You Can’t Take It With You: Protecting The Customer Base Using Restrictive Covenants

It is common to find clauses in employment agreements restricting an employee from soliciting an employer’s customers or competing in any respect with the employer, or both, during the term of employment and for a period thereafter. It is also common for courts to refuse to uphold these clauses to the fullest extent drafted. Two recent New York cases, however, one by the New York Court of Appeals, the other by the Federal Court of Appeals for the Second Circuit, may signal a new trend.

Both decisions hold that an employer has a right to protect the customers that it has nurtured at its cost and expense. The federal case can be read to allow an employer to restrict a former employee from competing for and soliciting any of the employer’s customers, whether or not the employee serviced those customers or brought those customers to the employer through the employee’s individual efforts. While it is unclear whether these recent decisions will trigger future similar reactions by New York courts, employers that rely on personal contacts to maintain their customer base should, now more than ever, attempt to protect themselves with appropriate restrictive covenants in employment agreements.

In BDO Seidman v. Hirschberg,¹ BDO Seidman promoted Hirschberg, one of its accountant-employees, to the position of manager (one step below partner). As a condition to receiving the promotion, the employee was required to sign an agreement stating that a fiduciary relationship existed between the employee and the accounting firm, and if the employee provided services to any former client of BDO Seidman’s Buffalo office within 18 months following the termination of his employment, the employee would compensate BDO Seidman in an amount equal to one and one-half times the fees BDO Seidman charged that client over the last fiscal year.

Defendant ultimately resigned, and in the 12-month period subsequent to his resignation, he allegedly solicited and provided services to approximately 100 former clients of BDO Seidman’s Buffalo office. The trial court granted, and the appellate division affirmed, summary judgment for the employee, finding that the restrictive covenant was overbroad, anti-competitive and unenforceable. Both the trial court and the appellate division refused to enforce the clause at all.

New York’s Court of Appeals disagreed, holding that the restrictive covenant was valid in part. It upheld the restriction to the extent that it prevented the employee from soliciting or providing services to BDO Seidman customers with whom the employee serviced while with BDO Seidman, and to the extent that those customers engaged the firm without independent recruitment effort by the employee (and which BDO Seidman recruited through a program of client development and expenditures). The court acknowledged that New York courts construe restrictive covenants narrowly, enforcing them only to the extent that they are “reasonable in time and area, necessary to protect the employer’s legitimate interests, not harmful to the general public and not unreasonably burdensome to the employee.”² The court also reasoned that it could only enforce a restrictive covenant to protect the employer against either, (i) misappropriation of the employer’s trade secrets or confidential customer lists, or (ii) unfair competition by a former employee whose services are “unique” or “extraordinary.”³

The decision emphasized that, in situations involving professionals, New York gives “greater weight to the interests of the employer in restricting competition within a confined geographical area.”⁴ It explained that an employer has a legitimate purpose in protecting customer information and customer relationships which are crucial to the employer’s goodwill and that the employee acquired in the course of employment. Based on this reasoning, the Court of Appeals reversed the lower court’s decision on summary judgment and held that BDO Seidman had a valid interest in preventing the former employee from exploiting or appropriating customers created and maintained at the employer’s expense. Although it held that the clause was unenforceable to the extent that it encompassed customers that either, (i) the employee brought to BDO Seidman through his own recruitment efforts and without BDO Seidman’s financial support, or (ii) the employee did not service, the Court held that the lower court erred in striking down the entire clause, since New York law permits the paring down of restrictive covenants to enforce them to the extent necessary to protect the employer’s legitimate interests. Since there was no evidence that BDO Seidman was overreaching, coercive or engaged in other anti-competitive misconduct, the Court ruled that partial enforcement was justified.⁵

The Federal Court of Appeals’ decision in Ticor Title Insurance Co. v. Cohen⁶ goes farther than BDO Seidman. Ticor involved a non-compete clause in an employment agreement between a title insurance company and one of its top salesmen, which prevented the salesman from competing in any manner with the employer (as opposed to simply soliciting former customers). The non-compete clause provided that, during his employment with Ticor and for a period ending 180 days following the salesman’s termination of employment, he would not engage in the business of title insurance in the State of New York in any capacity. The contract also stated that the employer was willing to enter into the employment agreement only on condition that the salesman accept the post-employment restriction with respect to subsequent re-employment. The salesman was made one of the highest paid Ticor sales representatives and was guaranteed annual compensation of $600,000, comprised of a base salary of $200,000 plus commissions. In 1997, the salesman’s total compensation exceeded $1.1 million dollars. The employee also received substantial expense account reimbursements, including fully paid memberships at exclusive clubs and tickets to sporting and theater events.

