter of the statement because the information relating to manager’s intent could have only be based on protected information. DuPont responded that the press release was based solely on publicly available information.

The court found that the press release statement relied on more than just public information. The court based its finding, in part, on its conclusion that the in-house counsel who drafted the statement had reviewed multiple sources of information relating to the meeting, and in drafting the statement in question, he could not possibly have "segregated the various categories of [publicly available and protected] information." Therefore, the press release was not based solely on public information. Rather, the statement about Kolon's purpose in attending the meeting was most likely based at least partly on privileged information that the in-house counsel had been exposed to throughout the course of his work with the government investigation.

The court also addressed the scope of the waived subject matter. Kolon sought production of "all communications in DuPont's possession relating to the Government's investigation of [Kolon's employee] and Kolon." The Court, however, more narrowly defined the scope of the waived subject matter to be those documents that "provide the factual basis for the statement in the press release that, in arranging for and attending . . . the meeting, Kolon had the purpose stated in the press release."

The Court also limited the waiver to fact work product and refused Kolon's request for opinion work product to be produced, finding that opinion work product is only discoverable in extreme circumstances. And the court found that an issuance of a press release is a common, not an extraordinary, circumstance in business.

This case serves as another warning to companies in litigation to carefully monitor the process of drafting press releases and what statements to include in them because press releases can lead to sanctions, waiver of work product and privileged information, and increase litigation costs. At the same time, companies in litigation often feel compelled to try to shape the public's perception of the litigation and the companies themselves. This is particularly true in cases involving unfair business practices or competition when the survival of a company's business model can be at stake. But, in doing so, they need to carefully weigh the risks of what they are saying publicly.

Court Recognizes Federal Claim for Employees' Theft of Electronic Documents

Some time ago (March 27, 2009), we wrote a post describing the applicability of the federal Computer Crimes and Abuse Act, 18 U. S. C. § 1030, (the “CFAA” or the “Act”) to unfair business practices cases. The Act provides a federal remedy for anyone who intentionally accesses a protected computer without authorization, or exceeds authorized access, and obtains information or who knowingly and with intent to defraud and in furtherance of the fraud, obtains something of value, unless the only thing obtained is the use of the computer and that use is not valued at more than $5000 in a one year period. An employer owned computer is “protected” under the statute.

It is becoming increasingly common for plaintiffs to use this Act as a vehicle for obtaining access to federal courts where diversity jurisdiction does not exist. As might be expected, a split of authority exists as to whether this statute may be so used, or whether it is intended only to address actions by computer hackers. At the present time, three federal Circuit Courts of Appeals (1st, 5th and 7th), as well as a number of District courts, have adopted a broad view of the statute and allow claims where an employee permissively accesses an employer’s computer system for an improper purpose. A common example is where an employee, who has accepted a job with a competitor or who intends to start a competitive company, copies proprietary electronic data from his employer’s system for use in his new job with the competitive company.

Those courts adopting the broader view reason that once an employee decides to join a competing company or has made arrangements to form one, his loyalty is divided between his existing employer and the new one. In that circumstance, by accessing the employer’s network and copying files, the employee violates his fiduciary duty of loyalty to his employer. Such conduct satisfies the CFAA requirement that the defendant “exceeds authorized access” to the computer system.

In a recent case, the federal district court for the Southern District of New York, Starwood Hotels & Resorts Worldwide, Inc. v. Hilton Hotels Corporation et al., 09-cv-3862 (June 16, 2010) joined those courts adopting the broader view. Click here for the opinion. The facts of the case, as alleged, are extreme. But they should serve as a cautionary tale to employees who are considering joining a competitive firm and as a roadmap for employers who have been victimized by departing employees.

In this case, two of Starwood’s executive officers who worked on its luxury hotel brands were recruited to join Hilton and accepted offers of employment. Both had access to Starwood’s most confidential data and both were subject to confidentiality agreements requiring that they safeguard Starwood’s confidential information and, once their employment ended, return all such information to Starwood and not disclose it to anyone.

After signing an employment agreement with Hilton but before notifying Starwood of his intent to resign, one of the executives asked his staff to compile a significant amount of confidential information for him that he then forwarded to his personal email account. This included digital images of thousands of documents that Starwood used in designing and branding its luxury hotels. As alleged, he forwarded this information to Hilton. He also copied electronic documents to his personal laptop computer and used that information to benefit Hilton. In addition, once he joined Hilton he solicited additional confidential information from other Starwood employees who used their personal email accounts to convey Starwood’s proprietary information to their former superior.

