This article is reprinted with permission from the
August 30, 1999
edition of
New York Law Journal.
1999 NLP IP Company.

 


Restrictive Covenants: 'BDO Seidman' Case

By Joseph E. Bachelder

 

In BDO Seidman v. Hirshberg1, decided May 13, 1999, the New York Court of Appeals introduced a new, highly questionable criterion in determining the enforceability of a restrictive covenant. That criterion is based on establishing different "categories" of clients.

The Court of Appeals upheld, in part, a restrictive covenant between an accounting firm and one of its employee-accountants. The restrictive covenant provided that if the employee served any client of BDO Seidman within 18 months after leaving the firm he would compensate the firm for its "loss and damages" attributable to the employee's taking the client. The agreement included a liquidated damages clause.

After leaving the firm, and within the 18-month period, the defendant Hirshberg provided services to clients of the firm, which BDO Seidman claimed violated the restrictive covenant. The lower courts decided in favor of Hirshberg on the ground that the restrictive covenant was overly broad. The Court of Appeals reversed in part, holding that as to certain clients the restrictive covenant was enforceable and as to others it was not.

The BDO Seidman decision, as noted, is troublesome because it creates "categories" of clients - some of whom could be taken by defendant Hirshberg without violating the restrictive covenant and some of whom could not. The Court does not reconcile its holding with a number of restrictive covenant cases that suggest a contrary result. For example, it does not distinguish, or even mention, Ticor Title Insurance Co. v. Cohen2, decided by the Second Circuit Court of Appeals in late 1998 (decision reported March 31, 1999), or Maltby v. Harlow Meyer Savage, Inc.3, decided by the Appellate Division, First Department in 1996. Each of these cases reaches what, in essence, is a result contrary to BDO Seidman in very similar circumstances involving restrictive covenants in the form of no-compete agreements.

Common Law Rule

Before a discussion of the BDO Seidman case, following is a brief summary of the common law rule, as in effect in New York, regarding restrictive covenants between employers and employees.4

The rule has its roots in an English law case involving the sale of a bakery business approximately 300 years ago.5 In New York, restrictive covenants ancillary to employment arrangements have been recognized as enforceable for more than 100 years.6

Restrictive covenants between employers and employees take a variety of forms. They may bar an employee, after leaving employment, from
   (A) going to work for a competitor of the employer,
   (B) soliciting or serving customers or clients of the employer or
   (C) soliciting or hiring an employee of the employer.

Restrictive covenants are scrutinized carefully by courts because they impose restrictions on employment and may be anti-competitive. These public policy concerns are to be measured against the justifiable needs of businesses to protect their legitimate interests against unfair practices by employees or others who may hire them away in order to gain an unfair advantage over the original employer.

Accordingly, to be enforceable in New York, a restrictive covenant between an employer and an employee must be
   (1) necessary to protect the legitimate business interests of the employer;
   (2) limited so that it does not unduly impede the ability of the employee to find employment; and
   (3) reconcilable with the interests of the public in optimizing availability of goods and services and encouraging competition.7

In elaborating on this basic rule, New York courts have adopted a number of ancillary rules:
   (a) The covenant must be reasonably limited in terms of time and geographic scope and
   (b) To establish that the restriction is necessary to protect its legitimate business interests, the employer must show that the restriction is necessary
       (i) to protect its trade secrets
       (ii) to protect other confidential information essential to its business or
       (iii) because the employee's services are special or unique.8

Manager's Agreement

In BDO Seidman, the dispute arose out of a "Manager's Agreement" that provided it would be a breach of the agreement and of the employee's fiduciary duty as a manager for the employee to "obtain the business" of BDO clients through the use of "confidential information" about such clients during the period of 18 months following a termination of his employment.9

"Confidential information" was defined to include confidential and proprietary information "developed, held and used" by the firm, including a client's identity as a client of the firm, all "information and knowledge" about such client, information about fees charged by the firm to such client, information about personnel of such client, and other such information about the firm's clients (specified in Article Fourth of the Manager's Agreement) as is "not generally known to the public."

Article Sixth of the Manager's Agreement provides:

It is agreed that Manager has a fiduciary relationship with the Firm because of all the Confidential Information he has obtained and will obtain concerning the Firm, its policies, practices and business and, as detailed in Paragraph FOURTH, its clients. It is also understood that the Manager, if he left the employ of BDO Seidman, would be in an advantageous position, because of the Confidential Information and proprietary business information known to him, to obtain the business of, and to serve, the Firm's clients; and it is agreed that the use of such Confidential Information and other information to obtain the business of BDO Seidman's clients would be a breach of the Manager's fiduciary responsibilities to the Firm as well as of this Agreement, prejudicial to the conduct of the Firm's practice, and adverse to its interests.

If the employee violated Article Sixth, then "for the loss and damages" suffered by the firm the employee was to pay the firm "by reason of the lost engagements" as a result of a client's leaving to do business with the employee "an amount equal to one and one-half times the fees charged for such engagement(s) by the Firm over the last full fiscal year during which the client was a client of the Firm..."