When the salesman resigned from Ticor and began working for a direct competitor, Ticor brought suit to enjoin the employee from working in the title insurance industry for the 6-month period subsequent to termination. The district court found for the employer and enforced the non-compete clause in its entirety, rejecting the employee’s arguments that the clause was over-broad, unreasonable and not tailored to protect the employer’s legitimate interests and its trade secrets and confidential information. The district court found that, since the employee enjoyed a “special” or “unique” relationship with Ticor’s clients, the salesman was a “special” or “unique” employee under New York law, and the clause was valid. Based on the court’s seemingly strained effort to make a special or unique employee out of a salesman whose services were not special or unique at all, the case appeared ripe for a reversal on appeal.

The Court of Appeals for the Second Circuit instead affirmed the lower court decision. The Court of Appeals did acknowledge that, usually, the “special” or “unique” status of an employee exists where the employee’s talents are “special” or “unique”, such as acrobats, musicians, professional athletes, actors or creative writers. Nevertheless, the Court relied on a 1995 state trial court decision⁷ to hold that the title insurance salesman’s personal relationships with Ticor’s clients were “special” or “unique,” noting that: (i) the cost and terms of title insurance are fixed by law; (ii) the potential client base is limited, consisting of New York law firms with real estate practices (well known throughout the industry); and, most importantly, (iii) competition for title insurance relies heavily on personal relationships. The court thus found that it is not necessary for an employee to have a “unique” or “special” talent; “unique” and “special” relationships with clients can also be protected. Moreover, where the employee is “special” and “unique”, he or she is liable for breach of a reasonable restrictive covenant, even though there is no disclosure of trade secrets or confidential lists.

Notably, the Ticor court did not pare down the broad non-compete, but instead upheld it in its entirety. Thus, the employer succeeded, not only in protecting customers in whom the employer had made a financial investment or with whom the employee dealt with and maintained a personal relationship, but also protecting customers that the employee, (i) never dealt with, and (ii) brought to the employer through his own efforts prior to or during employment. Ticor effectively was able to foreclose the employee from the entire New York State title insurance market for a period of 6 months.

Why would the Second Circuit Court of Appeals, which usually frowns upon clauses that attempt to prevent persons from earning a living, upheld the entirety of the Ticor non-compete provision? Though not entirely clear, the Court took note that the salesman was not in an inferior bargaining position, he was represented by counsel and the non-compete provision was drafted by his attorney and extensively negotiated. Perhaps most significant to the Court was that, at the time he left Ticor, the salesman’s new employer guaranteed him a minimum salary of $750,000 and a signing bonus of $2 million dollars, regardless of the outcome of the Ticor litigation. Accordingly, the Ticor decision may well have been result-driven.

There are significant differences between the holdings in BDO Seidman and Ticor. BDO Seidman holds that employers, especially professional firms, which rely on personal contacts, have a legitimate interest in protecting the client base they have developed through financial expenditures. At face value, Ticor holds that, so long as personal relationships are an essential part of the business, an employer may completely foreclose certain ordinary employees, such as salesmen, from competing in any manner for a limited period of time. While, admittedly, the employee in Ticor was highly paid, Ticor may open the door for employers to prevent post-employment competition by seemingly regular employees.

Whether or not Ticor and BDO Seidman signal a change in New York law, employers can take several steps to protect their client relationships. They should include reasonable restrictive covenants in their employment agreements, either at the time of employment or promotion, particularly where the employee is or will be in heavy contact with the employer’s customers. Those restrictive covenants should avoid the appearance of overreaching and coerciveness. In the event of a post-employment dispute, the employer should, if at all possible, commence its lawsuit in federal court, as opposed to state court, for purposes of utilizing Ticor as binding precedent.