a partner's income which is attributable to his or her accumulated capital interest would not be subject to self-employment tax, while the income which does not represent a fair return on capital (defined as 150% of the highest applicable federal rate, as determined under section 1274(d)(1), at the beginning of the partnership's tax year) would be subject to the self-employment taxes (Social Security, Federal Unemployment Insurance Tax, and Medicaid.) My general impression is that the proposal would represent a tax increase, without much benefit to organizers of limited liability organizations. Comments from members of the section would, however, be appreciated.
William A. Price
201 E. Loop Road
Wheaton, IL 60187
Tel. (630) 682-06042
Fax (630) 682-06010
Email: wpriceiit@hotmail.com
Establishing a protectable interest: forward thinking for clients that use restrictive covenants
By David M. Rownd, Fagel & Haber, Chicago
One of the worst nightmares for any business is to discover that a trusted employee has decided to leave and begin competing against it armed with its proprietary information and established relationships with its customers. To prevent this situation, employers often include restrictive covenants in their employment agreements that prevent employees from competing and require them to maintain the confidentiality of proprietary information.
But putting an agreement in place is only part of what an employer must do to adequately protect itself. A court will not enforce a post-employment restrictive covenant just because an employee has signed it. An employer who seeks to enforce a restrictive covenant must demonstrate, among other things,1 that it has a "protectable interest" which justifies the enforcement of the agreement. In any litigation to enforce a restrictive covenant, this will be an issue of fact on which the employer will have the burden of proof. Employers that have thought through the issue from the outset and implemented appropriate business practices will have a much better chance of meeting this burden. Accordingly, counsel drafting restrictive covenant agreements for employers can play an important role in their clients' ability to enforce these agreements by advising them about what will be required to enforce the agreements and by helping them develop a strategy to establish a protectable interest.
While one might think that one's business would always be a protectable interest, under Illinois law, there are only two situations in which a court will consider a business interest to be legally protectable such that it will justify the enforcement of a restrictive covenant against a former employee.2 The first is where the employer has "near permanent" relationships with its customers and but for the employee's employment he or she would not have had contact with those customers.3 The second situation is where a former employee acquires confidential information during the course of his or her employment and, after termination, attempts to use it for his or her own benefit.4
I. "Near permanent" customer relationships
A. The legal standards
The Illinois courts have developed two tests for determining whether an employer has "near permanent" relationships with its customers. Some courts evaluate this issue under a seven factor test often referred to as the "Agrimerica" factors, based on a frequently cited case of that name.5 Other courts use a "nature of the business" test to determine whether a "near permanent relationship" exists.6 There is no clear guidance from the courts at this time as to when the Agrimerica factors will be used or when the "nature of the business test" will be used.7 Accordingly, employers should be prepared to demonstrate "near permanent customers" under both tests.
1. Agrimerica factors
The seven Agrimerica factors are as follows:
1. the length of time required to develop the clientele;
2. the amount of money invested to acquire clients;
3. the degree of difficulty in acquiring clients;
4. the extent of personal customer contact by the employee;
5. the extent of the employer's knowledge of its clients;
6. the duration of the customers' association with the employer; and
7. the continuity of the employer-customer relationship.8
2. Nature of the business test
Under the "nature of the business" test, organizations which provide services are typically held to have "near permanent relationships" with their customers.9 Businesses involved in sales will have more difficulty establishing "near permanent relationships." Where an industry is highly competitive, the identity of customers or clients is well known in the industry, employers rely heavily on their sales force and customers utilize many suppliers simultaneously to meet their needs, courts will typically find that the employer does not have "near permanent" relationship with its customers.10
3. The "but for" element
Even if a company can satisfy the Agrimerica factors or the Nature of the Business test, a court will not find a protectable interest based on "near permanent relationships" with customers where the employee had contact with the customer or client prior to working for the employer seeking to enforce the restriction. Thus, a claim of "near permanent" customers can be defeated if the employee can show that he or she brought the customers or clients to the employer.11 Similarly, if the employee can show that the employer's customers are easily ascertainable from the phone book or professional directories, the court will be inclined to conclude that the employer has not satisfied the "but for" element of the near permanent relations requirement.12
B. Strategies for establishing "near permanent customers"
