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Liquidated Damages Clauses in Restrictive Covenant Agreements

Employers frequently face challenges in quantifying (and proving) the damages associated with enforcing violations of restrictive covenants by former employees. One strategy some employers have tried is the use of liquidated damages clauses. The advantage of using a liquidated damages clause is that employers have certitude in the damages amount they would be paid in the event of breach by the employee.  Employers thus avoid the challenges of proving damages where damages may be in dispute or are inherently difficult to ascertain or quantify.  Employers should, however, be aware of the consequences associated with using liquidated damages clauses. For example, by including liquidated damages provisions, employers should consider whether they undermine their right to seek actual damages, such as lost profits due to loss of client revenue. Similarly, employers should consider whether the availability of a liquidated damages remedy adversely affects their right to obtain injunctive relief that would be needed to prevent irreparable harm to the employer. In this article we analyze how employers who opt to include liquidated damages clauses in restrictive covenant agreements might draft such provisions most effectively.

Background

Liquidated damages are “an estimate, made by the parties at the time they enter into their agreement, of the extent of the injury that would be sustained as a result of breach of the agreement.” Truck Rent-A-Center, Inc. v. Puritan Farms 2nd, Inc., 41 N.Y.2d 420, 424 (1977). Liquidated damages clauses serve as courts’ recognition that “the award of a court or jury is no more likely to be exact compensation than is the advance estimate of the parties.” Beacon Plastic & Metal Prods., Inc. v. Corn Prods. Co., 293 N.Y.S.2d 429, 433 (1st Dept. 1968).

New York courts enforce liquidated damages clauses only where damages are not readily ascertainable at the time when the parties entered into the agreement and the fixed sum is reasonably proportionate to the probable loss. JMD Holding Corp. v. Cong. Fin. Corp., 4 N.Y.3d 373, 380 (2005). Courts will interfere only if the fixed damages are plainly or grossly disproportionate to the probable loss. Id. at 381. A liquidated damages clause “designed to induce performance, rather than . . . to provide ‘just compensation’ for losses” constitutes an unenforceable penalty and will not be enforced. Ryan v. Orris, 95 A.D.2d 879, 881 (3d Dept. 1983). In addition, “[w]here the court has sustained a liquidated damages clause the measure of damages for a breach will be the sum in the clause, no more, no less.” JMD Holding, 4 N.Y.3d at 380 (quoting Brecher v. Laikin, 430 F. Supp. 103, 106 (S.D.N.Y. 1977)).

Mutual Exclusivity

Employers choosing to include a liquidated damages clause preclude themselves from obtaining actual damages in the event of a breach. See United States Fid. & Guar. Co. v. Braspetro Oil Servs. Co., 369 F.3d 34, 71 (2d Cir. 2004). In Franklin First Fin., Ltd. v. Contour Mortg. Corp., 62 Misc. 3d 1220(A) (Suffolk Cty. Feb. 19, 2019), the court held that employers cannot recover both liquidated and actual damages because recovery of one precludes the other. Plaintiff Franklin First Ltd. (“Franklin First”) employed defendant Arthur W. Most II (“Most”) as its Chief Financial Officer. Most’s employment agreement prohibited him from disclosing confidential information and soliciting fellow employees. Most left to work for a competitor and Franklin First sued alleging, inter alia, that he misappropriated and used its confidential information.

The court held that Most breached his agreement as he refused to return more than 100,000 computer files in violation of a provision requiring him to return all documentation containing confidential information within five days of his termination. The agreement provided that such a breach would result in liquidated damages of $100 daily. The court held that Most failed to prove the liquidated damages clause was unenforceable either by demonstrating that damages were readily ascertainable at the time of contracting or by demonstrating that the penalty was disproportionate to Franklin First’s losses. The court also held that Franklin First failed to meet its burden to enforce the liquidated damages provision, because the agreement provided that Most was responsible for “actual damages incurred by Franklin First due to the loss, dissemination and/or non-return of its Confidential Information.” Id. at *5. The court refused to enforce the liquidated damages provision because the contract already provided “for the full recovery of actual damages,” because liquidated damages and actual damages must be mutually exclusive remedies under New York law. Id.

Actual Damages

Courts do not require evidence of actual damages or specific revenue loss for the enforcement of a liquidated damages clause. In Mathew v. Slocum-Dickson Med. Grp., PLLC, 160 A.D.3d 1500 (4th Dept. 2018), the court encountered a liquidated damages provision in the context of non-compete provisions in cardiologists’ employment agreements with a large medical practice. The plaintiff-doctors sought a declaration that the liquidated damages clause was unenforceable, and the medical group counterclaimed alleging breach and seeking liquidated damages. The court granted the defendant’s motion for summary judgment that the liquidated damages clause was enforceable and the plaintiffs appealed.

The Fourth Department began by noting that in-house referral is an important part of the defendant’s business model, that the plaintiffs had no patients before their employment with the defendant, and that they were treating approximately 12,000 of the defendant’s patients before leaving its employ. The court held that the liquidated damages clause was a reasonable measure of anticipated probable harm because damages flowing from a breach of the non-compete were not readily ascertainable when the parties entered into the agreement. Though there was no specific evidence of harm sustained by the defendant, the plaintiffs failed to account for “potential damages caused by the loss of intra-organizational referrals, the loss of goodwill caused by the departure of critical members of its professional staff, the investment made by defendant in the development of plaintiffs’ practices and the cost associated with the recruitment of replacement physicians and the development of those new practices.” Id. at 1503.

