HRMN 408 Assignment 3: The Law and Ethical Considerations

Employee Loyalty

• Competing with an Employer

• Trade Secrets and the Defend Trade Secrets Act

• Computer Fraud

• Loyalty by Contract

• Remedies for Breach of Contract

• Employee Dishonesty

CHAPTER 19

C o p y r i g h t 2 0 1 7 . S o c i e t y F o r H u m a n R e s o u r c e M a n a g e m e n t .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

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Book: The SHRM Essential Guide to Employment Law : A Handbook for HR Professionals, Managers, Businesses, and Organizations Author: Charles Fleischer Date: 2017

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The SHRM Essential Guide to Employment Law354

Every employee owes a common-law duty of loyalty to his or her employer. The duty is an implicit part of the employment relation- ship unless the employer and employee agree otherwise. Under this duty, an employee is bound to serve his or her employer diligent- ly and faithfully, to refrain from knowingly or willfully injuring the employer’s business, and to avoid any conflict between the employ- er’s interest and the employee’s own self-interest.

Corporate officers and directors have heightened duties of loy- alty to their employers. Officers and directors are generally consid- ered fiduciaries, meaning that they must act for the benefit of their employer and stockholders. They may not use corporate facilities or assets for personal gain. An even higher standard of loyalty and fidu- ciary duty is sometimes applied to trustees of charitable, nonprofit organizations. (See Chapter 23 on nonprofit organizations.)

COMPETING WITH AN EMPLOYER In the absence of a contract that restricts an employee’s right to compete with his or her former employer, the duty of loyalty ends when the employment relationship ends. So an employee is per- fectly free to quit and go with a competitor or start a competing business.

As a general rule, an employee may make plans to compete while still employed. This includes gathering information, consulting with advisors, developing a business plan, creating a business entity, arranging for financing, negotiating to purchase a rival business, and even letting existing customers and fellow employees know about his or her intentions.

But when the employee goes beyond the planning stages or engages in unfair, fraudulent, or wrongful conduct, he or she has crossed the legal line. Examples of improper conduct by an employ- ee include the following:

• actually beginning business in competition with a current employer • misappropriating the employer’s trade secrets • pirating confidential customer lists

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Employee Loyalty 355

• soliciting current customers or fellow employees for the new business

• conspiring to bring about a mass resignation of key employees • usurping business opportunities, such as by diverting new busi- ness or asking a customer to delay a purchase until the employee’s new company is operating

• corrupting the employer’s records or computer files

TRADE SECRETS AND THE DEFEND TRADE SECRETS ACT As a supplement to common-law duties of loyalty, most states have adopted the Uniform Trade Secrets Act (UTSA), which prohibits the misappropriation of trade secrets by improper means. A trade secret is defined as information that has economic value because it is not generally known to others and that the employer makes reasonable efforts to keep secret. Examples include a closely guarded process like the formula for a soft drink or a computer operating system’s source code. Improper means includes theft, bribery, misrepresen- tation, breach of duty to maintain secrecy, and espionage. So if an employee steals information or documents while still employed, in anticipation of leaving that job and going with a competitor, the company will have a claim under the UTSA.

Theft of a trade secret is also criminal under the federal Economic Espionage Act.

The UTSA authorizes the courts to issue an injunction prohib- iting an employee from misappropriating trade secrets. However, under the statute, there must be an actual or threatened misappro- priation. Normally, to base an injunction on threatened disclosure, the courts at a minimum require evidence of intent to disclose.

Courts in a few states—most notably, Illinois, North Carolina, and Ohio at this writing—have adopted a legal doctrine known as inevitable disclosure. Under that doctrine, even when no actual or threatened disclosure exists, the court may issue an injunction against a former employee who had access to highly confidential, specifically identified trade secrets, if the employee’s old and new

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companies are in direct competition and if the employee’s old and new jobs are so similar as to make disclosure of the secrets inevitable. Other courts have rejected the inevitable disclosure doctrine.

Defend Trade Secrets Act A relatively new federal law, the Defend Trade Secrets Act (DTSA), gives federal district courts jurisdiction to hear claims of trade secret misappropriation. The courts are empowered to award the usual remedies of injunctions and money damages. In addition, they can award exemplary (punitive) damages in cases of willful and malicious misappropriation, and they can order the misappropriator to pay the attorneys’ fees of the party that suffered the misappropriation. The federal courts can even order the seizure of property necessary to prevent the propagation or dissemination of the trade secret that is the subject of the suit without advance notice to the misappropriator.