The general argument to be made when seeking to establish "near permanent relationships" under either the Agrimerica factors or the "nature of the business" test is that the employer invests significant resources in the acquisition of new customers and maintains its existing customers by engendering loyalty and providing high quality service and but for the employee's employment, he or she would never have known this information. Accordingly, to put themselves in a position to establish "near permanent" relationships with customers under the Agrimerica factors or the Nature of the Business test, employers would be well advised to consider, among others, the following business practices:
* Document the amount of time and money that the company invests in acquiring its customers.13
* Require employees to maintain "call reports" reflecting the activities in which they engage in the pursuit of customers and the amount of time that they spend in these activities.14
* Document the amount and/or percentage of customers which are steady, repeat customers; the percentage of business which comes from a small percentage of the company's customer base; and the percentage of customers from prior years that are still customers today. This could include the maintenance of a database on prospects with the ability to generate monthly reports on customer usage.15
* Emphasize the service that the company provides to customers.16
II. The protection of confidential information
A. Legal standards
An employer can also enforce a restrictive covenant if it is necessary to protect confidential information.17 A customer list can be confidential information.18 So can marketing and pricing information.19 So can technical information.20 Even if information does not qualify as a trade secret, it can still be sufficiently confidential to justify the enforcement of a restrictive covenant.21 However, a salesman's knowledge of customers typically will not be considered confidential information.22 Nor will general knowledge about the employer's business.23 Additionally, an employer ordinarily cannot claim that information is confidential if that information could be easily obtained from some other source.24
B. Strategies for protecting confidential information
In order to establish a protectable interest in confidential or proprietary information, the employer must establish that the information has value because it is not generally known and that it has taken appropriate steps to preserve the confidentiality of the information.25 Accordingly, if a company wants certain information to be considered confidential, the company must have procedures in place that reflect its efforts to ensure the confidentiality of the information. While other procedures may be necessary depending upon the particular circumstances of a given employer, any company that wishes to protect confidential information should consider implementing the following practices to preserve the confidentiality of that information:
* Inform employees that the company considers certain information confidential and tell them what information the company considers to be confidential.26
* Keep confidential information in a locked office separate from other information.27
* Label confidential information.28
* Do not disclose confidential information to employees unless they have a "need to know" the information to perform their job duties and keep track of which employees have access to particular confidential information.29
* Use confidentiality agreements and restrictive covenants for all employees who have access to confidential information.30
* When employees leave, conduct an exit interview and reinforce their obligation to refrain from disclosing or using confidential information.31
Because employers have the burden to demonstrate that they have undertaken sufficient efforts made to maintain the secrecy of confidential information, such efforts should be documented so that the employer can more easily satisfy its burden of proof in the event that the need arises.
III. Conclusion
While any attempt to enforce a restrictive covenant will be subject to some uncertainty, if an employer can establish a protectable interest, it will be much more likely to be successful. Employers which get a head start in developing strategies to establish a protectable interest will be in a much better position when an enforcement need arises. Whenever drafting restrictive covenants, counsel should advise their clients appropriately to help them get that head start.
David M. Rownd
Fagel & Haber
140 South Dearborn, 14th Floor
Chicago, Illinois 60603
(312) 346-7500
© 2000 by David M. Rownd
_______________
1. Employers seeking to enforce a restrictive covenant must satisfy a number of issues including, among others, whether it is ancillary to a valid employment relationship, whether it is supported by consideration and whether it is reasonable in its scope and duration. Any one of these issues can be fatal to enforcement. This article focuses on the threshold issue of whether an employer can establish that it has a "protectable interest" which will justify the enforcement of a restrictive covenant.
2. This article focuses on restrictive covenants in the employment context. Restrictive covenants are also commonly used in Shareholder Agreements, Limited Liability Company Operating Agreements and agreements relating to the sale of a business. When the covenant is ancillary to the sale of a business, a "protectable interest" is more easily established Central Water Works Supply, Inc. v. Fisher, 240 Ill.App.3d 952 (4th Dist. 1993); Decker, Berta & Co., Ltd. v. Berta, 225 Ill.App.3d 24 (4th Dist. 1992). Specifically, courts have noted that "a covenant ancillary to the sale of a business ensures that the former owner will not walk away from the sale with the company's customers and good will, leaving the buyer with an acquisition that turns out to be only chimerical." Hamer Holding Group, Inc. v. First United Property Mgt. Co., 244 Ill.App.3d 1069 (1st Dist. 1993).
3. Office Mates 5, North Shore v. Hazen, 234 Ill.App.3d 557 (1st Dist. 1992).
4. Id.
5. Agrimerica, Inc. v. Mathes, 199 Ill.App.3d 435 (1st. Dist. 1990). See also Audio Properties, inc. v. Kovach, 275 Ill.App.3d 145 (1st Dist. 1995)(applying Agrimerica factors).
