When Bankruptcy Law Collides with Non-Compete Obligations

Non-compete proceedings for most employees are daunting undertakings. For that reason, most non-compete disputes get litigated in the "shadows," outside of reported court decisions.

And as any attorney representing an employee knows, the possibility of bankruptcy looms should litigation go poorly. Many employees are generally aware that a bankruptcy suit stays (or puts a stop to) other litigation. Although this can alleviate pressure in debt-collection suits, a stay is by no means a safe harbor when it comes to non-compete disputes.

That is because a creditor can file a lift-stay motion in bankruptcy court, which would allow it proceed against an employee for enforcement of the restrictive covenant. Like many other areas of non-compete law, this one too is somewhat opaque and not governed by a clear, bright-line rule. Generally, a bankruptcy court must balance the hardship to a creditor (i.e., employer) if it is not allowed to proceed with the lawsuit against the debtor. It also must consider prejudice to the debtor, the debtor's other creditors, and the bankruptcy estate itself.

A seminal case from 1984, In re Curtis, sets out twelve separate factors that bankruptcy judges must consider when ruling on a lift-stay motion. Those factors are:

(1) Whether relief would result in a partial or complete resolution of the issues;

(2) Lack of any connection with or interference with the bankruptcy case;

(3) Whether the other proceeding involves the debtor as a fiduciary;

(4) Whether a specialized tribunal with the necessary expertise has been established to hear the cause;

(5) Whether the debtor's insurer has assumed responsibility for defending the case;

(6) Whether the action involves primarily third-parties;

(7) Whether litigation in another forum would prejudice other creditors;

(8) Whether the judgment in another action is subject to equitable subordination (!?!);

(9) Whether the movant's success in the other proceeding would result in a judicial lien avoidable by the debtor;

(10) Judicial economy;

(11) Whether the parties in the other proceeding are ready for trial; and

(12) The impact of the stay on the parties and the balance of harms.

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It is important to remember that ongoing compliance with a non-compete is not dischargeable in and of itself, even if defending against the injunction would be costly. But still, an employer must show "cause" under Curtis to lift the stay and seek an injunction. The best argument for relief is that a denial of relief will moot any contract rights the employer has, because non-competes only last a short period of time (usually 6 months to 2 years). Conversely, an employee normally contends that the enforcement will hamper his ability to perform under a plan of reorganization (assuming a Chapter 13 case).

These are difficult interests to reconcile, and for that reason, bankruptcy courts will look to determine the likelihood an employer will prevail in a separate proceeding, and whether a non-compete injunction proceeding was well underway before the bankruptcy filing. Employees should not assume that bankruptcy court provides a safe have to avoid an injunction proceeding, as even that question is so fact-specific that it is difficult to predict accurately how a lift-stay motion will be resolved.

The "New" Defend Trade Secrets Act Gets an Important Revision

Congress is on the verge of agreeing on something.

While it may not be health care reform, a solution to illegal immigration, or taxes, it is agreement nonetheless. Count the little victories.

So what's the agreement? Landmark legislation affecting trade secret rights. The Defend Trade Secrets Act of 2016 is upon us, now voted favorably out of the Senate Judiciary Committee. There is no word yet on when the House of Representatives may consider the legislation or when a floor vote in the Senate may occur. But getting out of committee was a big deal.

(For my last summary of the DTSA, please click here.)

The Judiciary Committee also approved two amendments to the DTSA, some of which are technical but one of which appears vitally important. In the proposed section on Remedies, the DTSA provides that a court may grant an injunction to prevent any actual or threatened misappropriation of a trade secret, provided that the injunction "does not prevent a person from entering into an employment relationship, and that conditions placed on such employment shall be based on evidence of threatened misappropriation and not merely on the information the person knows."

The language, offered in the way of a substitute to the original legislation appears to be a firm rebuke of the so-called "inevitable disclosure" doctrine, which has divided courts across the country. Most attorneys feel there is a fine line between threatened disclosure of a trade secret, and "inevitable" disclosure. In all likelihood, that fine line rests on some indicators of bad faith, which could include facts like misleading a former employer about future plans or deleting e-mails outside the ordinary course of business.

