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

On January 13, 2011, in Holmes v. Petrovich Development Company, LLC, a California Court of Appeal ruled that emails sent by an employee to her attorney from a company computer were not privileged. 

Read our Seyfarth Shaw Labor & Employment Department's alert here.   This should be of particular interest in all employee-related cases, including trade secrets and non-compete cases.  As the alert notes:

This case reminds employers of the importance of having a strongly worded and clearly written policy on employee use of employer-provided technology such as computers, email systems and voice mail systems for personal reasons. These policies also should specify that employees have no expectation of privacy in their non-work communications and that all employer-provided technology is subject to monitoring, even if it is password-protected.

Having clear technology policies are also particularly important to protecting trade secrets and other confidential information.

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As we have posted previously, there is some question regarding the effective date of Georgia's Restrictive Covenant Act, O.C.G.A. § 13-8-50 et seq., the statute passed by the Georgia General Assembly in 2009 and authorized by passage of an enabling constitutional amendment in November 2010. The RCA changes Georgia’s legal regime regarding restrictive covenants.  Because of the uncertainty regarding the statute’s effective date (and resulting potential constitutional issues), the General Assembly has been considering a bill - House Bill 30 - that would re-enact the RCA to end any constitutional questions. 

HB 30 also addresses a second issue regarding the RCA. There has been some debate as to the meaning of the provisions of O.C.G.A. § 13-8-56, specifically whether it applies only to in-term covenants. HB 30 revises that section of the non-compete statute by making it clear that the presumptions contained in O.C.G.A. § 13-8-56 apply to in-term and post-term covenants. This provision is important to businesses and employersfor a number of reasons, including that Georgia employers will be permitted to list specific competitors in place of specifying a geographic area in a non-compete restriction. 

On Tuesday, February 22, 2011, the House of Representatives passed HB 30 by a margin of 104 to 58. The bill is now before the Senate. We will continue to monitor the progress of the bill.

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            When a defendant, sued by a former employer for misappropriating a manufacturing process that allegedly constituted a trade secret, denies that the process is confidential and files a counterclaim alleging that the plaintiff is engaged in sham litigation in order to stifle competition, is it appropriate for the court to instruct the jury that the evidence shows plaintiff does not have a valid trade secret? In a recent case, the trial judge gave such an instruction which led to a multi-million dollar jury verdict for the defendant. The appeal that followed is reported in Whitesell Int’l Corp. v. Whittaker, 2010 WL 3564841 (Mich. App., Sept. 14, 2010) (affirming the judgment below; 2-1 ruling that the instruction was appropriate), vacated on reconsideration, 2011 WL 165405 (Mich. App., Jan. 18, 2011) (vacating the judgment below and remanding for a new trial; unanimous decision that the instruction was inappropriate).

            The sole manufacturer of interconnected “pierce nuts” filed a trade secret misappropriation lawsuit in Wayne County, Michigan, against an ex-employee who allegedly was using the plaintiff’s manufacturing process in a competing business. Pierce nuts affix materials to sheet metal. 

            Responding to the lawsuit, which was the third one between the parties, the ex-employee successfully moved to dismiss the claim on the ground of res judicata. In a counterclaim for tortious interference with a business relationship and expectancy, he denied that the process was confidential, and he demonstrated that the process was readily visible to plant visitors and was disclosed in detail in an old, expired patent. He also proved that the plaintiff’s employees were not required to sign confidentiality agreements and that no document referred to the process as confidential. Accordingly, he maintained that the plaintiff was engaging in sham litigation which was a “flagrant violation” of the Michigan Antitrust Reform Act and part of an unlawful effort to preserve a monopoly. Insisting that it had acted reasonably in filing the lawsuit, the plaintiff produced witnesses who testified to their understanding that the process was confidential. 

