I recently ran across this newsletter article regarding taxation of non-compete clauses in the sale of closely held businesses and thought it worth passing along for those who find themselves negotiating non-compete agreements in the context of the sale of a closely held business.
By Robert Milligan and summer associate Alana Friedman
Production companies for Criss Angel, the star of Cirque de Soleil’s “Believe” and the A&E cable television show Mindfreak, were sued in New York state court recently by a twenty-three year old illusionist who claims that Angel’s companies have failed to pay him for the use of three alleged confidential and proprietary magic tricks that he claims that he created.
Jacob Spinney’s eight count complaint arises out of an alleged breach of contract involving certain confidential and proprietary magic tricks (e.g. methods of staging and performing three specific illusions or magical effects) that he claims to have permitted Angel to use pursuant to a written contract. Spinney claims that Angel failed to satisfy his end of an agreement that they purportedly entered in 2005. Pursuant to the alleged agreement, Spinney purportedly assigned the rights in three of his magical effects to Angel’s production company in exchange for a percentage of the net profits realized from the magical effects. Spinney is now seeking monetary compensation and for all rights to be returned to him on two of the three illusions.
Spinney, who allegedly makes his living by selling illusions and magical effects that he originates and creates, claims that in late 2004 Criss Angel (whose real name is Christopher Sarantakos) contacted him expressing interest in performing Spinney’s Chair Self-Levitation illusion where the performer appears to be floating above the ground. Spinney claims that Angel was interested in the illusion for his upcoming television series Mindfreak. In the 2005 Agreement which result from Angel’s alleged inquiry, Spinney claims that he assigned the rights in his confidential and proprietary magical tricks entitled Chair Self-Levitation, Chair Self-Suspension (performer appears to be suspended above the ground), and Fork Bending Gimmick (performer appears to bend a fork without exerting any physical pressure upon it) to Angel’s production company in exchange for 25% of the profits that it derived from the magical effects.
Spinney alleges that he invented, designed, and tested the method of performing all three illusions. He claims that levitation, suspension, and fork bending illusions or magical effects are valuable commodities in the magic industry because they are difficult to create and have significant audience appeal.
Their 2005 Agreement provides that “In the field of magic, a magician’s success depends upon the secrecy of the methods, apparatus, and workings of magical effects and illusions; and…a magician creates and establishes his reputation based upon the originality and novelty of the various magical illusions which are proprietary information, intellectual property and proprietary technologies, and constitute a trade secret.”
Spinney alleges that Angel performed the Chair Self-Levitation on the second episode of his Mindfreak television series which was later broadcast on the A&E Network and included on four separate Mindfreak DVDs. According to the complaint, Angel’s production company publicized the Chair Self-Levitation illusion as Angel’s most popular demonstration and featured the illusion on “Masterminds Volume 2: Self-Levitation,” a “how to” DVD featuring only the Chair Self-Levitation illusion. Spinney further alleges that the packaging on the Mastermind DVD advertised that “Criss teaches everything you need to know about this modern day miracle; step by step instructions on the method, how to construct it…and how to perform it.” Spinney claims that the Mastermind DVD retailed for $100 and sold over 3,900 copies in its first six months, grossing over $190,000 in profits.
Spinney alleges that despite the 2005 Agreement, Angel’s production companies did not pay Spinney any royalties from profits it made from the Mindfreak television show or DVDs and paid him only a small portion of the royalties from profits it made on the Mastermind DVDs. According to the complaint, the DVDs made approximately $267,000 in gross sales and Spinney received only $27,000.
Spinney also claims that his Chair Self-Levitation illusion is proprietary information, intellectual property and proprietary technology, and constitutes a trade secret. He further claims that Angel’s production companies benefited from learning the confidential and proprietary methods of performing the illusion by deriving profits from certain performances and by excluding others from marketing or selling the illusion. He claims that he has suffered a detriment because he was not adequately compensated for the illusion and continues to be precluded from marketing or selling the effect on his own or through alternative means.
Additionally, Spinney alleges that Angel’s production companies failed to make reasonable efforts to sell Spinney’s Chair Self-Suspension or Fork Bending Gimmick pursuant to the 2005 Agreement. Spinney seeks lost profits for the failure to sell or market the two illusions, an amount equal to the fair market value for the illusions, or a judgment returning to him the rights in both.