The inevitable disclosure doctrine is badly overused and serves a crutch for employers to bring anti-competitive lawsuits. In reality, the contours of the doctrine should be exceedingly narrow to begin with and the doctrine only should apply to a narrow slice of cases. It always should be the exception, not a default theory of misappropriation.

The presence of this limiting, substitute language could have a profound impact on how and whether employers use a federal statute. For those who seek to bring weak claims founded on the shaky inevitable disclosure doctrine, federal courts may not be so welcoming after all.

A Tale of Two Non-Competes

It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness...

--"A Tale of Two Cities," by Charles Dickens (1859).

Perhaps (er, certainly) this is a little dramatic, but this is what I thought of after reading two recent preliminary injunction rulings in non-compete disputes. One comes from Ohio, the other from Minnesota. And they produce results you might not expect given the facts.

The first is Independent Stave Co. v. Bethel, in which the district court partially enforced a broad non-compete agreement against a log buyer, who made less than $100,000 per year. The agreement contained a geographically unlimited non-compete restriction. The court found the employee inherently credible. There was no evidence the plaintiff lost any business, or that the employee misappropriated anything. Yet, the court issued a broad injunction, even if it was not quite what the employer sought.

The second case is Wells Fargo Ins. Svcs. v. King, where a federal court in Minnesota addresses a narrow customer non-solicitation covenant, finds that the employee solicited all his largest accounts, and determines he was in blatant breach of his contract. And in that case, the court refuses to enforce the restrictive covenant, finding money damages adequate and that an injunction would do nothing to cause the "stolen" clients to revert to the employer.

***

So what to make of this? Non-compete disputes are inherently fact-specific and are not susceptible to easy classification. What may be important to one judge is not necessarily of interest to another. In the King litigation, the judge may have been convinced that the presence of the new employer in the case would provide the plaintiff a deep-pocket in which to satisfy a money judgment. Perhaps in the Bethel case, the court felt it was narrowing the agreement in such a way to craft a middle-ground option for the employee while protecting the ex-employer.

***

Although this list is not complete, here are a number of A-list factors that may influence a court's decision to award an injunction in a non-compete dispute:

1. Witness credibility (and in particular the employee's good-faith conduct apart from the issue of "breach).

2. Constructing a compelling narrative during an evidentiary hearing, so that the presentation is a story rather than an accumulation of evidence.

3. Whether the degree and impact of competition within the relevant market is explained and understood.

4. The ability to describe actual, as opposed to speculative, harm.

I have written on each of these topics many times, and no doubt there are many more. And it also bears repeating that in about 60 percent of cases that go to an evidentiary hearing, the plaintiff ends up prevailing on at least one of the major issues in the case. But at a micro level, as King and Bethel show, reconciling the outcomes can be awfully difficult.

Rule 5.6 and the Indirect Restraint

We lawyers love to make rules for ourselves.

As a regulated profession, lawyers are bound by their state's Code of Ethics. And while many of those provisions have nothing to do with competition, one rule in particular stands out. Model Rule 5.6 is the most widely known public-policy exception that invalidates non-competes. Through its text, Rule 5.6 prohibits a lawyer from entering into an agreement that "restricts the rights of a lawyer to practice after termination of the relationship, except an agreement concerning benefits upon retirement." Clients that come to me with a non-compete just love to hear that, legally, I can't even have one.

Despite the relatively clear nature of the rule, courts have not treated it uniformly and its bounds are not well-defined. Without fail, pure non-competition agreements are invalid. Therefore, lawyers cannot be bound by agreements that restrict their practice area or ability to service specific clients.

The more vexing question concerns the indirect restraint, known commonly as forfeiture-for-competition clauses. A typical forfeiture clause provides that an attorney who withdraws from the firm (normally an equity partner) suffers a reduction of what she otherwise is owed if she takes her clients with her. The contract, therefore, does not prohibit competition but amounts to an indirect restraint. It places a financial disincentive on competing directly for firm clients.