The court did not require the defendant to submit evidence of specific revenue loss to its cardiology department resulting from plaintiffs’ breach of the employment agreements as proving actual damages was unnecessary so long as the liquidated damages provision was valid and enforceable. Additionally, the court held that the attorney fee clause in the agreement was not duplicative of the liquidated damages clause. Ultimately, the defendant received liquidated damages and reasonable attorney’s fees and costs.

Practice Suggestions

Liquidated damages are particularly valuable in situations where actual damages are difficult or impossible to prove and estimate. In those cases, employers should consider fixing damages with a liquidated damages provision as a way to enforce restrictive covenants. Employers also should consider the following measures to increase the likelihood that courts will allow them to recover when employees breach their post-employment restrictions.

Certainty. Liquidated damages clauses may decrease the uncertainty of proving damages. They are useful in restrictive covenant cases in circumstances where the computation of actual damages for the competition of a departing employee is often difficult. Such clauses provide a degree of assurance to the employer that, in the event of a breach, the employer would have a remedy even if the employee has not poached a client or solicited coworkers. Furthermore, the burdensome cost of litigation can be reduced as employers are still able to provide for the recovery of reasonable attorney’s fees and costs in addition to a liquidated damages provision. See Mathew, 160 A.D.3d 1504; Markham Gardens, L.P. v 511 9th, LLC, 143 A.D.3d 949, 951-52 (2d Dept. 2016).

Injunctive Relief. Consider liquidated damages as a complementary remedy to injunctive relief, as the two types of remedies are not mutually exclusive. Crown IT Servs. v. Koval-Olsen, 11 A.D.3d 263, 266 (1st Dept. 2004). However, the presence of a liquidated damages clause could weaken an employer’s claim of irreparable harm in the context of injunctive relief, because the employee could argue that money damages serve as an adequate remedy for the employee’s harm. See Long Is. Conservatory, Ltd. v. Jaisook Jin, 14 Misc. 3d 1219(A) (Nassau Cty. Jan. 19, 2007) (denying motion for preliminary injunction as employer had included a liquidated damages provision in non-compete). However, the presence of a liquidated damages clause is not dispositive of the issue of entitlement to injunctive relief, and employers can mitigate this argument by providing in the parties’ agreement that liquidated damages will have no impact on the employer’s ability to seek injunctive relief. See UMS Solutions, Inc. v Biosound Esaote, Inc., 2010 NY Slip Op 34038(U) (Westchester Cty. July 15, 2010). Nonetheless, should the court ultimately grant injunctive relief, that may weaken the chances that it also enforces a liquidated damages clause. See Gismondi, Paglia, Sherling, M.D., P.C. v. Franco, 104 F. Supp. 2d 223, 236 (S.D.N.Y 2000) overruled on other grounds, Gismondi, Paglia, Sherling, M.D., P.C. v. Franco, 206 F. Supp. 2d 597, 601 (S.D.N.Y 2002) (awarding liquidated damages in addition to injunctive relief would be so disproportionate to plaintiff’s loss as to render such damages an “unenforceable penalty.”).

Confidentiality and Non-Disparagement Agreements. Employers should also be aware that liquidated damages can be an effective enforcement mechanism in the context of confidentiality or non-disparagement agreements. Notably, a former Trump Campaign staffer was recently ordered to pay nearly $50,000 to the Campaign after violating her non-disclosure agreement. Zoe Tillman, A Former Trump Staffer Filed a Class Action to Invalidate All of the Campaign’s Nondisclosure Agreements, available at https://www.buzzfeednews.com/article/zoetillman/trump-campaign-nondisclosure-agreements-class-action-lawsuit (last visited May 28, 2019). However, she has filed a class action that seeks to invalidate all nondisclosure and non-disparagement agreements staffers signed with the Trump Campaign.  The lawsuit contends that the non-disclosure and confidentiality clauses are unlawful because they illegally penalize employees for exercising their right to sue to redress important wrongs, such as workplace discrimination and harassment, unpaid wages, and violations of workplace safety laws. Additionally, the New York State legislature is currently considering a bill to curtail the use of such clauses in harassment settlements. See 2019 NY Senate Bill S5469 available at https://www.nysenate.gov/legislation/bills/2019/s5469 (last visited May 28, 2019).

Additional Remedies. As in Franklin First, a court will refuse to enforce a liquidated damages provision if the contract already provides for the full recovery of actual damages. However, employers can provide for additional remedies under New York State law beyond actual damages. For instance, by noting that the contract preserves “all other remedies available” to the employer, an employer would have the right to seek other remedies such as specific performance or actual damages for breaches of other parts of the employment agreement. GFI Brokers, LLC v. Santana, 2008 WL 3166972, *11-12 (S.D.N.Y 2008).

Reprinted with permission from the June 4, 2019 edition of the NEW YORK LAW JOURNAL © 2019 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. ALMReprints.com – 877-257-3382 - reprints@alm.com.

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