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Liquidated damages: the forgotten remedy in noncompete disputes: damages are often difficult to prove in unfair competition cases. Attorneys who draft restrictive covenant agreements can provide their clients with a more effective - and efficient - remedy by being aware of the law concerning liquidated damages clauses.

When an employer files suit against an ex-employee for breach of a restrictive covenant, obtaining preliminary injunctive relief is almost always its main concern. (1) The substantial threat of losing key accounts, not to mention the erosion of business goodwill, can justify broad interim relief before a trial on the merits.

An employer's successful pursuit of injunctive relief almost always emboldens it to seek damages. However, damages can be difficult to prove, especially if a court issues an injunction soon after the ex-employee begins competing. A well-drafted liquidated damages clause can provide an employer with an added layer of protection in fighting to protect its customer base. Too often, however, this remedy garners little attention, or is not drafted to withstand court scrutiny.

This article reviews the application of a liquidated damages clause to an employment restrictive covenant agreement and emphasizes how practitioners can draft enforceable clauses for their business clients' protection.

Why include a liquidated damages clause in a restrictive covenant?

In noncompete disputes, an enforceable and well-drafted liquidated damages clause solves a number of problems. First, if an employer loses Customers due to an employee's breach of contract, an employer may not be saddled with the burden of demonstrating what it would have earned in the future from that particular account.

Proving lost profits is far from easy and requires an employer to speculate about future business. (2) Expert testimony on lost profits often is excluded because of faulty or incomplete assumptions and improper attribution of lost revenues to acts of unfair competition. (3)

Practically speaking, proving lost profits creates an enormous discovery burden for both the employer and the employee, mandating a look at historical sales and future projections, as well as a broad inquiry into how long a customer could be expected to retrain with the company and other micro- and macroeconomic factors contributing to a company's diminution in revenue. A liquidated damages clause can reduce the amount of discovery directed at third-parties, a tactic frequently used to drive a wedge between the former employer and its customers.

Second, an employer can create leverage to settle on the injunctive aspect of the lawsuit by holding the specter of liquidated damages over the employee. An employee's best defense often is that the employer has not incurred any damages even if a breach can be proven. An employer whose primary concern is to obtain a commitment from the employee to stay away from certain clients is in a better position to do this by offering to forgo liquidated damages.

Standards for application

The chief benefit of a liquidated damages clause is that it alleviates the burden of proving lost profits. That being said, the clause should serve as a reasonable substitute for a lost profits damage award. It should not be punitive or based on an arbitrary number or broad forfeiture penalty, all of which certainly deter a breach but create a risk of nullification by the courts. (4)

The leading Illinois case addressing liquidated damages in a restrictive covenant agreement provides that two conditions must be present for a liquidated damages provision to be enforceable: (a) the damages resulting from a breach must be difficult to calculate, and (b) the amount of fixed damages must be a reasonable forecast of the damage likely to occur. (5) Courts in Illinois will invalidate liquidated damages clauses which fail to meet this test, even if the parties are economically sophisticated. (6)

The damages must be for a specific amount for a specific breach. (7) However, the clause does not need to set forth a sum certain, if the amount can be readily computed.

Types of liquidated damages clauses

A practitioner must be prepared to explain to his or her client the considerations on which the damages clause should be based. Given the relative lack of case law on this subject in Illinois, a business attorney is well-advised to consider cases from other states which shed light on the types of clauses likely to be enforced, and those which run the risk of being construed as an unenforceable penalty.

Multiplier of previous years' profits, commissions, or sales. The best liquidated damages clause ties the pre-determined damages to the previous year's profits from a customer who is improperly solicited. Although an employee will argue that the customer would not have continued to conduct business with the company for an extended period, this formula for computing damages does not appear arbitrary, unlike some commonly used methods. An example of such a clause provides as follows:
 Employee and the Company agree that if Employee breaches his
 obligations under Section--, he shall pay the Company as liquidated
 damages the stun of two (2) times the previous fiscal year's
 commissions paid to Employee for cash customer which has ceased
 doing business with the Company as a result of such solicitation.


