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September 16, 2014 Articles

Examining the Duty of Loyalty and the Corporate Opportunity Doctrine

When an employee resigns, many factors must be considered to determine whether the employer has any legal recourse.

By Melissa M. Goodman and Janet Ayyad Ismail

Consider this scenario: Employee X, who has worked for Company A for several years but was employed at will and never signed any agreement containing restrictive covenants, has just resigned to start a competing business. In addition, Company A discovers that, as part of the competing business, Employee X will be exclusively offering a new product manufactured by one of Company A’s main suppliers. The new product falls squarely within Company A’s line of business and portfolio of products. Employee X has the exclusive right to market the new product for two years. Within a matter of months, Company A’s revenues begin to decline as Employee X’s business begins to flourish and the demand for the new product increases.

What can Company A do to protect itself from Employee X’s competition? The answer depends on many factors, including Employee X’s conduct during and after employment with Company A, Employee X’s position within Company A, and the circumstances surrounding Employee X’s exclusive right to market the new product.

Duty of Loyalty Employers expect each employee to act in the company’s best interest on matters within the scope of the employee’s employment. The duty of loyalty requires employees to do just that. All employees, regardless of position or at-will status, owe a duty of loyalty to their employer. The duty of loyalty requires employees to act solely for the benefit of the employer with respect to matters within the employee’s scope of employment, and it prohibits employees from engaging in conduct during employment that is adverse to the employer’s interest. SeeLamdin v. Broadway Surface Adver. Corp., 5 N.E.2d 66, 66–68 (N.Y. 1936) (finding breach of duty of loyalty where at-will employee engaged in a scheme to drum up business with customers in letters of credit (rather than the preferred method of cash) and employee received secret profits from the conversion of letters of credit to cash). The duty of loyalty has been shaped by the law of agency, which generally holds an agent to a duty of good faith and loyalty to its principal. See Navigant Consulting Inc. v. Wilkinson, 508 F.3d 277, 283–85 (5th Cir. 2007).

The duty of loyalty is not without limitations and is often tempered by the legitimate interest in encouraging competition. Therefore, courts have recognized that an employee may properly plan to go into competition with his or her employer and may even take steps to do so while still employed, without violating the duty of loyalty. See id. at 283–85. Absent contractual obligations to the contrary, the existence of a fiduciary relationship between the employee and employer does not preclude the employee from making preparations for a future competitive business and does not necessarily constitute a breach of fiduciary duties.

The range of activities that courts have held permissible as preliminary measures or steps to compete include the following:

• Incorporating or organizing a company. See Cooper Linse Hallman Capital Mgmt., Inc. v. Hallman, 856 N.E.2d 585, 592–93 (Ill. App. Ct. 1st Dist. 2006) (finding that former officer and former employee did not breach their fiduciary duties to the plaintiff, their former employer, where employees, while still employed with their employer, incorporated a competing business, drafted a business plan for the competing business and saved it on their employer’s computers, and began preparing advertising materials for the competing business); Harllee v. Prof’l Serv. Indus., 619 So. 2d 298, 300 (Fla. Dist. Ct. App. 1992) (stating that “an employee does not violate his duty of loyalty when he merely organizes a corporation during his employment to carry on a rival business after the expiration of his employment” and holding that opening bank account and obtaining office space and telephone listings while employed were permissible).

• Purchasing materials or supplies for a competing business. See James C. Wilborn & Sons, Inc. v. Heniff, 237 N.E.2d 781, 786 (Ill. App. Ct. 1st Dis. 1968) (finding no unfair competition or breach of duty of loyalty where employee formed a competing business and purchased machinery for the competing business before terminating employment with his employer).

• Drafting a business plan. See Cooper Linse Hallman Capital Mgmt., Inc., 856 N.E.2d at 592–93.

• Setting up a website in anticipation of forming a competing business. See Seastrunk v. Darewell Integrated Tech., Inc., No. 3:05-CV-0531-BF(G), 2008 U.S. Dist. LEXIS 26498, at *34–35 (N.D. Tex. Mar. 28, 2008).

Generally, an employee does not have a duty to disclose that he or she intends to leave employment or that other employees are leaving the company. See Abetter Trucking Co., Inc. v. Arizpe, 113 S.W.3d 503, 510 (Tex. App Houston [1st Dist.] 2003) (no petition).