For an employer to obtain exemplary damages and an award of attorneys’ fees against an employee or former employee, the employ- er must have given prior notice to the employee that he or she is immune from criminal or civil liability for certain trade secret disclo- sures, including a disclosure to law enforcement or an attorney and including a court filing if made under seal. Figure 19.1 is a suggest- ed form of notice for inclusion in an employee handbook and any employment contracts.

FIGURE 19.1: DTSA NOTICE

Pursuant to the federal Defend Trade Secrets Act of 2016 (DTSA), no employee will be held criminally or civilly liable under any federal, state, or local trade secret law for the disclosure of a trade secret that is made in confidence to a government official or to an attorney solely for the purpose of reporting or investigating a suspected violation of law. No employee will be held criminally or civilly liable under any federal state or local trade secret law for the disclosure of a trade secret that is made in a complaint or other document filed in a lawsuit or other proceeding, if such filing is made under seal. An employee who files a lawsuit for retaliation by an employer for reporting a suspected violation of law may disclose the trade secret to the attorney of the employee and use the trade secret information in the court proceeding, if the individual files any document containing the trade secret under seal and does not disclose the trade secret except pursuant to court order.

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Employee Loyalty 357

COMPUTER FRAUD The Computer Fraud and Abuse Act (CFAA) is a potentially power- ful weapon in an employer’s hands. The CFAA covers virtually any computer that is connected to the Internet.

Under the CFAA, it is criminal for anyone to access a protected computer without authority or to exceed authorized access. Traffick- ing in passwords or similar information is also a crime if done with intent to defraud. Persons or companies injured by violations of the CFAA can sue in civil court for money damages.

What makes the CFAA so powerful is that when, for example, a data entry clerk takes a peek at his or her boss’s personnel file using someone else’s password, the CFAA is violated. Even high-level employees who have access to the entire computer system can be charged with a CFAA violation if they access information for an improper purpose, such as to sell it to a competitor.

Intentionally causing damage to a company’s computer system by transmitting a program, information, code, or command is a viola- tion of federal criminal law. Denial-of-service attacks or deletion of valuable data are good examples.

LOYALTY BY CONTRACT An employer can gain protection beyond that provided by the com- mon-law duty of loyalty, the UTSA, the DTSA, and the CFAA. So long as the employer acts reasonably and for legitimate business rea- sons, an employer may require employees to sign binding contracts that go well beyond the limited protections provided by law. A typi- cal contract might contain some or all of the following clauses:

• a noncompetition clause (sometimes called a noncompete clause, a restrictive covenant, or a covenant not to compete)

• a nonsolicitation clause • a confidentiality clause • a work-for-hire clause

These clauses are discussed in the sections that follow.

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Noncompetition A contract that imposes restrictions on an employee’s ability to com- pete with a former employer is enforceable in most (but not all) states if the restrictions are reasonable. The general rule is that an employee’s agreement not to compete with an employer upon leav- ing employment will be upheld if the following conditions are met:

• The restraint is supported by adequate consideration. • The restraint is confined within limits that are no wider as to geo- graphic area and duration than are reasonably necessary for the protection of the employer’s business.

• The restraint does not impose an undue hardship on the employee. • The restraint is not contrary to the interests of the public.

Noncompete agreements may be used to prevent unfair compe- tition. They cannot, however, be used to gain an unfair advantage. For example, it would not be appropriate to ask lower-level or cleri- cal employees, whose employment skills are fairly fungible, to sign a noncompete. The general public also has an interest in free compe- tition. If your employee really can provide a product or service that is better, cheaper, and more reliable than yours, the public would certainly want him or her free to do so.

Here are some circumstances in which a noncompete agreement might be used:

• C-level positions (such as CEO and COO) • sales positions, when the business is heavily dependent on the rela- tionship between the salesperson and the customers and when the customers would likely follow the salesperson to a new employer

• professional practices, when the clients or patients tend to identify with particular professionals in the firm and not with the firm as a whole

• jobs for which the employer must make a substantial initial investment in the employee’s education or training or when the employee is unproductive while awaiting a security clearance or a special license or certification

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Employee Loyalty 359

• jobs requiring unique skill sets • jobs involving access to highly confidential trade secrets • high-tech positions in which the employee is likely to generate or have access to intellectual property such as computer programs or patentable devices

A noncompete agreement that restricts an employee for six months from working for companies that compete directly with the employ- er within a radius of 10 miles of the employer’s place of business is likely to be held reasonable. A restriction of as much as two or even three years may be upheld as reasonable depending on the circum- stances. But an agreement that prohibits an employee from working in any similar line of business, anywhere in the United States, for five years is likely to be held an unreasonable restraint of trade. Unfor- tunately, drawing the line between reasonable and unreasonable is a case-by-case process, and it is difficult to predict in advance whether the courts will uphold a particular restriction.