6. Lawrence and Allen, Inc. v. Cambridge Harmon Resources Group, Inc., 292 Ill.App.3d 131 (2d Dist. 1997); Outsource International, Inc. v. Barton, 192 F.3d 662 (7th Cir. 1999) (applying Illinois law); Office Mates 5, North Shore v. Hazen, 234 Ill.App.3d 557 (1st Dist. 1992); Springfield Rare Coin Galleries, Inc. v. Mileham, 250 Ill.App.3d 922 (4th Dist. 1993).
7. Springfield Rare Coin Galleries, Inc. v. Mileham, 250 Ill.App.3d 922 (4th Dist. 1993) (noting that the Agrimerica factors need not be used in every case).
8. Agrimerica, Inc. v. Mathes, 199 Ill.App.3d 435, 434-35 (1st. Dist. 1990).
9. Outsource International, Inc. v. Barton, 192 F.3d 662 (7th Cir. 1999) (applying Illinois law) (temporary labor business in which reliability of service was a paramount concern had "near permanent" relationships with its customers under the "nature of the business" test).
10. Office Mates 5, North Shore v. Hazen, 234 Ill.App.3d 557 (1st Dist. 1992); Springfield Rare Coin Galleries, Inc. v. Mileham, 250 Ill.App.3d 922 (4th Dist. 1993).
11. LSBZ, Inc. v. Brokis, 237 Ill.App.3d 415 (2d Dist. 1992) (beauty salon could not establish "near permanent" customers where it could not show that customers were its customers, rather than the customers of the stylist; the evidence showed that most of the stylist's customers came to her by word of mouth referral, rather than through the efforts of the salon); Carter-Shields v. Alton Health Institute, 2000 Ill.App. LEXIS 861 (5th Dist. 2000) (refusing to enforce a restrictive covenant against a physician and noting that "it is more likely that the patients would establish a near-permanent relationship with the physician, rather than a health care entity.")
12. Office Mates 5, North Shore v. Hazen, 234 Ill.App.3d 557 (1st Dist. 1992); Springfield Rare Coin Galleries, Inc. v. Mileham, 250 Ill.App.3d 922 (4th Dist. 1993); Rapp Insurance v. Baldree, 231 Ill.App.3d 1038 (5th Dist. 1992) (where most of the customers that the employee serviced were obtained through "cold calls," the court concluded that the employer could not establish that but for his employment, the employee would not have come into contact with the customers).
13. Agrimerica, Inc. v. Mathes, 199 Ill.App.3d 435 (1st Dist. 1990)("near permanent customers" shown where an employer could show that it had invested "hundreds of thousands of dollars" to develop new customers and that it was "nearly impossible" to make a sale on a first call to a customer); Arpac Corp. v. Murray, 226 Ill.App.3d 65 (1st. Dist. 1992) ("near permanent customers" shown where employer manufactured sophisticated expensive machinery which required a great deal of time and expense to market and where the employer depended on the loyalty of its customers to effectuate sales); Label Printers v. Pflug, 206 Ill.App.3d 483 (2d Dist. 1991)("near permanent customers" not shown where the evidence established that business could be developed without substantial investment, often on the basis of cold calls.)
14. Agrimerica, Inc. v. Mathes, 199 Ill.App.3d 435 (1st Dist. 1990) (employer's use of call reports demonstrated the extent of employee's customer contacts and the employer's knowledge of its customers for purposes of establishing "near permanent customers.")
15. Agrimerica, Inc. v. Mathes, 199 Ill.App.3d 435 (1st Dist. 1990) ("near permanent customers" shown where 75% of employer's sales were to customers it had for more than five years); Lyle R. Agency, Inc. v. Steward, 235 Ill. App. 3d 631 (3d Dist 1993)("near permanent" customers shown where 75% of the employer's customers had been customers for nine years and 90% of the employer's business was renewed annually); Millard Maintenance Service Co. v. Bernero, 207 Ill. App. 3d 736 (1st Dist. 1990) ("near permanent customers" shown where employer's seven largest customers composed 70% of its business); Preferred Meal Systems, Inc. v. Guse, 199 Ill.App.3d 710, 723-24 (1st. Dist. 1990) ("near permanent customers" shown where 70% of business was received from 20 customers; of 120 customers, 55 had been clients for more than 10 years and 85 had been clients for over five years); The Instrumentalist Co. v. Band, Inc., 134 Ill.App.3d 884 (1st Dist. 1985) ("near permanent customers" shown where the majority of the plaintiff's top advertisers had advertised for 15 years). Tyler Enterprises of Elmwood, Inc. v. Schafer, 214 Ill.App.3d 195 (3d Dist. 1991) ("near permanent customers" shown where employer had developed its customers over 10 years).
