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Disloyalty Doesn’t Pay: New York’s “Faithless Servant” Doctrine

Jacoby, Mark A.

(March 2004, Employer Update)



by Mark A. Jacoby and Marisa A. Leto
For more than a century, New York courts have held that so-called “faithless servants” – employees who have engaged in acts of disloyalty towards their employers – may be required to return employment compensation received during the period of disloyalty. In a decision rendered recently, the U.S. Court of Appeals for the Second Circuit took a hard line in addressing the scope of the “faithless servant” doctrine under New York law, ruling that the disloyal employee must disgorge all compensation received from the date of his first disloyal act. The Court reversed a decision by District Judge Shira Scheindlin who had ruled that the disloyal employee need not return compensation received for work that was unrelated to the disloyal acts. Phansalkar v. Andersen Weinroth & Co., L.P., No. 02-7928 (L), 2003 WL 22130902 (2d Cir. Sept. 16, 2003), rev’g and remanding No. 00 CIV. 7872 (SAS), 2001 WL 1524479 (S.D.N.Y. Nov. 29, 2001).

Phansalkar joined Andersen Weinroth & Co., L.P. (“AW”), a small merchant banking firm, in February 1998 as a nominal partner. He was to receive an annual salary of $250,000 and a discretionary share of the Partner Allocations – non-cash compensation, generally in the form of securities, which the firm received from its transactions. As an incentive to remain with the firm, Phansalkar also was given the opportunity to purchase shares of a particular company (“MCEL”) from firm partners at a “favorable price.” Phansalkar left AW in June 2000 to become the Chairman and CEO of OSICOM Technologies, Inc., a company with which AW and Phansalkar had worked.

While at AW, Phansalkar sat on the boards of directors of several companies involved in firm deals, receiving compensation from those companies in the form of directors’ fees, company shares and options to purchase company shares. AW policy required that all such directors’ compensation be disclosed and passed on to the firm. After Phansalkar left AW, the firm became aware that he had failed to disclose and turn over to the firm portions of the directors’ compensation that he had received while employed at AW in direct contravention of firm policy. AW brought suit against Phansalkar for breach of the fiduciary duty of loyalty, breach of contract, and conversion. The firm also withheld delivery to Phansalkar of the MCEL shares sold to him at a lower sale price. Phansalkar, in turn, sued AW for conversion of the MCEL shares, among other causes of action.

After a bench trial, the District Court found that Phansalkar breached his duty of loyalty to AW for failure to disclose portions of his directors’ compensation. However, in attempting to apply the New York faithless servant doctrine, the court limited AW’s damages to the compensation Phansalkar derived from those transactions in which he acted disloyally. The court did not require that Phansalkar forfeit his MCEL shares, although it found that such shares constituted employment compensation, because Phansalkar had not committed any disloyal acts in the MCEL transaction.

On appeal, the Second Circuit Court of Appeals reversed, holding that the lower court had erroneously failed to require Phansalkar to disgorge all compensation he had received after his first act of disloyalty. In so ruling, the Second Circuit declined to extend its own prior decisions in Musico v. Champion Credit Corp., 764 F.2d 102 (2d Cir. 1985) and Sequa Corp. v. GBJ Corp., 156 F.3d 136 (2d Cir. 1998), in which it had held that New York law permitted a disloyal employee to retain compensation received for those transactions in which the employee had been loyal. The Circuit Court ruled that such liberal applications of the New York faithless servant doctrine obtained only where: (1) the parties agreed to compensation on a task-by-task basis; (2) the employee was loyal in the performance of certain tasks; and (3) the employee’s disloyalty in other tasks “‘neither tainted nor interfered with the completion’” of the tasks in which the employee acted loyally. The Second Circuit declined to extend the more liberal approach of Musico and Sequa because neither the New York Court of Appeals nor lower New York courts have ever delineated the appropriate scope of forfeiture, and the Circuit Court’s existing approach has the benefit of drawing a clear line regarding forfeiture of compensation for employee disloyalty.

Variations Among State Laws

New York law, as interpreted by the Second Circuit, represents one extreme on the legal spectrum regarding compensation forfeiture for employee disloyalty. Several states fail to recognize any forfeiture remedy in any form for an employee’s breach of his duty of loyalty. For example, Connecticut law dictates that “past compensation, already payable,” can never be forfeited because “there is a strong public policy [in Connecticut] in favor of payment of earned compensation.”1 Florida has permitted compensation forfeiture as a remedy only for an “egregious breach” of the fiduciary duty to remain loyal.2