Whether an employee has merely taken steps to compete or engaged in competition during employment is a fact-intensive inquiry. There is no bright-line test for determining permissible measures that may be taken to compete versus impermissible measures that are considered a breach of the duty of loyalty. However, courts have routinely held that employees who engage in the following activities while employed will be considered to have breached the duty of loyalty:

• Soliciting customers or employees, or both, to end their relationships with the employer while still employed. See Bancroft-Whitney Co. v. Glen, 411 P.2d 921, 936 (Cal. 1966) (en banc).

• Using or disclosing confidential information of the employer in a manner adverse to the employer. See North Atl. Instruments, Inc. v. Haber, 188 F.3d 38, 47 (2d Cir. 1999) (finding former employee’s use of his former employer’s list of client contacts to solicit contacts for competitor post-employment was a violation of duty of loyalty under New York law).

• Establishing and operating a competing company while still employed. SeeMolex, Inc. v. Nolen, 759 F.2d 474, 475–76 (5th Cir. 1985).

• Diverting a business opportunity to a competitor. See Design Strategies, Inc. v. Davis, 384 F. Supp. 2d 649, 660–61 (S.D.N.Y. 2005), aff’d, 469 F.3d 284 (2d Cir. 2006) (finding breach of duty of loyalty where employee encouraged potential customer to give its business to a competitor prior to employee resigning to join the competitor).

Thus, whether Employee X breached a duty of loyalty depends on what actions were taken during employment by Company A and whether those actions constitute permissible steps in preparation of competition or impermissible steps. Whether Employee X’s conduct crossed the line resulting in a breach of a duty of loyalty is typically a fact question. Employee X’s actions will be viewed in their totality to determine whether they rise to the level of competition during employment rather than mere preparation to compete. Preparing to compete during working hours and using the employer’s property or premises may result in a breach of fiduciary duty. In addition, Employee X’s intent is an important factor that will be analyzed in determining whether his or her conduct constitutes a breach of his or her fiduciary duty. See Restatement (Third) of Agency § 8.04 cmt. b (2006) (an employee’s actions “may become wrongful when they constitute concerted action designed with the purpose of leaving the [employer] in the lurch”).

Absent a contractual obligation not to compete or otherwise unlawful conduct such as misappropriation of trade secrets, the duty of loyalty does not prohibit employees from competing with their employer post-employment. However, the duty of loyalty may continue after separation from employment. For example, an employee may not compete with his or her former employer by exploiting accounts obtained in breach of the duty of loyalty during the employment relationship. In addition, an employee may be bound by the duty of loyalty post-employment based on knowledge acquired during his or her employment. SeeComedy Cottage, Inc. v. Berk, 495 N.E.2d 1006, 1011–12 (Ill. App. Ct. 1st Dist. 1986) (finding breach of fiduciary duty where defendant vice president/general manager used knowledge he gained as a result of his position within the company to lease the company’s building for himself; holding that although “defendant did not begin competing for the lease until after his resignation, defendant remained bound by his fiduciary duty because his acquisition of the lease was based upon knowledge acquired during his employment”).

Corporate Opportunity Doctrine The duty of loyalty prohibits an employee from diverting opportunities to a competitor of the employee’s employer. But can the employee take for himself or herself a business opportunity discovered in the scope of his or her employment? The answer depends on several factors, including the employee’s position within the company and whether the business opportunity belonged to the employer.

Under the “corporate opportunity doctrine,” an employee is prohibited from misappropriating a business opportunity that properly belonged to the corporation. It can be difficult to determine what constitutes a “corporate opportunity,” and the test varies by jurisdiction. Whether an opportunity properly belongs to the employer is a question for the trier of fact and is dependent on the factual circumstances existing at the time the opportunity arises.

Courts apply various tests to determine whether usurpation of a corporate opportunity has occurred. There are three tests that have been applied as standards for identifying a corporate opportunity: the “line of business test,” the “interest or expectancy test,” and the “fairness test.” Regardless of the test applied, it is generally recognized that “a corporate opportunity exists when a proposed activity is reasonably incident to the corporation’s present or prospective business and is one in which the corporation has the capacity to engage.” See Kelegian v. Mgrdichian, 39 Cal. Rptr. 2d 390, 393–94 (Cal. Ct. App. 2d Dist. 1995).