            Immediately prior to the start of deliberations following a 25-day trial, the jury was instructed that the manufacturing process did not constitute a trade secret. Naturally, the jury then decided the counterclaim for the defendant. Including attorneys’ fees and pre-judgment interest, the counterclaimant was awarded more than $8 million.

            The manufacturer appealed with interesting results. Initially, the Michigan Court of Appeals affirmed, 2-1. The dissent insisted that the claim should not have been dismissed on res judicata grounds and that the counterclaim instruction was improper and highly prejudicial. On reconsideration, the panel vacated the judgment and remanded for a new trial, concluding that the dissent had been correct in saying that the judge below should have let the jury decide the trade secret question. However, the ruling in the initial opinion regarding res judicata was left unchanged. The judge who initially had dissented now concurred in the portion of the decision on reconsideration remanding because of the improper trade secret instruction, but he continued to dissent with respect to the reiterated ruling on res judicata.

            As this case illustrates, in trade secret misappropriation litigation a party alleging that a manufacturing process is confidential has an uphill battle to obtain a sustainable directed verdict where there is a dispute concerning whether the process constitutes a trade secret.

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An article published yesterday in the Gonzaga Law Review presents an interesting analysis of trade secret litigation in state courts. Authors David S. Alming, Darin W. Snyder, Michael Sapoznikow, Whitney E. McCollum, and Jill Weader published the follow-up article to their article last year concerning trade secret litigation in federal courts. According to the new article, they analyzed 2,077 state appellate court decisions issued between 1995 and 2009 and coded 358 of them for 17 relevant factors.

Here are some interesting findings from their article:

• In more than 90% of trade secret cases in both state and federal courts, the alleged misappropriator was either an employee or business partner of the trade secret owner.
• Just five states account for about half of all trade secret litigation in state appellate courts. California leads the pack (16% of cases), followed by Texas (11%), Ohio (10%), New York (6%), and Georgia (6%).
• State appellate courts affirmed 68% of trade secret decisions and reversed 30% of them.
• State appellate courts favor defendants. Alleged misappropriators (the defendants) prevailed in 57% of cases and trade secret owners (the plaintiffs) prevailed in 41%.
• State courts appear to be a tougher venue for trade secret owners who are suing business partners than for those suing employees. Trade secret owners won 42% of the time on appeal when the owner sued an employee, but only 34% when the owner sued a business partner.
• For decades following its 1939 publication, the Restatement (First) of Torts “was almost universally cited by state courts, and in effect became the bedrock of modern trade secret law.” James Pooley, Trade Secrets § 2.02[1] (2010). Those days are over. Only 5% of the cases in the state study cited the Restatement.
• Unlike federal courts, which cite persuasive authority in more than a quarter of cases, state courts cited persuasive authority in only 7% of cases.
• In contrast to the exponential growth of trade secret litigation in federal courts, trade secret litigation in state appellate courts is increasing, but only in a linear pattern at a modest pace.
• Of all the reasonable measures trade secret owners took, only two statistically predicted that the court would find that this element was satisfied: confidentiality agreements with employees and confidentiality agreements with third parties.

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By Paul Freehling

The national CPA firm of Mayer Hoffman McCann P.C. (“MHM”), based in Missouri, scored a major victory when the Eighth Circuit Court of Appeals affirmed a trial court’s injunctions and liquidated damages award of $1,369,921 against four former stockholder-employees in Minnesota. The injunctions prohibited them from soliciting MJM’s clients, directed them and their employees to make their office and home computers available to a computer forensic expert, and enjoined them from using (and ordered them to return) MJM’s trade secrets and confidential information. The appellate court’s decision is notable because of its analysis of when non-compete covenants and contractual liquidated damages provisions are enforceable, but also because of the court’s view that non-solicitation agreements are unenforceable.   

In 2005, the individuals executed a Stockholders Agreement pursuant to which they covenanted not to solicit MHM’s clients and customers for two years after leaving MHM’s employ. However, in 2008, immediately after their resignation from MHM, the individuals started a competing firm which proceeded to serve at least 124 MHM clients. 