A reasonable substitute may be a weighted-average formula for commissions earned from an account during the employee's tenure or a higher multiple for long-standing accounts. An employer must be able to present reasonable business facts to support its argument for choosing a certain multiplier.

A clause substantially similar to the above recommended example was upheld in Tomei v Tomei. (8) In that case, the language of the provision was drafted more broadly than the example above, since the availability of damages was not tied to actual loss of business but rather solicitation alone. The court specifically held that "damages resulting from an attempted solicitation are clearly difficult to calculate, since an attempted solicitation, may or may not result in future damage...." (9)

Nevertheless, the court found that the liquidated damages were tied to the previous year's commissions earned by the company from the customer improperly solicited. (10) It amounted to a fair and reasonable scheme for fixing damages. (11)

It is possible that a clause like the one at issue in Tomei may be unreasonable in certain cases. Practitioners should consider drafting the liquidated damages clause in such a way that unsuccessful solicitations do not trigger the damage calculation. (12) Another problem area could arise when employers request that a multiplier of revenues, as opposed to profits (or commissions), be the basis for the damage award. (13) This number is certain to be higher, but it is also amenable to attack by the employee as an unreasonable penalty.

For instance, in Coleman v B.R. Chamberlain & Sons, Inc, (14) the Florida District Court of Appeals found unenforceable a liquidated damages clause in a noncompete agreement providing that the financial advisor would be required to pay 200 percent of one year's gross revenues generated by each client for whom the advisor provided post-employment services." (15) The court stated that the payment was "clearly disproportionate to actual damages because Coleman was required to immediately pay the gross anticipated receipts from a client relationship, which would give Chamberlain more than the amount of its actual damages." (16)

The safest and most widely enforceable type of liquidated damages clause ties the agreed-upon payment to historical profits or commissions per lost customer, rather than gross revenues, although there are plenty of cases that will suggest revenues is an appropriate and reasonable figure in certain situations. (17) Attorneys who include the higher revenue figure as the basis for damages run the risk of having a court declare that the employer overreached and sought to impose a penalty that bears no actual relation to damages. Contract law permits a non-breaching party to recover lost profits, not lost revenues.' (18)

Withholding sums due. Other types of liquidated damages clauses have been held unenforceable because they impose a penalty for breach. (19) An example of a clause that lacks a reasonable basis for estimating damages can be found in Callahan v L.G. Balfour. (20)

In that case, the employee's contract provided that, in addition to injunctive relief, the employer could retain as liquidated damages any sums that may be due to the employee as earned commissions. (21) Because the amount that the employee could earn as a commission (as well as other equity payments) varied greatly with the number of orders placed, the provision amounted to a penalty and bore no reasonable relationship to the damages likely to occur from unfair competition. (22)

The real problem with a forfeiture provision like the one in Callahan is that it looks backward and is not a forecast of damages likely to occur as a result of unfair competition. Wage payment and sales representative statutes protect all individual's ability to be compensated for time worked or sales procured.

Therefore, a compensation forfeiture clause violates public policy, in addition to the fact that it lacks any real forecast of damages. In fact, if an employer tried to withhold wages or commissions, it conceivably could be in material breach of the employment contract, thereby releasing an employee from any noncompete obligations. (23)

Monetary penalty per day of illegal competition. In the context of a straight noncompete clause, assessment of damages may be more difficult. When an employee improperly solicits his old accounts, a well-crafted liquidated damages clause can be premised on the previous year's sales or profits. However, assuming that the only violation of an employment agreement is the simple act of going to work for a competitor, the damage analysis can be more attenuated, particularly if steps are taken to erect a "Chinese Wall" between the employee and accounts he serviced at his previous employer.

