Part 27 of the “The Restricting Covenant Series”: Disgorgement
Most of the action in restrictive covenant cases occurs in the beginning of the litigation at the temporary or preliminary injunction stage when a company seeks to stop someone from doing something immediately. However, after the dust settles and the case moves forward to discovery and trial, money damages often take center stage. There are different types of monetary relief that might be available to a company that is harmed by a former employee’s unlawful competitive conduct – compensatory, liquidated, equitable, or punitive, to name a few. This edition of The Restricting Covenant Series discusses a potentially potent form of equitable monetary relief in restrictive covenant and duty of loyalty cases – disgorgement of an employee’s compensation based on that employee’s competitive and disloyal conduct.
What Is Disgorgement?
“Disgorgement” is defined by Black’s Law Dictionary as “the act of giving up something (such as profits illegally obtained) on demand or by legal compulsion.” It frequently appears in the ad damnum, or prayer for relief, clause of a complaint seeking “disgorgement of profits” or “disgorgement of compensation.” Disgorgement often is used synonymously with its close cousin “restitution,” but there are some subtle differences between the two remedies. Restitution requires the wrongdoer to put the victim in the same position absent the wrongful conduct, such as returning the profits the victim would otherwise have earned but for the breach of the non-compete agreement; whereas disgorgement can be used to take away, or disgorge, the compensation or profits earned by the wrongdoer from the unlawful conduct. Thus, disgorgement focuses on the wrongdoer’s ill-gotten gains, while restitution focuses on the victim’s harm regardless of the amount of compensation or profits earned by the wrongdoer.
Unlawfully Competing While Still Employed Can Lead to Disgorgement of an Employee’s Compensation
Many courts find that it is not unlawful per se for an employee to “plan to compete” while still employed. However, courts also find that an employee’s actual competition or disloyal and nefarious conduct in assisting others to compete against his or her employer is actionable under a breach of a duty of loyalty theory of liability, and that disgorgement of some or all of the employee’s compensation may be an appropriate remedy. An employee’s duty of loyalty generally includes the duties not to compete and not to disclose confidential information. The general rule is that an employee is not entitled to compensation for services performed, or at least not all of that compensation, during the period he or she engaged in activities constituting a breach of the duty of loyalty even though part of these services may have been properly performed.
The seminal case in New Jersey addressing these issues is Cameco v. Gedicke (1999). Cameco was not a case in which an employee, while employed by one employer, advanced his own interests by seeking other employment with a competitor. Nor was it a case in which the employee surreptitiously tried to capture the employer’s business or divert its business to another company for a competitive advantage. In both of those situations, New Jersey courts have held that disgorgement of the employee’s compensation during the period of disloyalty may be an appropriate equitable remedy. Rather, Cameco involved a salaried employee, Donald Gedicke, who supplemented his income by creating a new “side” business that did not compete directly with Cameco but may have assisted some of Cameco’s competitors. The Supreme Court of New Jersey ruled that depending the facts and circumstances of the case, “[i]f the employee directly competes with the employer, aids the employer’s direct competitors or those with interests adverse to the employer’s interests, participates in a plan to destroy the employer’s business, or secretly deprives the employer of an economic opportunity, the employee may forfeit the right to compensation.” Ultimately, the Court did not decide whether Mr. Gedicke had breached his duty of loyalty because the record was incomplete, but it noted that on remand, if the trial court were to conclude that Mr. Gedicke had breached his duty of loyalty, disgorgement of part of his salary could be an appropriate equitable remedy.
Expanding on its analysis and decision in Cameco, and adopting the view of disgorgement as an appropriate equitable monetary remedy for the breach of an employee’s duty of loyalty as stated by the Restatement of Agency (Second and Third), the Supreme Court of New Jersey, in Kaye v. Rosefielde (2015), held that equitable disgorgement of an employee’s compensation was available to an employer even if the employer cannot show that it suffered any economic loss as a result of the employee’s disloyal conduct. The Court set forth several factors for trial courts to consider when deciding if disgorgement is an appropriate equitable remedy, including (1) the employee’s degree of responsibility and level of compensation, (2) the number of acts of disloyalty, (3) the extent to which those acts placed the employer’s business in jeopardy, and (4) the degree of planning to undermine the employer that is undertaken by the employee. The Kaye court also held that in imposing the remedy of disgorgement, “depending on the circumstances, the trial court should apportion the employee’s compensation, rather than ordering a wholesale disgorgement that may be disproportionate to the misconduct at issue.” Courts in other jurisdictions have followed a similar approach with respect to apportionment of an employee’s compensation based on the extent of the disloyalty and other relevant factors, including Wisconsin (Harford Elevator, Inc. v. Lauer, 1980), South Carolina (Futch v. McAllister Towing of Georgetown, Inc., 1999), Idaho (Rockefeller v. Grabow, 2001), and Connecticut (Wall Systems, Inc. v. Pompa, 2017).
A Disgorgement Dilemma in Restrictive Covenant Cases
When an employer seeks temporary or preliminary injunctive relief against a former employee for breaching a non-compete or non-solicit or otherwise breaching the duty of loyalty, courts require the employer to demonstrate that there is no adequate remedy at law to address the harm. Disgorgement is, by definition, a form of monetary relief that can be quantified. Therefore, at the outset of a case, particularly if an employer is seeking immediate injunctive relief, the employer should be cautious not to over emphasize or focus on disgorgement as an appropriate remedy. That’s not to say disgorgement should not be included in the complaint. But if the employer focuses too much on disgorgement of compensation or profits in the beginning of a case, a court might find that an injunction is not really necessary since monetary damages could be an adequate remedy to compensate the employer for the former employee’s unlawful conduct.
Also, when drafting restrictive covenant agreements, consider carefully whether the agreement should contain a disgorgement or forfeiture of compensation clause as a result of violating the restrictive covenants in the agreement. Similar to liquidated damages clauses, which provide for the forfeiture of a stated sum of money upon breach without proof of damages, courts in some jurisdictions might find that a disgorgement clause could undermine the need for injunctive relief. On the other hand, courts in some jurisdictions could find that liquidated damages and disgorgement provisions serve a different purpose than injunctive relief – the liquidated damage clause quantifies the cost for violations of the agreement after the fact, while the injunctive remedy is meant to prevent future violations of the agreement. Like most issues involving the drafting of restrictive covenants, state laws vary regarding enforcement of restrictive covenants and therefore the governing law of the parties’ dispute should be consulted when drafting them.