The covenants were challenged as lacking in consideration, being contrary to Missouri law, and having unenforceable remedy terms. The court discussed and rejected almost every challenge. Mayer Hoffman McCann, P.C. v. Barton, 614 F.2d 893 (8th Cir. 2010).

With regard to consideration, the defendants relied on a 1996 Missouri appellate court decision that invalidated, for lack of sufficient consideration, a non-compete clause contained in a buy-sell agreement. That court, however, was influenced by the absence of a contemporaneous employment contract and the failure of the buy-sell agreement to state that the clause was intended to protect special interests of the buyer.   In the Mayer Hoffman case, the individuals who signed the covenants were employees. Further, the Agreements contained mutual promises, recited that the purpose of the covenants was protection of MHM’s legitimate special interests -- its proprietary trade secrets to which the individuals had access -- and did not include restrictions greater than fairly required. So, consideration was adequate.

Several Missouri appellate court opinions identify the types of agreements in which restrictive covenants are permissible. No reported case involved a covenant ancillary to a shareholder’s agreement relating to a professional corporation. But the Eighth Circuit Appeals Court held that since a few decisions upheld covenants in agreements with various kinds of close corporations, and a professional corporation is a type of close corporation, the covenants at issue are enforceable. The two-year covenant was without geographical restrictions, but it was limited to MHM clients who the defendants solicited, and that was held to conform with Missouri law.

The defendants claimed that the non-compete clause failed because MHM had no protectable interest in clients who the individuals had begun servicing before signing the Stockholder Agreements. The court disagreed. MHM had invested money, time and effort in strengthening the pre-existing relationships. The court did concur with the defendants that, under Missouri law, MHM had no protectable interests in the defendants’ co-workers’ continued employment, and so the non-solicitation clause was unenforceable.

The Agreements provided that a violator of the covenant not to compete would owe liquidated damages equal to the sum of MHM’s total billings, for the two years prior to violation of the covenant, to the clients the violators successfully solicited. Overruling the defendants’ contention that the damages clause created an unenforceable penalty, the court held that the clause was valid because an accurate estimate of damages was difficult to make, and two years’ billings was a reasonable forecast of the harm caused by the individuals’ breach of contract. 

The injunctive and monetary award in Mayer Hoffman might be harsher than some courts would have rendered. However, the contract violation here was particularly egregious. In any event, the opinion suggests how to draft enforceable trade secret protection agreements, non-compete covenants, and liquidated damages clauses. The decision shows the horrendous consequences that may be faced by anyone who misappropriates trade secrets and breaches a covenant not to compete. For questions about the Mayer Hoffman case or other trade secret issues, please contact the Trade Secrets team at Seyfarth Shaw.

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By Robert Milligan and Joshua Salinas

A Colorado federal district court recently held that the computer forensic investigator costs of investigating Computer Fraud and Abuse Act (CFAA) violations constitute “loss” under the statute. (AssociationVoice, Inc. v. AtHomeNet,Inc.,No. 10-cv-00109-CMA-MEH, 2011 WL 63508 (D.Colo 2011)). The court echoed the growing trend in circuit and district courts, which permit civil claims under the CFAA absent any damage or interruption of service. Consequently, this decision underscores the viability of asserting CFAA claims in cases involving data theft and the importance of utilizing qualified computer forensic investigators in such cases.  

The plaintiff and defendants in AssociationVoice offered competing web-based software applications for homeowners associations (HOA). The defendants allegedly acted as fictitious HOA customers in order to purchase the plaintiff’s software and access the plaintiff’s password-protected “site admin” areas. In order to access the web site, the defendants also allegedly entered into a Services Agreement, which prohibited the defendants from reverse engineering and copying the plaintiff’s source code or using the plaintiff’s confidential and proprietary information. 

