One of the most high-profile non-compete disputes in the Chicago area has resulted in a victory for Citadel Investment Group and a set-back for two executives who defected to start their own high-frequency trading firm.

In a 36-page memorandum opinion and order Judge Mary K. Rochford enjoined Mikhail Malyshev and Jace Kohlmeier from violating non-compete restrictions contained in their Citadel employment agreements for the balance of the nine-month term. Effectively, this means that both Malyshev and Kohlmeier may be free to compete as soon as February of 2010, since the court refused to extend the non-compete term on an equitable basis for the period in which the defendants were in breach.

The case involves a shadowy, but highly profitable, business known as high-frequency trading (HFT). In essence, HFT relies on powerful computers to enter trade orders (often without human intervention), with algorithms deciding on specific aspects of the trade such as how much to buy, when, and at what price. HFT is a relatively new phenomenon, but it yields enormous profits. A disproportionate amount of equity trading volume is conducted by HFT firms.

Citadel itself invested heavily in HFT. It paid off - Citadel’s HFT unit reaped earnings of $1.15 billion in 2008. Malyshev and Kohlmeier were instrumental, key employees for Citadel’s HFT group. Neither had HFT experience prior to joining Citadel. For quite some time, each considered leaving to start his own proprietary trading firm. And each had a non-compete agreement, barring employment with a “Competitive Enterprise” for a period to be selected by Citadel upon departure, ranging from 0 to 9 months.

Upon their departure, Citadel elected the maximum 9-month period and paid Malyshev and Kohlmeier to sit on the sidelines. No surprise, there, given their access to proprietary information and involvement in recruiting R&D talent to Citadel. However, both ex-employees formed Teza Technologies and hired 15 employees, essentially daring Citadel to file suit.

It did. Citadel pursued each aggressively and sought preliminary injunctive relief. The court dispatched with a number of the arguments raised by the defense. Given that one of the defendants deleted a fair amount of Citadel information (despite a court order not to do so), the court really did not have to address whether a legitimate business interest supported the non-compete. The adverse inference it could draw about the document deletion was more than enough to demonstrate the defendants had access to and attempted to use Citadel’s confidential information.

The defendants also seemed to challenge the non-compete due to the fact that they really weren’t actively trading, but merely preparing the firm’s trading infrastructure to compete eventually. However, nothing in the non-compete allowed the defendants to wash their hands of liability based on this “preparing to compete” theory, and the theory itself ignored the fact that HFT firms depend heavily on building infrastructure. By getting a headstart in developing a trading platform, the defendants were essentially entering the market much faster than they agreed to under their employment contracts.

The most important feature of the decision, though, concerned the length of the injunction. And it is here where the defendants probably were able to take some solace in defeat. The court refused to extend, or equitably toll, the non-compete period for the time in which the defendants were in breach. The court looked at the Second District Appellate Court’s decision from two years ago to hold that, under Illinois law, a contract must specifically provide for an equitable tolling, or extension, remedy. Otherwise, the court will not imply the term under the contract.

This, of course, does nothing to mitigate the defendants’ damages during the non-compete period. But it does serve as a cautionary tale for counsel in drafting non-compete clauses. Unless an equitable tolling remedy is clearly contained in the contract, the court will not agree to extend it even if the defendants were in breach leading up to the injunction order.

The “inevitable disclosure” theory is by no means a panacea. In my opinion, it is more a tactic than a theory. For those unfamiliar, the doctrine serves a proxy for the term “misappropriation” in a trade secrets case. Put differently, instead of proving that a defendant misappropriated a trade secret - which are the basic elements of the case - a plaintiff need only establish that it’s inevitable he or she will do so.

Because application of the document can be tantamount to an implied non-compete, courts are understandably reluctant to apply it with any force.

Last year’s dispute between IBM and Mark Papermaster was somewhat of an anomaly, and people forget Papermaster had a non-compete. The case wasn’t just about inevitable disclosure. The doctrine helped aid enforcement of the agreement. The tougher cases involve employees who have no non-compete agreement, but who arguably have access to trade secret information.

Another New York case provides 2009’s most significant inevitable disclosure case to date, and it yields another employee-friendly result. The case involved the resignation of Charles F. Imhof, a senior-ranking employee of American Airlines’ New York Sales Division, who depared and left for Delta Airlines in a very similar capacity. Imhof had no governing non-compete agreement with American.

