Former Employees Preliminarily Enjoined from Carrying On New Business

On November 3, 2014, Justice Whelan of the Suffolk County Commercial Division issued a decision in First Manufacturing Co., Inc. v. Young, 2014 NY Slip Op. 51562(U), enjoining former employees from carrying on a new business they set up while working for their former employer.

In First Manufacturing Co., the plaintiff wholesaler of leather sought a preliminary injunction against former employees who had established a competing business. The court granted the motion, explaining:

Although an employee owes fiduciary duties of good faith and loyalty to an employer, the employee may incorporate a business prior to leaving the employer without breaching any fiduciary duty. The employee may not, however, solicit his or her employer’s customers or otherwise compete during the course of his or her employment by the use of the employer’s time, facilities or proprietary information. Where it is shown that trade secrets or other proprietary or confidential material belonging to the employer were used or there was other wrongful conduct by the employee, including the use of fraudulent methods or the engagement in a physical taking or copying of the employer’s documents, lists or files, such conduct is actionable in tort. In such cases, it is the employee’s misuse of the employer’s resources to compete with the employer that is actionable as a breach of fiduciary duty.

Once the employment is terminated, the relationship between a former employee and employer is not fiduciary in nature. The former employee is free to solicit customers or to otherwise compete with his or her former employer where remembered information as to specific needs and business habits of particular customers is not confidential or otherwise proprietary in nature. However, a former employee is not entitled to solicit customers by fraudulent means, the use of trade secrets or confidential information, even in the absence of a restrictive covenant.

Wrongful misappropriations of trade secrets or other confidential or proprietary information by former employees or others having no employment relationship with the plaintiff may be actionable as common law unfair competition claims. Such claims are rooted in the bad faith misappropriation of the plaintiff’s property, or its labors and expenditures or a commercial advantage belonging to the plaintiff such as its good will and generally concern the taking and use of such property right or commercial advantage to compete against the plaintiff. The bad faith misappropriation of a property or a commercial advantage belonging to the plaintiff by the infringement or dilution of a trademark or trade name or by the exploitation of proprietary information and/or trade secrets are both actionable as common law unfair competition claims.

To succeed on a claim for the misappropriation of trade secrets under New York law, a party must demonstrate: (1) that it possessed a trade secret, and (2) that the defendants used that trade secret in breach of an agreement, confidential relationship or duty, or as a result of discovery by improper means. Traditionally defined as relating to technical matters in the production of goods, trade secrets now encompass non-technical aspects of a business including, customer lists, price codes economic studies, costs reports, customer tracking and marketing strategies. In New York, a trade secret is defined as any formula, pattern, device or compilation of information which is used in one’s business and which gives the owner an opportunity to obtain an advantage over competitors who do not know or use it. An essential requisite to legal protection against misappropriation of such a formula, process, device or compilation of information is the element of secrecy. Secrecy has been defined in accordance with the § 757 Restatement of Torts as: (1) substantial exclusivity of knowledge of the formula, process, device or compilation of information; and (2) the employment of precautionary measures to preserve such exclusive knowledge by limiting legitimate access by others.

Customer lists and related information may thus constitute a trade secret provided that such list or information gives the owner an opportunity to obtain an advantage over competitors who do not know or use it. Documents, files and other assemblages of business data containing detailed, non-public information about customers, their specific or unique needs, the pricing of purchases, the credit terms of such purchases and customer class rankings may likewise constitute trade secrets and thus entitled to protection under unfair competition theories provided such assemblages are compiled through considerable effort on the part of the plaintiff and give the plaintiff a competitive advantage for the servicing of such customers and creating new business.

Knowledge of the intricacies of a business operation does not necessarily constitute a trade secret and, absent any wrongdoing, it cannot be said that a former employee should be prohibited from utilizing his knowledge and talents in this area. Information that is garnered by the defendant’s casual memory and knowledge does not constitute an actionable wrong. Where the information at issue is public knowledge or could be acquired easily and duplicated, it will not be considered a trade secret.

