Duty of Loyalty / Fiduciary Duty

In Nedschroef Detroit Corp. et al. v. Bemas Enterprises et al., the U.S. Court of Appeals for the Sixth Circuit recently affirmed an award of nearly $3.7  million in damages against two individuals found to have engaged in misconduct related to the operation of a business which competed with their employer.

Nedschroef Detroit Corporation (“Nedschroef”) services and provides replacement parts for fastener machines made by an affiliate in Europe.  Without Nedschroef’s knowledge, two of its employees formed a business – under their wives’ names – to do exactly what Nedschroef did.

After Nedschroef learned about this, it fired the two individuals and then filed suit against them and their competitive business.  The District Court granted summary judgment to Nedschroef on nine counts: breach of the duty of loyalty, breach of fiduciary duty and misappropriation of corporate opportunities, violation of the Michigan Uniform Trade Secrets Act, conversion, statutory conversion, unfair competition, tortious interference, unjust enrichment, and civil conspiracy.  The District Court also awarded $3.7 million in damages and permanently enjoined the defendants from providing replacement parts or services for these machines in North America.

On appeal, the defendants argued that they did not actually compete with Nedschroef, because they only provided parts and/or services to customers who had “previously requested a quote for the same part or service from Nedschroef” — but who had rejected Nedschroef’s quote.  The Sixth Circuit did not find this convincing, holding that the argument “ignor[ed] both common sense and the undisputed evidence in the case.”

On appeal, the defendants also challenged the District Court’s finding that they had misappropriated Nedschroef’s proprietary secrets.  However, the Sixth Circuit found no error in the District Court’s finding that the defendants obtained Nedschroef’s proprietary secrets through breach of a duty to maintain their secrecy, and “then used those drawings to manufacture and sell parts in direct competition with Nedschroef.”

Although the size of the award in this case is eye-catching, the controlling legal principles are well-established: barring a contractual limitation, an employee is generally free to take limited steps to prepare to compete with his employer, but he cannot actually compete while still employed, and he can never do so using his employer’s trade secrets or confidential information.

A former California State judge in an arbitration awarded nearly $1.7 million to an employer against its former employee based primarily on his acts taken going out the door.  His joking email with a co-worker after recruiting three others, characterizing their resignations as “Three bullets to the back of the head” of his employer, was clearly shooting himself in the foot in the eyes of the arbitrator.  The Award is interesting for many reasons – – the interplay between fiduciary duties and non-solicitation of employees provisions, the allowable damages when such a fiduciary duty is breached by co-worker solicitation, and the overriding difference of treatment of bad leavers versus good leavers.

Michael Valentine, a corporate vice president of Fortinet, Inc., a California based network security company, left for a competitor, Sophos, in the end of 2013.  The arbitrator found that due to his recruiting of several subordinates, both before and after he resigned, he had breached his fiduciary duty as an officer of Fortinet and his contractual obligations not to solicit employees for one year after his employment ended.  Despite Valentine’s affirmative defense that the clause was barred by California’s public policy [see California Business & Professions Code 16-600, et seq. and Edwards v. Arthur Anderson LLP, cf. Loral Corp. v. Moyes], the arbitrator awarded significant damages for his recruitment activity based upon the breach of his fiduciary duties.

While it appears from the Award that much of the evidence of pre-resignation solicitation was purely inferential, the arbitrator viewed the efforts to cover up such evidence, and the sentiment expressed in the email as being a “despicable” act, such that it caused him to find liability for the recruitment of the three subordinates and to award punitive damages on top of both actual damages and general damages.

The arbitrator awarded actual damages, the amount expended to replace the employees based on the time spent by the executive who recruited the replacements, at his hourly equivalent salary rate, or $39,560.  The arbitrator found general damages of $150,000 based on the “intentional tortious breach of fiduciary duty” and attributed that to his sense of a reasonable amount of the loss of valuable employees causing harm to the employer for likely lost business caused by delays in performance and the start-up time for new employees.  Finally, based on Valentine’s willful and intentional breach of his fiduciary obligations causing direct harm to Fortinet, the arbitrator awarded $250,000 in punitive damages and attorneys’ fees pursuant to contract of $1.2 million plus costs, rendering the total Award to be in excess of $1.75 million.

Had Mr. Valentine not spoken with his co-workers about joining him before he resigned, had he not taken steps to cover up such evidence of solicitation, and, most importantly, had he not callously joked about his egregious breach of duty in such a vivid and morbid email, he may have gotten the benefit of California’s public policy disfavoring employee non-solicit agreements.  But when you are a bad leaver, judges and arbitrators are definitely more likely to find breaches of duties and contractual obligations and enforce such provisions to the fullest extent.

“Gardening Leave” is a legal concept we have imported from England and is often used as a paid notice period to effectuate non-competition and a continuation of the duty of loyalty without the stigma of an outright non-compete. In a recent High Court decision, Thomson Ecology Ltd. v. Apem Ltd, et al. (9/24/13), Deputy Judge John Martin set strict standards on the conduct of a departing employee in terms of communicating his decision to leave to his superiors and to his colleagues and the legal implications of the timing of both.

Upon giving his thirty-day notice of resignation, the employer instructed the employee not to return to work and effectively “work in his garden.” The employee spent the month planting the seeds for his new employer, assisting in the recruitment of numerous co-workers by speaking with them about his plans and the opportunities presented by his new employer, as well as arranging interviews and sharing salary information of his colleagues with his new employer.

The High Court determined that a company employee who had given notice of termination of his employment and accepted an offer of employment from a competitor had breached his contractual duty of good faith and fidelity by failing to report to his superiors the threat presented by a competitor’s intention to build out an area with increased staffing and then by actively assisting the competitor in identifying and recruiting the company’s staff.

While the principle of “duty of loyalty” appears quite similar under English Law, the concept of an affirmative duty to speak up if aware of co-workers possibly leaving applicable to a mere employee versus one holding a fiduciary duty such as a partner or executive officer may be greater under English law than most U.S. based courts would impose upon a regular employee. While this case is just at the preliminary motion to dismiss stage we will continue to follow it and see what occurs on a more fully developed factual record.