The geographic restriction factor may be disappearing. As information technology assumes a greater role in the economy, and as the speed and ease of communications increase, it makes little difference whether a computer programmer works in the employer’s office, in the employee’s own mountain retreat, or in Bangalore, India. So merely prohibiting the programmer from competing within a 10-mile radius of the office will not be very effective.

ALERT! The code of ethics governing lawyers in most states prohibits lawyers from being

parties to a noncompete agreement except an agreement concerning benefits upon

retirement.

Nonsolicitation When an employee leaves with the intention of competing with a former employer, he or she will likely plan to contact former

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customers and invite them to become customers of the new busi- ness. Similarly, he or she will likely try to induce fellow employ- ees to come work for the new business. A standard provision in noncompete and confidentiality agreements is a prohibition on soliciting customers and fellow employees.

A nonsolicitation provision may prohibit the departing employ- ee from servicing the customers of the employer with whom the employee had contact or with whom he or she worked while employed. A nonsolicitation provision may even be applied to customers that the employee brought to the employer, since rela- tionships with those customers become part of the employer’s goodwill. Thus, in defending a claim for breach of a nonsolic- itation clause, it is no excuse that the customers for whom the employee did work after leaving the employer were also custom- ers for whom he or she had done work before starting with the employer.

However, a nonsolicitation provision that restricts the depart- ing employee from contacting all the employer’s customers, including those with whom the employee had no contact, may be deemed overbroad and unenforceable.

ALERT! Some states view nonsolicitation agreements as little more than thinly veiled non-

compete covenants and limit their enforcement to the same extent as noncompete

agreements.

One other aspect of nonsolicitation clauses deserves mention. Companies that provide contract services to other businesses know only too well the risk of having their business customers cherry-pick their best employees by hiring them away and bring- ing the contract work in-house. While nonsolicitation and non- compete clauses should help prevent that practice, the company is in an even stronger position if its business-to-business contracts prohibit nonsolicitation.

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Employee Loyalty 361

Confidentiality In a typical confidentiality clause, an employee acknowledges that all company information, trade secrets, customer lists, busi- ness plans, procedures, cost structures, profit margins, and so on belong to the company. The employee promises to maintain the confidentiality of that information throughout his or her employ- ment and after the employment ends.

Confidentiality agreements supplement the UTSA in import- ant ways. Such agreements demonstrate that the employer is making reasonable efforts to keep information confidential, thus bringing the information within the definition of trade secret. Such agreements also impose a duty to maintain secrecy, so that breach of a confidentiality agreement may in certain circumstanc- es be a violation of the UTSA as well.

Unlike noncompete agreements, confidentiality agreements may last for an indefinite period, or at least until the confidential information becomes known to the public generally.

Confidentiality provisions do run some risks, however. They cannot do the following:

• bar employees from filing discrimination charges or participat- ing in proceedings before the EEOC or state or local nondis- crimination agencies

• interfere with an employee’s right to engage in concerted activities under federal labor laws

• prevent employees of U.S. government contractors from reporting waste, fraud, or abuse

• prevent employees of public companies from reporting securi- ties law violations to the Securities and Exchange Commission (SEC).

Figure 19.2 is a suggested disclaimer to be included in employ- ee handbooks and noncompete agreements.

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FIGURE 19.2: CONFIDENTIALITY DISCLAIMER

Nothing in this handbook/agreement is intended to do the following:

• interfere with or restrain any employee’s rights under the federal labor laws, including the right to engage in concerted activities for the purpose of collective bargaining or other mutual aid and protection, and including the right to discuss with others the terms and conditions of employment

• prohibit an employee from complying with a lawfully issued summons or subpoena; answering questions truthfully while under oath in a judicial or administrative proceeding; or assisting or participating in an investigation, proceeding, or hearing before the U.S. Equal Employment Opportunity Commission or any other agency or commission in connection with a claim under any nondiscrimination law

• [for U.S. government contractors] prohibit an employee from reporting waste, fraud, or abuse to a government agency or official

• [for public companies] impede an employee from communicating directly with Securities and Exchange Commission staff about a possible securities law violation, including enforcing or threatening to enforce a confidentiality agreement with respect to such communications

Intellectual Property In general, the right to patent an invention belongs to the inventor personally, and ownership of the copyright of a work belongs to the author personally. When a patentable invention or a copyright- able work is produced by an employee, the law grants only limited rights to the employer.