An example of this tension can be found in Magic Valley Truck Brokers, Inc v Meyer. (24) In that case, the departing employee's restrictive covenant contained both a customer nonsolicitation clause and a general noncompetition clause. The Court of Appeals of Idaho upheld a determination that the liquidated damages clause, which assessed damages at $5,000 per month of illegal competition, was void as a penalty.

Significantly, in that case, the only "harm" was the employee's acceptance of a job with a competitor. The new employer took steps to ensure that the employee would not contact customers of his former employer, and the employee was assigned principally to two accounts that did not conduct business with his old company. Moreover, the new employer presented evidence that it actually lost money on the employee's services during his first year of employment. In view of all these facts, the liquidated damages clause was not a reasonable forecast of damages and amounted to an unenforceable penalty. (25)

Liquidated damages clauses that assess a fixed sum per day, week, or month of illegal competition are ripe for an argument that they are punitive and intended only to secure compliance with the agreement. As such, they are a poor indicator of actual damages. It would be difficult to provide an evidentiary basis for claiming that the fixed fee is a reasonable estimation of loss. These types of clauses should be avoided.

Flat-fee damages. Flat-fee liquidated damages also give the appearance of arbitrariness. Despite the ease of drafting such a clause, attorneys should refrain from employing such a contractual device.

For instance, in Allied Informatics, Inc v Yeruva, (26) the Court of Appeals of Georgia declared void a liquidated damages clause that provided for a graduated series of lump-sum payments by a departing employee. The contract provided for sum-certain damages pertaining to four events: (a) terminating employment during the pendency of a consulting project ($5,000); (b) terminating employment after completion of a project, but within 15 months of the start of employment ($10,000 for training costs); (c) failing to give 30 days' notice of resignation ($5,000); and (d) soliciting, or accepting work with, a firm client ($10,000). (27)

The court upheld the grant of summary judgment in favor of the employee and determined that "[n]o evidence shows that the sums identified in the contract bear any relation to the actual damages that could be incurred from a breach." (28)

Forfeiture of future salary. Another option for setting liquidated damages is to base them on the salary earned from work with a competing firm. While this would seem to constitute a penalty, akin to the withheld commissions from the Callahan case, at least one court has upheld the propriety of such a clause.

In Omicron Systems, Inc v Weiner, (29) the Superior Court of Pennsylvania upheld a liquidated damages award of $238,000 against an executive who breached a noncompete clause by accepting a job at a rival enterprise. (30) The employee's restrictive covenant contained a liquidated damages clause that empowered the court to render an "equitable accounting of all earnings, profits and other benefits arising from Such violation ...' (31) With very little analysis, the court cited a seemingly inapplicable prior case and stated the clause justified the trial court's award of what amounted to 22 months' employment income earned from his new employer--a rival of his old company. (32)

The decision is startling in scope, especially given the paucity of analysis on how the award bore a rational relation to any loss suffered by the former employer. Salary forfeiture from the new employer amounts to an unjust windfall and is inherently unconnected to any actual loss.

Although a Pennsylvania court validated such an agreement, counsel should be careful when recommending this as a method of fixing damages. If used at all, such types of damage provisions should be used only when the contract deals with a high-level executive in a position to disclose valuable trade secrets.

Drafting considerations

A well-drafted liquidated damages provision should accomplish three goals for a business client. First, the employer must be able to articulate before a trier of fact the reasoning behind the liquidated damages clause and its method of calculation.

If, as in the recommended example above, the employer selects a multiple of commissions or profits relative to a stolen customer, then it should have a basis for explaining why that multiple is rationally related to protecting the business interests of the company and compensating it for the breach. Such testimony could be based on the length of time it takes for the company to regain or make up for lost business, the expected or average duration of a client relationship or project, the amount of time and money invested in prospecting new customers, lost referral opportunities from existing customers, or out-of-pocket costs (e.g., additional labor hired, billing write-offs, or overhead incurred) associated with losing clients.