Is such an indirect restraint an impermissible restriction on the lawyer's right to practice. New York courts, for instance, have said "yes," that such clauses are unenforceable and against public policy. The state's Court of Appeals has said that a forfeiture-for-competition provision "would functionally and realistically discourages and foreclose a withdrawing partner from serving clients who might wish to continue to be represented by the withdrawing lawyer and would thus interfere with the client's choice of counsel."

One of the law's great anomalies is that the opposite view comes from the Supreme Court of California, where as a matter of policy non-competes are unenforceable in all lines of work. The Court in that case upheld a partnership provision that caused a withdrawing partner to forfeit withdrawal benefits if he practiced insurance defense work in a particular locale. The Court upheld the agreement, focusing on the changing nature of the law practice. In the Court's view, "these agreements address important business interests of law firms that can no longer be ignored." In fairness to this California decision and its seeming incongruity from the rest of non-compete law, the state's broad public policy restriction on non-competes does not apply to partnership contracts. So to this end, the state statute known as Section 16600 cannot provide a collateral source of rights for attorneys to attack forfeiture-for-competition clauses.

For its part, Maine goes further than California and declined to adopt an ethics rule similar to Rule 5.6. Lawyers, therefore, are free to sign non-competes without running afoul of that state's code of conduct. Just recently, a federal court in the District of Columbia - which had not addressed the scope of Rule 5.6 - predicted that it would follow New York's majority rule and bar indirect restraints.

Like many areas of non-compete law, this one is relatively unclear and varies from state to state. However, if lawyers are confused about the types of agreements to which they can be bound, they shouldn't expect sympathy from their clients in the real world. The landscape there is even more unsettled.

Writing Effective Cease-and-Desist Letters

For many business litigators, authoring a "cease-and-desist" letter is the go-to move when their clients face a threat of unfair competition. Although a cease-and-desist letter can be relatively easy in concept to draft, writing an effective one, however, is altogether different task.

The nastiness of a cease-and-desist letter often is inversely proportional to the actual threat posed by a competitor. In many cases, a strongly worded letter looks intimidating but rests on adverb-laden hyperbole, general legal principles, and unfounded assumptions of wrongdoing. These letters may placate a client, but they can do very little to help resolve a dispute. And the letter even can be a source of liability if it is defamatory or interferes with a person's employment opportunities.

So it's essential to write effective letters with a clear purpose. Having written and received many cease-and-desist letters over the years, I have distilled their principal, legitimate functions into three categories:

1. To notify a non-party of contract rights. Even if an ex-employee is clearly violating a non-compete, this does not entitle the enforcing party to seek a claim against the new employer. After all, the new employer may not know of the contract to begin with. In this respect, an employer can use the cease-and-desist letter (really, in this instance a "notification" letter) to establish on the record that the new employer is aware of the ex-employee's underlying breach. The issue of notice is particularly relevant to establishing a claim for contract interference.

2. To assist in making the case for injunctive relief. When an employer has clear evidence of a contract breach or trade secrets theft, a cease-and-desist letter may be an effective tool in helping secure an injunction. An ex-employee's refusal to respond to a clear call to action may prompt a court to understand that its immediate assistance is required. Judges never like hearing emergency injunction petitions, and an attorney who fails to make an attempt to resolve the situation before running into court may face some tough questions from a judge about whether she jumped the gun in filing a lawsuit.

3. To invite constructive follow-up from the recipient to resolve a potential dispute. Since most employers do not seek out litigation, an obvious purpose to a perceived threat is to avoid a dispute in the first place. In this respect, counsel faces a special challenge in drafting a letter in a way that pleases the client while also writing it to yield a constructive, amicable outcome short of a lawsuit.

On this third point, I have noticed that at least four out of every five cease-and-desist letters suffer from the same basic deficiency. They don't invite follow-up and simply generate a vaguely worded, unproductive response.

Something along the lines of this:

"In light of the above facts, Employer demands that you immediately cease and desist from violating the restrictive covenants contained in Paragraphs 1 and 2 of the Agreement, from maintaining any confidential information of Employer, and from interfering with Employer's business relationships. GOVERN YOURSELF ACCORDINGLY!"

