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Bench & Bar of Minnesota is the official publication of the Minnesota State Bar Association.

Duty-of-Loyalty Claims in Minnesota

Society has an interest in encouraging entrepreneurial employees to launch new businesses and also to ensure that those same employees perform their duties to their employers in good faith.  Apart from the strictures of contracts and trade secrets law, employees’ obligations include a duty of loyalty that attempts to balance the interests of employer and entrepreneur.

Potential causes of action an employer can assert against a former employee who becomes a competitor are few. Breach of contract (including noncompete, nonsolicitation or nondisclosure provisions) and misappropriation of trade secrets are the first and second most common claims. But breach of duty-of-loyalty claims are the RC Cola of departing employee litigation—just as caffeinated and not to be overlooked.

Duty of loyalty issues arise primarily, but not exclusively, when an employee of a business, while employed, communicates with the business’s customers about the possibility of her leaving and taking business with her.  Often, this is done without considering the legal consequences of a breach. The employee in breach may be barred indefinitely from seeking business from those customers and by that time it is too late to undo what has occurred.

An attorney with a client who wants to start her own business, therefore, should caution the client. If the employee has a close relationship with customers and is not subject to a noncompete restriction, she usually can leave her employer and—both successfully and legally—solicit those customers for her new business. Unfortunately, many budding entrepreneurs find themselves boxed in: having burned their bridges at the old employer and solicited former customers before they quit, they find themselves barred from working with those customers.

Two important points about duty-of-loyalty claims involving customers: First, the obligation arises whether or not there is a written employment agreement and regardless of the employee’s title at the company. Second, the timing and sequence of events are crucial. An employee who contacts a customer 15 minutes after she quits is in a more defensible position than one who does so while still employed by the company.

The “duty of loyalty” owed by every employee of a company1 is different from the similar but higher “fiduciary2 duty” owed by a corporate officer or shareholder.  In other words, all citizens of the kingdom owe a duty of loyalty to the king, but only a small circle of elite knights owe the higher fiduciary duty. The concepts are often intertwined, however, and courts sometimes refer to a “fiduciary duty of loyalty.”3

Legal Standard

In Minnesota, the seminal case on duty of loyalty is Rehabilitation Specialists, Inc. v. Koering.4 The Minnesota Court of Appeals held that “an employee’s duty of loyalty prohibits her from soliciting the employer’s customers for herself, or from otherwise competing with her employer, while she is employed.”5 In Rehabilitation Specialists, an employee left to start her own business. Before doing so she informed a major customer of her intention and the customer told her that there would probably be some new contracting opportunities. Hennepin County District Court Judge (now retired U.S. Magistrate) Jonathan Lebedoff dismissed the claim because the employee had not actually “solicited” the customer. The appellate court reversed, noting that “even if the characterization of her conduct as passive were accurate, it would not necessarily shield her from liability.”6 (It also stated, “if prospective customers undertake the opening of negotiations which the employee could not initiate, he must decline to participate in them.”) This holding is a warning to employees who are thinking of leaving their employer—they should ignore a major customer dropping hints to leave and start their own business.

The court in Rehabilitation Specialists also stated, “Employees who wish to change jobs or start their own businesses, however, should not be unduly hindered from doing so. An employee has the right, therefore, while still employed, to prepare to enter into competition with her employer.”7 This means that an employee may take certain steps, other than contacting or soliciting customers, prior to leaving. For example, he may form a corporation, secure lending, or enter into a lease while on his own time and without using company resources or connections. The Sanitary Farm Dairies court summed up the situation, “While it is true that an employee may take steps to insure continuity in his livelihood in anticipation of resigning his position, he cannot feather his own nest at the expense of his employer while he is still on the payroll.”8

Legal Background

An implied condition in every employment relationship is the employee’s duty of honesty and faithfulness to his employer.9 One Minnesota court recognized at least three claims upon which relief can be granted based on a violation of the duty of loyalty: (1) soliciting business of the employer prior to leaving, (2) disclosing or misappropriating information that the employer has treated as a secret, and (3) engaging in serious misconduct, such as embezzlement or referring customers to a competitor.10

The duty of loyalty is more elastic than those three categories, however. In one case, the employee was found in breach for having pulled his pants down at a public awards banquet and embarrassing his employer.11 In another, the employee breached his duty by encouraging a colleague to take and retain a severance check from the company even while rescinding his severance agreement.12 And, in Marn v. Fairview Pharmacy Services, LLC,13 the employee contacted his employer’s business partner and urged it to terminate a business arrangement.

