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February 19, 2013 Articles

When Does Preparation to Compete Become Unlawful Conduct?

Courts strike a balance between duty of loyalty and free enterprise.

By David L. Johnson and Junaid A. Odubeko

Under America’s free-enterprise system, workers frequently leave their employers to work for or start new competing ventures. Questions arise about whether an employee may be deemed to have breached the fiduciary duty of loyalty owed to his employer by taking preparatory measures, while still employed, to compete with his employer after termination. A related issue has to do with whether an employee or a former employee may be deemed to have breached a noncompetition covenant by taking such preparatory measures.

Duty of Loyalty
Courts have widely held that an employee, regardless of position, owes his employer a fiduciary duty of loyalty through the duration of the employment relationship. See, e.g., American Fed. Grp., Ltd. v. Rothenberg, 136 F.3d 897, 905 (2nd Cir. 1998). Under this common-law duty, an employee must act solely for the benefit of his employer in matters within the scope of his employment and may not engage in conduct adverse to the employer’s interest. Id. at 905–06. Thus it is generally recognized that “[t]hroughout the duration of an agency relationship, an agent has a duty to refrain from competing with the principal . . .” Restatement (Third) of Agency § 8.04 (2006).

Courts have also consistently found that, in the absence of an enforceable restrictive covenant and/or the misappropriation of trade secrets, an employee is not bound by any duty to refrain from competing with his former employer after the termination of the employment relationship. As explained by the United States Court of Appeals for the Third Circuit,

[A]n employee after leaving the service of an employer may carry on the same business on his own and use for his own benefits the things he has learned while in the earlier employment. If this were not so an apprentice who has worked up through the stages of journeyman and master workman could never become an entrepreneur on his own behalf. Any such system of quasi-serfdom has long since passed away. Necessarily the former employee may use what he learned in the former employer’s business while engaged in business for himself or some business competing with the former employer.

Midland-Ross Corp. v. Yokana, 293 F.2d 411, 412 (3rd Cir. 1961).

A more challenging issue, however, concerns whether an employee’s fiduciary duty of loyalty restricts him, while still employed, from taking preliminary measures to compete in the future with his employer. As noted by the Texas Supreme Court, “[a]n employer’s right to demand and receive loyalty must be tempered by society’s legitimate interest in encouraging competition.” Johnson v. Brewer & Pritchard, P.C., 73 S.W.3d 193, 201 (Tex. 2002). Courts generally have held that an employee does not breach his duty of loyalty by preparing to compete with his employer, provided that the employee remains within certain parameters. See, e.g., Navigant Consulting, Inc. v. Wilkinson, 508 F.3d 277, 284 (5th Cir. 2007). The Restatement (Second) of Agency sets forth the following:

After the termination of his agency, in the absence of a restrictive agreement, the agent can properly compete with his principal as to matters for which he has been employed. Even before the termination of the agency, he is entitled to make arrangements to compete, except that he cannot properly use confidential information peculiar to his employer’s business and acquired therein. Thus, before the end of employment, he can properly purchase a rival business and upon termination of employment, immediately compete. He is not, however, entitled to solicit customers to such rival business before the end of his employment nor can he properly do other similar acts in direct competition with the employer’s business.

Restatement (Second) of Agency § 393 cmt. e (1958).

An employee’s intent is very important and, therefore, preparatory measures taken by an agent “may become wrongful when they constitute concerted action designed with the purpose of leaving the principal in the lurch.” Restatement (Third) of Agency § 8.04 cmt. b. Moreover, an employee should not take preparatory actions to compete while “on the clock” for his employer and/or utilizing the employer’s premises or property; nor should an officer usurp a corporate opportunity. Berman v. Sugo, LLC, 580 F. Supp.2d 191, 206 (S.D. N.Y. 2008); Scott v. Beth Israel Med. Center, Inc., 47 A.D.3d 541, 850 N.Y.S.2d 81 (2008). See also Restatement (Third) of Agency § 8.04 cmt. c (although an employee who plans to compete with his employer does not owe a duty to disclose this fact, the employee does owe a “duty not to mislead” his employer of his intentions).

Courts have expressed reluctance to draw a precise line of demarcation between permissible preparatory measures and impermissible measures. Instead, this issue typically is a “question of fact,” taking into consideration the totality of the circumstances. See, e.g., Cenveo Corp. v. Southern Graphic Sys., 784 F. Supp.2d 1130, 1136 (D. Minn. 2011); see also Maryland Metals, Inc. v. Metzner, 382 A.2d 564, 570 (Md. 1978). Most courts have held that an employee does not breach his duty of loyalty by taking steps to incorporate a competing business. For instance, in ACI Chems., Inc. v. Metaplex, Inc., 615 So. 2d 1192 (Miss. 1993), the plaintiff brought suit after one of its former employees incorporated a business while still employed and thereafter positioned that business to compete with the plaintiff within three months after the employee’s resignation. Finding that “an agent is entitled to make arrangements to compete even before his termination,” the Mississippi Supreme Court held that the employee did not breach his duty of loyalty. Id. at 1198. See also ProductiveMD, LLC, v. 4UMD, LLC, 821 F. Supp.2d 955, 964 (M.D. Tenn. 2011) (finding that an employee does not breach his duty of loyalty merely by “filing a corporate charter for a new competing company”).