Nevertheless, confidential information not amounting to a trade secret may be protected from pirating and subsequent use under common law theories of unfair competition. To qualify for such protection, the confidential and/or proprietary material at issue must have been garnered by the defendant by way of tortious, criminal or other wrongful conduct. The remedy of an injunction against the use or divulgement of trade secrets has long been available to the plaintiff. Such remedy is also available to restrain the defendant’s use of other confidential or proprietary material provided that such material was appropriated through tortious conduct or other wrongful means.

(Internal quotations and citations omitted) (emphasis added).  The court went on to hold that the plaintiff had shown that it was entitled to the injunction it sought based on evidence that “included uncontroverted proof that the individual defendants engaged in the surreptitious and otherwise wrongful copying and taking of trade secrets and/or confidential proprietary material while in the employ of the plaintiff and that these defendants used and transmitted such material for purposes of competing directly and unfairly with plaintiff following the termination of their employment . . . .”

Claims Dismissed for Failure to Present Evidence of Proximate Causation

On June 30, 2014, Justice Sherwood of the New York County Commercial Division issued a decision in Mizrahi v. Adler, 2014 NY Slip Op. 31701(U), granting defendants summary judgment dismissing the complaint because the plaintiff could not show that the defendants’ misconduct caused his damages.

In Mizrahi, the plaintiff asserted legal malpractice, fraud and other claims against the defendants in connection with a real estate investment into which the defendants allegedly induced the plaintiff to enter.  In granting the defendants’ motion for summary judgment, the court held, among other things, that the claims against them failed because the plaintiff failed to show that his damages were proximately caused by the defendants, explaining:

Plaintiff’s action fails on the question of proximate cause. While the issue of proximate cause can often be a jury question, the court may always determine whether there are questions of fact. In Laub v Faessel, dealing with claims for fraud, negligent misrepresentation and breach of fiduciary duty, the court, discussing proximate cause, distinguished between a misrepresentation which induces a plaintiff to engage in a transaction (“transaction causation”), and misrepresentations which directly cause the loss to plaintiff (“loss causation”). Loss causation is the fundamental core of the common-law concept of proximate cause: An essential element of the plaintiffs cause of action for negligence, or for any tort, is that there be some reasonable connection between the act or omission of the defendant and the damage which the plaintiff has suffered. Transaction causation is often synonymous with but for causation.

In the present context of a legal malpractice claim, plaintiff alleges transaction causation, because he says that he would not have entered into the agreements had he known that they bore any risk. That is, but for Adler’s representations, there would have been no transaction. However, even assuming that the representations are a basis for finding transaction causation, plaintiff cannot establish loss causation, because many factors led to the failure to close on Unit 6401, or any other unit in the Trump Towers. Plaintiff’s losses were caused by the precipitious drop in real estate prices, and the value of the Trump Towers units in 2008; the Joss of his job; and plaintiff’s failure to obtain financing. . . . As a result, plaintiff has failed to plead proximate cause.

(Internal quotations and citations omitted) (emphasis added).

This decision shows how the artificial, if necessary, line drawing needed to do causation analysis can leave a plaintiff that has been damaged without a claim because of its inability to tie the defendants tightly enough to the injury.

Action Against Referral Service Fails

On June 9, 2014, Justice Sherwood of the New York County Commercial Division issued a decision in Vista Food Exchange, Inc. v. Benefitmall, 2014 NY Slip Op. 31491(U), dismissing an action against a referral/management service.

In Vista Food Exchange, the parties’ dispute began when the defendants allegedly referred the plaintiff, a small food wholesaler, to a third party for HR services. After the HR firm apparently collapsed, leaving the plaintiffs’ employees without health or workers’ compensation coverage, and the plaintiff’s tax obligations unpaid, the plaintiff sued the defendants under several legal theories.

The Court dismissed most of the plaintiff’s causes of action with prejudice. Negligent misrepresentation was dismissed because no special relationship existed that would create a duty independent of contract (the parties’ 20-year relationship was insufficient) and the economic loss rule also restricted the plaintiff to a contract remedy. Breach of fiduciary duty and professional malpractice claims were also dismissed because—absent facts not found here—a relationship with a management consultant is not of sufficient “trust and confidence” to elevate it beyond a “conventional business relationship.”