16. Although some of these cases were decided prior to the formal articulation of the Nature of the Business test, the following types of businesses with a service component have been held to have a protectable interest in "near permanent customers." Outsource International, Inc. v. Barton, 192 F. 3d (662 (7th Cir. 1999)(applying Illinois law)(temporary labor business); Frank B. Hall & Co. v. Payseur, 78 Ill.App.3d 230 (1st Dist. 1979) (insurance brokerage); Booth v. Greber, 48 Ill.App.3d 213 (1st Dist. 1977) (electrolysis); Wolf & Co. v. Waldron, 51 Ill.App.3d 239 (1st Dist. 1977) (accountants); Arpac Corp. v. Murray, 226 Ill.App.3d 65 (manufacturer of sophisticated and complicated shrink or plastic wrap packaging machinery); Agrimerica, Inc. v. Mathes, 199 Ill.App.3d 435 (1st. Dist. 1990) (manufacturer and seller of flavoring ingredients, mold inhibitors and surfactants to large scale animal feed producers); A.B. Dick Co. v. American Pro-Tech, 159 Ill.App.3d 786 (1st Dist. 1987) (maintenance and repair services for copiers, microfiche and offset printing equipment); McRand Inc. v. Van Beelen, 138 Ill.3d 1045 (1st Dist. 1985) (designing and coordinating management and incentive award programs for major corporations and businesses).
17. The protection of confidential information is only a legitimate basis for the enforcement of a restrictive covenant where the employer can show that the former employee has attempted or will attempt to use the information. Cincinnati Tool Steel Co. v. Breed, 136 Ill.App.3d 267 (2d Dist. 1985)(restrictive covenant could not be enforced where there was no evidence that the defendant disclosed any confidential information); Ellis & Marshall Associates, Inc. v. Marshall, 16 Ill.App.3d 358 (1st Dist. 1973)(same); Shapiro v. Regent Printing Co., 192 Ill.App.3d 1005 (1st. Dist. 1989) (confidential information cannot justify the enforcement of a restrictive covenant if the employee never had access to it). However, an employer can satisfy this burden by showing that the departing employee had extensive and intimate knowledge of the employer's confidential information and that employment by a competitor would lead to an "inevitable disclosure" of the information. PepsiCo v. Redmond, 54 F.3d 1262 (7th Cir. 1995) (applying Illinois Law).
18. 765 ILCS 1065/2 (d).
19. Millard Maintenance Service Co. v. Bernero, 207 Ill. App. 3d 736 (1st Dist. 1990)(janitorial service contractor's confidential information about customers and pricing justified enforcement of restrictive covenant); Lyle R. Jager Agency, Inc. v. Steward, 253 Ill.App.3d 631, 639-41, 625 N.E.2d 397, 402 (3d Dist. 1993) (customer files containing information relating to pricing were protectable trade secrets); PepsiCo v. Redmond, 54 F.3d 1262 (7th Cir. 1995) (affirming injunction against former PepsiCo employee and PepsiCo competitor preventing competitor from hiring former employee to perform any duties relating to pricing, marketing and distribution). See also Elmer Miller, Inc. v. Landis, 253 Ill.App.3d 129, 133-35, 625 N.E.2d 338, 342-43 (1st Dist. 1993) (affirming entry of Preliminary Injunction in the absence of a restrictive covenant agreement and holding that customer list containing sales and marketing information was a protectable trade secret); Brostron v. Warmann, 190 Ill.App.3d 87, 90; 546 N.E.2d 3, 5 (3d Dist. 1989) (gross profit information for construction projects was a protectable trade secret); Brunswick Corp. v. Jones, 784 F.2d 271 (7th Cir. 1986) (finding that access to confidential marketing strategies, financial performance and projections, gave a competitor the unfair advantage to cut the time and costs required to develop a new product, preempt the plaintiff's new products before they reached the market, and enabled the competitor to determine how aggressively to price its products);
20. Donald McElroy, Inc. v. Delaney, 72 Ill.App.3d 285 (1st Dist. 1979) (employer in the business of recovering silver from photographic materials had a protectable interest where the employee was exposed to the employer's recovery equipment capabilities, yield figures and bid calculation methodology); Tower Oil Technology Co. v. Buckley, 99 Ill.App.3d 637 (1st Dist. 1981) (employer had a protectable interest in technological data concerning lubrication business).