The defendant left BDO Seidman and, in alleged violation of the Manager's Agreement, took with him, within the 18-month period, a significant number of BDO Seidman clients. BDO Seidman sued for damages pursuant to the liquidated damages clause.

The core issue before the Court of Appeals was whether the restrictive covenant satisfied the first of the three tests under the common law rule on enforceability of a restrictive covenant, as set out above: Was the covenant essential to the protection of BDO Seidman's legitimate business interests?

With regard to the "unique or extraordinary nature" of the employee or his services, the court concluded as follows:

defendant's unchallenged averments indicate that his status in the firm was not based upon the uniqueness or extraordinary nature of the accounting services he generally performed on behalf of the firm, but in major part on his ability to attract a corporate clientele. Nor was there any proof that defendant possessed any unique or extraordinary ability as an accountant that would give him a competitive advantage over BDO. (slip op. at 7-8)10

Notwithstanding its failure to find that Hirshberg's accounting services were unique or extraordinary and also its finding that "there is no evidence that the employee obtained a competitive advantage by using confidential information" (slip op. at 9) the Court concluded that BDO Seidman had a legitimate interest to protect. It commented as follows:

"Protection of customer relationships the employee acquired in the course of employment may indeed be a legitimate interest." (slip op. at 9)

"The employer has a legitimate interest in preventing former employees from exploiting or appropriating the goodwill of a client or customer, which had been created and maintained at the employer's expense, to the employer's competitive detriment." (slip op. at 10)

"BDO's legitimate interest here is protection against defendant's competitive use of client relationships which BDO enabled him to acquire through his performance of accounting services for the firm's clientele during the course of his employment." (slip op. at 10)

In a nutshell, the Court of Appeals is saying that while there were no trade secrets, confidential information or anything particularly unique or extraordinary about Hirshberg's accounting services, his relationships with clients were something special and involved legitimate, protectible business interests of BDO Seidman.

Two Exclusions

If the Court had concluded its holding at this point, this column might not have been written. However, the Court felt compelled to exclude two categories of BDO Seidman's clients from the reach of the restrictive covenant:

(1) clients of BDO "who came to the firm solely to avail themselves of his services and only as a result of his own independent recruitment efforts, which BDO neither subsidized nor otherwise financially supported as part of a program of client development" (slip op. at 11-12) and

(2) clients of BDO Seidman as to which the defendant "never acquired a relationship through direct provision of substantive accounting services during his employment." (slip op. at 11)

Having announced these guidelines, the Court of Appeals leaves to the lower court to resolve "any contested issue as to which of BDO's former clients served by defendant the restrictive covenant validly covers." (slip op. at 16)

Among the problems posed by the Court's decision are the following:

1. Client Category One: The Court of Appeals excludes Hirshberg's "personal" clients from the restriction of the covenant. In this connection, the Court makes the following statement: "Because the goodwill of those clients [who were the personal clients of Hirshberg] was not acquired through the expenditure of BDO's resources, the firm has no legitimate interest in preventing defendant from competing for their patronage." [Insert added.] (slip op. at 12)

This statement is, to say the least, a puzzling one. One of the purposes of having an accountant like Hirshberg is to encourage client development for which BDO Seidman financially supported him through compensation and otherwise. Presumably, in addition to salary, bonus and benefits, the firm provided him with an office, secretarial services and support staff as well as collateral professional services. In addition, had not BDO Seidman spent decades of time, effort and expense in building goodwill for the firm in the Buffalo area? How can the Court have concluded that "the goodwill of those clients [coming to Hirshberg during his employment by BDO Seidman] was not acquired through the expenditure of BDO's resources"? [Insert added.] (slip op. at 10)

2. Client Category Two: The Court excludes those clients for which defendant provided no "direct, substantive accounting services." (slip op. at 10) In this regard:

A. What about indirect services performed by Hirshberg for a client such as providing supervisory or advisory services through another accountant? Could he not have developed a relationship with a client through such indirect services?

B. The Court states, "there is no evidence that the employee obtained a competitive advantage by using confidential information." (slip op. at 9) Just before making that observation, it notes: "If the employee abstains from unfair means in competing for those clients, the employer's interest in preserving its client base against the competition of the former employee is no more legitimate and worthy for contractual protection than when it vies with unrelated competitors for those clients." (slip op. at 9)

As to its first statement, as quoted in the preceding paragraph, the Court ignored the Manager's Agreement, an exhibit in the case, in which the parties agreed that Hirshberg would be privy to all kinds of confidential information regarding the firm and its clients including fees, firm policies, documents, financial data, etc. Fee structures alone provide confidential information as to billings of clients that can be very important to a client relations hip.11 Clearly a professional need not serve particular clients, directly or indirectly, to learn much about the relationship between the firm and such clients. To conclude that a professional employee like Hirshberg with years of service with a firm like BDO Seidman is in no different position than "unrelated competitors" in vying for the clients of BDO Seidman - including clients he may not have worked for personally - ignores the reality of how a service firm works.

