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CONTRACTS - RESTRICTIVE COVENANT - REIMBURSEMENT CLAUSE - PARTIAL ENFORCEMENT - REASONABLENESS - LEGITIMATE BUSINESS INTEREST - UNIQUE OR EXTRAORDINARY SERVICES

A "reimbursement clause" in an agreement between an employer and a former manager can be partially enforced to the extent necessary to protect the employer's legitimate business interest.

[SUMMARY] | [ISSUE & DISPOSITION] | [AUTHORITIES CITED] | [COMMENTARY]

SUMMARY

BDO, a national accounting firm, brought suit against Defendant, a former manager, whose "Manager's Agreement" acknowledged a fiduciary relationship between himself and the firm. Defendant agreed that if he served any of Plaintiff's former clients within eighteen months of his termination with the firm, he would compensate Plaintiff at a rate of one and a half times the amount Plaintiff had charged that client over the prior fiscal year.

Defendant subsequently resigned from the firm and this suit was initiated. During discovery, Plaintiff submitted a list of 100 former clients who had allegedly been lost to Defendant. Defendant denied having served some of the clients, averred that a substantial number of them were personal clients he had brought to the firm, and claimed that some were clients for whom he had not been the primary BDO representative on the account.

The New York Supreme Court granted summary judgment for the Defendant, finding that the reimbursement clause was an over-broad and unenforceable anti-competitive agreement. The Appellate Division agreed, and refused to enforce the covenant, holding that the entire agreement was invalid.

ISSUE & DISPOSITION

Issue(s)

Whether a "reimbursement clause" in an agreement between Plaintiff, a general partnership of certified public accountants, and Defendant, a former manager, which requires Defendant to compensate Plaintiff for serving any client of Defendant's regional office within eighteen months of his termination, must be invalidated as an unenforceable restrictive covenant.

Disposition

No. The Court of Appeals held that the reimbursement clause could be partially enforced to the extent necessary to protect Plaintiff's legitimate business interest.

AUTHORITIES CITED

Cases Cited by the Court

  • Columbia Ribbon & Carbon Mfg. Co. v A-1-A Corp., 42 N.Y.2d 496 (N.Y. 1977).
  • Gelder Med.Group v. Webber, 41 N.Y.2d 680 (N.Y. 1977).
  • Truck Rent-A-Center, Inc. v. Puritan Farms 2nd, Inc., 41 N.Y.2d 420 (N.Y. 1977).
  • Reed, Roberts Assocs. Inc. v. Strauman, 40 N.Y.2d 303 (N.Y. 1976 ).
  • In re Freemançs Estate, 34 N.Y.2d 1 (N.Y. 1974).
  • City of Rye v. Public Serv. Mut. Ins. Co., 34 N.Y.2d 470 (N.Y. 1974).
  • Karpinski v. Ingrasci, 28 N.Y.2d 45 (N.Y. 1971).
  • BDO Seidman v. Hirshberg, 247 A.D.2d 923 (N.Y. App. Div. 1998).
  • Singer v. Habif, Arogeti & Wynne, 297 S.E.2d 473 (Ga., 1982).
  • Holloway v. Faw, Casson & Co., 572 A.2d 510 (Md., 1990).
  • Philip G. Johnson & Co. v. Salmen, 317 N.W.2d 900 (Neb., 1982).
  • Technical Aid Corp. v. Allen, 591 A.2d 262 (N.H., 1991).
  • Smith Batchelder & Rugg v. Foster, 406 A.2d 1310 (N.H., 1971).
  • Peat Marwick Main & Co. v. Haass, 818 S.W.2d 381 (Tex., 1991).

Other Sources Cited by the Court

  • N.Y. Educ. Law §7404.
  • N.Y. Educ. Law §7409.
  • N.Y. Educ. Law §6509-6511.
  • N.Y. Comp. Codes R. & Regs. tit. 8, § 70.1.
  • N.Y. Comp. Codes R. & Regs. tit. 8, § 70.3.
  • N.Y. Comp. Codes R. & Regs. tit. 8, § 70.6.
  • Restatement (Second) of Contracts §184 (1979).
  • Restatement (Second) of Contracts § 188 (1979).
  • Blake, Employee Agreements Not to Compete, 73 Harv. L. Rev. 625, (1960).
  • American Institute of Certified Public Accountants Code of Professional Conduct §53, art II.
  • Denburg v. Parker Chapin, 82 N.Y.2d 375 (N.Y. 1993).
  • Leo Silfen, Inc. v. Cream, 29 N.Y.2d 382 (N.Y. 1972).
  • Purchasing Assoc. v. Weitz, 13 N.Y.2d 267 (N.Y. 1963).
  • Briskin v. All Seasons, 206 A.D.2d 906 (N.Y. App. Div. 1994).
  • Pezrow Corp. v. Seifert, 197 A.D.2d 856 (N.Y. App. Div. 1993).
  • Service Sys. Corp. v. Harris, 41 A.D.2d 20 (N.Y. App. Div. 1973).
  • Lincoln Steel Prods. v. Shuster, 49 A.D.2d 618 (N.Y. App. Div. 1975).