Not long before Imhof quit American, he e-mailed to a family account certain corporate documents, one of which was a 2008 sales presentation on Power Point. He also bought a personal digital assistant and transferred some of his business contacts to a personal hand-held device. Imhof’s departure was, initially, far from acrimonious - even when he disclosed where he was going. However, when American found out he e-mailed himself business information, it made a demand to Delta that Imhof cease working altogether.

At this point, Delta did what most sophisticated entities are doing now in the face of such demands. It conducted a litigation trade secrets audit, which included the following:

(a) immediately disclaim any need for Imhof’s American Airlines documents;
(b) facilitate destruction or complete return of the same; and
(c) conduct a thorough inspection of any digital medium to confirm no traces of the information.

Ultimately, those steps - along with the fact Imhof did not appear to have sent anything to Delta - ruined American’s chances to succeed on the inevitable disclosure doctrine.

District Judge Kaplan issued an interesting, thorough opinion. Of particular interest were the following comments:

(1) He found Imhof was not a threat to disclose any corporate information of American because Delta demonstrated no interest in anything and because the litigation itself obviously was a strong deterrent from doing anything suspicious in the future;

(2) Though Imhof did copy and send to himself a few documents, he did not copy a lot, which suggested a less-than-nefarious intent;

(3) Imhof was a sales manager - albeit a highly positioned one - not, in the words of the court, a “food chemist privy to the secret formula for Coca-Cola. The document upon which American relied was a 2008 sales presentation that contained rote talking points about how good the company was or what ends it sought to achieve (which, presumably, someone in sales would want known to others).

The last point is, in my opinion, most important because the theory of inevitable disclosure as applied to salesmen is considerably more abstruse. Access to “sales strategies” or “customer information”, for instance, may sound interesting in theory, but it’s tough to apply and define as a trade secret.

Sales operational information tends to become stale quickly and may be widely known or publicly available (as was the case with Imhof). Furthermore, it’s highly general. The following key passage from Judge Kaplan’s opinion elucidates this point rather powerfully:

“The lack of detailed information concerning what Mr. Imhof allegedly knows and why it is both confidential and important means that American essentially asks me to accept the word of those of its personnel who have described these matters in the most general of terms for the proposition that the details, whatever they may be, in fact would be harmful to American if used against it by Mr. Imhof at Delta. But, at the risk of banality, the devil is in the details. Without them, it is extremely difficult for me to know exactly what information American fears that Mr. Imhof inevitably would retain in his memory…“

Fender Musical Instruments Corporation, one of the acknowledged innovators in electric guitars, just lost a six year battle in which it was seeking to trademark some of the best-known (and best-loved) electric guitar body shapes, shapes it created more than fifty years ago.  Fender rocked the music world with its Stratocaster and Telecaster guitar and bass styles in the mid-1950’s, and the styles have become two of the most recognizable guitar shapes in the world.  Unfortunately for Fender, it made too many mistakes over the last fifty years and cannot fully capitalize on its innovation, as the United States Patent and Trademark Office Trademark Trial and Appeal Board has ruled (.pdf file) that Fender will not enjoy trademark rights in its iconic designs.

According to the evidence cited in the ruling, the 1960’s and 1970’s saw an explosion of guitar manufacturers issuing their own versions of guitars and basses modeled directly from the Fender Stratocaster and Telecaster body styles.  One manufacturer even testified that he obtained Fender guitars in the 1970’s and traced their bodies to create his own template to manufacture identically-shaped guitars.  Fender not only failed to object to the imitations, but also acknowledged them in advertising by exhorting consumers to buy “the true Fender sound” instead of one of the many “look-alikes.”  Finally, Fender actively pursued companies who used their trademarked names “Stratocaster” and “Telecaster,” and even pursued companies for copying the shape of their headstock (for the unitiated, that would be the opposite end of the instrument), but never pursued any claim of trademark regarding the body shape.

The end result is devastating - though the Board acknowledged that Fender had created iconic designs (one of which even appears as the generic picture of a guitar in the dictionary and in the clipart attached to this post), it determined that Fender could not assert a trademark in those designs because they are now a generic element that cannot be associated with a single manufacturer.  The Board said that Fender further compounded this problem by failing to even try to protect its body designs from copying while proving that it knew how by jealously protecting other design elements of the guitar.  The company has lost untold potential licensing fees from other manufacturers who testified they could not remain in business if they did not manufacture guitars using the classic Fender designs.