The other executive, while still at Starwood and after engaging in discussions with Hilton representatives, allegedly acted as a corporate spy for Hilton and collected and forwarded to Hilton confidential information related to Starwood’s business and development opportunities.

Starwood knew nothing of the extent of this piracy until, in discovery, Hilton produced eight large boxes of computer hard drives, thumb and zip drives and paper records containing large quantities of Starwood documents. Indeed, the computer drives contained over 100,000 downloaded files.

At issue in the recent opinion was Hilton’s motion to dismiss the count for a violation of the CFAA because the Act was not intended to cover such conduct. The court noted at the outset that this case did not involve an employee who accessed his employer’s computer in the ordinary course of his duties and then, at some later time, used some of that information to benefit a competitor. Rather, here the information was obtained with the specific intent to use it against the employer through “trickery and deceit.” The court concluded that once the executives accepted employment with Hilton, they “no longer had Starwood’s authorization to access this information. Thus, even construing the statute narrowly to prohibit only accessing computer information without permission, Starwood’s complaint adequately alleges a claim under the CFAA.”

The court also held that Hilton could potentially be liable under the Act because, as alleged, it used one of the executives, as well as others, as corporate spies to steal Starwood’s confidential information. Finally, the court found that Starwood’s expenditure of sums to investigate the damage sustained as a result of the former employees’ actions, which exceeded $5000, met the damages requirement of the statute. Thus, Hilton’s motion to dismiss the claim was denied.

Unquestionably, these actions were extreme. But apart from the volume of electronic documents that were pilfered, the story line is not that unusual. Departing employees often take confidential information belonging to their employer for use in their new employment, thinking that it will make them more valuable to the new employer. And it is not unusual for them to contact former colleagues, once at the new employer, and ask for information they “forgot” to take with them. This case adds to the growing line of authorities that recognize that, under such circumstances, the CFAA provides a potential remedy to the former employer. Moreover, unlike in Starwood, where confidentiality agreements existed, such agreements are not an essential predicate to applicability of the statute. The common law duty of loyalty prohibits employees from using confidential information to benefit a new employer.

A Virginia Court Redefines a LLC's Unanimous Consent Requirement to Permit the LLC to Sue One of Its Members

A circuit court in Virginia was faced with the question of whether a Limited Liability Company can sue one of its three Members when, under the LLC’s Operating Agreement, the decision to file a law suit required that all three Members agree, including the Member being sued. For obvious reasons, no Member would vote to be sued. The case is Infinite Design Electric Assoc. LLC, et al. v. Donald R. Hague, 2010 Va. Cir. LEXIS 27 (Fairfax Cir. Ct. 2010).

The question presented the court with a classic legal dilemma by arguably pitting a just outcome against a technical legal interpretation that would deprive the aggrieved party of a remedy.

The LLC member being sued in the Infinite Design case allegedly engaged in the unfair business practices of forming a competing company, courting the existing LLC's clients using that LLC's "client lists, estimate strategies, and proposal forms to out maneuver [the existing LLC] and steal its clients."

In reaching its decision, the court could have framed the legal question in a number of different ways, but chose to ask: "Should a manager of an LLC be able to hold the entity hostage when it is the bad acts of that manager that the LLC seeks to redress?" The problem for the court in answering that question is that it found "no Virginia statutory or case law directly on point with this situation . . . ." Thus, the court looked to “analogous authority from Virginia and other states."

But the court looked to more than just analogous statutes, relying instead on other states' statutes that have no parallel in the Virginia Code; finding that "Pennsylvania does not allow interested managers to vote to sue if that manager has 'an interest in the outcome of the suit that is adverse to the interest of the company.' 15 Pa.C.S. § 8992(2) (2009). New York's LLC act precludes managers of LLCs from transacting with the LLC when that manager has a 'substantial financial interest' in the transaction. NY CLS LLC § 411 (2010)." The decisions of the Pennsylvania and New York legislative bodies, however, may have no bearing on how Virginia's General Assembly might address that issue in the future.

The court also relied upon a 1937 Virginia Supreme Court case that "suggests that the vote of a director of a corporation who has a personal interest in a matter is not to be counted in relation to that matter," citing Crump v. Bronson, 168 Va. 527, 537, 191 S.E. 663 (1937). The court's use of the word "suggests" is apt because the Court in Crump faced the question of whether an interested director could be used to constitute a quorum under the old Code requirement that every corporation have at least three directors. Now, however, there are many single member LLCs where the member is necessarily an interested director for any vote pertaining to the member’s compensation and rights.