COMMENTARY

State of the Law Before BDO Seidman

The common law standard of reasonableness for employee agreements not-to-compete requires that the covenant: (1) be no greater than is required for the protection of the legitimate interest of the employer, (2) not impose undue hardship on the employee, and (3) not injure the public. Technical Aid Corp. v. Allen, 591 A. 2d 262, 265-66. If the covenant failed to satisfy one prong, it would be rendered invalid.

In New York, however, restrictive covenants in employment agreements have been held enforceable if they are: (1) reasonable with respect to time and area, (2) necessary to protect the employerçs legitimate interest, (3) not unreasonably burdensome to the employee, and (4) not harmful to the general public. See Reed, Roberts Assocs. v. Strauman, 40 N.Y.2d 303, 307 (N.Y. 1976). The rationale for this test was that "powerful considerations of public policy militate against sanctioning the loss of a mançs livelihood." See Purchasing Assoc. v. Weitz, 13 N.Y.2d 267, 272 (N.Y. 1963). New York also adopted an alternate standard when dealing with agreements not-to-compete between professionals: the court will give greater weight to the interests of the employer in restricting competition within a defined geographical area. See Karpinski v. Ingrasci, 28 N.Y. 2d 45, 49 (N.Y. 1971). This standard has been justified on the ground that professionals provide unique or extraordinary services.

With respect to time, restrictive covenants have been enforced even if the parties agreed never to compete. See id. With respect to the geographic area, covenants have been enforced if "coverage coincides precisely with the territory over which the practice extends." See Id. at 50. Unless the employee had engaged in unfair means of competition, protection of the entire client base of a national organization whose customers "names and addresses were readily found by those engaged in the trade," was not considered a legitimate employer interest. Leo Silfen, Inc. v. Cream, 29 N.Y.2d 382, 393 (N.Y. 1972). Restrictive covenants have not been held invalid simply because they were unreasonably burdensome to the employee. "Harm to the general public" has been the sole test used to invalidate restrictive covenants entered into by lawyers. See Denburg v. Parker Chapin, 82 N.Y.2d 375, 380 (N.Y. 1993).

Generally, courts have held overly broad restrictive covenants unenforceable. See Briskin v. All Seasons, 206 A.D.2d 906 (N. Y. App. Div. 1994); see also Pezrow Corp. v. Seifert, 197 A.D. 2d 856 (N. Y. App. Div. 1993). In one instance, however, the court indicated that it had power to enforce such covenants partially but refused to do so because of an insufficient record in that case. See Columbia Ribbon & Carbon Mfg. Co. v. A-1-A Corp., 42 N.Y.29 496, 499 (N. Y. 1977). Partial enforcement of an overly broad restrictive covenant was eventually permitted in Karpinski. See 28 N.Y. 2d at 53.

Injunctive relief has been granted if the employeeçs services were unique or extraordinary, the covenant was reasonable, and there was no indication of fraud or overbearing on either side. See Reed at 308; see also Service Sys. Corp. v. Harris, 41 A.D.2d 20, 23 (N.Y. App. Div. 1973). Injunctive relief has been granted to a member of the medical profession even when the employeeçs services were arguably not extraordinary or unique. See Karpinski, 28 N.Y. 2d 45 (N.Y. 1971). Injunctive relief has also been granted when the employeeçs knowledge qualified for protection as a trade secret. See Lincoln Steel Prods. v. Shuster, 49 A.D.2d 618, 619 (N. Y. App. Div. 1975).

In addition to injunctive relief, actual damages suffered during the period of the breach have been awarded. See Karpinski at 53. Courts have generally refrained from awarding both liquidated damages and injunctive relief. See Id. at 53.

Effect of BDO Seidman on Current Law

In BDO Seidman the Court upheld the four pronged reasonableness test for determining a restrictive covenant's validity. An employer has the right to forbid a former employee, through a restrictive covenant, from servicing a client that was acquired through direct, substantive work for the employer in the course of the employee's tenure at the employer's business. Restrictive covenants, however, that reach beyond this scope are overly broad and thus invalid. For example, extending the restrictive covenant to cover BDO's clients with whom the Defendant never had contact would render the agreement overbroad.