The opinion provides some simple and important lessons to anyone hoping to obtain or retain a trademark:

1. If you create a distinctive and recognizable variation of some consumer good, act to preserve your rights immediately;
2. Do not tolerate imitations or homages, no matter how flattering they may be; and,
3. Take some time to review all the possible design elements that may be subject to trademark or other intellectual property protections, to be sure that you are protecting all of your rights equally and sufficiently.

Resting somewhere on the continuum between actual misappropriation of trade secrets and inevitable disclosure is the notion that one can be liable for threatening to steal confidential information. While cases concerning inevitable disclosure are now legion, relatively few decisions have articulated what constitutes threatened disclosure under trade secrets statutes.

In IOSTAR Corp. v. Stuart, a federal district court in Utah started putting some parameters on this issue. The dispute arose when IOSTAR attempted to obtain funding for development of an aerospace on-board nuclear power technology. To qualify for a federal loan, IOSTAR needed to raise seed money - about $300 million in liquid assets. As with most start-up ventures, this brought together a diverse group of characters. IOSTAR affiliated with one Richard Busch, who had designed satellite communications technology, and it also began a relationship with a fundraiser - James Stuart - as well as an aerospact industry investor, George French. IOSTAR had plans to make French the majority shareholder in the company.

All three signed non-disclosure agreements, and it was clear all three had access to information IOSTAR felt was proprietary - financial information, technical reports, and contracts. By mid-2007, the relationship between French, Stuart, and Busch, on the one hand, and IOSTAR on the other had become frayed. Stuart quit as President, and French had all but given up on investing in IOSTAR.

In the late summer or early fall of 2007, French, Stuart and Busch had discussions about forming a business in the field of communications satellites and satellite power systems. It appears undisputed the intent was to compete in the same field as IOSTAR, which got wind of the plan when an e-mail was sent to Busch inadvertently at his former IOSTAR account. IOSTAR filed a lawsuit shortly thereafter under a variety of legal theories, including trade secrets misappropriation.

It was clear from the facts IOSTAR could not prove actual misappropriation of trade secrets by any of the defendants; it made no claim for inevitable disclosure. Its hoard of evidence consisted entirely on the mistakenly sent e-mail among its former key group of employees, a series of e-mails months before where the defendants discussed IOSTAR’s technology, and their retention of documents (which were not wrongfully acquired in the first place). Nothing indicated any of the defendants attempted to use IOSTAR information in their nascent (albeit competitive) venture.

The court had little trouble granting summary judgment on the trade secrets claim. In particular, the court distinguished between a risk of disclsoure, and a tangible threat to disclose. The statute did not guard against risk, which was too tenuous of a concept on which to order injunctive relief. Specifically, the court stated if it were to accept IOSTAR’s argument about the risk of misappropriation, “the Court would essentially be creating a mandatory injunction anytime a party lawfully obtains trade secret information and then leaves his employer to take a position in the same or a similar field. In many instances, this could even create an implied statutory noncompete clause simply by lawfully receiving and lawfully possessing trade secret information.”

The IOSTAR case teaches that mere access to trade secrets and an intent to compete won’t suffice. A plaintiff must show some intent or threat by a defendant to use specifically identifiable information in direct competition.

Back on February 17, I wrote about a temporary restraining order partially granted in the case of Hal Wagner Studios v. Elliott, a non-compete dispute out of the Southern District of Illinois. At that time, the court granted the plaintiff only part of what it requested - a TRO requiring the defendants to return certain business documents taken from their former employer prior to their sudden departure at the end of 2008. I also noted that the court declined to enforce the covenant not to compete against the main defendant, Kris Elliott. That said, the court warned Kris Elliott that - in essence - he was proceeding at his own peril.

Less than a month later, Hal Wagner Studios was able to obtain the broad relief it initially requested. As my previous post indicates, the dispute arises out of the photography services business. HWS sells photography and yearbook services to schools in a number of different regions, including Missouri and Southern Illinois. Kris Elliott was in the same business in 1994, at which time HWS purchased the assets of Elliott’s business. Apparently, Elliott’s non-compete agreement was signed at or around the time he sold his business to HWS.

The non-compete was fairly narrow, particularly for one arising out of the sale of a business. In essence, it barred Elliott from competing with school photography accounts in a defined territory which appears commensurate with the geographic region he serviced before the sale to HWS.