Second, the liquidated damages clause should recite the legal standard and contain an acknowledgement by the employee that (a) it would be difficult to ascertain the amount of damage that the employer will sustain if the employee breaches his noncompete or nonsolicitation obligations and (b) the agreed-upon formula is a reasonable forecast of the damage likely to occur following a breach. Acknowledgment clauses in noncompete agreements are far from infallible, but it can only help the employer argue before the court that the parties contemplated that the damage clause would be acceptable.

Third, the liquidated damages clause should state that nothing in the clause will prohibit the employer from seeking, in addition to liquidated damages, equitable relief for a breach or threatened breach by the employee of the restrictive covenants. This language eliminates any argument that an employee could raise concerning exclusivity of remedies. The law is fairly clear that a provision for liquidated damages in the event of a breach does not preclude injunctive relief. (33)

For liquidated damages to be the sole and exclusive remedy, the contract must contain language specifically providing as such. (34) A simple recitation concerning the availability of other remedies will leave no doubt that the employer can avail itself of both legal and equitable remedies for a noncompete violation.

Conclusion

Liquidated damages clauses are an underused tool by practitioners who draft employment agreements.

However, since they will be scrutinized by courts carefully, corporate lawyers should consult with their clients to learn how a business is likely to suffer monetary harm in the event of breach. While lost profits are difficult and expensive to prove, a liquidated damages clause that is well-drafted provides an employer with a powerful tool to discourage unfair competition and obtain a damage judgment in the event of breach.

(1). See Richard L. Miller 11, FROs: A Guide to Winning Emergency Relief in Illinois, 93 Ill Bar J 530 (Oct 2005) and William Lynch Schaller, Some Preliminary Thoughts About Preliminary Injunctions, 85 Ill Bar J 12 (Jan 1997).

(2.) See Med+Plus Neck and Back Pain Center, SC v Noffsinger, 311 Ill App 3d 853, 859, 726 NE2d 687, 692-93 (2d D 2000) (articulating standard by which plaintiffs must prove lost profits award); Damron v Micor Distributing, Ltd, 276 Ill App 3d 901, 909, 658 NE2d 1318, 1324 (1st D 1995) (discussing burden on damage experts to account for other contributing causes of lost profits).

(3.) Schiller & Schmidt, Inc v Nordisco Corp, 969 F2d 410, 411-16 (7th Cir 1992) (noting that expert in trade secrets case neglected to consider effects of lawful competition on lost profits damages analysis): KW Plastics v United States Can Co. 131 F Supp 2d 1289. 1292-94 (MD Ala 2001) (excluding, under Illinois law, expert testimony in trade secrets dispute, when expert failed to take into account production capability and cost increases in projecting lost profits).

(4.) See Checkers Eight Ltd Partnership v Hawkins, 241 F3d 558, 562 (7th Cir 2001) (stating Illinois rule than "[i]f the amount of damages is invariant to the gravity of the breach, the clause is probably not a reasonable attempt to estimate actual damages and thus is likely a penalty.").

(5.) Tomei v Tomei, 235 Ill App 3d 166, 172, 602 NE2d 23, 27 (1st D 1992).

(6.) Checkers Eight, 241 F3d at 563.

(7.) Noffsinger at 860 726 NE2d at 693.

(8) Tomei (cited in note 5). See also, Overholt Crop Ins Service Co v Travis, 941 F2d 1361, 1369-70 (8th Cir 1991) (stating that liquidated damages of twice the amount of premiums lost by insurance agency were a reasonable estimate of damages that were difficult to calculate following breach of a restrictive covenant).

(9.) Tomei at 172, 6112 NE2d at 27.

(10.) Id.

(11.) Id.

(12.) See Habit, Arogeti & Wynne. PC v Baggett, 231 Ga App 289, 498 SF2d 346, 356 (1998) (explaining that liquidated damages clause mandating payment of 150% of prior year's billings even if solicitation was not successful, was unenforceable penalty provision).

