THE EMPLOYEE PARADOX

1. THE EMPLOYEE PARADOX Thursday, May 21, 2009 Presented by: David C. Burton Sean M. Gibbons Michael C. Lord

2. The Employee Paradox • These are troubling economic times. As businesses struggle to keep their heads above water, they have to rely more and more on their most successful and profitable employees. • Unfortunately, these are the employees that can do the most damage to an employer if they become a competitor. • Let’s look at an example.

3. The Employee Paradox • Company A is a computer software design company that last year won a big contract with a fortune 100 company. The contract was obtained by the Vice-President of Sales John Smith. Smith is the biggest rain maker at the Company and he is highly respected by many of the employees. Smith has no employment contract and has threatened many times, usually when his yearly raise is discussed, to leave the company and take all of his friends with him. This year the company has asked Smith to sign an employment contract that contains numerous restrictive covenants. Negotiations have not gone well and a week ago Smith resigned his employment.

4. The Employee Paradox The day after Smith left, the president of the company, Jim Milktoast, arrives at work to find that Smith has cleaned out his office, including the files on which he was negotiating potential sales to several braches of the federal government and the military, and has made a copy of his computer hard drive, because “it contained his personal photo library, iTunes library, and checking account information.” Of course the computer also contained all of the company’s confidential financial information and pricing guidelines.

5. The Employee Paradox Three days later Milktoast learns that Smith has started up a branch office for a competitor right down the street in an office space Company A had been negotiating to take over. Suddenly, many of the employees that Smith brought to Company A resign to take jobs with Smith’s new company. Two days ago Smith’s clients start calling Milktoast stating they are moving their business to Smith because “Company A no longer has the ability to service them and the rumor on the street is that the company is going out of business.”

6. The Employee Paradox Milktoast thinks to himself, “Too bad I never got the employment agreement with Smith.” Despite not having an employment agreement with restrictive covenants, the company still has many protections. First we will focus on the law of fiduciary duty/duty of loyalty.

7. Duty of Loyalty Every employee owes his/her employer a duty of loyalty. This duty requires that while employed an employee: • Owes his/her employer an undivided duty of loyalty. • Should be careful to avoid taking any actions that are not in the best interests of his/her employer.

8. Duty of Loyalty (cont’d) • Does this mean that employees cannot moonlight. • State law immunizing employees from discipline while engaged in lawful activities “off the clock.” • Officers and directors of a company owe an even greater duty of loyalty.

9. Duty of Loyalty (cont’d) • The second component of loyalty is that an employee is prohibited from engaging in self-dealing and diverting or usurping opportunities that belong to his/her employer. Employees may not solicit clients of their employer while still employed by their employer. • This duty ends with employment unless the employee has violated his duty while employed or entered into an enforceable contract prohibiting post-employment competition.

10. Exceptions • Virginia does permit employees to prepare to compete while still employed as long as the following criteria are met: • The preparation occurs during non-working hours. • The employee does not solicit co-workers to take actions to leave the company through a process of mass resignations. • No proprietary or confidential information is taken or used to benefit the employee or the new employer. • The fiduciary duty continues to be owed after an employee starts a new business or joins a new company.

11. Exceptions • En masse hiring recognized in North Carolina as an unfair trade practice in unique circumstances. • In North Carolina, general rule is that employee’s breach of loyalty does not entitle the employer to sue. Instead, the misconduct provides the employer with justification to end the employment relationship and a defense against a claim of wrongful discharge. • A breach-of-loyalty claim, however, will lie against those few employees who can literally control the company.

12. Documents • Documents are deemed confidential if they contain: • Information designated in some way as confidential by the employer; or • Information that a reasonable employee should know that his/her employer does not want disclosed.

13. Restrictive Covenants Can protect the employer from: • Direct competition from former employees. • Former employees’ solicitation of clients and employees. • Former employees’ use of confidential information.

14. Non-Competes • One size does not fit all. • There is no “form” non-compete or non-solicitation. • Don’t “copy” old agreements because facts are always different. • Need to balance terms, no magic duration or geographic scope. • Don’t be greedy. • No “perfect” non-compete or non-solicitation.

15. Standard of Reviewfor Non-Competes Three-part Balancing Test: • Is the restraint, from the standpoint of the employer, reasonable in the sense that it is not greater than necessary to protect the employer in some legitimate business interest? • Is the restraint, from the standpoint of the employee, reasonable in the sense that it is not unduly harsh in curtailing individual’s legitimate efforts to earn a livelihood? • Is the restraint reasonable from a public policy standpoint?

