Business Divorce, LLC Law
Sometimes when partners are starting up a business, they fail to follow corporate formalities. Whether because of a lack of funds, lack of attention to detail, lack of time, lack of desire to crimp new business relationships or simply a lack of desire, corporate founders can fail to exercise various good corporate governance practices. Written agreements among owners are vital to make clear (and enforceable) the agreements between new partners in a startup company, and can be especially important to minority partners. One of the reasons that limited liability companies have become the go-to corporate form is because the New York Limited Liability Company Law allows tremendous flexibility in the terms of operating agreements – the agreements governing the relationship between the members of the company. But, to take advantage of these vast corporate governance rights, the LLC Law states that operating agreements have to be in writing.
A New York plaintiff in 2015 came to learn the downside to laxity in demanding a written agreement when a limited liability company is formed. In Shapiro v. Ettenson, 2015 N.Y. Slip Op. 31670(U) (Sup. Ct. N.Y. Co. Aug. 16, 2015), aff’d 146 A.D.3d 650, 45 N.Y.S.3d 439 (1st Dep’t 2017), three founding members, each with an equal 1/3 ownership interest, formed a limited liability company. Two years later and without prior notice, the plaintiff received a notice from the two other members stating that they had adopted a written operating agreement, which provided for management action to be approved by only a majority in interest of the members. A year later, the two other members provided notice to the plaintiff, pursuant to the new operating agreement, stating that the other members (constituting a majority in interest) voted to issue a capital contribution call and that plaintiff’s equity interest would be diluted if he failed to make the capital call and another member did so in his place.
The plaintiff refused to recognize the validity of the operating agreement and make the capital call pursuant to the agreement. The other two members diluted the plaintiff’s membership. The plaintiff sued claiming that the three members orally agreed that such decisions would require unanimous consent (a common provision with two or more members with equal membership interests).
The case started in a Manhattan trial part and ended in an appeal to the First Department Appellate Division (the appellate court that covers New York County and Bronx County). The appellate court affirmed the holding of the trial court that the alleged oral agreement requiring unanimity in corporate decision-making was void and unenforceable under the New York LLC Law. The LLC Law expressly provides that in the absence of a written operating agreement, action may be taken after a vote of the majority in interest of the members (i.e. over 50%). The court found the defendant members, collectively holding a majority interest, properly adopted the operating agreement, made the capital call and diluted the plaintiff’s membership interest – all without notice to the plaintiff and without the plaintiff’s consent.
Damages, Misappropriation, Trade Secrets, Unfair Competition
What damages may a business recover when its trade secrets are stolen and used by a competitor? Traditionally, courts have allowed businesses to recover actual losses caused by the trade secret theft – such as lost opportunities for profit. Are there other potential avenues of recovery? For example, can a business recover the amount of costs the competitor avoided by not having to develop the stolen trade secret? After all, the competitor avoided potentially onerous costs associated with years of research, development, trial and error by simply stealing the trade secret. Recently, the appellate Federal court covering New York State asked New York State’s highest court, the Court of Appeals, this exact question – and the Court of Appeals said “no.”
The misappropriation of trade secrets occurs when a competitor improperly obtains and uses another’s formula, pattern, device or compilation of confidential business information that provides a competitive advantage. In essence, it is a type of “unfair competition.” E.J. Brooks Company v Cambridge Security Seals, 858 F3d 744 (2d Cir 2017), presented a quintessential theft of trade secrets claim. Plaintiff manufactures plastic security seals (as seen here). Several of plaintiff’s employees jumped ship to defendant, a direct competitor, and brought with them plaintiff’s confidential, fully-automated plastic seal manufacturing process, which defendant immediately began to use. Plaintiff sued defendant for, among other things, misappropriation of trade secrets. After trial, the jury found defendant liable to plaintiff for $3.9 million, which represented the amount of costs defendant “avoided” by stealing the manufacturing process rather than developing it. Following an appeal of the award, the United States Court of Appeals for the Second Circuit asked the New York Court of Appeals whether, under New York law, “avoided costs” were an available form of damages for unfair competition claims.
In addressing the question in E.J. Brooks Co. v. Cambridge Sec. Seals, 2018 N.Y. Slip Op. 03171 (May 3, 2018), the Court of Appeals noted that the “fundamental purpose” of compensatory damages is to “make the victim whole” – in other words, to restore the injured party to the position it would have been in but for the misconduct. The Court reiterated the long-standing rule that a victim of trade secret misappropriation is not entitled to recover the revenue or profits actually received by a defendant. While those amounts might be relevant in determining plaintiff’s losses (e.g. “I would have earned what defendant earned”), the Court cautioned that there is “no presumption of law or of fact” that defendant’s profits, revenues, cost savings, etc. will approximate plaintiff’s losses. Rather, plaintiff’s actual damages must be measured by plaintiff’s actual losses, like lost opportunity for profit and the loss of investment to develop the confidential trade secret. The Court held a defendant’s “avoided costs” are not an available form of damages because they have no bearing on plaintiff’s lost profits. The Court further held that while plaintiff’s investment costs in developing a trade secret can show the value plaintiff placed on the secret, defendant’s avoided costs are “wholly unsubstantial and imaginary” (maybe defendant would have been really efficient in developing the stolen secret) and not an adequate approximation of plaintiff’s investment losses.
If you have any questions about theft of trade secrets or other unfair competition that have affected you, please do not hesitate to contact us.
