Employers who want to hire from a competitor frequently have to contend with the potential fallout from the new employee’s non-compete. Any misstep in that hiring process can easily lead to costly and time-consuming litigation. If an employer wants to go forward with that hire but try to minimize its risk of litigation, one popular approach is to implement affirmative steps safeguarding the prior employer’s trade secrets and avoiding solicitation of the former employer’s customers (see my previous posts on how that strategy has been used successfully by Hewlett Packard and Google in other cases). However, there is another more unconventional approach: paying an employee to sit out the duration of her non-compete (what is known as a “garden leave”) and indemnifying that employee from a future lawsuit so long as she abides by her non-compete. This approach was successfully implemented in a recent dispute in the highly competitive and apparently lucrative e-discovery market. The case, Document Technologies, Inc. v. LDiscovery, LLC, 17-2659-cv (2nd Circuit April 24, 2018), offers a nice case study on the use of indemnity provisions to defuse allegations of breach and provides a roadmap for employers who may have the pocket book to support this approach.
Factual Background: In response to non-compete and trade secret claims brought by the former employer Document Technologies, three employees and their new employer, LDiscovery, LLC, argued that the employees did not violate their non-competes because the employees had agreed to “Sit Out” the required one year of their non-competes. Although not specifically discussed in the relevant rulings that led to the dismissal of the claims under FedR.Civ.P. 12(b)(6), evidence at an evidentiary hearing revealed that the employees were to be paid seven figure bonuses while they sat on the sidelines.
In particular, the parties sparred over the significance of an indemnification provision included in the agreements between LDiscovery and the employees. In commercial cases, lawyers frequently argue that indemnification provisions are circumstantial proof of consciousness of wrongdoing that encourage a breach because they insulate the breaching party from the financial consequences of his breach. Not surprisingly, LDiscovery made this very point, emphasizing the indemnification provision was proof of LDiscovery’s intent to cause violations of the non-competes and that the court should infer that the agreements were in exchange for the former employee’s alleged misconduct.
However, the indemnification provision was well drafted. It expressly stated that LDiscovery’s offer of indemnification would end if the former employees “engaged in any ‘material misconduct . . . relating directly to the issues of [the employees’] contemplated transitions.” That carve-out proved to be fatal to Document Technologies’ claim that the defendants were violating, or being encouraged to violate, their non-competes. In fact, both the trial court (U.S. District Court Judge Jed Rakoff) and the U.S. Court of Appeals for the Second Circuit inferred the very opposite: that the provision actually created an incentive for the former employees to abide by their agreements; if they were to do otherwise, they would be liable for those acts. That the new agreement also expressly provided that the former employees would not receive commissions until after the expiration of the non-competes further cut against the argument they were being encouraged to violate the non-competes.
The trade secret claim in the case probably warrants quick mention, since it involves one common in cases involving sales representatives — namely, the sharing of the employee’s historical sales revenue and performance information with a new employer. In this case, since no client identities were shared, Judge Rakoff concluded that this “information is not protectable as a matter of law because ‘it is industry practice for e-discovery providers to ask potential sales hires for their past revenue figures and that it would be extraordinarily difficult (if not impossible) for the Individual Defendants to get a sales job with another employer if they were not able to disclose such information.'” While this holding appeared to address facts outside the four corners of the complaint (improper in the motion to dismiss context), Judge Rakoff cited other authority and simply found that the information could not be protectable as a matter of law. The Second Circuit sidestepped this ruling, and essentially concluded that it was implausible that this information would result in any trade secret misappropriation (one could argue that both courts’ analyses on this issue left something to be desired).
Takeaway: A tip of the cap is in order to the defendants in this dispute (and thanks to Rick Sanders of Aaron Sanders for bringing the case to my attention). While the approach taken by LDiscovery here appears to be an expensive one at first blush — paying multiple seven-figure bonuses while the sales reps sit out for a year — it may prove economical in the long run. While LDiscovery didn’t avoid litigation in this dispute (the case was extensively litigated with top law firms on both sides), it did test and establish this precedent. A competitor, therefore, may think twice about challenging LDiscovery’s resolve, now that it has the imprimatur of a ruling by the Second Circuit.
As I mentioned previously, indemnification provisions can be tricky because courts and juries sometimes see them as efforts to fund wrongdoing. The infamous indemnity against trade secret theft that Uber provided to Anthony Levandowski and his companies is perhaps the best example of an indemnity gone wrong. However, the indemnity here incentivized the employees to behave since it abundantly made clear they would be on their own if they didn’t. This served to refute the circumstantial arguments that Document Technologies tried to make in the absence of a clear violation.
For an aggressive competitor in an expanding market, willing to pay seven figure bonuses for a garden leave, this strategy may make financial sense over the long haul in the right industry.