Client pinching… not such a clever idea?

This information paper deals with legal issues associated with ex-employees soliciting business from a former employer’s customers when the ex-employee leaves to join a competing business. The issues noted in this Information Paper are not intended to be exhaustive.

Overview

A loss of business can occur through ex-employees soliciting business from a former employer’s customers when the ex-employee leaves to join a competing business. This can be improperly assisted by the ex-employee copying client lists of the former employer before leaving. This can have a significant impact where the ongoing customer relationship has a specific expiry date (e.g. insurance and leasing). In those cases customer identity and details of the products/services supplied can be particularly valuable information to the ex-employee and the competing business.

However, a decision of the New South Wales Court of Appeal has made it clear that copying client lists may not be such a clever idea as the Court decided that both a former employee account manager of an insurance broker and the new broker engaging the ex-employee (new broker) as a sub-broker on an independent contractor basis were both liable to ‘account for profits’ derived from the use of lists of client’s that the former employee took from his former employer before he ceased employment with his former employer.

The Court reached this conclusion on the basis that the ex-employee breached his fiduciary duty to the former employer by taking copies of his employer’s client lists.

The reasons for including appropriate confidentiality provisions in standard employment documentation for personnel who have access to relevant confidential information are explained below.

Points to note

No Restraint: The particular case concerned the remedy of an ‘account of profits’ for misuse of confidential information by the ex-employee and not the enforcement of a restraint of trade clause imposed on an employee for a period after the termination of the employment of the employee.

Status of Ex-employee: The remedy of an ‘account of profits’ is not dependant on the ex-employee becoming an employee of the competing business. In this particular case the ex-employee was engaged by the new broker as a sub-broker on an independent contractor basis and not as an employee.

Confidential Information: The client lists prepared by the ex-employee from the computer system of the former employer were held by the Court to contain confidential information. The fact that separate items of information on the lists were either in the employee’s memory or in public records (e.g. white pages) does not prevent the information being confidential. In concluding that the customer lists contained confidential information the Court noted that the fact that the ex-employee went to the trouble of surreptitiously obtaining the customer lists established both the importance of the lists to the ex-employee and their confidential nature. Accordingly a former employer needs to be able to show that access to the information concerned is restricted so that it may properly be regarded as confidential.

Breach of Fiduciary Duty: The Court found that the ex-employee had been in a fiduciary relationship with the former employer while employed and had acted in breach of his fiduciary duty to his former employer by compiling the lists of clients from the records of the former employer and using them to canvas the clients of the former employer.

Account of profits: The ‘account of profits’ remedy against a fiduciary is based on the receipts of the ex-employee and the competing business and not the losses of the former employer. In an ‘account of profits’ it is necessary to determine as accurately as possible the true measure of the profit or benefit obtained by the ex-employee in breach of his fiduciary duty. The cardinal equitable principle is that the remedy ordered by the Court must be fashioned to fit the nature of a case and the particular facts.

Allowances to be made: Whether it is appropriate to allow an errant ex-employee a proportion of profits or to make an allowance in respect of skill, expertise and other expenses is a matter of judgment for the Court dependant on the facts of the given case. However, as a general rule, a Court will not apportion profits in the absence of an antecedent arrangement for profit-sharing with the ex-employee but will make allowance for ‘skill, expertise and other expenses’. This should be borne in mind in drafting employment terms

Allowances for ex-employee: In the ‘taking of accounts’ to calculate the amount of profits to be paid by the ex-employee to the former employer:

the Court may allow the ex-employee a proper allowance for the ex-employee’s ‘time, trouble and expertise’ in securing the transfer of the former employer’s clients to prevent the former employer being ‘unjustly enriched’ (a seemingly curious result given that the situation arises from the wrongful act of the ex-employee).
the rationale for this is that if the ex-employee is to be compelled to account for the profits derived from his activities without any allowance for his time, trouble and expertise, the former employer would be better off for the period of the account of profits than it would have been if the ex-employee had remained employed by the former employer as the ex-employee would have been remunerated by the former employer, presumably on the basis of a salary and allowances, and perhaps a share of profits (seemingly this analysis by the Court seems to overlook the simple fact that the ex-employee has in fact left and that as a practical matter the former employer may, at cost to the former employer, have engaged a substitute employee to service the business secured by the new broker through the efforts of the ex-employee).
to avoid this the Court permits to the ex-employee a ‘proper allowance for his time, trouble and expertise’. Prima facie the appropriate rate is the basic remuneration of the ex-employee at the former employer immediately before the ex-employee left the employment of the former employer without any allowances or share of profits.
if the ex-employee has no overhead office expenses for rent, office telephone, typing, accounting or postage (as these may be covered by the new broker) the ex-employee will receive no offsetting expense allowance for those items of cost. Although in the particular case the ex-employee may have had some incidental or overhead expenses of a minor nature which were not met by the competing business those expenses were ignored as the taking of the accounts is not undertaken with ‘mathematical exactness but [is] only a reasonable approximation’.

Position of competing business: In obtaining an ‘account of profits’ against a competing business employing an ex-employee the Court considers whether use of the information by the ex-employee was use by the competing business. In the particular case the Court considered that it was clear that the new broker, by their agent (the ex-employee), made use of the former employee’s confidential information to obtain new business for the new broker.

