Business Tip: Include a liquidated damages clause in your restrictive covenant agreements that clearly sets forth how damages will be calculated in the event your employee breaches the non-competition agreement.
As a President, CEO or General Counsel of your company, you have recognized the need to have your key executives and employees enter into non-competition or non¬-solicitation agreements. Those non-competition agreements are usually a cost effective way to stop your key executives and employees from competing against when they leave your company. However, in those instances where you have to go to court to enforce your non-competition agreement, the experience can be costly, in terms of attorneys' fees, your time and your company's resources.
One of the factors that makes the enforcement of a restrictive covenant costly is that damages can be difficult to prove as it is hard to quantify the damaging effect of the competition on your business. Often times you will have to hire an expert to determine the appropriate damages formula to use and calculate what damage your company has incurred as a result of your former executive or employee competing against you. A cost effective way to help minimize some of this cost is to include a provision in your agreement with the key executive or employee that sets forth the damages that your company will be entitled to recover if they violate their restriction.
Unfortunately, such a damages provision cannot provide that if your key executive or employee violates the restriction that your company is entitled to hundreds of thousands or millions of dollars in damages. In fact, if a court views the damages provision as imposing a penalty, it will not enforce the provision. A penalty is one which is grossly disproportionate to the probable loss that your company is likely to incur. Instead, the damages provision must be a "reasonable forecast" of the damages that your company is likely to incur as a result of the breach of the restriction.
What is a "reasonable forecast" of damages for one type of business or employee may not be a "reasonable forecast" for another type of business or employee. Therefore, care needs to be given in the drafting of such damage provisions. An examination of several cases that have discussed such damages provisions is instructive in determining what types of clauses courts have found to be "reasonable forecasts" and which have been found to be penalties.
Two Times Lost Profits A Reasonable Forecast. Two securities traders agreed if they traded any of the products that they had traded for their employer in the three months before they left their securities trading firm, their employer would be entitled to between $700,000 and $800,000 in damages or, alternatively, would be entitled to obtain an injunction against them. When the securities traders violated their non-competition agreement, their former employer sought damages in the amount of the profits that the securities traders generated for their new employer while breaching their non-competition agreements. While the court recognized that it would be difficult if not impossible to calculate the trading profits the securities trading firm would have made but for the violation of the non-competition agreements, the court held that the profits earned by the securities traders for their new employer was not necessarily equivalent to the losses suffered by the securities trading firm as damages. Instead, the proper measure of damages in this case were the profits the securities trading firm would have made on sales it could reasonably have expected to secure had the securities traders not sold securities in breach of their non-competition agreements. However, the court noted that had such a provision been included in the non-competition agreement, that upon breach of the agreement, the securities trading firm could have recovered the profits earned by the two securities traders while breaching their non-competition agreement.
Two Times Previous Years Customer Commissions A Reasonable Forecast. One shareholder of a closely held company purchased the shares of the other shareholder under an agreement that precluded the selling shareholder from competing against the company for three years. In the event that the selling shareholder violated the non-¬competition provision, he agreed to pay two times the previous year's commissions for the customer or account to which the breach relates. The court found that since the damages calculation was directly tied to the previous year's commission earned from the customer to whom the breach related, the calculation was a reasonable method of calculating damages.
Two Times Lost Annual Premiums A Reasonable Forecast. An insurance salesman had an employment agreement that contained a non-solicitation provision that prevented him from soliciting the insurance companies' clients for two years after he left the insurance company. Further, in the event of breach of that provision, the agreement provided that the insurance company was entitled to recover as damages two times the annual premiums it lost as a result of the violation. The court found that because the insurance company had an historic renewal rate of ninety percent, the loss of one customer had the potential to have recurring impact. Therefore, the court found the formula to be reasonable in determining damages.
One And One Half Times Lost Fees Could Be A Reasonable Forecast. A manager at the Buffalo office of a national accounting firm entered into a non-competition agreement with his employer in which he agreed that since his position gave him an advantage in attracting certain clients to the accounting firm, that if he served any former client of the Buffalo office within eighteen (18) months of his departure from that accounting firm, that he would compensate the accounting firm one and one-half times the fees that the accounting firm had charged that client over the preceding fiscal year. The rationale for this formula was that it used a client's gross billings to value the loss of the client. While the court recognized that such a formula had been accepted by other courts in evaluating accountant non-competition agreements, the court said that in this case evidence needed to be presented that showed that such a formula compensated the accounting firm for the actual damages that it had incurred as a result the loss of client as opposed to penalizing its former employee.
The goal of any damages formula provision should be twofold. First, the provision should allow former employers to easily calculate damages, saving it the cost and expense of proving complicated damages at trial. Second, the provision should serve as a deterrent to the employee (and possibly the new employer) by establishing the damages the employee may have to pay as damages for violating the restriction. Such provisions may give a company another basis to stop employees from competing against them.