Breach of Contract, Contracts, Modification, UCC
Oftentimes businesspeople sign a contract and put it in a drawer never to see the light of day again – unless a dispute arises. Especially with long-term contracts, trying to informally work things out might be efficient from a business perspective at the time, but it can lead to waiver of important legal rights in the end.
A 2017 decision by a New York appellate court, Kamco Supply Corp. v. On the Right Track, LLC , 149 A.D.3d 275, 49 N.Y.S.3d 721 (2d Dep’t 2017), certainly provided a wake-up call to anyone who believed in the casual administration of a contract. Kamco Supply Corp.concerned disputes arising out an approximately 18 month long distribution agreement. The intermediate appellate court held that the seller, by accommodating the underperforming purchaser, waived the right to enforce minimum purchase requirements for the construction product under the contract. The parties entered into the distribution agreement in mid-2005. The agreement required the purchase of 15 million feet of the product during the remainder of 2005 and ramped up dramatically to require purchase of 164 million feet in 2006 with a monthly minimum of 8 million feet. The purchaser agreed to use its “best efforts” to market, sell and distribute the product.
From the start, the purchaser failed to meet the 2005 purchase requirements, let alone the tenfold increased requirements in 2006. The seller did not default the purchaser, but instead tried to work with the purchaser. By May 2006, the purchaser opened discussions with the seller to end the relationship and, by July 2006, the seller recognized the purchaser would miss all purchase requirements. Regardless, the seller decided to stick with the purchaser as the seller’s best hope to increase sales of the product. By the end of 2006, in an act that surely stung, the nonperforming purchaser sued the seller for breach of contract in failing to refund $17,500. The seller countered with claims of breach of the purchase requirements seeking $71 million in damages.
The court focused on the importance of “course of performance” in “relational” contracts (i.e., contracts involving continuing relationships) in determining not only whether a party committed a retrospective waiver of a prior obligation, but also whether a party prospectively waived an executory, or future, obligation of the other party. The court held that where a contracting party waives an ongoing obligation, it may retract the waiver on reasonable notice and without undue prejudice to the counterparty. The case, involving the sale of goods, also triggered the Uniform Commercial Code, which recognizes the importance of course of performance in interpreting agreements and finding waiver of future rights. The court upheld the trial court’s finding that, despite an express “no waiver” provision in the contract prohibiting oral waivers, the seller by its conduct (i) waived the past due purchase requirements; (ii) made an election not to terminate the contract because of those breaches; and also (iii) waived the future purchase requirements because the seller failed to give timely notice withdrawing its waiver. The court dismissed the seller’s claims because the seller did not enforce the purchase requirements or make written reservations of rights and, instead, made accommodations to the purchaser in the hopes of increased sales.
The end result for the seller was that after 11 years of litigation (over seven times longer than the contract term), and after trial and appeal, the court granted the purchaser a $17,500 verdict on its breach of contract claim and dismissed the seller’s claims holding the seller waived the purchaser’s admitted breaches of every purchase requirement in the contract. This case provides a cautionary tale that contracting parties should avoid informal changes, and instead enforce their contracts and document amendments and new understandings.
While the above presents an extreme situation, you might face a less severe situation that could still result in a court later finding you waived your rights by failing to enforce your contract rights or by making oral changes without reservations of rights and proper documentation. If you have any questions about your contractual relationships and how you can best protect your business (whether to enforce or avoid a particular contract), please do not hesitate to contact us.
Employment Law, Non-Compete, Restrictive Covenants
Many employers and employees alike assume that a non-compete covenant in an employment agreement will be enforced without issue if an employee violates it. The reality, however, is far less certain. In New York, the general public policy favoring “robust and uninhibited competition” weighs “against sanctioning the loss of a man’s livelihood.” As such, New York courts will “rigorously examine” restrictive covenants and enforce them “only to the extent necessary to protect the employer from unfair competition.” If a restrictive covenant is reasonable in time and geographic scope (which is different for each case), a court will enforce a non-compete if it is necessary to protect 1) the employer’s trade secrets; 2) confidential customer information; 3) the employer’s client base; and 4) “irreparable harm” where the employee’s services are “unique or extraordinary” – such as a professional athlete or musician, or a broker, trader or salesperson who has a “unique relationship” with the employer’s clients.
Even if an employer can meet the rigorous test to demonstrate a restrictive covenant is necessary to protect it, the First Department Appellate Division (the appellate court that covers New York County and Bronx County) recently confirmed that an employer may not enforce a non-compete covenant against an employee terminated without cause. The court drew on prior cases that referred to the inherent unfairness of an employer seeking to prevent an employee from working when that employee did nothing to bring about her own discharge. The court confirmed that an employer’s “continued willingness to employ” the employee is a required part of enforcing a non-compete. New York courts simply will not prevent a laid off employee from trying to earn a living.
It is important to note, however, that a termination must be without cause to render a non-compete covenant unenforceable. A federal district court in New York recently explained that a termination for cause will not affect the enforceability of a non-compete because of the perverse incentive it would create. Specifically, the court stated that “to hold otherwise would be to permit employees to avoid reasonable non-compete agreements simply by ‘creating’ cause for their dismissal.” Lest one think that scenario far-fetched, this exact scenario played out in an earlier case where the court found that a doctor “purposely engaged in a course of conduct that was designed to induce [his employer] to fire him” with the hope of rendering the doctor’s non-compete unenforceable. Because the court found the non-compete was necessary to protect the employer from unfair competition, the non-compete was enforceable against the scheming doctor.
If you are an employer or an employee with any questions about non-competes and other types of restrictive covenants, please do not hesitate to contact us.