The duty of loyalty, which is a subset of unfair competition, has been characterized as “a general category of torts recognized by Minnesota courts to protect commercial interests.”14 The duties of loyalty and unfair competition do not necessarily have specific elements.15 However, employees still have a “common law duty not to ‘wrongfully use confidential information or trade secrets obtained from an employer.’”16

The employee’s duty of loyalty precludes him from soliciting a former or current employer’s customers prior to resignation and from failing to give sufficient notice of an intention to resign.17 However, “[t]here is no precise line between acts by an employee which constitute prohibited ‘solicitation’ and acts which constitute permissible ‘preparation.’”18 “Because of the competing interests, the actionable wrong is a matter of degree … . Whether an employee’s actions constituted a breach of her duty of loyalty is a question of fact to be determined based on all the circumstances of the case.”19 “What is required is a balancing of the employer’s legitimate interest in having its business advanced by an employee, and the employee’s legitimate interest in bettering him or herself in a new business and providing for his or her continuing livelihood.”20

It is clear that an employee breaches his fiduciary duty by disclosing confidential information and by competing with his employer.  In Eaton Corp. v. Giere,21 an employee left to attempt to sell a transaxle that he was developing to Toro, a Minnesota corporation that makes lawn mowers. The employee was found to have violated both his common law duty of confidentiality and his duty of loyalty by approaching Toro, corresponding with Toro, and meeting with its representatives while he was employed by Eaton.

More than an Individual Matter?

The duty of loyalty extends only to individuals. Until recently, the question of what liability, if any, attaches to a “new” business entity that the individual either creates or joins has gone unanswered.  In Cenveo Corp. v. Southern Graphic Sys. Inc.22 the United States District Court in Minnesota dismissed a duty of loyalty claim against Southern Graphic Systems because “SGS never owed Cenveo a duty of loyalty given its status as a competitor.”23 The employee of a printing company had taken steps to divert a major customer to SGS and worked with SGS while still employed by his old company. The court affirmed summary judgment for breach of loyalty against the individual employee, but dismissed the claim against SGS under a “joint tortfeasor” or conspiracy theory.

In one state court action,24 decided prior to Cenveo, the plaintiff asserted a claim for “aiding and abetting” against the partner of an employee who had contacted his employer’s customers for his own account and then started a new business with the partner, who never worked for the employer.
The court declined to dismiss the aiding and abetting claim on summary judgment.  Minnesota appellate courts have not recognized the validity of aiding and abetting claims in this context.

The 8th Circuit Court of Appeals looked at the question under Iowa law in PFS v. Darrell Raduechel.25 It affirmed dismissal of an aiding and abetting claim and denied a new trial on the issue of breach of duty of loyalty.  The plaintiff had sued two former employees for breach of duty of loyalty and sued their bank and accounting firms for aiding and abetting.  The court held that Iowa law might allow such a claim where a “person knows that the other’s conduct constitutes a breach of duty and gives substantial assistance or encouragement to the other so to conduct himself.”26 At trial, the aiding and abetting claim against the banking and accounting defendants failed and the appellate court denied a motion for a new trial.  The court of appeals held that it was not an erroneous jury instruction to state that the plaintiff must prove the defendant “knew” the conduct “constituted a breach of fiduciary duty.”27  This creates the unusual possibility that ignorance of the law is a defense.

Remedies

A variety of remedies are potentially available to employers who establish breach on the part of the employee.

Equitable or Injunctive Relief. At least one Minnesota court has granted injunctive relief for an alleged breach of duty of loyalty. In Workers Compensation Recovery, Inc. v. Marvin28 an employee left to start her own competing business. Before leaving, she had a conversation with one of her employer’s most important clients, BHS, during which they talked only about her leaving and starting her own business. After she left, the employer sought and received a temporary restraining order and, subsequently, a temporary injunction enjoining her from conducting business with BHS for six months. The injunction was upheld by the Minnesota Court of Appeals. Marvin is a useful template for businesses facing the threat of a departing employee. It stands for the proposition that injunctive relief is appropriate and that six months is a reasonable timeframe.

Restitution. There are currently no model jury instructions on damages for breach of duty of loyalty or of fiduciary duty. In Storage Technology Corporation v. Cisco Systems, the 8th Circuit Court of Appeals (interpreting Minnesota law) stated:

An employee who breaches a noncompetition or nondisclosure covenant can be required to account for his profits. Cherne Indus. v. Inc. v. Grounds & Assoc., Inc. 278 N.W.2d 81, 94-95 (Minn. 1979). The remedy for breach of duty of loyalty is also restitutionary. See, Miller v. Miller, 301 Minn. 207, 222 N.W.2d 71, 78 (remedy for breach of fiduciary duty is constructive trust).29

The court upheld dismissal of a duty-of-loyalty claim where the plaintiff failed to substantiate any amount of damages or restitution. This suggests that the measure of damages is similar to that in a case involving breach of a noncompete agreement, which can be measured by lost profits of the injured party.30 Storage Technology also suggests, however, that the measurement could be an accounting or disgorgement of the offender’s profits (“can be required to account for his profits”). The downfall of the plaintiff here was that, either way, the actual harm or damages must be proven.