Without commenting on the sheer idiocy of lawyers who include phrases like the last one, the call to action in the typical cease-and-desist letter's penultimate paragraph is highly ineffective. Assume the employee provides the letter to his new company. In most cases, corporate counsel will then take the heavy lifting. The cease-and-desist letter invites no response, and a savvy lawyer representing the new employer simply can respond with something as trite as the following:

"We can assure you that NewCo respects and honors its competitors' proprietary information and contract rights. We have assured Employee not to violate any enforceable terms of the Agreement, to disclose any confidential information, or to use any confidential information in working for NewCo. We have communicated your concerns to Employee, and if for any reason we suspect that she has ignored our admonitions, we will contact you promptly."

A more effective cease-and-desist letter follows a two-part format. It first lays out the known facts and the pertinent contract terms. It then reads like a series of specific, written interrogatories that require specific answers.

Examples of the types of questions that employers should ask in this interrogatory format include:

1. Have you contacted for business purposes any Restricted Client (as defined in the Agreement) since leaving Company's employment?

2. If yes to (1), which Restricted Client and what is the name of the key contact person at the client?

3. For each contact with a Restricted Client, what types of services did you sell or offer to sell to them?

4. Have you provided NewCo with any business information belonging to Company and, if yes, to whom?

5. Have you notified NewCo of the terms of the Agreement? If yes, please provide us a copy of that notification and any response NewCo gave to you.

6. Do you contend that any aspect of Company's factual investigation (as outlined above) is inaccurate, and if yes, please describe how.

***

These are illustrative examples. Each employee's situation, of course, is different and will demand some customization. The idea, though, is to write a very specific letter to get a very specific response. That response may necessitate further fact-gathering, further dialogue among the parties, or the filing of a lawsuit.

But if you serve a generic, threatening cease-and-desist letter, expect a crummy response that does nothing for your client.

The Three Categories of Business Information

The Sixth Circuit Court of Appeals recently had the opportunity to assess the three categories of business information that are at the center of nearly all non-compete and trade secrets cases:

(1) Trade secrets;

(2) Confidential information; and

(3) General skills and knowledge.

The question that often appears in lawsuits is to what extent the law protects these three categories of information. As discussed in Orthofix, Inc. v. Hunter (and countless other articles and cases), the law generally answers the question in the following way:

(1) Trade secrets are protected in most states by statutes (and in a few by the common law), irrespective of any contractual agreement. They are protected under the law of property and of confidence.

(2) Confidential information is protected if there is a specific contractual arrangement in place to do so, and information that does not rise to the level of a trade secret still can vest the owner with legal rights based on contract law.

(3) General skills and knowledge are protectable only through a non-competition agreement, which must be limited in time, scope, and duration. Importantly, the skills and knowledge must derive from the employment relationship - not the individual's free-standing experiences.

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Professor Orly Lobel has written that "[e]mployers have been going after employees for using what many courts have defined as general problem-solving abilities. In response, courts repeatedly struggle with separating trade secrets from employees' aptitude, mental and physical abilities, and skills." Talent Wants to Be Free (Yale Univ. Press), at p. 107. She notes several flash-points in the law, where courts have struggled and taken different views as to the three types of business information:

(1) Training (which some courts use as a justification for enforcing restrictive covenants);

(2) Negative know-how (or, the knowledge of what does not work); and

(3) Memorized or internalized information (the so-called "embedded knowledge" problem).

Coming up with a way to differentiate trade secrets and confidential information is not an easy task, but as a shorthand approach, trade secrets typically are used continuously in the operation of a business while confidential information tends to be more ephemeral and have a shorter shelf life.Though this question is difficult in its own right, the harder question may be coming up with an intelligible standard to divide confidential information from general skills and knowledge.

And it becomes more difficult when the subject "skills and knowledge" were developed on the job (as opposed to some pre-existing job experience). The Restatement (Third) of Unfair Competition provides only the following general guidance:

(1) Separating out general skills and knowledge from protectable business information is intensely fact-specific.