The third leg supporting the Court's decision was the LLC's incorporation of Virginia Code § 13.1-1024.1 that "requires managers to carry out their duties with 'good faith business judgment [that is in] the best interest of the [LLC].'" The incorporation of this section, according to the court, was a clear reflection of the LLC’s "intention to hold managers' actions to a certain standard. A manager would never vote to authorize a suit against himself, but bringing suit is the only course of action an LLC ca[n] take in the case of manager misconduct."

For those reasons, the court held that the LLC "did not need unanimous approval of the managers to bring suit when the suit was intended to be brought against one of its managers. Such a reading of the Operating Agreement would amount to a situation of 'suicide by operating agreement', and would paralyze the LLC from remedying any suspected malfeasance by one of its managers."

The court, however, did not address several countervailing Virginia Code sections and legal principles. First, Virginia Code § 13.1-1002 defines an "Operating agreement" as “an agreement of the members as to the affairs of a limited liability company and the conduct of its business . . . ." Second, § 13.1-1001.1.C. provides that the Virginia Code sections governing LLCs "shall be construed in furtherance of the policies of giving maximum effect to the principle of freedom of contract and of enforcing operating agreements." (Emphasis added.) Third, § 13.1021.A.1. states that "A limited liability company is bound by its operating agreement whether or not the limited liability company executes the operating agreement. An operating agreement may contain any provisions regarding the affairs of a limited liability company and the conduct of its business to the extent that such provisions are not inconsistent with the laws of the Commonwealth or the articles of organization."

In addition, a significant body of Virginia case law arguably dictates a different result. In a decision also coming out of Fairfax County Circuit Court, Coker v. State Farm Fire & Cas. Co., 45 Va. Cir. 510 (Fairfax Cir. Ct. 1998), the court explained that it was "precluded from rewriting a contract between two parties, quoting a series of Virginia Supreme Court cases that state: "It is not the province of this Court to rewrite contractual language. Rather, it is incumbent upon courts to construe the language drafted by the parties."; "It is the function of the court to construe the contract made by the parties, not to make a contract for them."; "Courts will not rewrite contracts; parties to a contract will be held to the terms upon which they agreed."; "A court is not at liberty to rewrite a contract simply because the contract may appear to reach an unfair result." (Citations omitted.)

Finally, there are economic consequences to the LLC and the member being sued. Both the LLC and the member hired their respective attorneys. The member being sued, however, has to pay his pro rata share for both the LLC’s lawyer and his own lawyer, even if the member prevails at trial.

The Infinite Design court's decision to rewrite the operating agreement, if followed, presents future courts with the question of which circumstances justify rewriting operating agreements or other corporate documents. Although courts will invariably try to limit those circumstances, those attempts will be more difficult if courts frame the question like the Infinite Design court and ask: "Should a manager of an LLC be able to hold the entity hostage when it is the bad acts of that manager that the LLC seeks to redress?" For instance, the member being sued might vote against the LLC entering into profitable contracts to starve the LLC, thereby making it impossible for the LLC to pay for its attorneys. Would the court then waive the unanimous consent requirement and contractually bind the LLC against one member’s interests?

It will be interesting to track whether the Infinite Design decision gets appealed to the Virginia Supreme Court, or whether other Virginia Circuit Courts follow or extend it.

Eastern District of Virginia Holds that Minimum Contacts Must be Demonstrated for Each Count in Complaint

Your Virginia company has been damaged by unfair business activities of another individual or business that is located outside of Virginia. You file a multi-count suit in federal court alleging both breach of contract and tort causes of action based upon diversity of citizenship. The defendant moves to dismiss the suit on the basis that the court lacks personal jurisdiction over the nonresident defendant for some, if not all of the counts. What test does the court employ in resolving that motion?

Under the Constitution, a court may exercise personal jurisdiction over an out of state defendant in two situations: (1) where the defandant has "systematic and continuous" contacts with the forum state; or (2) where the contacts with the forum state "give rise to the liabilities sued on." International Shoe v. State of Washington , 326 U.S. 310,317,320 (1945). The first situation is referred to as "general jurisdiction," It is a hard test to meet and generally requires significant contacts over a period of several years. Most cases proceed based upon the second situation that is referred to as "specific jurisdiction."