As with many change-in-control situations where the seller party is retained following a sale, the relationship deteriorated. At least from the court’s opinion, it appears the source of Elliott’s grievance with HWS concerned the amount of money he was being paid and his bonus structure. At the end of 2008, Elliott and his wife, Pam, led a mass exodus out of HWS’ Edwardsville, Illinois location. The resignations were abrupt and an array of key business documents and electronic files were missing. Pam Elliott, in an effort to avoid her husband’s non-compete restrictions, solicited at least 21 accounts in the former Elliott territory.

The primary issue at the preliminary injunction stage concerned the enforceability of the non-compete agreement in Kris Elliott’s contract. The contract was governed by Missouri law. Elliott’s main defense concerned his argument that HWS was in breach of its obligation to him by reducing his income and salary. In this respect, Elliott’s own words appeared to do him in.

The court cited a number of exhibits where it appeared Elliott agreed to the changes in bonus structure and salary rate, indicating that Elliott confirmed the alterations with Hal Wagner and appeared - at least at the time - satisfied with what he was being paid. Though it appears HWS could have been more diligent in complying with the requirement that any modifications be in writing, the court clearly had little sympathy for Elliott - particularly since he did not voice any objections about the change in pay and actually documented his consent to them.

The case did not discuss whether the non-compete agreement should be adjudicated under the traditional employee standard or the less stringent sale-of-business standard. In Illinois, it seems clear that the non-compete would be viewed under the sale-of-business standard, which in essence presumes that a legitimate business interest exists in favor of the promisee (here, HWS). The non-compete Elliott signed was incidental to the sale of assets to HWS. Whether it was included within the asset purchase agreement, a covenant not to compete, or an employment agreement is irrelevant.

Given the patently reasonable terms of the non-compete (a covenant far less restrictive than those typically seen in a sale of business) as well as the insufficient evidence adduced as to HWS’ alleged breach of contract, Elliott appears to have little hope of avoiding a permanent injunction for the balance of his non-compete term.

Finally, the injunction order issued by the court prohibited Pam Elliott, Kris’ wife, from soliciting accounts as well - despite the fact she had no governing non-compete agreement. This was an easy call for the court, as Pam’s work in recruiting HWS clients at her husband’s direction presented a paradigm case of impermissible indirect solicitation.

There are a number of obvious signs when a court will enforce a non-compete agreement, and this dispute presented quite a few of them, including:

(1) a non-compete signed in an arms-length transaction;
(2) the taking or misappropriation of important company documents;
(3) deletion of corporate data;
(4) surprise resignation or an orchestrated mass exodus of employees;
(5) trying to crawl through a non-compete loophole by funneling sales activity to someone not a party to the agreement; and
(6) confused third-party customers.

A federal district court opinion and order rendered last week highlights the problem of conducting discovery in a trade secrets case. Normally, it is standard operating procedure for the parties to agree on a protective order to facilitate the orderly, efficient flow of discovery. Indeed, the Uniform Trade Secrets Act actually requires a court to enter a protective order to safeguard against even “an alleged trade secret.”

In an Indiana dispute between administrators of yellow pages advertising, the parties were not quite so amenable to agreeing on the terms of a protective order. The defendants challenged the very entry of the protective order claiming that the trade secret information at issue was readily ascertainable in the industry. The court sensibly concluded that this argument went to the ultimate merits of the case, and that plaintiff’s allegations demonstrated good cause for entry of a Rule 26(c) protective order.

However, the court addressed a number of other concerns litigants have over the terms of the order. The Seventh Circuit, which includes federal district courts in Indiana, has taken a more hands-on approach to scrutinizing protective orders so that trial judges simply are not allowed to rubber-stamp agreed orders parties place in front of them. The case of Citizens First Nat’l Bank v. Cincinnati Ins Co., 178 F. 3d 943 (7th Cir. 1999), instructs that parties can keep trade secrets out of a public court record if:

(a) the judge satisfies himself that the parties know what a trade secret is and are acting in good faith in deciding which parts of the record are trade secrets; and

(b) the judge makes explicit that either party and any interested member of the public can challenge the secreting of any particular information.

In the case before it, the plaintiff proposed a protective order that did not have a sufficiently demarcated category of confidential information. Specifically, the proposed order defined “trade secrets” as “defined by Indiana Code Section 24-2-3-2 and Indiana case law.” The court demurred on plaintiff’s attempt.