(2) Trade secret rights are recognized only in specialized information.

(3) Courts will assess whether the employee took some "physical embodiment of the information" with her.

Ultimately, the Restatement (and common sense) seems to suggest that if what the employer is trying to protect is central to the employee's marketability in general, then the information likely falls within general skills and knowledge. If, however, the employer is trying to protect something unique that others have been unsuccessful in developing, then legitimate trade secrets and confidential concerns arise.

In the Sixth Circuit's Orthofix case, the court addressed a common plus-factor that allowed the employer to retain rights to certain confidential information (without concluding the same was a trade secret). The employee who left took that information with him and apparently conceded that it would take months to recreate it. The value of this specific information to the employer, coupled with a physical taking, therefore removed it from the general-skills-and-knowledge category.

Illinois Federal Courts Continue to Turn Away from Fifield Rule

When it comes to non-compete agreements, the rift between Illinois state and federal courts continues to deepen.

The so-called Fifield rule generally holds that for employment itself to constitute sufficient consideration for a non-compete agreement, the employment must continue for a period of two years. As developed, the rule applies with equal force to both existing and new employees. In this respect, Illinois appears to drift further away from a minority rule on "continued employment as consideration." That minority position looks to whether the employment continuation is "substantial" but courts adopting this position have not done stated the rule with respect to new hires - only existing ones.

For all its analytical foibles, Fifield at least provides some guidance for lawyers when drafting contracts. This is the benefit of a bright-line rule. The downside, of course, is that bright-line rules do not adjust for idiosyncratic fact-patterns, which (in truth) define non-compete suits.

And therein lies the problem for federal courts.

Their charge is to predict what the state supreme court would say, and appellate decisions are persuasive but not binding. State courts must follow appellate authority, regardless of their disagreement with it. Federal courts now have tread their own path and mostly have found that Fifield is not a case the supreme court would follow. The rationale: courts look to the totality of the circumstances when assessing a non-compete's reasonableness, so the same view should color their view as to consideration.

The Northern District of Illinois followed this very reasoning in Traffic Tech, Inc. v. Kreiter last week when it decided not to follow Fifield, denying an employee's motion to dismiss a complaint on the grounds of inadequate consideration. Of particular importance to the court's decision was the defendant's decision to leave voluntarily and the $250,000 signing bonus he received at the time he was hired (regardless of whether it was earmarked as non-compete consideration). Kreiter would be decided differently were it a state court case.

Kreiter illustrates that non-compete disputes, at their core, often rest on notions of equity. The defendant's position simply was not as appealing as those found in other cases, where at-will employees received nothing other than a job, suffered a change in their commission structure, a reduction in their sales territory, or even were terminated. In this respect, if one views consideration as a reflection of "equity," Fifield tends to fall apart quickly. If one subscribes to the need for predictability, Fifield starts to garner more merit.

The federal courts' position on Fifield seems to rest on their view that the Supreme Court of Illinois views equity as the foundation for enforcement of non-compete cases. And equity, viewed under the "totality of the circumstances" approach, demands a very fact-specific assessment as to not only the agreement's terms but also what the employee received for signing it. It is likely that the federal courts are right on this point, but it continues to be a major source of discontent for non-compete lawyers and the clients they advise. And it means that, first and foremost, any attorney needs to look at jurisdictional rules when advising on a non-compete matter. That is no simple task.

End of the Year Post: Why I Support the Defend Trade Secrets Act

This year, I am taking a different approach for my end of the year post. Instead of recapping the year's highlights, I would like to give my perspective on the most significant development in the law of trade secrets and non-competes we're likely to see in some time: the likely passage of the Defend Trade Secrets Act of 2015. Here's my take:

***

On December 1, 2015, I added my name to a Trade Secrets Practitioners' Letter, which was sent to the U.S. House and Senate sponsors of the Defend Trade Secrets Act of 2015 (a copy of the proposed legislation can be found here).