21. Millard Maintenance Service Co. v. Bernero, 207 Ill. App. 3d 736 (1st Dist. 1990).
22. Callahan v. Balfour, 179 Ill.App.3d 372 (1st Dist. 1989).
23. IGL Industries, Inc. v. Scott, 49 Ill.2d 88 (1971); Service Centers of Chicago, Inc. v. Minogue, 180 Ill. App. 3d 447 (1st Dist. 1989) (allegedly confidential pricing formula was not confidential because it was merely a collection of components derived from years of experience in the employer's business); Capsonic Group v. Swick, 181 Ill. App. 3d 988 (2nd Dist. 1989) (general knowledge of and expertise in employer's business was not protectable confidential information)
24. Office Mates 5, North Shore v. Hazen, 234 Ill.App.3d 557 (1st Dist. 1992).
25. George S. May Int'l. Co. v. International Profit Assoc., 256 Ill.App.3d 779 (1st Dist. 1993)(where allegedly confidential information was routinely distributed to trainees prior to signing confidentiality agreement and to prospective clients, information was not sufficiently confidential to justify enforcement of restrictive covenant); Lyle R. Jager Agency, Inc. v. Steward, 253 Ill.App.3d 631 (3rd Dist. 1993)(where customer information was compiled and organized at a single location, such information was sufficiently confidential to justify enforcement of a restrictive covenant).
26. Jackson v. Hammer, 274 Ill.App.3d 59 (4th Dist. 1995) (customer list was not a trade secret where employer did not explain the secrecy of the list to employees); Gillis Associated Industries, Inc. v. Cari-All, Inc., 2605 Ill.App.3d 184, 191 (1st Dist. 1990) (where employee manual referenced "confidential information" but did not identify what information the employer deemed confidential, employer had not taken reasonable measures to preserve secrecy of information).
27. Millard Maintenance Service Co. v. Bernero, 207 Ill.App.3d 736 (1st. Dist. 1990) (confidential information kept under lock and key justified enforcement of restrictive covenant).
28. Gillis Associated Industries, Inc. v. Cari-All, Inc., 2605 Ill.App.3d 184, 191 (1st Dist. 1990) (where allegedly confidential information was not labeled as "confidential", employer had not taken reasonable measures to preserve secrecy of information).
29. George S. May Int'l. Co. v. International Profit Assoc., 256 Ill.App.3d 779 (1st Dist. 1993)(where allegedly confidential information was routinely distributed to trainees prior to signing confidentiality agreement and to prospective clients, information was not sufficiently confidential to justify enforcement of restrictive covenant)
30. Gillis Associated Industries, Inc. v. Cari-All, Inc., 206 Ill.App.3d 184, 191 (1st Dist. 1990) (where there was no evidence that employees with access to confidential information had signed a confidentiality agreement or restrictive covenant, employer had not taken reasonable precautions to preserve the secrecy of information).
31. Id. (where employer did not conduct exit interviews, the court found that it did not take reasonable measures to preserve secrecy of information).
Offshore trust upheld by Second Circuit
By Howard Z. Gopman
In Securities Exchange Commission v. Brennen, Docket No. 00-6128, decided on October 26, 2000, by the Second Circuit Court of Appeals, the court interpreted the automatic stay provisions of the bankruptcy code to protect an offshore asset protection trust. In this case of first impression, the Second Circuit Court of Appeals upheld an offshore asset protection trust. (See https://www.tourolaw.edu/ 2ndCircuit/October00/00-6128.html)
The case arose out of the operations of Robert E. Brennen and First Jersey Securities, Inc. (First), a discount broker-dealer run by Brennen. The SEC sued Brennen and First and obtained a judgment ordering the disgorgement of approximately 75 Million in ill-gotten gains and prejudgment interest. Brennen filed for Chapter 11 bankruptcy protection. In addition, prior to the entry of the judgment, Brennen established an offshore asset protection trust in Gibraltar with $5 million in municipal securities. Mr. Brennen's three adult sons and his personal foundation were the beneficiaries of the trust. The trust terms provided that the trust had no obligation to make payments to the beneficiaries during the life of the trust. Moreover, under the terms of the trust, the principal and accumulated interest would revert to Brennen after ten years (or at some point thereafter as established by the trustee).
The SEC alleged that Brennen exercised control over the trust to support his "lavish, globetrotting lifestyle." The SEC noted that the trust had been relocated twice since the bankruptcy filing, first from Gibraltar to Mauritius and then from Mauritius to Nevis. The transfers were made allegedly because of a flight clause in the trust which requires the trustee to relocate the trust upon the occurrence of an "event of duress," which includes collection action by a governmental body such as the SEC.
The SEC and the Bankruptcy Trustee diligently chased the Trust, even going so far as to bring an action in High Court of St. Kitts and Nevis where the High Court dismissed the action for failure to state a claim under Nevis law.
In addition, the SEC pursued Brennen in the main federal action and obtained an order, requiring Brennen to repatriate the assets of the offshore trust.