The breach of contract claim was more complicated. The defendants moved to dismiss for a number of different reasons, including: (1) that the plaintiff failed to specify which contract provisions were breached; (2) that to be enforceable, any contract to provide referrals must be in writing, pursuant to GBL § 5-701(a)(10); (3) the plaintiff’s allegation that the defendants’ duties extended beyond mere referral to due diligence and monitoring are purely conclusory; and (4) the plaintiff’s failure to allege actual damages—as opposed to possible future damages due to a double tax liability—makes their contract claim unripe. The contract claim was dismissed upon the court’s finding that the plaintiff had failed to allege the elements of a contract, including damages, but the plaintiff was given leave to replead that cause of action.

Court Identifies Elements of Claim for Aiding and Abetting Undue Influence

On February 28, 2014, Justice Scarpulla of the New York County Commercial Division issued a decision in Goldberg v. HSBC Securities (USA), Inc., 2014 NY Slip Op. 30481(U), examining the elements of a claim of aiding and abetting undue influence.

In Goldberg, the executor of an estate brought claims related to alleged undue influence over the decedent, including a claim for aiding and abetting undue influence against two defendants. In deciding the motion to dismiss brought by those defendants, the court considered whether such a tort existed and, if so, what its elements were, explaining:

No authoritative New York case concludes that there exists in New York a cause of action for aiding and abetting undue influence. Plaintiff relies on Medeiros v. John Alden Life Ins. Co., 1990 U.S. Dist. LEXIS 10393, 1990 WL 115606 (S.D.N.Y. 1990) for the proposition that one may be held liable for aiding and abetting another’s undue influence. On a motion for summary judgment, the court in Medeiros found that “[u]nder New York law, however, a person may be liable for aiding and abetting the tortious act of another where plaintiff demonstrates: (1) that the principal/third party violated the law or engaged in tortious conduct; (2) that the defendant knew or should have known that the violation or conduct was occurring; and (3) that defendant’s conduct gave substantial assistance or encouragement to the principal to engage in the violation or tortious conduct.”

The standard articulated by the court in Medeiros is essentially that for aiding and abetting fraud. Critical to a claim for aiding and abetting fraud is that the plaintiff plead “substantial assistance.” In addition, aiding and abetting fraud must be pleaded with the specificity sufficient to satisfy CPLR 3016 (b). Substantial assistance exists where (1) a defendant affirmatively assists, helps conceal, or by virtue of failing to act when required to do so enables the fraud to proceed, and (2) the actions of the aider/abettor proximately caused the harm on which the primary liability is predicated.

(Internal quotations and citations omitted). The court went on to find that the plaintiff had failed “to allege substantial assistance with sufficient particularity to satisfy CPLR 3016(b).”

Board Did Not Have Fiduciary Duty to Maximize Shareholder Benefit in Merger Where There was No Change of Control or Break-up

On January 13, 2014, Justice Friedman of the New York County Commercial Division issued a decision in Badowski v. Carrao, 2014 NY Slip Op. 50042(U), dismissing breach of fiduciary claims relating to a merger.

In Badowski, the class action plaintiff alleged that the

individual defendants, the former directors and officers of Vertro, Inc. (Vertro), breached their fiduciary duties to Vertro’s former shareholders by failing to maximize shareholder value, acting in their own interest, and failing to disclose material information in connection with Vertro’s merger with Inuvo, Inc. (Inuvo). Plaintiff further alleges that corporate defendants Vertro, Inuvo, and Anhinga Merger Subsidiary, Inc. (Anhinga) aided and abetted those breaches. Plaintiff seeks rescission of the merger of the two companies, which was completed on March 1, 2012, or, in the alternative, rescissory damages. Defendants move to dismiss the Second Amended Complaint in its entirety for failure to state a claim, pursuant to CPLR 3211(a)(7).

The Badowski decision addresses several interesting issues of Delaware corporate law; we suggest that you read the entire decision. This post addresses only the issue of the duty to maximize shareholder value.