Apart from its unique and colorful facts, the case highlights some of the issues that exist when confidential information or trade secrets are licensed, such as: 1) ensuring that a reasonable royalty is provided in the agreement with clear definitions of permitted use and payment terms; 2) including language in the agreement providing that the licensee agrees to keep the secrets confidential notwithstanding its use in the ultimate product or service; 3) requiring the licensee to use best efforts to market and sell the ultimate product or service if payment under the agreement is tied to sales; 4) closely monitoring sales of the ultimate product or service in the marketplace to ensure that all royalty payments are made; 5) licensors should consider using a flat fee amount for use of the confidential information and/or trade secrets in lieu or in addition to royalty payments; 6) licensors should closely protect the confidentiality of the target confidential information or trade secrets in the negotiation process with prospective licensees; and 7) the licensor should prohibit independent development of the target confidential information or trade secrets by the licensee in the agreement.
By Carolyn Sieve and summer associate Rina Wang
A California federal court has added to the body of decisional law on preemption under the California Uniform Trade Secrets Act, Cal. Civ. Code §§ 3426, et seq. (“CUTSA”). In Aversan v. Jones, No. 2:09-cv-00132-MCE-KJM, 2009 WL 1810010 (E.D. Cal. June 24, 2009), the Court denied defendants’ motion to dismiss plaintiff’s claims for interference with contractual relations, interference with prospective economic advantage, breach of duty of loyalty, and unfair competition, finding that plaintiff had sufficiently pled facts supporting these claims without relying on the same nucleus of facts as its CUTSA misappropriation of trade secrets claim.
Civil Code section 3426.7 provides that CUTSA “does not affect (1) contractual remedies, whether or not based upon misappropriation of a trade secret, (2) other civil remedies that are not based upon misappropriation of a trade secret, or (3) criminal remedies, whether or not based upon misappropriation of a trade secret.” (Emphasis added.) This provision has been interpreted to mean that CUTSA preempts common law claims that are based on the same nucleus of facts as the CUTSA claim. Thus, preemption is not triggered where the facts in an independent claim are similar to, but distinct from, those underlying the misappropriation claim.
Defendants Jones and Mellse were employees of plaintiff Aversan, which recruits and trains engineers to perform services for Aversan’s customers and clients of its customers. They later quit to work for one of Aversan’s clients, Ambire, which had retained Aversan to provide engineers to one of Ambire’s clients, CalPERS. Defendants had been assigned by Aversan to work on the CalPERS project. While assigned to CalPERS, defendants wrote custom software programs using Aversan’s proprietary software script.
Aversan’s complaint alleged that defendants violated CUTSA by using Aversan’s proprietary and confidential information to continue performing work for Ambire and CalPERS. Defendants also allegedly used Aversan’s confidential information to solicit employees, contractors and recruits. In addition, Aversan sought damages for Jones’ alleged interference with a residential lease agreement, and defendants’ supposed interference with Aversan’s customer relationships.
Defendants moved to dismiss plaintiff’s claims for interference with contractual relations, interference with prospective economic advantage, breach of duty of loyalty, and unfair competition. The district court denied the motion, holding that the facts supporting these tort claims were sufficiently independent of the CUTSA claim. Under these causes of action, Aversan claimed that defendants prevented Aversan from participating in and profiting from its agreements with Ambire by working directly for Ambire and that defendants allegedly interfered by usurping Aversan's position with CalPERS. Aversan also claimed that Jones encouraged and convinced an apartment lessor to terminate its lease with Aversan. Aversan had already paid for that month's rent as an employee benefit to Jones and re-let the same apartment unit to Jones directly. These claims survived dismissal because they did not rely on the same nucleus of facts as Aversan's CUTSA claim and they sufficiently stated an independent claim for relief.
Aversan thus provides some guidance as to what allegations will overcome dismissal of tort claims in a case alleging CUTSA violations. If a party in a trade secrets case is faced with a possible preemption argument, it is worth comparing this decision with the recent California Court of Appeal decision in K.C. Multimedia, Inc. v. Bank of America Technology & Operations, Inc., 171 Cal.App.4th 939 (2009).
In the wake of its ultimately successful efforts to obtain an injunction against former executive Mark Papermaster following Papermaster’s move to Apple, IBM recently sought to enjoin David Johnson from joining Dell. Johnson, who was IBM’s Vice President of Corporate Development, recently joined Dell as its Senior Vice President of Strategy. After conducting a preliminary injunction hearing, Judge Stephen Robinson of the U.S. District Court for the Southern District of New York denied IBM’s motion for preliminary injunction.