Other preparatory acts that courts have deemed lawful include registering a trademark, Abraham Zion Corp. v. Lebow, 593 F. Supp. 551, 571 (S.D. N.Y. 1984); purchasing equipment, Maryland Metals, 382 A.2d at 571; negotiating for the purchase of a competing business, Tulumello v. W.J. Taylor Intern. Constr. Co., 84 A.D.2d 903, 446 N.Y.S.2d 673, 674 (1981); and opening a bank account and obtaining office space and telephone listings, Harllee v. Prof’l. Serv. Indus., Inc., 619 So. 2d 298, 300 (Fla. Dist. Ct. App. 1992). 

Courts have also generally held that an employee does not breach his duty of loyalty (or a nonsolicitation covenant) by advising his employer’s clients that he intends to resign and discussing his future plans. ProductiveMD, 821 F.Supp.2d at 964; American Credit Indem. Co. v. Sacks, 213 Cal. App.3d 622, 636, 262 Cal. Rptr. 92 (1989). However, if these communications are deemed solicitations, then the employee has crossed the line. Id.; Johnson, 73 S.W.3d at 202; Prof’l Energy Mgmt., Inc. v. Necaise, 684 S.E.2d 374, 378 (Ga. Ct. App. 2009).

Similar challenges are presented in instances in which an employee has arguably utilized proprietary information relating to his employer’s products to launch a competing product. Typically, the outcome of such cases has turned on whether the employee misappropriated his employer’s genuine trade secrets, in which case the preparatory conduct would be deemed a breach of the duty of loyalty as well as a misappropriation of trade secrets (although the latter cause of action may be preempted by the applicable state trade secrets statute). ProductiveMD, 821 F. Supp.2d at 964; Johnson, 73 S.W.3d at 202. For instance, in Taser Int’l, Inc. v. Ward, 231 P.3d 921 (Ariz. Ct. App. 2010), the defendant, a former employee of the plaintiff, was privy to the plaintiff’s proprietary information about plans to create a clip-on camera device. Shortly before resigning, the defendant began exploring the possibility of developing his own competing concepts, including consulting legal counsel, developing a business plan, and investigating and developing a clip-on camera device. After the defendant began marketing a competing product subsequent to his resignation, the plaintiff sued the defendant for breach of fiduciary duty (in addition to misappropriation of trade secrets).

The Arizona Court of Appeals found that the defendant did not breach his duty of loyalty by developing a business plan or by consulting with legal counsel, as such “pre-termination activities are qualitatively different than ‘direct competition’ and cannot form the basis for liability.” Id. at 927. The court similarly determined that “any preliminary research and development efforts aimed at assessing the possibility of developing a camera device did not constitute direct competition.” Id. The court, however, found that “substantial design and development efforts by [defendant] during his employment would constitute direct competition with the business activities of [plaintiff] and would violate his duty of loyalty.” 928. Therefore, the court concluded that this presented a question of fact for the jury and that summary judgment should not be awarded. Id.

Restrictive Covenants
This issue of preparing to compete also routinely arises in the context of an employee subject to a noncompetition covenant. Courts addressing such circumstances typically first apply a basic interpretation of contract principles to determine whether the contract precludes the employee from taking preparatory measures to compete. If the language in the contract is broadly worded as such, then courts will next determine whether such a broad restriction against preparing to compete is enforceable. See, e.g., J.T. Shannon Lumber Co, Inc. v. Barrett, 2010 WL 3069818 *6 (W.D. Tenn. 2010); Avisena, Inc. v. Santalo, 65 So. 3d 14 (Fla. Dist. Ct. App. 2011). As a general matter, it likely would be difficult for an employer to demonstrate that it has a legitimate, protectable business interest in precluding a former employee from merely preparing to compete during a restrictive period.

In Berardi’s Fresh Roast, Inc. v. PMD Enter., Inc., 2008 Ohio App. Lexis 4618 (Ohio Ct. App. 2008), the defendant sold his ownership interest in the plaintiff and, in connection with the transaction, was precluded from operating a business in the coffee industry for three years. Before the restrictive period elapsed, the defendant incorporated a competing business; approached lenders about financing; gathered information about pricing, products, and supplies; signed a lease; and equipped the facility. Id. at *4. Citing duty of loyalty case law that “preparing to compete does not equate to actively competing,” the Ohio Court of Appeals concluded that the defendant “was not actively engaging in the coffee industry” and “[i]nstead was merely making preparations so that he could commence business the day after the noncompetition agreement expired.” Id. at *14. See also Brooks Automation, Inc. v. BlueShift Tech., Inc., 2007 Mass. App. Unpub. Lexis 1, *5 (Mass. App. Ct. 2007) (noting that a former employee’s noncompetition covenant did not explicitly preclude preparation to compete and stating that “[n]o case in our jurisdiction stands for the proposition that a current or former employee, even one subject to a noncompetition agreement or a duty of loyalty, may not prepare to compete with his or her employer”).

Long-standing public policy principles of free enterprise support courts’ decisions to allow employees to engage in competition with their former employers, using their general knowledge, skills, and experience. This competition must be fair, however, and not place employers at an unfair competitive disadvantage. Provided that employees have not unfairly manipulated their relationships with their employers, courts have appropriately allowed employees to take preparatory measures to compete without running afoul of their fiduciary obligations. Moreover, courts have appropriately enforced reasonable contractual restrictions only to the extent necessary to protect an employer’s legitimate business interests. In doing so, courts strive to strike a fair balance between the interests of the employee to prepare the new venture and the interests of the employer, such as protecting its confidential information, its relationships with its customers, and its investment in employee training.

Keywords: litigation, business torts, duty of loyalty, free enterprise, preparing to compete, noncompetition covenant, restrictive covenants

David L. Johnson and Junaid A. Odubeko – February 19, 2013