Massachusetts takes an intermediate position, rejecting what it terms the “extreme remedy” of complete forfeiture. Under Massachusetts law, a disloyal employee may be required to forfeit only that compensation that exceeds the value of his services to his employer.3 Similarly, Delaware law has permitted disloyal employees to retain reasonable compensation for services “legitimately performed,” so as to avoid the unjust enrichment of employers.4 Pennsylvania law similarly limits forfeiture of compensation to that derived from transactions in which the employee acted disloyally, permitting an employee to retain compensation for properly performed transactions.5 New Jersey also proffers a less rigid rule, allowing set-offs from forfeiture remedies to provide compensation for “properly performed services” during a period of disloyalty. Moreover, New Jersey requires courts to apply a facts and circumstances analysis, taking into account various factors, such as the egregiousness of the employee’s conduct, when fashioning a remedy.6 Texas law also mandates a facts and circumstances analysis to cases of employee disloyalty, including consideration of the severity of the breach, to determine whether and to what extent forfeiture is appropriate.7

However, New York is not alone in its relatively strict view of compensation forfeiture for employee disloyalty. California has required forfeiture of all compensation, including bonuses, by a disloyal employee. However, California has limited compensation forfeiture to compensation derived solely from services disloyally performed where the employment contract allocates compensation on a task-by-task basis.8 The United States District Court for the District of Columbia also has held that “no compensation is owed an employee who has breached his duty of loyalty to his employer,” requiring an employee to return to his employer all compensation he earned after his disloyal act.9

Choice of Law Issues

Such variance among state laws concerning the faithless servant doctrine gives rise to the issue of what law applies when the disloyal employee is employed in one state by an employer incorporated in another state. In New York, the so-called “internal affairs” doctrine generally governs in such circumstance. That doctrine specifies that the law of the state of incorporation governs “the obligations of fiduciaries in engaging in transactions with their corporations,” including an employee’s duty of loyalty.10 However, this rule is not automatically applied. In Greenspun v. Lindley, the New York Court of Appeals, in dicta, expressly left open the question of what law would be applicable in a case where an employer incorporated elsewhere had significant contacts with New York.11 In Schonfeld v. Hilliard, a federal court in New York attempted to answer this question by applying New York law to claims of breach of fiduciary duty where the corporation was incorporated under the laws of Delaware, but the Shareholders Agreement explicitly invoked New York law, the documents were drafted inNew York, all significant business meetings, negotiations, and announcements took place there, and the plaintiff President, Chairman and one-third shareholder of the company was a resident of New York.12

The question of what constitutes sufficiently significant contacts to override the presumptive application of the internal affairs doctrine creates some uncertainty regarding what law courts will apply. To further secure application of New York law to faithless servant cases, employers may wish to include a choice of law provision in their employment contracts and employee handbooks that explicitly invokes the application of New York law to the employment relationship.

  1. Dunsmore & Assocs., Ltd. v. D’Alessio, No. 409906, 2000 Conn. Super. LEXIS 114, *48 (Conn. Super. Ct. Jan. 6, 2000) (unpublished). Alaska, Hawaii, and Rhode Island also reject compensation forfeiture as a remedy for employee disloyalty.
  2. Wallace v. Odham, 579 So. 2d 171, 175 (Fla. Dist. Ct. App. 1991).
  3. Meehan v. Shaughnessy, 535 N.E.2d 1255, 1266-67 (Mass. 1989).
  4. Technicorp Int’l II, Inc. v. Johnston, No. 15084, 2000 Del. Ch. LEXIS 81, *196, *199 (Del. Ch. May 31, 2000). See also Citron v. Merritt-Chapman & Scott Corp., No. 3130, 1977 Del. Ch. LEXIS 183, *12 (Del. Ch. May 4, 1977).
  5. Fidelity Fund, Inc. v. Di Santo, 500 A.2d 431, 439-40 (Pa. Super. Ct. 1985).
  6. Cameco, Inc. v. Gedicke, 724 A.2d 783, 790-91 (N.J. 1999).
  7. Burrow v. Arce, 997 S.W.2d 229, 241-42 (Tex. 1999).
  8. See J.C. Peacock, Inc. v. Hasko, 16 Cal. Rptr. 518, 522-24 (Cal. Ct. App. 1961).
  9. Riggs Inv. Mgmt. Corp. v. Columbia Partners, L.L.C., 966 F. Supp. 1250, 1266 (D.D.C. 1997).
  10. See Geffner v. Linear Rotary Bearings, Inc., 936 F. Supp. 1150, 1184 (E.D.N.Y. 1996); BBS Norwalk One, Inc. v. Raccolta, Inc., 60 F. Supp. 2d 123, 129 (S.D.N.Y. 1999).
  11. Greenspun, 330 N.E.2d 79, 81 (N.Y. 1975).
  12. Schonfeld, 62 F. Supp. 2d 1062, 1070-71 (S.D.N.Y. 1999).
   
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