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.
Monday, April 25, 2011
Friday, February 25, 2011
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.
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.
Tuesday, September 7, 2010
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.
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.
Monday, July 12, 2010
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.
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.
Tuesday, July 6, 2010
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.
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.
Thursday, June 17, 2010
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.
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.
Monday, May 3, 2010
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.
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.
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