As to a patentable invention created by an employee on the employ- er’s time and using the employer’s money, property, and labor, the shop rights doctrine grants the employer a nonexclusive right to use the invention. However, the employee owns the patent rights and can use the invention himself or herself, license it for use by others, or assign the patent to third parties, all without the employer’s consent.

While federal copyright law does provide that an employer is con- sidered the author of a work made for hire—defined as a work pre- pared by an employee within the scope of his or her employment—a question can arise whether a particular work was prepared within or outside the scope of employment.

EXAMPLE: A salesperson’s job is to sell complex medical equipment to hospitals and to train hospital personnel on the

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equipment. If the salesperson writes a lengthy manual on the maintenance and use of the equipment, who owns the rights to the manual—the salesperson or the employer? The salesper- son’s employer certainly cares about ownership of the manual because it likely contains valuable information not generally available to the public. The employer could also profit from the manual, either by selling it to customers or by giving it to them as part of a service package. Alternatively, the employer may want to keep the manual secret and out of the hands of competitors. The employer gains no benefit and actually stands to be harmed if the manual is not a work made for hire. If the salesperson was instructed to write the manual and did so on the company’s time and money, using a company word pro- cessor, then the manual is probably a work made for hire, and therefore owned by the employer. But if the employee wrote the manual on his or her own time, at home, using a home computer, then probably the employee owns the manual, even though the employee acquired most of the information in the manual during the course of his or her work.

In short, when an employer hires someone to work on a poten- tially patentable invention or a copyrightable work, the employer needs greater protection than federal law provides. The solution is to have the employee sign an agreement that all inventions and works created during employment and for some reasonable period after the employment ends are considered made for hire and belong to the employer. Such agreements usually contain an express assignment of all rights to the employer.

Consideration As a matter of basic contract law, for a contractual promise to be enforceable it must be supported by consideration. In the case of a newly hired employee, the consideration for a noncompete agree- ment is the offer of employment itself. Even an offer of employment

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at will is sufficient consideration in most states to support a non- compete agreement.

In the case of existing employees, continuing employment may provide the consideration. Employers should be aware, however, that not all states reach that conclusion. Some states require fresh consideration to support an existing employee’s promise not to com- pete, in the form of a raise, a bonus payment, or some other benefit or item of value.

Departing employees are often asked to sign noncompete, nonsolicitation, and confidentiality agreements. In that case, the employer must definitely offer fresh consideration, such as a sev- erance payment or salary continuation. The departing employee is also unlikely to sign the agreement in the first place without some new consideration. For these reasons, it makes sense to have noncompete agreements signed at initial hire or at least at a time when employment is likely to continue for some substantial period.

ALERT! Threatening to withhold a departing employee’s final paycheck until he or she signs a

noncompete agreement does not solve the consideration problem, since the employer

has no right to withhold pay that is clearly due.

REMEDIES FOR BREACH OF CONTRACT The typical remedy sought by an employer when a former employee breaches a noncompete, nonsolicitation, confidentiali- ty, or work-for-hire agreement is an injunction. An injunction is a court order prohibiting specified conduct, violation of which could result in fines or jail time. The alternative remedy would be a suit against the employee for money damages, but the employer may have difficulty proving the dollar value of the injury suf- fered or proving that a decline in sales was caused by this partic- ular employee’s disloyalty and not by market conditions or some other event.

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QUICK TIP A liquidated damages clause, specifying the amount of damages recoverable in case of

breach, could overcome the problem of proving damages, so long as the amount speci-

fied is a reasonable estimate of actual damages and not merely punitive.

When an employer learns that a former employee is now working for the competition in violation of a noncompete agreement, the first step should be to write a cease and desist letter to the former employ- ee. Whether the employer should also write to the new employer depends on how confident the employer is that the noncompete agreement is valid and enforceable.

