The Chicago Tribune’s business reporter, Ameet Sachdev, writes this morning on the hotly contested dispute between Kathleen Lawlor and North American Corp. of Illinois, a case recently tried to judgment in the Circuit Court of Cook County.

The dispute touches on a number of hair-trigger employment law issues, including rights to privacy, unpaid commissions, theft of confidential information and threats to steal customers. It also makes an oblique reference to another issue that always underscores the difficulty of employment litigation: Lawlor’s attorneys’ fees have approached $1 million.

The case involves the marketing services industry, and the dispute arose right after Lawlor, a successful salesperson, left in 2005. She claimed she was owed accrued commissions, and her employer feared she would steal customers. It also had her followed by a somewhat amateur gumshoe, a fact that would later prove to be damaging to North American.

There was no hint in Sachdev’s article that Lawlor was bound by a non-compete contract, so North American was left to pursue common-law remedies. It found potential smoking guns when a North American consutant swore out an affidavit that Lawlor offered to introduce him to a competitor before she quit, and when Lawlor disclosed historical sales and margin data to a competitor on a job interview.

This conduct directly implicated Lawlor’s duty of loyalty to her then-employer. That duty prohibits an employee from disclosing confidential information, facilitating a mass exodus of co-workers, and diverting business opportunities away from the employer. Employees must take this duty seriously - a violation can result in salary forfeiture during a period of disloyalty, an injunction against competitive conduct (even in the absence of a non-compete agreement), and punitive damages.

At trial, the parties appeared to split their claims against one another. Lawlor ended up prevailing on her invasion of privacy claim, after North American’s overzealous investigators improperly obtained Lawlor’s phone records and gave them to the company. North American, on the other hand, was able to obtain some measure of compensation forfeiture, presumably based on Lawlor’s pre-termination activity with existing customers or improper disclosure of North American financial data. Despite relatively low actual damages ($78,781), the trial judge imposed punitive damages of $551,467 - a multiple of seven.

Aside from the enormous fees generated in this case, the litigation serves as a reminder that the absence of a non-compete agreement does not - by any stretch - sanitize an employee’s conduct on the way out the door. Breach of the common law duty of loyalty provides for extensive legal and equitable remedies. Proving such a claim can be difficult for an employer, but if the employer is able to marshall evidence of improper pre-termination activity (often learned through a forensic examination of the ex-employee’s computer), it may be able to put a halt to anti-competitive conduct and obtain significant monetary relief.

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 sights are off on the Second Amendment debate as both sides miss the target strictly for political reasons. The debate takes aim at personal and home defense by the law-abiding and the competing rights of criminals, ignoring the rights of the people to ensure the security of “free” States. Thus, in another politically-charged 5-4 opinion, District of Columbia v. Heller, and its later interpretation, both sides continue to overreach and ignore facts, then decry each other for doing exactly that, as I have noted in my previous blogs on these partisan opinions.

The Right consistently overplays its hand to excite political passions by claiming the Second Amendment secures law-abiding citizens’ ability to have guns to defend themselves and their homes against criminals. If this tack cannot mobilize conservatives, nothing will. The Left likewise overreaches to excite political passions by invoking circular reasoning to abrogate any right to keep and bear arms and thus allow gun bans purportedly to protect innocent bystanders, including “the children.” If this tack cannot mobilize liberals, nothing will.

Despite the urgings of the Heller majority, the Second Amendment is not rooted in personal and home defense but ensures only that “the people” have armed militias ready to protect the security of free States (particularly where police cannot or simply will not). The best modern example of this is New Orleans after Katrina, where police either evacuated or were overwhelmed and thus could not provide security for that portion of the free State of Louisiana. (Only because rampant criminals threatened security there was personal and home defense involved.) The people who remained, without police and effectively having been disarmed, were unable to invoke their militia to provide security and instead had to wait days for the US military to do so. This is exactly why militias always are necessary and exist in at least inchoate form.