A threshold question where "specific jurisdiction" is alleged, is whether, once a plaintiff proves minimum contacts with the forum state related to one cause of action, he may add other claims to the suit that do not arise out of those contacts? For example, assume that the parties negotiated and executed a contract in Virginia and the plaintiff sues in Virginia for breach of that contract. But in addition to that count, the plaintiff adds tort counts that are based upon actions that took place in the state where the defendant is located. The plaintiff asserts that the effects of those actions were felt in Virginia. Can all of the claims constitutionally proceed in Virginia where the action was filed? The Fourth Circuit Court of Appeals has never directly addressed these issues. Recently, a district court in the Eastern District of Virginia did.

In Gatekeper. Inc. v. Stratech Systems, Ltd., 2010 U.S. Dist. LEXIS 56625 (June 9, 2010), click here, the district court found that "specific jurisdiction" requires proof that the defendant's contacts with the forum state give rise to each claim alleged in the complaint. Thus, using the example above, it is the plaintiff's burden to demonstrate that each tort claim is supported by the requisite minimum contacts with Virginia. That there were sufficient contacts to support the breach of contract claim is not enough to save the tort claims. According to the court, if the plaintiff cannot meet that requirement, the unsupported claims must be dismissed for lack of personal jurisdiction. Moreover, that the effects of the bad acts were felt in Virginia, while relevant, is not dispositive.

This is an important decision, not only in the Eastern District of Virginia, but throughout the Fourth Circuit, given that it is a matter of first impression in this Circuit.

Breach of Contract Will Not Support Statutory Business Conspiracy Claim in Virginia

In an important new case, the Supreme Court of Virginia has clearly held that breach of contract will not support a claim of statutory business conspiracy under Sections 18.2-499 and 500 of the Code of Virginia. The case, Station #2, LLC v. Lynch, (Virginia, June 10, 2010), click here, involved a claim that Lynch and others had conspired to deny Station #2 the ability to soundproof a portion of leased space above a restaurant it operated in Norfolk, Virginia. As a result of the dispute, the City of Norfolk ordered the restaurant to cease all live musical performances, and ultimately the restaurant failed.

In its Complaint, Station #2 argued that the breach of Lynch's agreement to allow the soundproofing satisfied the unlawful act or unlawful purpose requirement of Sections 18.2-499 and 500. The Supreme Court disagreed.

The Court held that: "[W]e presently are of opinion that a conspiracy merely to breach a contract that does not involve an independent duty arising outside the contract is insufficient to establish a civil claim under Code Section 18.2-500." It added: "To permit a mere breach of contract to constitute an 'unlawful act' for the purposes of the conspiracy statute would be inconsistent with the diligence we have exercised to prevent 'turning every breach of contract into an actionable claim for fraud,'" quoting Dunn Constr. Co. v. Cloney, 682 S.E.2d 943, 946 (Va. 2009); Augusta Mut. Ins. Co. v. Mason , 645 S.E.2d 290, 295 (Va. 2007); Richmond Metro Auth. v. McDevitt Street Bovis, Inc., 507 S.E.2d 344, 348 (Va. 1998). According to the Court, to support a statutory conspiracy claim, the duty must arise from a statute or independently by common law.

The Protocol: The Financial Services Industry Potentially Changes the Common Law By Contract

This blog has discussed the concepts of employee fiduciary duties, proprietary and trade secret information and corporate raids in many contexts. But what if an entire industry or major players within that industry negotiate a method for handling: (1) how employees leave their employers; (2) what types of information they can take with them; and (3) whether “corporate raids” are acceptable? Are such agreements enforceable between the parties to such an agreement? And what about companies in that industry that are not parties to the agreement?

That scenario presented itself to my firm several weeks ago in a litigation matter when a large financial services company filed a law suit, claiming that our clients, two of the plaintiff’s former financial advisors and their newly formed company, misappropriated the plaintiff company’s trade secrets. The plaintiff also asserted that the former employees violated their fiduciary duties owed to the plaintiff company. What is important is not the result of this particular case—we as blog authors do not talk about our specific cases anyway—but the financial services industry’s attempt to shift the common and statutory law by contract.

The shift is designed by the over thirty financial services companies that are signatories to the “Protocol for Broker Recruiting”. The Protocol provides that: “If departing [brokers] and the new firm follow this Protocol, neither the departing [advisor] nor the firm that he or she joins would have any monetary or other liability to the firm that the [advisor] left by reason of the [advisor] taking the information identified below or the solicitation of the clients serviced by the [advisor] at his or her prior firm, provided, however, that this Protocol does not bar or otherwise affect the ability of the prior firm to bring an action against the new firm for “raiding.” The signatories to this Protocol agree to implement and adhere to it in good faith.”