The legislation, which is likely to pass with robust bi-partisan support, creates a federal civil cause of action for trade secrets misappropriation. If passed, federal law will protect all four branches of intellectual property rights - trade secrets, patents, trademarks, and copyright. It is no secret that trade secrets are an increasingly important component of our knowledge economy, and federal courts already are adept at handling these cases under their diversity jurisdiction call or as part of a case featuring a federal claim.

I was at first reluctant at supporting the DTSA, and I believed that state courts' traditional role at handling trade secrets and non-compete litigation was one that we lawyers should continue to honor. However, proponents of the DTSA have persuaded me to the merits of a federal cause of action. My rationale is different, though, than my counterparts. And although my specific reasons for supporting the bill are not contained in the Practitioners' Letter (my background is far to modest to even suggest offering changes), that's not essential to my endorsement of this potential new law.

So why do I support the DTSA? My reasons are two-fold. First, I believe federal courts have the muscle to parse out spurious claims of misappropriation and hold plaintiffs accountable for bad-faith filings. To this end, I think the existence of a federal cause of action will deter counsel from filing claims with a questionable factual basis, since federal district courts have a strong record of imposing fees for claims filed in bad-faith. State courts simply don't have this interest or capacity. The bench is often very close to the bar in state courts, meaning that judges understandably are reluctant to impose sanctions for frivolous claims. State judges also do not have the support of law clerks to conduct the necessary legal and factual research. They do not have the bandwidth to watch cases closely and are unable to engage in the type of analysis that is required to determine whether defense fee-shifting is appropriate.

Second, the changes to the Federal Rules of Civil Procedure (which went into effect today) are likely to reduce the cost of litigation and bring suits to trial more quickly than in state court. Federal courts, particularly with engaged and knowledgeable magistrates, have much greater capacity to monitor discovery for proportionality. The new rules are designed to achieve this end and should allow smaller litigants to defend cases more efficiently. State courts largely count on the cooperation of counsel to self-police discovery. Teeing up discovery disputes rarely leads to positive outcomes in state court, absent active judicial engagement. And unfortunately, many state courts lack this capacity. Therefore, I believe that the federal rules changes will cause counsel to try cases through the discovery phase more efficiently.

***

On November 15, a group of law professors wrote a lengthy letter opposing the DTSA. I do not believe their concerns are sufficient to override the DTSA's benefits at reducing litigation cost and remediating bad-faith claims. These are the concerns:

1. The DTSA's Ex Parte Seizure Provision May Harm Small Businesses, Startups and Other Innovators.

The DTSA contains a controversial provision that allows for the seizure (on an ex parte basis) of the instrumentalities of trade secrets theft. This is not the law's most outstanding feature, to be sure. But it's not an independent reason to defeat the law. For starters, I have a hard time believing that federal courts will warm to the idea of this remedy. It will be deployed sparingly. And the professors give judges short shrift. Judges are competent enough to snuff out abuses and impose damages for an wrongful seizure of property. This remedy potentially is a paper tiger, and it will work itself out in practice.

2. The DTSA Appears to Implicitly Recognize the Inevitable Disclosure Doctrine.

This argument stems from the provision of the DTSA that says a court may impose injunctive relief to prevent actual or threatened misappropriation, "provided the order does not prevent a person from accepting an offer of employment under conditions that avoid actual or threatened misappropriation."

How the professors conclude this endorses the "inevitable disclosure" rule is simply beyond me. No canons of statutory construction allow for this rather extraordinary position. Given the robust debate around the "inevitable disclosure" doctrine, the DTSA easily could have expanded the rights associated with seeking injunctive relief to bring the doctrine within the statutory language. It does not do so. To read some implicit endorsement of the doctrine is simply unreasonable.

3. The DTSA Likely Will Increase the Length and Cost of Trade Secret Litigation.

As discussed above, the opposite will occur - particularly given the change to the Federal Rules of Civil Procedure.