(13.) One federal court upheld a liquidated damages provision in a licensing agreement, which stated that the damages would be a multiple of twelve (12) times the highest monthly sales by the licensee during the year preceding termination. DAR & Assoc, Inc v Uniforce Services, Inc, 37 F Supp 2d 192, 201-04 (ED NY 1999).

(14.) 766 Sold 427 (Fla D Ct App 2000).

(15.) Id at 430.

(16.) Id.

(17.) See H & R Block Enterprises, Inc v Short, 2006 WL 3437491 at *7 (D Minn 2006) (upholding liquidated damages clause for employee's breach of non-compete and client non-solicit covenants in context of tax preparation services, when formula took into account the average fee charged by die defendant to her clients during her final year, multiplied same by two and then discounted the number by her average client retention rate).

(18.) Magestro v North Star Environmental Const, 356 Wis 2d 744, 753-54, 649 NW2d 722. 736-27 (Wis App Ct 2002).

(19.) Courts may not overturn penalties that were negotiated in an arms' length bargaining process, In Gorman Publishing Co v Stillman. 516 F Supp 98 (ND Ill 1980), the court upheld as a reasonably liquidated damages clause a provision mandating that the employee pay the employer the sum of $500 per day during the period of unfair competition, noting that the figure was reached "after a process of serious negotiation between sophisticated parties assisted by counsel who were even more aware than this court of the ambiguous nature of the interests being protected." Id at 109.

(20.) 179 Ill App 3d 372, 534 NE2d 565 (1st D 1989).

(21.) Id at 376-77, 534 NE2d at 567-68.

(22.) Id at 377, 534 NE2d at 568.

(23.) Compare Francorp, Inc v Siebert, 126 F Supp 2d 543, 547 (ND Ill 2000) (stating that former employers failure to pay salary for several weeks necessitated employees' departure and excused them from non-compete obligations).

(24.) 133 Idaho 110, 982 P2d 945 (Ct App 1999).

(25.) Id at 95 i; see also, Fingerlakes Chiropractic, PC. v Maggio, 730 NYS2d 632, 269 AD2d 790. 791 {App Div 4th Dept 2000) (upholding trial courts refusal to enforce liquidated damages clause when chiropractor only provided competitive services by substituting for a few days for a colleague, and for rendering services to family and friends without payment).

(26.) 251 (:a App 404,554 SE2d 550 (2001).

(27.) Id at 404, 554 SE2d at 551-52.

(28.) Id at 406, 554 SE2d at 552; see also, Press-A-Dent, Inc v Weigel, 849 NE2d 661, 670-71 (Ind Ct App 2006) (holding liquidated damages clause unenforceable where damages set arbitrarily at $50,000 and bore no rational relation to potential damages); Willard Packaging Co, Inc v Javier, 169 Md App 109, 135-36, 899 A2d 940, 955-S6 (Spec App 2006) (same). But see St. Clair Medical, PC v Borgiel, 270 Mich App 260, 270, 715 NW2d 914. 920-21 (2006) (holding that liquidated damages clause in physician's employment contract, which provided for $40,000 payment in event of breach of non-compete clause, was not a penalty where penalty loss was difficult to calculate).

(29.) 860 A2d 554 (Pa Super Ct 2004).

(30.) Id at 565.

(31.) Id.

(32.) Id.

(33.) Brian McDonagh, SC v Moss, 20, Ill App 3d 62, 65, 565 NE2d 159, 160 (1st D 1990); McRand, Inc v Van Beelen, 138 Ill App 3d 1045, 1055, 486 NE2d 1306, 1313 (1st D 1985).

(34.) McDonagh at 65, 565 NE2d at 160.

Kenneth J. Vanko <vanko@ccmlawyer.com> is a partner in the Wheaton firm of Clingen Callow & McLean, LLC and concentrates in business lain and unfair competition litigation.
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Title Annotation:Illinois
Author:Vanko, Kenneth J.
Publication:Illinois Bar Journal
Date:May 1, 2007
Words:3660
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