The defendants allegedly copied, reverse engineered, and misappropriated information from the plaintiff’s password-protected site and allegedly added at least forty-four new features to the defendants’ own applications.

The plaintiff filed suit against the defendants, alleging, inter alia, violations of the CFAA, copyright infringement, trade secret misappropriation, and breach of the Services Agreement.

The plaintiff moved for two preliminary injunctions. The plaintiff sought to enjoin the defendants, per the Services Agreement, from providing the defendants’ customers with the allegedly copied, reverse engineered, and misappropriated features. Additionally, the plaintiff sought to enjoin the defendants, pursuant to the CFAA, from further accessing the password-protected “site admin” areas.

The court denied the Services Agreement injunction because the plaintiff did not make a “strong showing” of the four injunction factors to justify altering the status quo. However, the court granted the CFAA injunction.

The noteworthy aspect of this case is the court's analysis of the “likelihood of success” factor in granting the plaintiff’s CFAA injunction. 

In order to bring a civil claim under the CFAA, the plaintiff was required to prove that the violations resulted in the loss of at least $5,000 within a one-year period. (18 U.S.C. § 1030(g) and (c)(4)(A)(i)). The parties disputed whether the plaintiff’s hiring of a third-party computer forensic investigator to assist with its investigations constituted a “loss.” Additionally, the defendants argued that the plaintiff could not bring a claim because it suffered no interruption of service. 

The court recognized that the majority of courts find the costs of investigations and responses to security breaches constitute “loss,” regardless of whether service is interrupted. (See, e.g.,A.V. v. iParadigms, LLC, 562 F.3d 630, 646 (4th Cir. 2009);EF Cultural Travel BV v. Explorica, Inc., 274 F.3d 577, 584 (1st Cir. 2001);SuccessFactors, Inc. v. Softscape, Inc., 544 F.Supp.2d 975, 980-81 (N.D.Cal. 2008); Res. Ctr. for Indep. Living v. Ability Res., Inc., 534 F.Supp.2d 1204, 2111 (D.Kan. 2008);Patrick Patterson Custom Homes, Inc. v. Bach, 586 F.Supp.2d 1026, 1036 (N.D.Ill 2008); NCMIC Fin. Corp. v. Artino, 638 F.Supp.2d 1042, 1064 (S.D. Iowa 2009)).

The court reasoned that the plain language of “loss” defined in § 1030(e)(11) distinguishes between the costs of responding to CFAA violations and the consequential damages from interruptions of service. In fact, the legislative history of the CFAA indicates that it the statute was designed to address situations in which damage never occurred. The court found this case almost identical to the California district court decision in SuccessFactors. In SuccessFactors, the court held that  when confidential information is obtained, it is necessary for the violated party to discover who has the confidential information, how they accessed it, and what the violators were doing with it. Thus, the defendants’ alleged access of the plaintiff’s protectable confidential information naturally incurred the costs of an investigation. Specifically, the court stated "[i]t, therefore, is not surprising that Plaintiff also had to go to great lengths to uncover Defendants’ identity, as well as to uncover the extent of their unauthorized access and the methods they used. Accordingly, Defendants should not be allowed to complain about the costs Plaintiff incurred in doing so."

While the court in AssociationVoice followed the growing majority, the Second Circuit and district courts in Florida, Virginia, Connecticut, and Louisiana still require an interruption of service in order to bring a claim under the CFAA. (See, e.g., Nexans Wires S.S. v. Sark-USA, Inc., 166 Fed.Appx. 559, 563 (2d Cir. 2006)).

What does this mean? The CFAA remains a viable option to combat data theft. Although some courts have narrowed the applicability of the CFAA, many courts, like the AssociationVoice court, recognize CFAA claims even where the defendants' actions do not result in any interruptions of service. Some courts have even extended the “costs to respond” to include investigations into ways to improve security. (See, e. g., JedsonEng’g, Inc., v Spirit Construction Services, Inc., (S.D. Ohio 2010). Accordingly, in order to satisfy the "loss" requirement under the CFAA, make sure that  qualified computer forensic investigators are utilized (in coordination with legal counsel) to respond to and assess the computer breach as soon as your company learns of the data theft.  