The court held that the actions of the individual defendants were not subject to the heightened Revlon standard of maximizing shareholder value, and instead that it would examine their actions under the business judgment rule. The court explained:

In Revlon, a case involving a hostile take-over, the Court held that once it became apparent that the break-up of the company was inevitable or that the company was for sale, the duty of the board changed from the preservation of the company to the maximization of the company’s value at a sale for the stockholders’ benefit.

As subsequently refined by the Delaware Courts, the Revlon requirement that the directors seek the best value reasonably available to shareholders applies in at least the following three scenarios: (1) when a corporation initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the company; (2) where, in response to a bidder’s offer, a target abandons its long-term strategy and seeks an alternative transaction involving the break-up of the company; or (3) when approval of a transaction results in a sale or change of control. The Courts have further clarified that the Revlon duty of value maximization is triggered only when a company embarks on a transaction — on its own initiative or in response to an unsolicited offer — that will result in a change of control. In the context of a stock-for-stock merger, a change of control for Revlon purposes can be triggered if the target’s shareholders are relegated to a minority in the resulting entity, and the resulting entity has a controlling stockholder or stockholder group. Where, however, ownership of the merged company will remain in a large, fluid, changeable and changing market, Revlon is not implicated.

(Internal quotations and citations omitted) (emphasis added).

The court held that the Revlon factors had not been adequately alleged, including that there was no allegation that “the shares of the resulting entity will not be freely traded in the marketplace or that the former Vertro shareholders will be subjected to a controlling shareholder or block of shareholders,” that the sale would not result in a break-up of the company and that triggering “change-in-control provisions contained in contracts of Vertro’s officers and directors” did not “establish change of control for Revlon purposes.”

While there are many take-aways from this decision, one is the importance of transactional counsel to help guide a board through the myriad requirements of Delaware law affecting mergers.

Director Breaches Fiducary Duty in Selling Corporate Shares to Himself

On December 24, 2013, Justice Whelan of the Suffolk County Commercial Division issued a decision in KNET, Inc. v. Ruocco, 2013 NY Slip Op. 33543(U), addressing the propriety of a director’s sale of additional shares to himself.

In KNET, Inc., the court addressed a number of issues, including whether a corporate director breached his fiduciary duty by selling additional shares of the corporation to himself. The court held that in light of the facts of that action, he did, explaining:

As a general rule, directors of a corporation cannot issue or dispose of the corporate stock to themselves for an inadequate consideration. Directors owe a fiduciary responsibility to the shareholders in general and to individual shareholders in particular to treat all shareholders fairly and evenly. So, a breach of fiduciary duty is established by proof that the directors failed to treat all stockholders fairly and evenly. When issuing new stock, a director, such as [defendant], must treat existing shareholders fairly. It is an inflexible rule that directors cannot exercise the corporate powers for their private or personal advantage or gain. [A] director breaches his obligation to shareholders when he obtains stock at an inadequate price. [A] clearly inadequate consideration invokes the same principles as the absence of consideration.

[The defendant] is considered an interested director since he is receiving a direct financial benefit from the challenged transactions, that are different from the benefit received generally by all shareholders. Where directors have an interest in the challenged action, the burden of proof shifts to the interested director to establish that the actions involved were reasonable and fair. His testimony failed to satisfy that standard.

(Internal quotations and citations omitted) (emphasis added).

The interested share sale discussed above was just one of the defendant’s many improper acts addressed in the court’s opinion. Yet the particular point addressed above is something to which corporate directors and their counsel should be sensitive even in more innocent contexts. Controlling shareholders in close corporations that also control the company as directors need to remember that whatever their interests as a shareholder, their duties as a director run to all shareholders.

Statute of Limitations Not Tolled by Equitable Estoppel

On October 28, 2013, Justice Whelan of the Suffolk County Commercial Division issued a decision in North Coast Outfitters, Ltd. v. Darling, 2013 NY Slip Op. 32731(U), declining to apply the doctrine of equitable estoppel to toll the statute of limitations in a shareholder dispute.