Willfully ignoring this example, the Heller dissents quickly dismiss such state militias as “obsolete” and no longer in existence, disposing of any constitutional right of the people to keep and bear arms. Yet constitutional rights are not so fleeting, which is why amendments are so difficult to pass. (Indeed, if imaging technology eventually obviates physical searches, will these dissenters likewise dismiss as “obsolete” the right against unreasonable physical searches?) This hasty disposition of state militias enables the specious claim that the right to keep and bear arms relates only to military action and thus cannot be infringed only as to that purpose. Yet without state militias, the only possible military action is under the federal government, meaning the only guns it cannot take from the people are those used in serving its own military. But the Bill of Rights guarantees rights of the people against the federal government. The dissents even note that the Second Amendment was written out of fear that a federal standing army (which, of course, police never would fight against) could threaten the security of a free State.

The more sound reasoning is that the principally controlling plain language of the Second Amendment guarantees the right of the people to keep and bear arms for having state militias ready to provide security for their free States (or portions thereof) when the people’s security “proxies” can or will not. It is not hard to fathom an Al Qaeda cell storming a municipality and overwhelming local police, leaving a disarmed people helpless until other police and US military can arrive. There, the militia will be the first responders with the best chance of stopping the carnage that likely would ensue before other police or US military could respond. And with the right to keep and bear arms ensuring militias are ready for such security purposes, those arms will be available also to defend ourselves and our homes against criminals and otherwise.

The Fourth District Appellate Court of Illinois has just made it substantially more difficult for employees to break their non-compete agreements.

Justice Steigmann authored an opinion that built upon his special concurrence two years ago in Lifetec, Inc. v. Edwards, a case where he called into question the applicability of the so-called “legitimate business interest” test used by Illinois courts to analyze restrictive covenants. This time around, Steigmann succeeded in convincing his robed colleagues to abandon the test altogether, overturning a number of Fourth District cases in the process. The decision does nothing to alter the test in other districts, and each of those still uses the test which is widely believed to be employee friendly.

By way of brief background, Illinois courts have essentially used a two-part analysis to determine whether a non-compete agreement is valid. First, it must be reasonable in scope. Second, it must protect a legitimate business interest. The second part of the test demanded an employer show that it had an interest in misuse of confidential information or near-permanent customer relationships acquired through the employee’s association with the employer. This is not a marked departure from what other states require, though some would argue Illinois is fairly narrow in not recognizing other types of business interests, such as special training. However, Justice Steigmann could not find Illinois Supreme Court authority for part two of the test.

By reviewing Supreme Court precedent, Steigmann is correct in that the Court never formally adopted the test which has been used for years by all five district appellate courts. He casually neglects to mention that in the past 60 years, the Court has taken on a grand total of six non-compete cases, and several of those looked at covenants outside the employment context. His analysis is not entirely accurate because his discussion also neglects to confront one of the Court’s leading precedents, House of Vision v. Hiyane. That case was authored by Justice Schaefer, probably Illinois’ most famous jurist.

In House of Vision, the Court specifically discussed at length the interest of a business in protecting customer relationships. It even distinguished prior precedents (also cited by Justice Steigmann) where the Court noted that in a sale-of-business non-compete, the legitimate interest to be protected concerned intangible goodwill. Covenants ancillary to a sale of a business are always easier to uphold, and it may well be true that a legitimate business interest is virtually presumed in such circumstances. But it seems illogical that the Court would discuss a legitimate business interest in connection with a sale-of-business covenant, and then deem the test inapplicable to more problematic employment covenants. Steigmann has assured us the Court will have to take an employment non-compete case soon to resolve the tension between the Fourth District and the rest of the state’s appellate courts.

Justice Steigmann’s analysis defaults to the reasonablenes test he cites from what he considers binding precedent: an employer must show that the covenant is no greater than is necessary for its protection. As applied to the facts involving Sunbelt Rentals and Neil Ehlers, the court concluded the 50-mile non-compete was reasonable even though the employment agreement also contained a well-drafted client non-solicitation clause.

It’s hard to see, though, how a court can determine whether a covenant is “no greater than is necessary for its protection” without analyzing what business interest it seeks to protect in the first place. The legitimate business interest test fills that vacuum and allows a court to fashion an appropriate restraint, or strike one entirely if the employer can’t articulate the need for a restriction.

One of the most significant risks facing a business seller is the cost associated with educating a potential purchaser in the event a deal falls through. It is standard practice to require any potential acquirer to execute a non-disclosure agreement, but the breadth of that contract can go a long way to mitigating the seller’s risk.

Most buyers will balk at an industry non-compete clause following failed negotiations. Indeed, in most cases, the buyer will already have substantial experience in the seller’s business. But often times, a general non-disclosure clause will not be enough to protect the seller. A recent case out of Alabama serves as a compelling example.