Thus, to recover on a breach-of-loyalty claim, an employer must do more than identify acts of improper solicitation of customers. It must also show that the employee’s actions proximately caused an identifiable loss.31 In Graphic Directions, Inc. v. Bush, the Colorado Court of Appeals reversed the lower court and held that although evidence at trial “was sufficient to establish the existence and the breach of a fiduciary duty,” the “evidence of damages was insufficient to permit the claim to go to the jury” as a matter of law.32

In a case in which the author was involved prior to Storage Technology, the former employer attempted to argue that “disgorgement” of all income earned by the departing employee and his new business was the proper remedy since, the employer argued, the claim involved a species of breach of fiduciary duty. The case settled on the eve of trial without a decision by the trial court on this issue, but, at the time, little or no law supported this theory. In an earlier Illinois case, an action based on an alleged breach of the duty of loyalty by the employee, a federal district court held that equitable relief in the form of disgorgement is available only when proof of actual damages is shown to be so complicated as to be impossible.33

Lost Profits. In some states, the actual proximate injury may be demonstrated by measuring lost profits caused by the breach. In ABC Trans Nat Transport, Inc. v. Aeronautics Forwarders, Inc. 34 the Illinois appellate court affirmed the trial court’s award to a plaintiff-employer of lost profits proximately caused by the defendant’s fiduciary breaches as proven by an expert.

Forfeiture of Wages. Another potential remedy for breach of fiduciary duty by an employee is forfeiture of payments made to the employee during which time she was engaged in the breach of loyalty. One treatise states that, in the event that an employee breaches his duty of loyalty, “[a]n employer may recover damages or withhold the payment of wages in the event of a breach of this duty.”35

If an employee is found to have breached her duty of loyalty, she is deemed to have never effectively earned the wages that she is claiming.36 Because the employee did not satisfy the terms and conditions of the employment contract, she never effectively earned the wages.37 But an employer may still be required to show that it has suffered damage as a result of a breach of the duty of loyalty.38

An employer can withhold certain benefits and bonuses if the duty of loyalty is breached. In Brozo v. Oracle Corp.39 management exercised its rights under an employment contract when it “decided that [the employee] deserved no incentive bonus in a year in which he breached his duty of loyalty by soliciting employees and customers to join him in a competing venture.” The court stated, “[t]hat type of employee misconduct will be penalized almost anywhere.”

Unresolved Issues

No reported case in Minnesota has addressed whether an employee who discusses plans to compete with a referral source (which essentially controls the spigot directing the flow of customers to the employer) could be liable for a breach of duty of loyalty. Courts might look at the practical impact of the discussion and the relationship of the parties, but Rehabilitation Specialists and its progeny seem to be limited to “customers” on their face. Similar questions arise with regard to vendor relationships, although the court in Signergy Sign Group, Inc. v. Adam40 seemed unconcerned about contacts between “two suppliers of equipment and material” and the departing employees of a sign company.

The question has arisen whether an employee who also holds shares in a closely held corporation is free to compete once he leaves employment, but before his share ownership is redeemed. One means of resolving this is to have the employee/shareholder tender his shares or give them up (without payment) to be clear. Advanced Comm. Design, Inc. v. Follett41 reached the surprising conclusion that a minority shareholder (who does not have voting stock, was never a director, and resigned as an officer) does not owe a fiduciary duty to the corporation. But beware of relying on this narrow holding: nonvoting stock is relatively rare, and shareholders are generally charged with some duty to the corporation.

It is not uncommon for a major customer to ask a key employee of a vendor to join it in an “inhouse” position.  This can limit or eliminate the work formerly directed to the former employer and could be seen as a breach of duty of loyalty, but no court has adopted this view where the employee does not start his own business.  The situation may be more clear-cut where the employee has arranged to become an independent contractor of the customer before leaving employment.

However these and related issues may ultimately resolved, the duty of loyalty should not be taken lightly by any employee or his counsel.

Notes

V. John Ella is of counsel to the Minneapolis office of Jackson Lewis LLP. He practices in all aspects of employment law and advises clients in the areas of employment contracts, handbooks, sexual harassment claims, discrimination, trade secret and noncompete litigation, drug testing law, plant closings, ERISA benefits litigation, wage and hour compliance, commission claims, defamation, whistleblower and Sarbanes-Oxley claims as well as closely held corporation and partnership disputes. He is certified by the Minnesota State Bar Association as a Labor & Employment Law Specialist.

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