Justice Whelan explained:

[T]he doctrine of equitable estoppel applies where plaintiff was induced by fraud, misrepresentations or deception to refrain from filing a timely action and the plaintiff demonstrates reasonable reliance on the defendant’s misrepresentations. To be successful, the party seeking to invoke the estoppel doctrine bears the burden of demonstrating that it was diligent in commencing the action within a reasonable time after the facts giving rise to the estoppel have ceased to be operational. Where concealment without actual misrepresentation is claimed to have prevented a plaintiff from commencing a timely action, the plaintiff must demonstrate a fiduciary relationship exists, out of which. an obligation arises to inform the plaintiff of facts material to the underlying claim. In cases like the instant one wherein a fiduciary duty is owing from the defendant, the plaintiff must establish that the defendant’s failure to inform the plaintiff of material facts contributed to the delay in bringing the action.

Justice Whelan found that equitable estoppel did not apply because the plaintiff had not raised “a genuine issue of fact regarding the existence of any lack of knowledge of true facts on the part of the plaintiff or of any subsequent acts of concealment or other failure by [defendant] to disclose material facts he had a duty to disclose which caused the plaintiff’s failure to bring its claim in a timely manner.”

Existence of Fiduciary Duty Depends on Role in Which Party is Acting

On October 30, 2013, the Second Department issued a decision in Varveris v. Zacharakos, 2013 N.Y. Slip Op. 07028, examining when a corporate officer/director owes a fiduciary duty to the corporation’s shareholders.

In Varveris, the defendant was “a director, officer, shareholder, and managing agent of” a close corporation of which plaintiff was a shareholder. Defendant purchased another shareholder’s shares in the corporation. Plaintiff sued defendant for breach of fiduciary duty in connection with the sale, claiming that defendant had a duty to allow plaintiff to participate in the purchase. The Second Department held that defendant had no fiduciary duty to plaintiff in this situation, writing:

Contrary to the plaintiff’s contention, [defendant]’s status as an officer, director, or shareholder of a close corporation does not, by itself, create a fiduciary relationship as to his individual purchase of another shareholder’s stock.

(Emphasis added) (citations and internal quotations omitted).

Varveris illustrates the importance of context in determining whether someone is a fiduciary.

First Department Affirms Broad Scope of Documentary Evidence that Can be Considered on Motion to Dismiss

Two advantages defendants in commercial litigation enjoy when litigating in New York state court instead of federal court are the availability of the interlocutory appeal to New York’s Appellate Divisions before a final judgment and the ability to file a pre-answer motion to dismiss one or more of plaintiff’s causes of action under CPLR 3211(a)(1) by presenting “documentary evidence” that conclusively establishes that the cause(s) of action fail to state a claim as a matter of law, notwithstanding allegations to the contrary in the complaint.  The First Department’s October 3, 2013, decision in Zyskind v. FaceCake Marketing Technologies, Inc., 2013 NY Slip Op. 06433, showcases the importance of a motion to dismiss based on documentary evidence.

The First Department held that former Commercial Division Justice Bernard Fried properly followed applicable law when he considered only the agreements between the parties, which were attached as exhibits to defendant’s motion papers, and not the contents of the defendant’s affidavit to which the exhibits were attached.  This demonstrates the important distinction between relying on an affidavit to authenticate documentary evidence (which is permissible and often necessary for a properly documented motion to dismiss based on documentary evidence) and relying on an affidavit alone to contradict allegations in a complaint (which cannot be considered as “documentary evidence”).

In partially affirming Justice Fried on the merits, the First Department also highlighted an important distinction in pleading accounting causes of action in disputes involving closely held entities.  Specifically, the court affirmed the dismissal of the accounting cause of action on the ground that plaintiffs failed to plead the requisite element of a fiduciary duty between the plaintiff’s shareholders and the defendant business corporation.  Unlike most partnerships and limited liability companies, New York business corporations usually do not owe fiduciary duties to their shareholders (such duties are owed by officers and directors of the corporation to the corporation itself and thus claims requiring the existence of a fiduciary duty are usually brought derivatively by shareholders on behalf of the corporation and against the officers or directors).
For a detailed description of the facts and procedural history of the Zyskind litigation, as well as a thoughtful analysis of the First Department’s treatment of the claims involving the anti-dilution provisions in the parties’ agreements, see Peter Mahler’s blog post here.