Trading Secrets : Trade Secrets Lawyers & Attorneys : Seyfarth Shaw Law Firm : Computer Fraud, Confidentiality Agreements, Corporate Espionage

A California appellate court held in a recent decision that a broad “no-hire” provision contained in a consulting agreement was unenforceable as a matter of law because it was an impermissible restraint on trade in violation of the California Business and Professions Code Section 16600.

Despite the frequent use of “no-hire” and “non-solicitation” provisions in consultant and employment agreements, the validity of these provisions in California, especially broad “no-hire” provisions, is far from certain in light of the Court of Appeals for the Fourth Appellate District’s recent decision in VL Systems Inc. v. Unisen Inc., 152 Cal.App. 4th 708 (2007).

The full text of the Court’s decision can be found at http://www.courtinfo.ca.gov/opinions/archive/G037334.PDF

Though the holding in VL Systems appears to be limited to broad “no-hire” provisions, the Court’s policy analysis in the decision suggests, though it is far from certain, that even more narrow “non-solicitation” provisions would be subject to scrutiny by California courts and enforceable only to the extent that they are necessary for legitimate business reasons and are not overly broad in time and scope.

The contract in question included a “no-hire” provision. Specifically, the contract provided that defendant would not hire any of plaintiff’s employees for 12 months after the computer consulting contract’s termination, subject to a liquidated damages provision.

In analyzing the validity of the “no-hire” provision, the Court found that this type of contractual provision may seriously impact the rights of a broad range of third parties, including those who were not even employed by plaintiff at the time of its contract with defendant.

To this end, the court noted that the employee in question was not employed by plaintiff at the time the contract was performed, and that the employee had independently sought employment with defendant.

The court recognized that certain narrower restrictions have been held valid in the past by California courts and expressly stated that it took no position on whether a more narrowly drawn and limited “no-hire” provision would be permissible under California law.

However, it found that the “no-hire” clause at issue was too broad in that it covered not only solicitation by defendant, but all hiring, and it applied to all of plaintiff’s employees, regardless of whether they worked for defendant or were even employed at the time.

The court’s emphasis on the employees’ freedom of mobility protected by Section 16600 of the Business and Professions Code suggests that any contractual restriction on such mobility will be highly scrutinized by California courts.

In light of VL Systems, businesses should reconsider the inclusion of broad “no-hire” provisions in both business service agreements and employment agreements.

Prior to requiring your California employees to sign agreements containing such restrictive covenants, a consultation with a Seyfarth Shaw LLP attorney is recommended.

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In Kinesis Advertising, Inc. v. Hill, 652 S.E.2d 284 (N.C. Ct. App. 2007), the North Carolina Court of Appeals reversed the trial court’s grant of summary judgment and touched on two important issues under North Carolina law. Kinesis filed the action, attempting to enforce non-compete and non-solicitation provisions against its former employees, Larry Hill and Dan Robinette, as well as the former employees’ new business, Altyris Incorporated, among other claims. The trial court found that the agreement containing the restrictive covenants was unenforceable, and therefore, granted summary judgment in favor of the defendants on the breach of contract claim. The trial court had two bases for finding that the covenants were unenforceable: (1) Kinesis did not provide consideration to Hill and Robinette when they signed the agreements, and (2) the restrictions were overly broad. The Court of Appeals reversed on both grounds.

Kinesis contended on appeal that it had transferred shares to Hill and Robinette. The Court of Appeals found conflicting evidence as to whether Kinesis had actually done so. The parties agreed that Hill and Robinette never received stock certificates representing their shares, so the Court of Appeals sought to determine whether Kinesis had performed the tasks necessary to issue uncertificated shares under North Carolina’s Business Corporations Act. The Court of Appeals found conflicting evidence on the point and concluded that final determination of the question was a province of the jury. The Court of Appeals concluded that ”a genuine issue of material fact remains as to whether the Kinesis shares promised to Mr. Hill and Mr. Robinette were actually issued, such that they constituted valuable consideration to make the covenant-not-to-compete and confidentiality and non-solicitation agreement valid and enforceable.”

On the question of the scope of activity proscribed by the agreements, the Court of Appeals distinguished between non-competes that prevent employees from performing any type of activity for competitors and non-competes that prevent employees from performing acts in competition with their former employer. Kinesis’s agreement was the latter rather than the former and was therefore enforceable because “the restrictions imposed by Kinesis in the covenant-not-to-compete are ‘no wider in scope than is necessary to protect the business of the employer.’” The Court of Appeals concluded by stating that the question of whether Hill and Robinette actually were engaging in activities similar to those they performed for Kinesis was a matter for a jury.

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Polar Molecular Corp. v. Amway Corp., et al., No. 1:07-CV-460, 2007 WL 3473112 (W.D. Mich. Nov. 14, 2007).