Judge Robinson issued his ruling on June 26, 2009, 22 days after Judge Karas of the Southern District issued an order authorizing expedited discovery and permitting Johnson to work for Dell, subject to a restriction that he could not advise it regarding Dell or IBM strategy. Judge Karas had also required Johnson to supply his counsel with a daily log of his activities at Dell with “reasonable specificity,” including the amount of time spent on the activities and the persons involved. The log was to be made available to IBM’s counsel on request, if ordered by the Court.
Judge Robinson’s primary reason for denying IBM’s motion was a rather basic one: he found it unlikely that IBM could show that Johnson agreed to the non-compete provision upon which IBM based its claim. Johnson worked for IBM for 27 years, the last nine of which he directed IBM’s mergers, acquisitions, and divestitures strategy. In 2005, IBM asked Johnson to sign a non-competition agreement as part of a company-wide effort to have senior executives do so. Johnson was reluctant to sign the agreement without researching his future with the company, so he took the creative step of signing the agreement on the signature line for IBM. When IBM learned of Johnson’s tactic, it sent him a blank agreement to execute. IBM’s human resources department followed up with a number of calls and e-mails to ask Johnson to sign the agreement on the employee line. IBM did not execute the version of the agreement that Johnson signed on the IBM line, nor did it retain an original copy of the agreement. IBM also provided Johnson with annual equity award for 2005-08, despite the fact that entitlement to such awards in 2005 and 2006 was dependent on executing the non-compete agreement.
The Court found that IBM faced a “daunting, if not insurmountable, task” in establishing that Johnson signed his non-compete agreement. It stated that Johnson’s conduct in not agreeing to the non-compete document by signing on IBM’s signature line was ambiguous, thus exposing him to the risk that IBM would misunderstand his intent not to assent. However, when IBM asked Johnson to re-sign the agreement and he refused to do so, his statement of his intentions became unambiguous. IBM’s subsequent efforts to induce Johnson to sign, as well as its general counsel’s raised eyebrows when Johnson disclosed the HR department’s efforts indicated that IBM did not believe that Johnson had executed the agreement. The Court further found that IBM’s 2005 and 2006 equity awards to Johnson were not concurrent with his “signing” of his non-compete agreement. Finally, the Court rejected IBM’s argument that Johnson had intended to mislead it, concluding that Johnson instead intended to buy himself more time to clarify his position at IBM. Of no small import was the Court’s conclusion that Jonson was “an extremely credible and reasonable witness.”
The Court also addressed IBM’s claims regarding the hardship that it would suffer without injunctive relief. In that section, the Court shifted its focus from whether Johnson signed his non-compete agreement to whether Johnson possessed (and presumably would inevitably disclose) IBM trade secrets. The Court addressed IBM v. Papermaster directly. It cited the technical knowledge that Papermaster possessed regarding IBM microprocessors and concluded that Johnson’s business knowledge was, in comparison, not clearly proprietary to IBM. Ultimately, the Court concluded that the balance of equities tipped away from IBM because Johnson’s skill-set would erode if he were enjoined from working in the industry, as would his relationships with a “large personal network” of investment bankers, consulting groups, and chief information officers. Thus, Judge Robinson denied IBM’s motion for preliminary injunction and vacated Judge Karas’s June 4, 2009 order.
IBM appealed Judge Robinson’s decision immediately. On June 29, 2009, the Second Circuit Court of Appeals reinstated Judge Karas’s order placing restrictions on Johnson’s work for Dell and establishing reporting requirements. The Court of Appeals intends to hear IBM’s appeal on an expedited basis.
In the back and forth battle between companies and former employees regarding the confidential nature of customer information, the United States District Court for the District of Nebraska has just issued a decision of note in Softchoice Corp. v. MacKenzie, 08-cv-00249. By the decision, the Court dismissed the action as against the defendant, finding that despite plaintiff’s treatment of the information as secret, had plaintiff truly wished to protect the information it should have had defendant enter into a properly tailored covenant not to compete instead of only having him sign a nondisclosure agreement.
The action was brought by Softchoice against MacKenzie, a former employee, alleging the usual panoply of claims: breach of confidentiality, misappropriation of trade secrets and confidential business information, unfair competition and tortious interference with business relations. The confidential information was alleged to be customer contact information and pricing. MacKenzie had not signed a non-compete covenant, but had signed a nondisclosure agreement.