However, the court accepted the plaintiff’s affidavit submitted in support of its motion in which plaintiff broke down categories of alleged trade secrets into sub-categories: Workflow Information, Order Information by Client, Billing Preferences by Region, Databases That Show Billing Preferences by Location and Region, Client Databases Detail by Location, Contact Databases, and Nat Reports by Region or Location. Each category contained examples and identifications of the types of data that plaintiff used to operate is business.

The court incorporated those terms and held that they were “sufficiently specific to satisfy the Court that the parties know what a Trade Secret is…” Finally, the court held that most of the information in the proposed protective order (except, oddly, for Non-Party Private Information) could be designated as “attorneys-eyes only.”

Entering a protective order in federal court - especially in districts within the Seventh Circuit - requires much more work and diligence than it does in state court. Normally, defense attorneys can mitigate any concerns about agreeing to or acknowledging that certain information constitutes a trade secret. The easiest way to do this is by inserting a simple clause that states a party’s mere designation of a document as “confidential”, or the other party’s decision not to challenge such a designation with the court, does not operate as an admission as to the trade secret or proprietary status of the document itself.

In fact, defense attorneys who challenge the propriety of a protective order in the first place will be hindering their own chances at discovery and will only add to the time and expense of litigation.

For some time now, many inside the Massachusetts technology community have been debating whether restrictive covenants have hampered its competitiveness, particularly with California companies.

On January 12, 2009, Rep. Will Brownsberger filed a bill to ban non-compete agreements in Massachusetts. The text of the bill makes void and unenforceable any written or oral contract “arising out of an employment relationship that prohibits, impairs, restrains, restricts, or places any condition on a person’s ability to seek, engage in or accept any type of employment or independent contract work, for any period of time after an employment relationship has ended.”

At first glance, the text contains one glaring loophole. It would not prohibit a non-compete if the initial relationship is between a principal and an independent contractor. The bill also does not address sale-of-business covenants, or covenants set forth in partnership or shareholder agreements. Presumably, those would still be valid.

If passed, the bill could be interpreted similar to Oklahoma’s law against restraints of trade, which prohibits non-compete agreements but not customer non-solicitation covenants. California recently rejected this so-called “narrow restraint” exception to Section 16600 of its Business and Professions Code, which contains a prohibition not all that dissimilar to what Rep. Brownsberger’s bill proposes.

A federal district case out of Southern Illinois illustrates the difficulty employers face in attempting to enforce restrictive covenants - even those reasonably drafted.

The case of Hal Wagner Studios v. Elliott arises out of the school photography business. HWS provides yearbook and portrait services to schools in the Southern Illinois area. At the end of 2008, several of its key employees defected to a competitor, Herff Jones, and immediately began soliciting key HWS accounts. HWS also produced substantial evidence that certain of the employees misappropriated a substantial number of corporate documents. To its credit, HWS listed the specific documents missing, produced logs indicating suspicious copying and printing activity, and outlined for the court how it would be harmed by the defendant’s use of those documents.

HWS also produced a non-compete agreement with the lead defendant, Kris Elliott. The non-compete was well-drafted and reasonably tailored; it only barred Elliott from soliciting school photography accounts which were in his defined territory or which he produced for HWS. (A separate aspect of the non-compete further barred Elliott from engaging in other competition with respect to those accounts, but the reasonableness of this clause was not discussed.)

HWS immediately filed suit and moved for a TRO on both the non-solicitation covenant and on several common-law claims seeking return of the information taken by the defendant group around the time of their mass exodus. The court denied HWS’ effort to prevent Elliott from soliciting clients, but granted an affirmative injunction mandating return of documents.

In denying relief on Elliott’s non-solicitation covenant, the court found that it was of questionable applicability under Missouri law because HWS had failed to pay Elliott commissions for a period of time. Though HWS claimed it adjusted Elliott’s salary instead, the court found that a provision of the contract requiring modifications or amendments to be in writing doomed HWS’ explanation. As such, and even though the court warned Elliott about the risks of further solicitation, the court could not issue a TRO in light of the likelihood HWS would not prevail on the merits.

The issue regarding return of documents proved easier for the court. Under a fiduciary duty theory, the court exercised its power of equity to demand immediate return and an accounting of documents HWS identified as missing. Key to this finding was the balance of harms analysis. Not only was HWS likely to prevail on the merits, but HWS was in a far worse position from not retrieving its documents than the defendants were from having unlawful continued access to them.

To its credit, the court issued a very specific TRO outlining by document name what should be returned and how the documents needed to be accounted for. Frequently, courts issue overbroad TROs without any degree of required specificity.