A Michigan federal court recently declined to dismiss a petroleum additives company’s claim under the Michigan Uniform Trade Secrets Act (“MUTSA”) against several manufacturers and distributors of its fuel additive product, but held that the company’s common law claims of misappropriation and conversion were displaced by the statute.

Polar Molecular Corporation (“Polar”) sued twelve defendants, alleging violations of the Lanham Act, breach of contract, misappropriation of trade secrets under the MUTSA, and common law claims for misappropriation, conversion, and conspiracy. Polar had entered into a series of licensing agreements with certain defendants (the “Amway Defendants”) to make, use, and sell its fuel additive, called “DurAlt” and marketed as “Freedom Fuel.” Pursuant to the agreements, Polar provided the Amway Defendants with confidential formulas for DurAlt. After the parties had a falling-out over failed negotiations concerning royalties and fleet sales, Polar alleges that the Amway defendants provided its confidential formulas to another group of defendants (the “DNS Defendants”), who used the formulas to manufacture and sell a “knock off” of DurAlt called “ProFuel” and marketed as “Freedom 2.” Polar further alleges that the defendants misrepresented to potential customers that they had a licensing agreement with Polar for the manufacture and sale of “Freedom 2.”

The defendants argued that Polar’s claim under the MUTSA should be dismissed because Polar published the DurAlt formula in a patent, and thus it was no longer secret. Polar countered that, during the course of its licensing arrangement with the defendants, it had provided Amway with additional, improved DurAlt formulas that were not disclosed in the patent, including the specific formula at issue in this litigation. The court observed that “[a]lthough information disclosed in a patent cannot be a trade secret,…the existence of a patent covering the general subject matter does not necessarily mean that the patent disclosed the specific formula (the trade secret) used to produce a specific commercial product.” The court then concluded that the allegations in the complaint—that the defendants had obtained confidential information not known to others and that this information gave them a competitive advantage—were sufficient to state a claim for misappropriation of trade secrets under the MUTSA.

However the court also had before it the defendants’ motion for summary judgment on the MUTSA claim. The court found that Polar’s evidence was insufficient to controvert the seven affidavits produced by the Amway Defendants asserting that there had been no unauthorized disclosure of Polar’s confidential information and that ProFuel had been independently developed based on a reverse-engineering analysis of the Freedom Fuel product and the information in Polar’s expired patent. But the court concluded that Polar had shown a need for some discovery to resolve the issue, and thus declined to rule on the summary judgment motion until after a sixty-day period of limited discovery.

The court also dismissed the common law misappropriation and conversion claims, concluding that they were preempted by the MUTSA because Polar had not sufficiently alleged that these claims were based on wrongful conduct independent of the misappropriation that served as the basis for the MUTSA claim. But the court declined to dismiss the conspiracy claim as preempted, to the extent that, rather than being based upon the alleged theft of a trade secret, it was based on “palming-off or unfair competition” arising out of the defendants’ alleged representations that Pro-Fuel was a “knock off” of DurAlt and their alleged false statement that they manufactured it pursuant to a licensing agreement with Polar. The court also declined to dismiss the trademark infringement claim under the Lanham Act and granted summary judgment to the Amway defendants on the breach of contract claim to the extent that it was based upon a certain provision of the licensing agreement.

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The District Court for the Southern District of New York recently demonstrated the importance of including nonsolicitation language in employment agreements, in addition to noncompetition language, where employers seek to protect their customer base from departing employees. In Silipos, the court, despite finding that the noncompetition covenant in the subject agreement was not enforceable, nevertheless found that the nonsolicitation covenant was enforceable and that the defendant would be bound by the restriction - effectively preventing defendant from competing with plaintiff for its customers.

In the action, the court found that the defendant, a former executive vice president of plaintiff, had entered into a valid employment agreement containing: (1) a post-employment, worldwide, one-year noncompetition covenant prohibiting defendant from having employment with anyone direct or indirect competitor in plaintiff's industry; and (2) a post-employment, worldwide, one-year nonsolicitation covenant prohibiting defendant from soliciting any of plaintiff's current or prospective customers, distributors, suppliers and/or vendors.

The court, applying New York law, repeated the well-established precept that noncompetition and nonsolicitation covenants are enforceable only to the extent necessary to protect Silipos's "legitimate interests." In the action, plaintiff asserted that both covenants were necessary to protect three legitimate interests: (1) protection of its trade secrets; (2) protection of its confidential customer information; and (3) protection of its client base. Plaintiff further alleged that defendant, due to his position within the company and his responsibilities, had access to various types of information during his employment, including business strategy information and pricing information, which constituted trade secrets and/or confidential customer information.

The court, however, found that plaintiff only had one demonstrable "legitimate interest," to wit, protecting its client base. In particular, the court concluded that none of the business information to which defendant had access rose to the level of trade secrets or confidential customer information, and as such, plaintiff lacked a "legitimate interest" to warrant enforcement of the noncompetition covenant.