In 2006 and 2007, an entrepreneur named Mark Greenshields became interested in purchasing a video-racking division owned by Movie Gallery US, LLC. This business involves placing movie rentals in racks at consumer locations, such as grocery or convenience stores. The deal fell through in May of 2007, and Greenshields started his own video-racking business shortly thereafter. He hired three former Movie Gallery employees within a few months after the transaction imploded, and the new business eventually took about ten former Movie Gallery customers.

It’s not at all clear that the defendants’ monetary exposure was that great. Movie Gallery itself had been losing money in this business and was trying to jettison the video-racking division to focus on more profitable business segments. However, it sued Greenshields and the entities he formed for breach of the transaction non-disclosure clause.

The court, ruling under Alabama law, found that Movie Gallery failed to prove that the defendants breached any confidentiality obligation. Noting the evidence largely was circumstantial, the court highlighted the following as important flaws in Movie Gallery’s theory of breach:

(1) Less than half of the defendants’ new customers were ex-Movie Gallery customers;
(2) Ten customers was a relatively small number given that three former employees were working full-time in the business;
(3) No profitability analysis was ever conducted on the lost customers, suggesting that there was no evidence defendants targeted profitable, quick-paying accounts;
(4) The supply sources were known by the new employees given their long history in the business;
(5) The customer lease agreements were drafted by defendants’ counsel, and the terms were generally known in the business and ascertainable simply by asking the customers themselves.

The court was unable to make the leap in logic demanded by Movie Gallery: that Greenshields had to be using information disclosed to him during due diligence of the failed transaction. The following summarizes succinctly the quandary faced by the court, which suggests it believed Movie Gallery should have required Greenshields to sign a more extensive non-disclosure agreement:

“The fact that Greenshields may have, through viewing confidential information over the course of several months, become more familiar with the specific accounting and business principles involved in a racking operation surely is not the equivalent of his using specific pieces of confidential information….[The non-disclosure] agreement specifically contemplated that Greenshields may compete, and it is only logical that Movie Gallery could not expect him to rid his mind of general knowledge acquired through his months of studying an industry new to him.”

At a bare minimum, a seller of a business ought to require a buyer not to hire or engage a seller’s employees for a period of time. In a case like Greenshields’, his lack of experience in the business was not a deterrent to opening a competitor rather quickly; he took three long-time employees away from Movie Gallery to do the leg work.

Additionally, sellers need to consider limited customer non-solicitation covenants requiring a purchaser to avoid certain accounts following the termination of a potential deal. Sellers also can line-out customer names until the transaction negotiations reach a certain point, but in many cases this is neither feasible nor acceptable.

The Illinois Home Repair and Remodeling Act (815 ILCS 513/1 et seq.) (view it on the web here) declared that “the business of home repair and remodeling is a matter affecting public interest” and found that “improved communications and accurate representations between persons engaged in the business of making home repairs or remodeling and their consumers will increase consumer confidence, reduce the likelihood of disputes, and promote fair and honest practices in that business in this State.”  815 ILCS 513/5.

Courts have taken the Act very seriously, strictly enforcing its edicts that a contractor 1) must have a written contract for any remodeling or repair work over $1,000; 2) must provide specific notice of certain provisions if they are present in a contract; and, 3) must provide a consumer with a brochure detailing the consumer’s rights.  As I have previously written in a CC&M Briefing to clients (CC&M Briefing, Fall, 2008, available here), in their effort to enforce the policy set forth in the Act, courts have denied sizable claims by contractors based on their failure to comply with it.

Courts in Illinois’ Third and Fourth Appellate Districts have denied contractors’ claims for roughly $11,000 and $14,000 due to failure to obtain written contracts (Central Illinois Electrical Services, LLC v. Slepian, 358 Ill. App. 3d 545 (3d Dist. 2005; Smith v. Bogard, 377 Ill. App. 3d 842 (4th Dist. 2007)).  Most importantly, those courts determined that the contractors were not only precluded from bringing contract actions, but were also precluded from making claims in quantum meruit (a theory allowing a party to seek the fair value of work and materials actually provided to and accepted by the consumer in order to preserve substantial fairness).  Thus, under these analyses, a contractor would have no recourse to obtain payment for work, no matter how satisfactory, if the contractor did not fully comply with the Act.