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We informed our readers on March 31, 2009 about Illinois House Bill 4040, titled "Illinois Covenants Not to Compete Act" (link). House Bill 4040 attempted to limit non-compete enforcement to employees or independent contractors who:

• have substantial involvement in the executive management of the employer’s business;
• have direct and substantial contact with the employer’s customers;
• possess knowledge of the employer’s trade secrets and/or proprietary information;
• possess such unique skills that they have achieved "a high degree of public or industry notoriety, fame, or reputation as a representative of the employer;" or
• are among the highest paid 5% of the employer’s work force for the year immediately preceding the separation.

House Bill 4040 also attempted to change Illinois law by:

• eliminating an employer’s ability to enforce a non-competition covenant if the employer failed to notify the new employee two weeks prior to the first day of his employment that a covenant not to compete is required, or if the covenant is not accompanied by a "material" advancement, promotion, bonus or compensation increase;
• creating a rebuttable presumption that a non-competition covenant is invalid if the covenant exceeds one year, the geographic restrictions in the covenant cover areas beyond which the former employee provided services "during the one year preceding his termination;" or if the covenant concerns personal services activities that the employee did not perform during the "one year preceding termination of their employment;"
• forbidding a court, if it chooses to modify an existing covenant, from imposing a damages award for the employee’s original breach of the covenant;　
• instructing a court to interpret any attorneys’ fees provision found in a non-competition covenant to allow either the employer or the employee to recover their attorneys’ fees
• empowering the court to award attorneys’ fees to the employee if, through a declaratory judgment action brought by the employee, the court declares the non-competition covenant unenforceable.

House Bill 4040 was introduced by Representative Rosemary Mulligan (Republican - 65th District) and never made it out of committee. Hence, the Bill terminated when the Illinois House of Representatives concluded its session. However, Representative Jil Tracy (Republican - 93rd District) introduced a bill identical to House Bill 4040 on January 12, 2011. Representative Mulligan became a co-sponsor of Representative Tracy’s bill, House Bill 0016, on February 4th. So far, House Bill 0016 has not attracted significant public attention or traction in the Illinois House. Nevertheless, we will continue to monitor House Bill 0016 and any other actions the Illinois House or Senate may undertake with respect to non-competition agreements or trade secrets.

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On January 20, 2011, Massachusetts State Representatives Lori Ehrlich, William Brownsberger, and Alice Hanlong Peisch re-filed the Massachusetts non-compete bill, aptly entitled “An Act Relative to Noncompetition Agreements.”  The bill was originally submitted in late 2009 as House No. 1799, and since that time has undergone significant review, comment, and revision.  While much of the bill remains the same, its sponsors made changes to address several concerns the business community had expressed about particular provisions.  There is no current timeline for a vote on the bill, but we do expect there to be ample opportunity to provide additional input.

What Remains the Same As the Prior Bill?

The bill applies to non-compete agreements in the context of employment, including forfeiture for competition agreements (agreements that impose adverse financial consequences if an employee engages in competitive activities).  However, the bill specifically excludes non-solicitation agreements (both of customers and employees); non-compete agreements outside the employment context, such as those that are executed in the sale of a business; forfeiture agreements (agreements that impose adverse financial consequences as a result of termination regardless of whether the employee engages in competitive activities); and agreements not to reapply for employment.  The bill does not apply to non-disclosure or confidentiality agreements. 
In essence, the bill codifies the existing common law rules, which provide that non-compete agreements are enforceable only if they are reasonable in duration, geographic reach, and scope of proscribed activities necessary to protect the employer’s trade secrets, confidential information, or goodwill, and are consonant with public policy.  In addition, the bill does not change current Massachusetts law permitting courts to reform or modify unreasonable non-compete agreement provisions.