3. Why did the Court of Appeals begin its opinion by describing this as a case involving "reimbursement" for departing clients? Its opinion does not clarify that opening reference. If some sort of pre-agreed "reimbursement" was its theory of the case, it does not explain the basis for such a theory.12 Certainly such theory (if it even existed in the Court's thinking) failed to take the Court out of the "bramblebush" of restrictive covenant authorities forming the basis for its opinion. And rightly so. Whether one calls the payment owing by Hirshberg to BDO Seidman "liquidated damages" (as does the Manager's Agreement) or a "reimbursement," the choice of words does not alter the nature of the restrictive covenant giving rise to the payment. Certainly the Court would not suggest that labeling a payment as a reimbursement would justify an escape from public policy considerations long applicable to restrictive covenants.

4. What are the implications of BDO Seidman for restrictive covenants in the form of no-compete agreements? Assume the same facts as in BDO Seidman except that the restrictive covenant was in the form of a no-compete clause for, say, six months. These are facts patterned very much along the lines of Ticor and Maltby. It is difficult to see how the Court of Appeals, based on its decision in BDO Seidman, could have enforced the no-compete. Or would the Court propose some form of judicial alchemy whereby a no-compete covenant is converted into a limited no-solicit or no-serve covenant affecting only some of an employer's customers or clients? Any such results would be very troubling to the stability of existing law in New York regarding no-compete agreements.


FOOTNOTES:

1 BDO Seidman v. Hirshberg, 93 N.Y.2d 382, 690 N.Y.S.2d 854 (May 13, 1999), aff'g 247 A.D.2d 923, 668 N.Y.S.2d 537 (4th Dept. 1998).

2 Ticor Title Insurance Co. v. Cohen, 173 F.3d 63 (2d Cir. March 31, 1999), aff'g 1998 U.S. Dist. LEXIS 9700 (S.D.N.Y. July 1, 1998). (The reporting of the Ticor Title Insurance Co decision is somewhat confusing. The Court of Appeals for the Second Circuit issued its decision November 18, 1998 and that decision is reported at 159 F.3d 774. Notwithstanding this, the opinion setting forth the reasons for the decision as reported at 173 F.3d 63 indicates the decision date to be March 31, 1999).

3 Maltby v. Harlow Meyer Savage, Inc., 223 A.D.2d 516, 637 N.Y.S.2d 110 (1st Dep't 1996), aff'g 166 Misc.2d 481, 633 N.Y.S.2d 926 (Sup.Ct. 1995).

4 Under New York practice rules, lawyers, in contrast to accountants, are under a disciplinary rule that prohibits restrictive covenants (except as a condition to payment of retirement benefits). DR2-108 of the Code of Professional Responsibility (22 New York Codes, Rules and Regulations 1200.13). Thus, lawyers are not subject to the common law rule as to restrictive covenants.

5 Mitchel v. Reynolds, 24 Eng. Rep. 347 (Q.B. 1711).

6 Diamond Match Co. v. Roeber, 106 N.Y. 473, 13 N.E. 419 (1887).

7 See Restatement (Second) of Contracts 188 (1981); a similar statement of the rule is contained in BDO Seidman v. Hirshberg, cited supra note 1. The actual statement of the New York Court of Appeals appears at page 4 of its slip opinion. References in this column are to the typed version of the slip opinion because the official report was not available at the time this article was being prepared. For a general discussion of New York law applicable to no-compete agreements, see Sara C. Kinsey, Note, "Enforceability of Non-Competition Provisions in Executive Employment Agreements: A Fresh Look at New York Law," 36 N.Y.L. Sch. L.Rev. 427 (1991).

8 See Reed Roberts Associates, Inc. v. Strauman, 40 N.Y.2d 303, 307, 386 N.Y.S.2d 677, 679 (1976); see also Lumex, Inc. v. Highsmith, 919 F. Supp. 624 (E.D.N.Y. 1996).

9 The BDO Seidman Manager's Agreement with Jeffrey Hirshberg, dated July 1, 1989, is "Exhibit A" annexed to the "Affidavit of Hirshberg" filed in the BDO Seidman v. Hirshberg proceeding.

10 As explained in note 7 supra, the page references are to the slip opinion.

11 In footnote 2 of its opinion, the Court states that: "A different result might obtain had BDO submitted any proof that defendant had used confidential firm information to attract BDO clients with whom he had not had a relationship while employed there." (BDO Seidman, slip op. at 10). This statement is difficult to understand, in light of the circumstances of this case, including, as noted in the text, the Manager's Agreement.

12 At page 3 of the slip opinion, the Court notes that the agreement does not expressly bar the defendant from servicing clients of BDO Seidman (which would be consistent with a theory that the former employee was simply entitled to "purchase" or "reimburse" BDO Seidman for clients he took with him). But almost immediately thereafter, at page 4 of the slip opinion, the Court refers to the remedy of BDO Seidman for loss of clients to defendant as being for "loss and damages" and it describes the agreement as "a form of ancillary employee anti-competitive agreement."