The Illinois Court of Appeals for the First District has recently disagreed with its sister courts.  In an interesting case (K. Miller Construction Company, Inc. v. McGinnis, No. 1-08-2514, 1st Dist., August 10, 2009, available here), the Court determined that fundamental fairness did not allow it to restrict a contractor so completely, even in the absence of a written contract for work.

In K. Miller, the contracting company’s sole owner and the homeowners were friends who reached an oral agreement for remodeling work, but never reduced the agreement to writing.  The homeowners initially agreed to pay $187,000 for the work, but later expanded the scope of the project to a price of slightly more than $500,000.  The project was completed in accordance with the expanded plans, and the parties conducted a “walk-through” of the property.  The homeowners allegedly accepted and approved the work after agreeing to a small ($300) credit to address some minor flood damage.  The homeowners made some further payments to the contractor, but refused to pay more than a total of $177,580.33.

The Court quickly dispensed with any question of a contract claim or claim for foreclosure of a mechanic’s lien, acknowledging that the Act strictly precluded such actions in the absence of a written contract.  However, the Court more carefully considered the contractor’s claim in quantum meruit and determined, at least under the facts of this case, the claim should be allowed.

The Court carefully considered the effect of the Home Repair and Remodeling Act and the cases that had previously construed it.  After a lengthy discussion of the history of quantum meruit actions and their main purpose, i.e., providing a fair payment to a party for work that it has done.  The Court determined that allowing the claim to go forward in this case would be most equitable, allowing the homeowners to contest the fair value of the work they received but allowing the contractor to attempt to prove its entitlement to payment for the work it had done.

This case is interesting in its effect, creating a conflict between Illinois Appellate Districts that is ripe to be resolved by the Illinois Supreme Court.  However, additional facts considered by the Appellate Court may limit the applicability of the case in other Appellate Districts that have not yet ruled on the effect of the Act.  The Court took great care to note that there were significant allegations affecting the fundamental fairness questions in this case.  Most notably, the homeowner in this instance was allegedly an attorney who has practiced real estate law for nearly forty years, and the contractor was allegedly relying on a past business relationship and friendship with the homeowner when he entered this relationship without a written contract.  These additional facts seem to have had some impact on the Court’s analysis in balancing the fairness of denying any claim.  The Court specifically stated, “Such a consumer, after receiving the benefit of the contractor’s services, could use the Act, meant as a shield to protect vulnerable consumers, as a sword to deprive a contractor of the reasonable value of his services.”  The Court also stated, “Rejecting Miller’s claim would only penalize a reputable contractor, who, relying on a past business relationship and friendship with the consumer, performed remodeling work to the consumer’s satisfaction, with no involvement of predatory remodeling practices the Act sought to address.”  In other words, the Court was persuaded that a court should not be denied its equitable power to do justice between parties where one of those parties could have intentionally sought to achieve an injustice based on a technicality.

While a resolution of the conflict created by this case will be interesting, contractors and consumers are better off avoiding conflicts created by the Act.  Obtaining the advice necessary to comply with the Act when entering into a relationship will protect both the honest contractor and the honest consumer, assuring that all parties understand and agree to their rights and responsibilities under a contract and avoiding some unpleasant surprises during the project or after work is completed.  However, it will be interesting to follow the evolving case law regarding the Act, evolving law that has the potential to continue providing creative legal arguments for all parties involved in this kind of conflict.

A few years ago Harvard University disclosed that it had used anonymous proxies to purchase 52 acres of land in Boston. Boston officials exploded in outrage, but Harvard responded that the secrecy was motivated by a desire to avoid price gouging (not to mention that the lower purchase price reduced Harvard’s property tax bill). The motivations expressed by Harvard are not uncommon. Indeed many business owners take advantage of the secrecy provided by the various corporation acts and limited liability company acts for legitimate business reasons. Forming a new entity often does not require disclosure of the owners.

The relative informality of American corporate law varies significantly from most of the world. Privately held corporations and limited liability companies typically do not have to publicly disclose their owners, can issue stock with relatively few restrictions and often can be formed within 24 hours of submitting an application. Also unusual is the patchwork of corporate law across the 50 states reflecting varying public policy decisions in each of these jurisdictions. While there have been attempts to encourage states to standardize corporate and commercial laws in the last 50 years through the adoption of model statutes, the corporation acts and limited liability acts often vary markedly. Some states, like Nevada, have aggressively marketed their jurisdiction as a venue for incorporation by trumpeting the limited disclosure requirements of their corporate laws.