A letter to the new employer, informing it about the agreement and insisting it not participate in the employee’s breach of the agree- ment, can often be the simplest and cheapest means of enforcing the agreement. This works because the new employer, once on notice of the agreement, can be sued for tortious interference with contract if it ignores the agreement and continues to enjoy the benefits of the former employee’s misconduct.

On the other hand, if the noncompete agreement has been poorly drafted so as not to apply in this particular circumstance or if it is unreasonably broad or otherwise unenforceable, the employer may have liability for interfering with the new employment relationship.

QUICK TIP Arbitration agreements that require employment disputes to be resolved by binding arbi-

tration instead of by lawsuits should contain an exception permitting the employer to go

to court for an injunction against violations of restrictive covenants. (Arbitration agree-

ments are discussed in Chapter 1.)

EMPLOYEE DISHONESTY Employee theft is a recurring and, some say, growing problem. It covers a wide range of activities—from personal long-distance phone calls, to the misappropriation of goods held for sale, to embezzle- ment of hundreds of thousands of dollars—all of which are costly

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to the employer. Listed below are some safeguards that can deter employee dishonesty:

• Obtain background checks on prospective employees, particularly those who will have access to company finances or merchandise.

• Consider instituting a drug-testing program. • Be sure company financial records are secure. Electronic records should be protected by passwords, passwords should be changed frequently, and an electronic log should be maintained showing who accessed the records and when he or she did so.

• Separate financial functions. The employee who draws company checks should not be the same person who signs them. Bank and other financial institution statements should be reconciled by yet a third person.

• Assign someone not involved in company finances to open all mail and maintain a log of all payments received. The log should be reconciled periodically against bank deposits.

• Insist on seeing original vendor invoices before signing checks. Once a check is signed, the invoice should be marked paid, and the date and check number should be written on the invoice.

• Compare invoices against a current list of vendors to guard against fictitious bills. Invoices should also be checked against contractual arrangements to prevent an overbilling or kickback scheme.

• Except in emergencies, limit check-signing responsibility to one person whose familiarity with billing cycles will help spot unusual invoices.

• Require a second signature for checks over a specified limit. • Review payroll records periodically to weed out phantom employees. • Cancel a departing employee’s password and signature authority over bank accounts.

• Distribute company credit cards sparingly and have a supervisor who is familiar with specific employee assignments review each employee’s monthly account statement.

• When a company event is being charged on a credit card, require that the card of the highest-ranking employee present be used, so

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that the charge record is reviewed by someone above him or her who did not participate in the event.

• Require employees with financial responsibilities to take periodic vacations so they are not able to continue a cover-up of improper activities.

• Adopt, publicize, and enforce a company code of ethics for all employees.

• Buy employee dishonesty insurance coverage.

If employee dishonesty is discovered, the employee involved will likely be terminated or at least be removed from the duties that enabled him or her to commit the dishonesty. If termination is appropriate, standard termination procedures (listed in Chapter 4) should be followed. The employer will also want to give prompt notice of any loss to its insurance carrier.

The decision whether to report employee theft to law enforce- ment is a delicate one. Some companies are reluctant to go public with internal problems for fear their clients or customers will lose confidence in them. On the other hand, the company’s insurance carrier may require a police report as a condition to covering the loss. One thing the company cannot do is threaten the employee with criminal charges unless he or she repays the loss; doing so con- stitutes blackmail.

If the terminated employee applies for unemployment insurance benefits, the company’s decision about going public may have to be made quite quickly. Misconduct usually disqualifies an employee from benefits, either permanently or for a specified period depend- ing on the degree of misconduct. Gross misconduct also disqualifies a fired employee from COBRA benefits.

Faithless Servant Doctrine New York and a handful of other states have developed a legal rule known as the faithless servant doctrine (servant being an outdated term for employee). Under the doctrine, an employee who is disloy-

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al—who, for example, competes with the employer, steals from the employer, or takes kickbacks from vendors—must disgorge (repay) all compensation paid during the period of disloyalty and forfeits any contractual right to future compensation. In those states that have adopted the doctrine, courts require disgorgement even though the employer suffered no actual damages from the disloyalty and even though the employee’s services were otherwise of value to the employer.

The doctrine is based on the notion that an employee is a fidu- ciary who owes duties to his or her employer much like a trustee’s duties owed to the beneficiaries of a trust. It is a powerful weapon in the hands of the employer because the disgorgement and forfeiture remedies go far beyond what the employer might otherwise recover in a breach of contract suit against the disloyal employee.

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