Pursuant to the “interest or expectancy test,” a corporate officer is prohibited from acquiring a business opportunity “in which the corporation has a ‘beachhead’ in the sense of a legal or equitable interest or expectancy growing out of a preexisting right or relationship.” See id. at 393–96 (analyzing whether plaintiff corporation established any corporate interest or intent to repurchase shares for the benefit of the corporation). In some jurisdictions, such as New York, the corporation’s ability to readily perform the work associated with the business opportunity is a significant factor in determining whether the employee should be liable for diverting that opportunity for his or her own benefit. If the corporation is unable to demonstrate it was capable of readily performing the work, the court is likely to find that the corporation did not have a tangible expectancy in the business opportunity; thus, it did not properly belong to the corporation. See Design Strategies, Inc., 384 F. Supp. 2d at 671–74.

The “line of business” test focuses on whether the opportunity is in the line of the corporation’s business and is of practical value to the corporation. Whether the corporation has the financial resources to take advantage of the opportunity is also a determining factor. Texas, Florida, and Delaware courts, among others, have applied the “line of business” test, which looks at (1) whether the opportunity embraced an activity that the corporation has fundamental knowledge of, practical experience in, and ability to pursue; (2) whether the opportunity was, logically and naturally, adaptable to the corporation’s business, with due regard to the corporation’s financial position; and (3) whether the opportunity was commensurate with the corporation’s reasonable needs and aspirations for expansion. SeeFarber v. Servan Land Co., 662 F.2d 371, 377 (5th Cir. 1981) (applying Florida law) (citing Guth v. Loft, Inc., 5 A.2d 503 at 511 (Del. 1939)); Imperial Grp. (Tex.), Inc. v. Scholnick, 709 S.W.2d 358, 365–66 (Tex. App. Tyler 1968) (writ ref’d n.r.e.).

The “fairness test,” which is the most subjective, focuses on the fairness of the employee’s conduct. Looking at the totality of the circumstances, whether a corporate opportunity exists is determined by an application of the ethical standards of what is fair and equitable to the facts. See Durfee v. Durfee & Canning, Inc., 80 N.E.2d 522, 529 (Mass. 1948). The “fairness test” is often applied in conjunction with one of the other two tests, as “fairness” is an underlying basis for those tests as well. See id.

Whether an employee is subject to the corporate opportunity doctrine may depend on the employee’s position within the company. In most states, including Texas and Delaware, the usurpation of corporate opportunity is limited to officers, directors, and majority shareholders who are fiduciaries to the employer. See DSC Commc’ns Corp. v. Next Level Commc’ns, 107 F.3d 322, 326 (5th Cir. 1997); Guth, 5 A.2d at 510–11. In other states, such as New York and Illinois, the corporate opportunity doctrine may extend to employees who are not officers, directors, or majority shareholders. See LCOR Inc. v. Murray, No. 97 C 1302, 1997 WL 136278, at *22 (N.D. Ill. Mar. 20, 1997); Alexander & Alexander of N.Y. Inc. v. Fritzen, 147 A.D.2d 241, 246 (N.Y. App. Div. 1st Dep’t 1989) (stating that the corporate opportunity doctrine applies to “corporate fiduciaries and employees”).

Ultimately, whether Employee X unlawfully diverted a corporate opportunity depends on many factors. If Employee X works in a jurisdiction where the corporate opportunity doctrine applies only to officers, directors, or major shareholders, Employee X may not be in breach of the corporate opportunity doctrine, depending on his or her position within Company A. Assuming Employee X is subject to the corporate opportunity doctrine, it appears the corporate opportunity is incident to Company A’s current business. Whether the opportunity is one Company A had the capacity to act on is likely relevant, as is the timing of when Employee X learned about the new product and the opportunity to market it exclusively. Assuming Company A had the capacity to act on the opportunity, if Employee X learned about the new product and kept the information secret instead of presenting the opportunity to Company A, Employee X is likely in violation of the corporate opportunity doctrine.

Conclusion  When an employee resigns to work for a competitor or start a competing business, the employer is likely to question whether the employee acted in the company’s best interest prior to leaving the company. Suddenly, the employee’s conduct before his or her separation of employment falls under the microscope, subject to heightened scrutiny to determine whether the employee engaged in any unlawful conduct. Did the employee breach his or her duty of loyalty? Did the employee divert a corporate opportunity? These are questions employers are frequently faced with, and many factors must be considered to determine whether the employer has any legal recourse.

Keywords: litigation, business torts, duty of loyalty, preparing to compete, corporate opportunity doctrine, duty to disclose corporate opportunities

Melissa M. Goodman and Janet Ayyad Ismail – September 16, 2014