Entity formation abroad is significantly more regulated. In many European countries stock is not certificated but instead has to be registered with a public authority. Some countries impose a public auditing requirement on all businesses. Forming a new company can take up to a month and “expedited” filings could take as long as a week. While American lawmakers often abhor European style regulations of businesses, in a post 9/11 world Congress and American law enforcement have approvingly noted the security benefits from European Union laws requiring disclose of beneficial owners of corporations.

Congress is considering Senate Bill 569 that would require states to implement a system requiring the disclosure of each beneficial owner of new corporations and limited liability companies (including indirect owners if the owner is a corporation, LLC or other entity) at formation. The bill does not address ownership of limited partnerships and other partnership entities.

In addition, beneficial ownership must be updated by annual reporting or each time when a change occurs. If beneficial owners are not citizens or permanent residents, a formation agent must verify their name and address and obtain a copy of the government owned identification with photograph. Intentionally failing to provide or update this information could result in penalties of up to $10,000, or up to 3 years in prison, or both. The bill requires “formation agents” (which definition includes attorneys or accountants who assist in the formation of the corporation or limited liability company) to certify that they verified the identity of any beneficial owner who is not a United States citizen or permanent residence.

The potential legal liability of accountants and attorneys guarantees that this bill, if enacted into law, will increase the transaction cost and time needed to form a new entity.

The bill also creates the likelihood of a patchwork of differing laws across the states. Since the states will collect the beneficial information, each state will decide whether the ownership information should be disclosed to the public or simply transmitted to the federal government. Also, some states may simply collect information for domestic corporations while other may collect this information for foreign corporations qualifying to do business.

Overlooked in this discussion is the fact that the federal government already has beneficial ownership information for many small businesses, particularly those taxed as “pass-through” entities. Businesses have to disclose ownership information when they obtain their federal tax identification numbers. In addition, the Internal Revenue Service already receives Schedule K-1 forms reporting income allocated to owners of S-Corporations, limited liability companies and partnerships. Since the current draft of the bill does not include limited partnerships and other partnerships, proper analysis of the information already in the government’s possession should provide it with more information than the bill would provide. It is unclear whether the burdens and penalties of the proposed bill outweigh the benefits.

Could an employer find a noose hanging in the workplace, receive a complaint from its only African American employee that a coworker has threatened him and his family, conduct an investigation without uncovering the identity of the perpetrators of either incident and still avoid Title VII liability?  The answer is YES so long as the employer takes prompt and reasonable action to prevent the coworker harassment from recurring.   See Porter v. Erie Foods Int’l Inc., 7th Cir., Case No. 08-1996 (Aug. 7, 2009).

The Porter decision demonstrates that in order to avoid Title VII liability for coworker harassment, the employer’s managers/human resources personnel should at least take the following steps:  (1) inform their own supervisors of the harassment allegations; (2) conduct a prompt and diligent investigation to find out who is responsible; (3) remind all employees of the company’s anti-discrimination policies; (4) follow up with the complainant on a regular basis in efforts to obtain additional information and attempt to shield the complainant from any future harassment (e.g., by offering him/her to work a different shift).  In reaching its decision, the Seventh Circuit Court of Appeals emphasized that “a prompt investigation is the hallmark of a reasonable corrective action,” which based on the facts of this case translated into a 24-hour rule.  

Furthermore, the Court noted that in assessing the reasonableness of the employer’s corrective action, “the focus is not on whether the perpetrators were punished by the employer, but whether the employer took reasonable steps to prevent future harm.”  Needless to say, those “reasonable steps” will vary based on the specific facts of the situation being addressed.

The Court’s decision also illustrates that in determining whether a plaintiff is constructively discharged on the basis of one of the protected categories under Title VII, the courts not only consider the egregiousness of the harasser’s conduct but also the reasonableness of the employer’s response.  In Porter, the Court indicated that the plaintiff’s allegations of repeated use of a noose combined with implied threats of physical violence were egregious but that because the employer had “a means in place for remedying complaints of workplace harassment” and conducted a diligent investigation, the employer was able to defend itself successfully against the plaintiff’s constructive discharge claim.