It is relevant to note that in the particular case the new broker was not strictly a ‘third party’ for present purposes because the ex-employee was the agent of the new broker, and used the confidential information in the course of carrying on part of the business of the new broker as their sub-broker. The authority of the ex-employee to act on the behalf of the new broker in acquiring business was unfettered although some controls were exercised over other parts of the activities of the ex-employee.

The Court considered that the authority of the ex-employee in conducting part of the business of the new broker as its sub-broker attracted the principle that ‘some agents so far represent the principal that in all respects their acts and intentions and their knowledge may truly be said to be the acts, intentions and knowledge of the principal. …..Where the employment of the agent is such that in respect of a particular matter in question he really does represent the principal, the formula that the knowledge of the agent is his knowledge’ applies.

Accordingly the Court concluded that it did not matter that the directors of the new broker were not personally aware of the ex-employee’s misuse of the former employer’s confidential information.

Period for account of profits: The ‘account of profits’ remedy ordered by the Court ‘must be fashioned to fit the nature of a case and the particular facts’. In the case of a business the
Courts take the view that it may be inappropriate and inequitable to compel the errant ex-employee to account for the whole of the profit of his conduct of the business or his exploitation of the principal’s goodwill over an indefinite period of time. However, the ex-employee has the onus of establishing that it would be inequitable to order an account of profits against the ex-employee on any particular basis. It is for the ex-employee to establish that it is inequitable to order an account of the entire profits.

The period for an account of profits is not be limited to the same period as an injunction to restrain the ex-employee’s misuse of the confidential information. The Court of Appeal considered that a 12 month period was appropriate in the particular case as against the ex-employee and the new broker. Again this seems to fail to take into account the fact the reasonable expectation of the former employer of retaining the client was interrupted at an early time by the wrongful actions of the ex-employee. To obtain a longer period a restraint clause, of no more than a ‘reasonable period’, would need to be imposed on the ex-employee.

What To Do?

From the perspective of a former employer:

from a practical point of view it is vital that the former employer makes some form of very quick contact with all of its customers who were serviced by an outgoing employee to cement the relationship with the client.
the former employer will need to show that the relevant information was regarded by the former employer as ‘confidential’. Therefore employment contracts should acknowledge that all clients lists and other information of the employer relating to the identity of clients as assembled by the employer in the usual course of its business is to be treated by the employee as confidential to the employer.
the ability of the former employer in the particular case to prove the taking of the lists by the ex-employee enabled the former employer to be successful in this case. As a consequence employers, whose business prosperity relies on a confidential client list, should establish computer systems for restricted access to relevant client information and also monitor usage of the computer system for this purpose. With computer systems now linked to the internet the taking of the client information is even more difficult to detect.
employment contracts may include a provision that the payment of all entitlements due on termination are dependent on the ex-employee supplying a statutory declaration to the employer in which the outgoing employee confirms that confidential client information has not been taken at any time and will not be used to the detriment of the former employer except as may be permitted under law as to confidentiality. Whilst this may not be effective on all occasions most people will not make a false declaration and leave themselves liable to the potentially severe consequences.

From the perspective of a new broker and ex-employee:

the structuring of their relationship as an independent contractor (as opposed to an employee) to reduce the prospect of an ‘account of profits’ being ordered against either or both is not effective to achieve that objective.
proof that an account of direct expenses for the use of the competing business’ premises, staff, business equipment and facilities in the ex-employee’s activities as its sub-broker should be kept as between the ex-employee and the new broker during the period of the account of profits, if the new broker was reimbursed, or allowed in account, for the amounts shown to be due to it, as they would be a proper expense item in the ex-employee’s account thereby reducing the amount that the ex-employee would have to pay to the former employer but equally reducing the amount that the ex-employee would be paid by the new broker. Whether an adjustment would then be made to the account of profits between the new broker and the former employer is not stated in the case. If no such account was kept at the time, these expenses should be ignored in taking the account against the new broker.

Why have a confidentiality provision in standard employment terms:

A confidentiality provision should be used in employment contracts because:

it avoids the need to establish elements of fiduciary duty, breach of confidence, trespass or other causes of action upon which other forms of protection are based;
it should avoid any doubt about whether protection will encompass information innocently observed by the employee outside the course of employment;
the clause should be restricted to the particular confidential information in question as far as possible; and
a greater (but not unlimited) range of information can be protected by that means because:
- the existence of the clause places the employee on notice;
- numerous cases have placed reliance on the employer’s ‘self help’ measures, particularly efforts to warn the employee of confidentiality of information;
- the clause will protect the employer’s goodwill or knowhow even though that information would not be protectable as trade secrets.

However, only a restraint of trade covenant will protect the employers secret where information is made up of trade secrets and know how (general knowledge and skill) which are not ‘readily separate’ so that a ‘man of average intelligence and honesty’ would be placed in an impossible position if restrained from using the information. A restraint of trade must be reasonable to be valid.

Disclaimer: You should not rely on the information in this Information Paper without first obtaining advice from a qualified professional on the purpose to which you intend to put the information. This publication is distributed on the terms and understanding that the authors are not responsible for the results of any actions taken on the basis of information in this publication, nor for any error in or omission from this publication.

Client pinching… not such a clever idea?