In dismissing the action, Judge Joseph F. Batailon found that:
“The plaintiff cannot succeed on its claims for breach of contract, misappropriation of trade secrets or unfair competition without a showing that the information he allegedly misappropriated was a trade secret … MacKenzie has [] shown that he obtained the only information that could arguably be categorized as ‘secret,’ that is, pricing information, from the potential customers themselves, who freely shared the information with him in hopes of obtaining a lower price. MacKenzie has also shown that his suppliers shared this sort of information …”
This segued into the Court’s interpretation of the extent nondisclosure agreements will protect customer information:
“Softchoice, or its predecessor, could have limited MacKenzie’s contact with his former customers, and consequently protected its pricing information, through a narrowly drawn, valid and enforceable covenant not to compete, but id did not do so. Softchoice cannot achieve by way of a nondisclosure agreement what it could not have obtained via a non-solicitation agreement …”
It will be interesting to watch if any other courts pick up on Judge Batailon’s interpretation of nondisclosure agreements.
By Robert Milligan and summer associate Andrew Larratt-Smith
In a decision that encourages cost efficient corporate mergers in Nevada, the Nevada Supreme Court in HD Supply Facilities Maintenance v. Bymoan, 2009 WL 1635924 (June 11, 2009) recently ruled in an en banc decision that restrictive employment agreements acquired through corporate mergers do not require a showing that the agreements’ assignment provisions were negotiated at arm’s length or are supported by separate consideration.
The court clarified its previous decision in Traffic Control Servs. v. United Rentals, 120 Nev. 168, 172 (2004), which held that employee noncompetition agreements are nonassignable when acquired through an asset purchase transaction, absent an explicit assignment clause negotiated at arm’s length supported by separate consideration. The Traffic Control decision was based on the notion of “honoring an obligor’s choice to contract with only the original obligee, thereby ensuring that the obligor is not compelled to perform more than his or her original obligation.” Further, the decision supports the general proposition that personal services contract are not assignable absent consent. In its Traffic Control ruling, the Nevada Supreme Court used broad language, leading some to believe that the nonassignability of employee noncompetition agreements extended to agreements acquired as the result of mergers as well as to those acquired through asset purchase transactions.
But in HD Supply the Nevada Court distinguished employment restrictive covenants found in mergers from asset purchase transactions. The court emphasized the contractual nature of an asset purchase transaction, whereas a merger is a creation of statute. The court stated that in a merger “two corporations unite in a single corporate existence” whereas “the acquiring corporation in an asset purchase transaction becomes… a wholly new employer.” Consequently, the court reasoned that Traffic Control’s general rule of non-assignability did not apply to covenants of noncompetition, nonsolicitation, or confidentiality as a result of a merger.
The court found that when a relevant merger statute exists, the issue of a covenant’s assignability is not controversial, stating “[a]s the majority of courts have concluded when considering this issue, in a merger, the right to enforce the restrictive covenants of a merged corporation normally vests in the surviving entity.” Further, in support of its decision, the court noted that although Nevada courts have not addressed this exact issue before, the court had previously acknowledged a hard and fast distinction between the implications of a merger, which is a statutory creature, and an asset purchase, which is not.
Despite ruling that restrictive employment agreements acquired through mergers do not need to comply with the strict rule of assignability found in Traffic Control, under Nevada Revised Statute 613.200(4) and applicable case law, such covenants must still be reasonable in scope and duration. The HD Supply decision is significant because it removes a significant obstacle for businesses who obtain employment restrictive covenant agreements as a result of merger and thereby reduces additional costs arising out mergers in Nevada.
The California Court of Appeal’s recent decision in FLIR Systems, Inc. v. Parrish, 2d Civil No. B209964, 2009 WL 1653103 (Cal. App. 2d Dist. June 15, 2009), affirming a $1.6 million attorney fee award to defendants upon a finding that the action was brought in bad faith, provides a useful and interesting discussion of various factors that may lead a court to conclude that a misappropriation case has been brought in bad faith. The decision highlights the importance of considering carefully whether to bring a misappropriation claim against former employees, particularly where there is little or no evidence of actual damage, or of actual misappropriation or threatened misappropriation.