In contrast to the noncompetition covenant, however, the court found that the worldwide nonsolicitation covenant was enforceable because the protection of a client base was a "legitimate interest" of plaintiff. Consistent with this "legitimate interest," the court enforced the nonsolicitation covenant with respect to: (1) customers that defendant brought to Silipos; (2) customers for whom defendant was the primary contact; and (3) customers with whom defendant had a substantial degree of long-term involvement. The court moreover found that the restriction was not unreasonably broad, holding that "in light of [Silipos's industry's] intimate yet geographically diffuse nature, Silipos's legitimate interests in protecting its customer base extend worldwide."

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A recent ruling from the U.S. District Court for the District of Delaware serves as a reminder that, in addition to civil liability, an ex-employee stealing his or her former employer’s trade secrets can face jail time and a fine. On November 6, 2007, former DuPont employee Gary Min was sentenced to 18 months in prison and two years of supervised probation, fined $30,000, and ordered to pay $14,500 in restitution to his former employer. According to a statement released by the company, Min had been a senior scientist. Shortly before he resigned to take a position with another company, he “misappropriated a significant volume of confidential and proprietary DuPont technical documents.” DuPont filed a civil suit against him in federal court, and that “suit was resolved to our complete satisfaction” according to the company's statement. Then, he was indicted for theft, entered a plea of guilty and was sentenced. United States v. Min, No. 1:06-cr-00121-SLR (D.Del.).

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RRK Holding Co. v. Sears, Roebuck & Co., No. 04-CV-3944, Verdict (N.D. Ill. Nov. 19, 2007)

A family-owned Wisconsin company that makes power tools recently won a $21.5 million verdict against Sears, Roebuck and Co. after the jury found the national retailer guilty of stealing the design for the popular Craftsman all-in-one cutting tool. Plaintiff RRK Holding Co., formerly known as Roto Zip, convinced the federal jury in Chicago that Sears had willfully and wantonly misappropriated its trade secrets under the Illinois Trade Secret Act and breached the parties’ nondisclosure agreement.

In the late 1990s, Roto Zip was one of Sears’ major suppliers of the rotary saw. The suit alleged that in 1999, pursuant to a nondisclosure agreement, Roto Zip disclosed to Sears drafts for a next generation, hand-held combination power saw, but after negotiations broke down over price, Sears declined to make a deal. Instead, Sears took the design to a Chinese manufacturer for lower-cost production. Unaware of Sears’ breach of the nondisclosure agreement, Roto Zip continued to develop the tool to bring it to market. While Roto Zip’s finished product sold for $119, Sears’ Craftsman combination tool undercut at just $59. Sales of Roto Zip’s rotary saw declined dramatically after the Sears version launched.

The $21.5 million verdict includes $13.5 million for lost profits and an additional $8 million in punitive damages. Sears plans to appeal. http://www.suntimes.com/news/metro/658969,CST-NWS-tool20.article; http://ip.law360.com/secure/ViewArticle.aspx?Id=41303

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New lawsuit filed in Utah accuses a former research scientist employed by a nutritional supplement company of stealing trade secrets, customers, and employees when forming a rival vegan supplement company.

Systemic Formulas, Inc. claims that its former research director, Daeyoon Kim, is using Systemic’s trade secrets and proprietary information as the basis for its formula in the rival vegan supplement company. In its complaint against Kim, Systemic alleges that Kim executed Confidentiality and Non-Disclosures Agreement intended to protect Systemic’s proprietary information. Systemic alleges that Kim was specifically hired to develop a line of nutritional supplements without the RNA/DNA factor that is considered to be an animal product and therefore less appealing to certain portions of the supplement-consuming public that want a more natural supplement. Kim asserts that his primary duty was an employee manager and claims that Systemic did not have a research facility. However, Systemic’s website states, “Systemic Formulas uses a technologically advanced research and production facility to manufacture the bottling and capsulation process of its product’s raw materials.”

After Kim resigned from Systemic, he requested a modification to the Confidentiality Agreement to allow Kim to manufacture a line of vegan dietary supplements. Systemic alleges that Kim admitted that the proposed line of vegan dietary supplements would represent a line of products in conflict with his obligations under the Confidentiality Agreement and therefore requested a modification. Kim asserts he reached an agreement with Systemic in June regarding his request to develop the vegan supplements and that the lawsuit surprised him.

This case should be full of classic trade secret issues including an analysis of the scope of the confidentiality agreement and Kim’s exposure to proprietary information as a research director or an employee manager. Another area of inquiry will no doubt be whether the confidentiality agreement was altered by an oral or written agreement. Ultimately, the degree of similarity between Systemic’s supplements and Kim’s vegan supplements will be a major factor in this dispute. Another interesting issue may be whether Kim had a certain amount of knowledge before he was an employee of Systemic or whether he developed his vegan formula idea independently from the scope of his duties at Systemic.

This case can be monitored under Case No. 07-CV-159 in the District Court of Utah, Central Division.

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