16. Standard of Reviewfor Non-Competes Five-part Test in North Carolina. Covenant must be: • In writing. • Made part of the employment contract. • Based on valuable consideration. • Reasonable as to time, territory and post-employment activities in light of the legitimate business interests to be protected. • Consistent with public policy.

17. Time, Geography, Activities • Generally, courts will examine three factors. • Time:the duration of the restraint. • Geography:the geographic scope of the restraint. • Scope: the activity being restricted. • It is important to note that these elements are always balanced and weighed against each other in light of the facts of each case.

18. Time, Geography, Activities • What is reasonable amount of time to restrict an employee from competing with his former employer? • There is no magic number. • What is a reasonable geographic scope of a restricted covenant? • Several factors impact the analysis of a geographic limitation, including the: • Area or scope of the restriction. • Area assigned to the employee prior to termination. • Area the employee actually worked.

19. Time, Geography, Activities • Area in which the employer operated. • Nature of the employer’s business. • Nature of the employee’s duty and his knowledge of the employer’s business operations. • Thus, It is important for you to have a good understanding of your actual marketplace when considering a reasonable geographic scope. Practically, this is the easiest place for a court to shoot down the restrictive covenant.

20. Time, Geography, Activities • What activities are reasonably restricted? • Companies must narrowly tailor the activities that they are attempting to prohibit. The restricted activities prong has become a very popular prong to attack, not only based on the duties of the employee, but also based on the specific services provided by the company. • “Janitor defense.”

21. Non-Solicitation Agreements • Judges more inclined to enforce. • Still, you must make sure they are narrowly tailored. • Defining who a “client” is helps. • Someone who paid you, etc. • Provide some temporal scope, i.e. be careful to include someone that last paid you for services in 2003 in the definition of “client.” • Don’t overreach and include “prospective clients.” • Like non-competes, need a duration. • Also consider geographic scope issues.

22. Drafting Considerations • Strictly construed against employers. • Virginia courts have been unwilling to modify terms of an overly broad non-compete to make it enforceable. • North Carolina judges wield a limited blue pencil. • Agreements must be carefully drafted to accurately reflect the balance between the employer’s right to restrict competition and the employee’s right to earn a livelihood. It is important to ask what legitimate interests the agreement is designed to protect, and if none, perhaps consider not entering into the agreement.

23. Drafting Considerations • Non-compete agreements should specifically restrict competition by an employee only in the branches or lines of the employer’s business in which the employee has performed work. • Non-solicitation agreements should define “client” and “employees.” • Choice of Law provisions. Don’t automatically choose Virginia or North Carolina.

24. Drafting Considerations • Check for state statues on restrictive covenants (California, Colorado, Florida) that may make them unenforceable. • Check state law on “blue-penciling.” • You may want to include a “forum selection” clause. • Be careful about consideration. Continued employment provides adequate consideration in Virginia but not North Carolina. • If you use “continued employment” you better mean it.

25. Drafting Considerations • Consider using non-solicitation, anti-raiding, and confidentiality provisions without the need for non-competes. • If possible, include language that the non-compete clause is not intended to restrict the employee from performing work in some role that does not compete with the business of the employer.

26. New Employer ChecklistThings to consider when you are hiring someone: • Ask candidate if they have any agreements with current employer. If they do, have agreements reviewed by counsel. • Be sure that the departing employee has not made plans with other employees to bring them along. • If possible, avoid communicating with candidate via e-mail. In light of electronic discovery obligations, nearly all e-mails will be reviewed by the other side.

27. New Employer Checklist • Do not ask candidate for confidential salaries and/or pricing information of current employer. • Confirm that candidate has not disclosed any confidential information of current employer and inform candidate that you have no interest in such information. • Do not ask candidate to copy or take anything from current employer. • Avoid discussions about which clients and/or employees would leave current employer.

28. New Employer Checklist • You should not discuss when or how they should resign. But, you can discuss when you would like them to start. • Do not have candidate perform any services for you until actual employment begins. • Do not encourage candidate to solicit any customers or other employees prior to leaving their current employer.

29. New Employer Checklist • Send out announcements after employee begins working. • Do not suggest or encourage that candidate should divert any work to us until after start date. • Obtain acknowledgement that the new employees have not disclosed any confidential information from their former employer to us and that new employee will not violate enforceable terms of any contract.

30. Questions & Answers David C. Burton 757.473.5354 dburton@williamsmullen.com Sean M. Gibbons 804.783.6499 sgibbons@williamsmullen.com Michael C. Lord 919.981.4093 mlord@williamsmullen.com