In 2004, FLIR acquired the assets of Indigo, of which defendants Parrish and Fitzgibbons were officers. Indigo manufactures and sells microbolometers, devices used in connection with infrared cameras, night vision, and thermal imaging. After the sale, defendants continued to work for Indigo. About a year later, defendants decided to start a new company to mass produce bolometers. The new company was based on a business plan developed by Fitzgibbons several years before FLIR acquired Indigo. Before leaving Indigo, defendants advised FLIR and Indigo of their business plan and invited FLIR and Indigo to participate. FLIR rejected the offer.
In 2006, defendants began negotiations with Raytheon Company in accord with their business plan. Defendants assured FLIR and Indigo that they would not misappropriate Indigo’s trade secrets and that they would use an intellectual property filter similar to the one used at Indigo to prevent the misuse of trade secrets. In June 2006, FLIR and Indigo sued defendants on the theory that defendants could not mass produce low-cost microbolometers without misappropriating trade secrets. Upon learning of the lawsuit, Raytheon terminated business discussions with defendants, and one month after the suit was filed, defendants advised FLIR and Indigo that they would not go forward with their new business.
FLIR and Indigo, before trial, dismissed their damages claims and tried only the misappropriation of trade secrets and California Unfair Competition Act claims. On December 6-17, 2007, the case was tried. In a statement of decision issued in June 2008, the trial court found no misappropriation or threatened misappropriation of trade secrets. It was undisputed that defendants received no funding for their business plan, never started their new business, had no employees or customers, did not lease any facility or develop technology, and did not design, develop or sell any infrared products. The trial court ultimately denied permanent injunctive relief and awarded defendants $1,641,216.78 in attorney fees.
The California Uniform Trade Secrets Act allows for an award of reasonably attorney fees to the prevailing party where the claim was brought in bad faith. Civ. Code § 3426.4. The court ultimately held that FLIR and Indigo had essentially brought the action based on the doctrine of “inevitable disclosure,” as there was no evidence of misappropriation or threatened misappropriation, and the FLIR and Indigo witnesses were unaware of such evidence though they maintained suspicions that misappropriation would occur. Given that the “inevitable disclosure” doctrine has been definitively rejected in California, the Court found FLIR and Indigo to have brought and maintained the action in bad faith. The items the Court considered significant:
• The absence of any economic harm.
• The absence of any evidence of misappropriation or threatened misappropriation of trade secrets. Notably, there was evidence at trial that one of the defendants, Parrish, had downloaded technological data onto a hard drive before leaving Indigo, and that he destroyed the hard drive a few months before the lawsuit was filed. Although evidence that an employee has downloaded confidential information shortly before leaving his employer is typically significant to support a misappropriation claim, here, the evidence was discounted because defendants first learned of the download after the complaint was filed, so it was not a consideration for bringing suit, and the download was not a threatened misappropriation because there was no evidence that the contents of the hard drive, “if such contents existed, were improperly accessed, used, or copied before the drive was destroyed.”
• Evidence that FLIR and Indigo had an anticompetitive motive in filing the lawsuit. On this point, the court found significant the testimony of FLIR’s CEO, who testified that “we can’t tolerate a direct competitive threat by [Parrish] and [Fitzgibbons],” inferring that the CEO had no evidence of wrongdoing but was bothered that defendants planned to compete with FLIR in the future. The Court also found significant the fact that another FLIR officer had voted to file the lawsuit but had no personal knowledge that defendants had committed a wrongful act.
• Failure by FLIR and Indigo to identify what trade secrets would be subject to the permanent injunction. The Court found as “strong evidence of bad faith” FLIR and Indigo’s proposed injunction, which barred defendants from developing certain products for a 12-month period even if they did not use FLIR and Indigo’s technology or trade secrets.
• Imposition of unnecessary settlement conditions. When defendants notified FLIR and Indigo of their business plan, FLIR and Indigo responded with a demand for $75,000, a non-competition agreement, and agreement that defendants would not hire FLIR and Indigo’s employees, and agreement that they would not challenge Indigo’s patent applications. The Court found these restrictions to be unlawful restraints on trade.
• FLIR and Indigo’s experts at trial admitted there was no scientific methodology to predict trade secret misuse and agreed that no trade secrets were misappropriated.
The FLIR decision is a reminder to employers to be cautious when determining to bring a lawsuit against former employees for trade secret misappropriation. California courts may not tolerate the filing of misappropriation claims where it appears the employer is merely fearful or suspicious of wrongdoing. In such cases, the employer plaintiff risks not only a dismissal of its claims but the possibility of being sanctioned for bringing the action.
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