The Protocol then describes what a departing advisor may copy when the advisor changes jobs: “[w]hen [advisors] move from one firm to another and both firms are signatories to this Protocol they may take only the following account information, client name, address, phone number, email address, and account title of the clients that they serviced while at the firm (“the Client Information”) and are prohibited from taking any of her documents or shall include a copy of the Client Information that the [advisor] is taking with him or her.”

The Protocol does not demand perfection from departing advisors. Rather, it offers advisors a safe harbor, provided that they operated in good faith and “substantially complied with the requirement that only Client Information related to clients he or she serviced while at the firm be taken by him or her.”

The Protocol’s impact upon trade secret law is potentially significant because companies will often claim that client account information constitutes trade secrets. But many courts consider the “crucial characteristic of a trade secret [to be] secrecy . . . .” Microstrategy Inc. v. Li, 268 Va. 249, 262 (Va. 2004) (internal citations omitted). Thus, if companies agree that the certain account information may be copied by a departing advisor—provided that the Protocol is followed and the departing advisor goes to another Protocol signatory firm—it becomes difficult to later contend that the account information constitutes a trade secret if either of the prerequisites are not followed.

Similar questions may be raised regarding how the Protocol may affect an advisor’s common law fiduciary duties to the advisors employer or other unfair business practices tort claims.

There is also the question of how much impact being a signatory of the Protocol should have on a court’s decision. The Protocol only requires a party to be a signatory to receive the benefits when recruiting an advisor. Of course, it also subjects itself to the added risk of allowing departing advisors to take more information than might otherwise be allowed. But, a small company might elect to become a signatory immediately before recruiting advisors to shield their efforts from liability, without facing a practical threat of losing its own advisers. And there is no restriction limiting when a company can sign the Protocol or how long a company must remain a signatory. This is the system that the signatories elected, however, so a court might not have much sympathy to a complaining signatory company in that circumstance.

Some courts have used the Protocol as a reason not to grant an injunction, holding that when a financial services company “permits its financial advisors to leave for 38 other financial institutions and solicit their former clients with Client Information they took from [the company], it cannot credibly contend that the harm that will result if . . . [defendants are] allowed to do the same at a 39th firm is so substantial and so irreparable. . .” as to require an injunction. Smith Barney Div. of Citigroup Global Markets, Inc. v. Griffin, 23 Mass. L. Rep. 457; 2008 WL 325269 at *5 (Mass. Super. 2008). The court further held that “[b]y setting up such a procedure for departing brokers to take client lists, [the financial services firm] tacitly accepts that such an occurrence does not cause irreparable harm.’” Id.; quoting Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Brennan, et al., 2007 U.S. Dist. LEXIS 34501 at *7 (N.D. Ohio 2007) (finding that in the case where client contact information is transferred to non-Protocol firms, mere agreement to the Protocol constitutes tacit acceptance that transfers of client contact information do not cause irreparable harm).

It will be interesting to see whether and how courts in the Washington DC area treat the Protocol when faced with one of the myriad issues associated with competing companies, departing employees and the removal of otherwise confidential information.

Maryland Court Upholds Non-compete Covenant and Enters Prospective Permanent Injunction

The United States District Court for Maryland recently granted summary judgment in a case upholding a covenant not to compete involving a former Director of Strategic Accounts for TEKsystems, Inc. In doing so, it signaled a willingness on the part of Maryland courts to enforce such covenants even where there was no evidence of lost profits by the employer. TEKsystems, Inc. v. Bolton, 2010 U.S. Dist. LEXIS 9651 (February 4, 2010). Click here.

TEKsystems is a technical staffing and services company. Jonathan Bolton worked in the New York City region. At the time he was hired he entered into an employment agreement containing a restrictive covenant that barred him from "engaging in the business of recruiting or providing on a temporary or permanent basis technical service personnel ... industrial personnel ... or office support personnel ... within a radius of fifty (50) miles of the office in which EMPLOYEE worked at the time his/her employment ended ..." The covenant effectively barred him from competing in the New York City area.