Separately, the Professors rely on a study showing that the cost of IP litigation ranges from $250,000 (for cases worth less than $1 million) to $1.6 million (for cases where over $25 million is at stake). However, this statistical evidence does not necessarily mean that trade secrets cases in federal court are more expensive. For starters, many of those cases are high-stakes patent cases. A lot of trade secrets claims are in the mold of employment (as opposed to IP disputes). Too, the Professors' reliance on this study assumes that the cost is lower in state court. I am not so sure about this, since state courts are more apt to grant continuances - the biggest cause of increased legal fees. With federal courts, you have some assurance that judges will enforce deadlines strictly.

4. The DTSA Will Likely Result in Less Uniformity in Trade Secret Law.

This justification also seems insufficient. The states have developed rules under the Uniform Trade Secrets Act, and with some exceptions, the law is indeed predictable. There are some differences in the Uniform Act concerning attorneys' fees availability and the statute of limitations. To this end, a federal law certainly will help bridge any differences.

It will take time for courts to resolve some areas of the law - like the "inevitable disclosure" doctrine - but it is very likely that courts will look to the laws in their states until such time as the circuit courts step in. That is a fairly long process that must play out, but it won't hurt parties and won't confuse lawyers. The permutations in trade secrets law among the states simply aren't that great that we will need to worry about having to cite to new law and new cases.

***

I realize that the arguments on both sides of this debate are well thought-out and well-intentioned. But having absorbed this debate now for a couple of years, I remain convinced that trade secrets lawsuit in federal court will weed-out weak, spurious claims and will result in a quicker disposition of cases by judges who have the staff to handle them.

Second Circuit Adopts Narrow View of Computer Fraud and Abuse Act

As the Second Circuit wades into the long-simmering fray over the Computer Fraud and Abuse Act, I am starting to wonder if this is all worth the trouble. In other words, do we have reason to be concerned about the CFAA reaching seemingly innocuous conduct, or is the statute working as intended?

For those unfamiliar with the dispute over this once-obscure law, the statutory language "exceeds authorized access" has divided federal courts for more than ten years. The CFAA imposes both civil and criminal liability for those who exceed authorized access from a protected computer and obtain certain types of information. The term "exceeds authorized access" means to access a computer with authorization and to use such access to obtain or alter information in the computer that the accesser is not entitled to obtain or alter.

The dispute in employment contexts almost always arises when an employee, before leaving to compete, accesses a company database and digitally copies proprietary files (they do not have to be trade secrets under the CFAA). The employee's access is technically authorized, but if the employee acquires information contrary to his duty of loyalty and then misuses company data, some courts have held that this improper purpose qualifies as "exceeding" authorized access. Other courts take the opposite view.

An interesting (and very disturbing) case from the Second Circuit has fueled this split in authority. The case is not an employment case and involves a disgusting set of facts that I won't repeat. The case of United States v. Valle arose when a New York City police officer accessed a computer program called Omnixx Force Mobile, which allowed him to search restricted databases like the federal National Crime Information Center database, to gain sensitive personal information about an individual. The purpose of his access was to learn details about a woman the officer knew from high school, and whom he and a co-conspirator intended to kidnap. As such, the officer had no valid law enforcement purpose for accessing the database.

Reversing a conviction under the CFAA, the Second Circuit waded into the fray over the meaning of "exceeds authorized access" and the application of that statutory term to the officer's conduct. The court acknowledged a deep circuit split over the term's meaning and then took a deep, even nauseating dive, into the CFAA's legislative history. After going through that exercise, the court ultimately found that both the narrow and broad view found some support. And because of that, the court determined that a criminal statute had to be construed narrowly (the so-called rule of lenity).

The Second Circuit then adopted the "parade of horribles" approach, articulated by Judge Kozinski in United States v. Nosal. In that case, Judge Kozinski described the potential reach of the CFAA if the court had authorized a broad definition of "exceeds authorized access," a reach that would in his view criminalize a wide range of innocuous, everyday behavior. The examples include an employee using a computer to check Facebook, in violation of a corporate computer policy and similar conduct qualitatively different than that before the court.