The Court also upheld the additional considerations previously recognized for the validation of restrictive covenants in the professional arena; namely, if the professional is located in a rural area or if the professional is deemed to provide "unique or extraordinary services." BDO at para. 9 (citing Gelder Med. Group v. Webber, 41 N.Y.2d 680 (N.Y. 1977); Karpinski v. Ingrasci, 28 N.Y.2d 45 (N.Y. 1971)).

The decision, however, highlights that the application of the reasonableness test must ultimately be based on the specific factual circumstances that gave rise to the covenant. The Court required that the lower courts apply the reasonableness test to professionals in the same manner as it is applied to non-professionals. The Court stressed that the "learned profession" provisions must not diminish the need to carefully apply the reasonableness test and analyze its results in the context of restrictive covenants.

The Court upheld the power to grant partial enforcement for an overly broad employee restrictive covenant, as long as the unenforceable aspect is not an essential part of the restrictive covenant. This is an explicit rejection of a per se rule which would invalidate an entire restrictive covenant even if only a non-essential part of the document is rejected by the court.

Unanswered Questions

In BDO Seidman the Court found that the covenant was not coercive, and stressed as part of this finding, that the covenant was imposed in connection with promotion to a position of responsibility, not as a condition of initial or continued employment. Would the Court have decided differently if the covenant had been imposed at the time of initial employment? Is it possible that a covenant that was entered into by the employee in connection with a promotion could under some circumstances be considered coercive?

The Court refused to apply case law that had enforced restraints on competition. In support of its decision, the court cited the fact that BDO is a "national accounting firm seeking to enforce the agreement within a market consisting of the entirety of a major metropolitan area." BDO at para. 10. What is the standard for determining if this case law is triggered? More specifically, if BDO were a local firm, would this fact be enough to trigger such case law? If BDO had been a national firm, but only trying to restrict competition in a rural area, would the case law be triggered? Or must both criteria be met in order to enforce a restraint on competition? Is this an attempt by the court to narrow the definition of the "unique and extraordinary" requirement?

It is conceivable that a firm may have serviced a client in the past, the client left the firm for another firm, and then independently decided to hire the employee after the employee left the firm. Since the covenant would provide damages because the employee serviced a client, would this rule invalidate the covenant? Would such servicing conflict with any legitimate interest of the employer?

Survey of the Law in Other Jurisdictions

As the Court notes, other states' courts have invalidated covenants not to compete based on such covenants failing to differentiate between clients independently recruited by the employee and clients the employee serviced while working for the employer. In 1991, a Texas court found a partnership agreement, requiring damages for provision of services to any client within twenty-four months after termination, was overly broad and an unreasonable restraint on free trade. See Peat Marwick Main & Co. v. Haass, 818 S.W.2d 381 (Tex., 1991). The Texas court, however, abrogated the entire agreement; the Texas approach is unlike that adopted by New York, in which the Court blue-penciled out only the clause that penalized the employee for taking work from clients the Defendant independently recruited. Other states which have adopted the Texas approach include New Hampshire, see Smith Batchelder & Rugg v. Foster, 406 A.2d 1310 (N.H. 1971) and Nebraska, see Philip G. Johnson & Co. v. Salmen, 317 N.W.2d 900 (Neb. 1982).

Georgia, like New York, invalidated a liquidated damages clause in a covenant not-to-compete because the covenant was not limited to what was necessary to protect the employer's legitimate interests and because it was not limited to providing damages only for those clients that the former employee had serviced. The court thus determined that the agreement was overly broad. See Singer v. Habif, Arogeti & Wynne, 297 S.E.2d 473 (Ga. 1982).

Not all courts have taken such an unfavorable view of covenants not to compete. The highest court in Maryland found that a covenant not to compete may be valid, and that the determination must be made on a case by case basis. Holloway v. Faw, Casson & Co., 572 A.2d 510 (Md. 1990). The court upheld a covenant not to compete that provided damages for any clients of the employer's firm serviced by the former employee. Maryland, therefore, appears to grant wider latitude to covenants not to compete than does New York.

Prepared by:

  • Cassie R. Ehrenberg '00
  • Stacey Hanna '01
  • Richard Mills Robertson '01
  • Matthew E. Morningstar '01
  • Eric M. Sprague '01
  • Rebecca J. Whitcombe '01