The bill requires non-competes to be in writing, signed by both parties, and “to the extent reasonably feasible,” they must be provided to the employee at least seven business days in advance of employment.  If the agreement is executed after the commencement of the employment relationship, the employee must be provided with notice and “fair and reasonable” consideration (beyond continued employment).

The bill restricts non-compete agreements to one year, except for “garden leave” clauses (agreements by which the employer agrees to pay the employee during the restricted period), which may last up to two years. 

The bill mandates the payment of attorneys’ fees to employees if a court refuses to enforce “a material restriction or reforms a restriction in a substantial respect,” or if it finds that the employer acted in bad faith.  Attorneys’ fees are not mandated, however, if a particular provision is “presumptively reasonable,” as defined by the statute, or if the employer made “objectively reasonable efforts to draft the rejected or reformed restriction so that it would be presumptively reasonable,” even if a court refuses to enforce or reforms the provision.  An employer may be entitled to its legal fees if it prevails only if they are otherwise permitted by statute or contract, the agreement is presumptively reasonable, the non-compete was enforced, and the employee acted in bad faith.

What Has Changed From the Prior Bill?

Perhaps the most significant change in the current version of the bill is that it no longer restricts the use of non-compete agreements to employees making more than $75,000 per year.  Instead, the bill calls for courts to consider the economic circumstances of, and economic impact on, the employee.  This is important because there are many companies doing business in the Commonwealth, oftentimes start-ups, that employ individuals who are paid less than $75,000 per year, but who are otherwise provided with potentially lucrative equity interests, stock options, or the like.  The departure of these employees to a competitor can cripple a start-up company and can even cause hardship to well-established companies that may utilize these other types of non-monetary compensation and pay key employees less than $75,000.  This salary benchmark was also a concern for companies that employ part-time or seasonal employees, and staffing agencies, to name a few, which may not meet the $75,000 salary benchmark in a calendar year.    

Another change in the bill relates to the award of mandatory attorneys’ fees to employees.  While this provision remains in the bill, as discussed above, an employer can avoid paying fees if the court determines that it undertook “objectively reasonable efforts to draft the rejected or reformed restriction so that it would be presumptively reasonable,” even if unsuccessful.  This provision, however, does not provide clear guidance to employers as to the parameters of such “objectively reasonable efforts,” and remains a significant departure from existing law that litigants pay their own attorneys’ fees, win or lose.

Like some other states, including California, the bill, in its prior and current versions, explicitly rejects the inevitable disclosure doctrine (which holds that even in the absence of an enforceable non-compete agreement, a former employee may be prevented from working for a competitor based on the expectation that the employment would inevitably lead to the disclosure of trade secrets or confidential information of the former employer).  The newest version of the bill, however, recognizes that employers may nevertheless protect themselves using other laws and agreements, including applicable trade secrets laws and non-disclosure agreements.   

Other changes from the last version of the bill include: (a) non-competes executed after the commencement of employment no longer must be accompanied by a 10% increase in salary to be presumptively reasonable; now, they must simply be supported by “fair and reasonable consideration”; (b) non-compete agreements no longer need to be separate documents; (c) garden leave clauses are permitted; and (d) the scope of restrictions placed on forfeiture agreements has been limited.

Finally, it is important to note that the bill is not retroactive, and will not apply to agreements entered into before January 1, 2012.

Seyfarth Shaw plans to monitor and participate in the legislative process and will report on the status and evolution of this bill on our blog, Trading Secrets, at www.tradesecretslaw.com.  If you have any questions or would like to provide input on the bill, please contact the Seyfarth Shaw attorney with whom you work or any Trade Secrets, Computer Fraud & Non-Compete attorney on our website (www.seyfarth.com/tradesecrets). Click here for Seyfarth Shaw's Management Alert on the bill.

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