Given the Second Circuit's adoption of a narrow view (and its agreement with the Fourth and Ninth Circuit), the circuit split over the CFAA's reach has become deeper. It is possible that U.S. Attorney Preet Bharara will seek to file a petition for writ of certiorari over this question. Though Congress in the past has entertained amendments to the CFAA, no legislative activity is imminent. In my view, Congress easily could find a middle ground between the two lines of authority to ensure that the CFAA does cover the type of conduct at issue in Valle and even civil cases that resemble some form of insider hacking or sabotage.

But even though I have in the past endorsed the narrow view of the CFAA, I question whether prosecutors are abusing the law. While the result in Valle seems wrong strictly in terms of justice, the Second Circuit's reversal in no way suggests that prosecutors overreached by charging Valle under the CFAA. Nor am I seeing an overuse of the CFAA in the civil context. Cases like Nosal, to be sure, seem more appropriate for a civil remedy. But are they outliers? Is the CFAA actually being used selectively, rather than punitively? If so, then perhaps we need not worry so much about individuals being hailed into court based on a "confused, accidental, or otherwise inappropriate use" of a database (the coin the phrase used by the dissenting judge in Valle). Maybe we have struck the right balance and done our best with an imperfect law that can, at times, be used effectively.

Fifth Circuit Addresses Meaning of "Fundamental Policy" In Choice-of-Law Dispute

Choice-of-law clauses are one of the most important procedural frontiers in non-compete disputes.

State law concerning enforceability of covenants not to compete often contains unique twists and turns. Witness Illinois' rather unique rule on consideration in the at-will employment context. Increasingly, choice-of-law clauses are becoming prevalent in non-compete litigation. This paradigm arises because of our increasingly mobile economy where employees work for companies domiciled in other states, the effect of mergers and acquisitions, and corporate counsel's more informed awareness to selecting a particular state's law when drafting contracts in the first place.

I have written many times on the tensions posed by choice-of-law clauses, and generally courts need to assess several questions, including the connection that the chosen state's law has to the litigants. Choice-of-law clauses pose even more difficult questions when the state with the greater interest in the lawsuit has a strong public policy concerning non-competes.

A stark illustration of these choice-of-law rules comes from the recent Fifth Circuit case of Cardoni v. Prosperity Bank. The case involved a very common set of facts that can give rise to choice-of-law disputes. Prosperity Bank in Texas bought an Oklahoma-based bank called F&M, and in connection with that acquisition had key F&M employees sign new employment contracts governed by Texas law. Those contracts contained typical non-competition, non-solicitation, and non-disclosure covenants. Four bankers, who all were Oklahoma residents, then left to compete against Prosperity.

The Fifth Circuit's analysis of the choice-of-law clause focused on the degree to which Oklahoma's public policy was "fundamental" and whether it was sufficient to override the Texas choice-of-law clause. The court described the notion of a "fundamental policy" as an "elusive concept" but made clear to note that it is not one that focuses on assessing potential outcomes of the case. Put another way, courts do not look to whether the difference in state law changes the result at trial. The "fundamental policy" question must strike deeper than that. (This is not the standard in a minority of other states.)

As applied to the bankers' contracts in Cardoni, the court found that Oklahoma's public policy against enforcement of employment non-compete agreements was "fundamental" on account of its state statute. It is fairly safe to assume that a state's enactment of a statute directly concerning non-competes expresses the will of the people or, less colloquially, a "fundamental policy" for purposes of a choice-of-law analysis. Oklahoma, for its part, is one of a handful of states (along with California and North Dakota) that generally ban non-competes.

The court's analysis was different for the bankers' non-solicitation clauses, which the same Oklahoma statute generally permits. The law in Oklahoma is nuanced as to those clauses' permissive scope, but even the narrower limits of enforceability do not implicate a fundamental policy (at least in the Fifth Circuit's eyes). Therefore, in Cardoni, the court reached a somewhat unusual result that Texas law (the chosen law in the contracts) governed the non-solicitation covenants but not the broader non-competition covenants.

The result illustrates the importance counsel must pay to choice-of-law questions when cross-border disputes arise. It is crucial to examine the nature of the contacts the parties have to the competing states, the relationship of those contacts to the actual dispute, and the permutations of the law between the respective states.