After resigning from TEKsystems, Bolton became employed by another IT-staffing company and operated from his home in New Jersey that was within the 50 mile radius of his former office. He was given the title "Managing Director of New York City." The evidence established that during his first year in the new position Bolton made nine placements, none of which were to companies that had been TEKsystems' clients. TEKsystems sued to enforce the covenant not to compete and sought both injunctive relief and damages.

The employment agreement provided that any dispute arising under the contract would be governed by the law of Maryland. In its opinion, the district court provides a thorough discussion of Maryland's law relating to the enforcement of covenants not to compete. Bolton challenged the covenant on the basis that it was overbroad, failed to protect a legitimate business interest, imposed an undue hardship on him and violated the public's interest.

Under Maryland law, covenants will be enforced "if the restraint is confined within limits which are no wider as to area and duration than are reasonable for the protection of the business of the employer and do not impose undue hardship on the employee or disregard the interests of the public." Id. at *12, quoting Ruhl v. F.A. Bartlett Tree Expert Co., 225 A.2d 288 (Md. 1967). Where the scope is reasonable, courts may also consider other factors, such as: "whether the person sought to be enjoined is an unskilled worker whose services are not unique; whether the covenant is necessary to prevent the solicitation of customers or the use of trade secrets, assigned routes, or private customer lists; whether there is any exploitation of the personal contacts between the employee and customer; and, whether enforcement of the clause would impose an undue hardship on the employee or disregard the interests of the public." Bolton, at *12-13, quoting Budget Rent A Car of Wash., Inc. v. Raab, 302 A.2d 11 (Md. 1973).

The court first upheld the 50 mile radius geographic scope of the covenant, noting that Maryland courts had upheld covenants that had unlimited geographic limitations. It found significant that, while TEKsystems operated nationally and internationally, the covenant only applied to the New York City area. The court also found the 18 month period to be reasonable, as Maryland courts have routinely upheld covenants that spanned two years.

Bolton also charged that the covenant was overbroad in that it barred him from engaging "in any activity which may affect adversely the interests of the Company." The court rejected the argument, noting that Maryland courts have "sanctioned restrictive covenants that prohibit former employees from securing employment with competitors." Bolton at *15.

It also noted that employers have a protective interest in preventing an employee from using customer contacts post employment, especially where the "personal contacts between the employee and the customer are an important element determining the business's success." Id. at 16-17, quoting Intelus Corp. v. Barton, 7 F. Supp.2d 635, 639 (D. Md. 1998). Here, the court found that TEKsystem's business depended overwhelmingly on the personal connections between its employees and its clients, and Bolton was one of TEKsystem's most important employees in the New York City area. In Maryland "[c]ourts are more willing to enforce restrictive covenants when the employee at issue possesses unique or specialized skills." Bolton at *18.

Bolton also claimed that enforcing the covenant would create an undue hardship on him because it barred him from competing in the New York City area. Again the court rejected the argument, holding that, while such a claim might be inconvenient, it did not rise to a level of undue hardship.

Finally, the court considered the public interest at stake and noted that "the public benefits from the enforcement of reasonable restrictive covenants. ... Such measures facilitate and protect business growth, especially in technology-related and information-based fields." Id. at *20. And it quoted approvingly from Intelus, supra, regarding Maryland's policy as to such covenants: "As long as employers do not restrict employees from earning a living and do not limit fair competition, they must be given the opportunity to provide a service to their customers without risking a substantial loss of business and good will every time an employee decides to switch employment." Id. quoting Intelus , 7 F. Supp.2d at 642.

Turning to remedies, the court denied compensatory damages finding that there was no proof that any of TEKsystem's customers had paid any fees to Bolton for work with his new employer. It reserved, however, on the issue of whether the parties had a desire to litigate further on the damages issue.

And as for equitable relief, the court awarded a permanent injunction, barring Bolton from operating in the New York City area. It noted, however, that the original 18 month period had expired in December 2009. Given prior Maryland precedent that "if the non-compete period is not enforced through equitable extension, it could 'reward the breach of contract, encourage protracted litigation, and provide an incentive to dilatory tactics,'" Bolton at *28, quoting PADCO Advisors, Inc. v. Omdahl, 179 F. Supp.2d 600, 613 (D. Md. 2002)(quoting Roanoke Engineering Sales Co. v. Rosenbaum, 290 S.E.2d 882 (Va. 1982)) the court prospectively enjoined Bolton from violating the terms of his restrictive covenant for 18 months from the date of the court's order.

This case should be viewed as a cautionary tale to employees who are dismissive of the legal import of covenants not to compete that are governed by Maryland law.