Labor & Employment Law Daily Liquidated damages provisions in employees’ restrictive covenants were unenforceable penalties
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Thursday, January 2, 2020

Liquidated damages provisions in employees’ restrictive covenants were unenforceable penalties

By Marjorie Johnson, J.D.

While the damages were difficult to ascertain, and Indiana’s high court had indicated an unwillingness to interfere in parties’ “freely negotiated contracts,” the liquidated damages provisions were facially unreasonable and not correlated to the employer’s actual losses.

In a civil engineering firm’s lawsuit against former employees who left to work for a competitor, a divided Indiana Supreme Court struck the liquidated damages provisions contained in the employees’ restrictive employment covenants. Affirming the trial court, the majority held that the provisions—which required all the former employees to pay a percentage of each poached employee’s prior annual salary, and the one who solicited clients to also pay a percentage of previous billings—were unenforceable penalties and that the company could only seek its actual damages for its breach of contract claims. While one justice dissented in part and would have found the liquidated damages provisions enforceable, the full court also affirmed denial of summary judgment on the employer’s tortious interference claims (American Consulting, Inc. v Hannum Wagle & Cline Engineering, Inc., December 18, 2019, David, S.).

Liquidated damages provision. One of the employees had served as the vice-president of sales for American Structurepoint, Inc. (ASI) and executed noncompete and non-recruitment agreements. A liquidated damages provision provided that if he breached the noncompete, he would pay 45 percent of the amounts ASI had billed that client during the prior 12 months. If he breached the non-recruitment agreement, his liquidated damages would be 50 percent of the poached employee’s total compensation from ASI for the prior 12 months. The other two employees had worked for ASI as project representatives and their noncompete contained a liquidated damages provision that required them to pay 100 percent of the poached employee’s past year’s pay.

ASI sued the former employees and the competitor alleging a myriad of claims, including breach of contract and tortious interference, and presented evidence that the employees successfully recruited seven others from ASI and that the VP solicited various clients. The trial court granted summary judgment for defendants on the issue of liquidated damages, but denied it as to tortious interference. An appeals court affirmed as to the tort claim, but in a divided opinion reversed on the liquidated damages issue, finding the provisions to be enforceable.

Facially unreasonable. ASI argued that because the agreements were freely negotiated, and the amount of damages difficult to ascertain, the liquidated damages clauses were enforceable. Disagreeing, the Indiana Supreme Court sided with the defendants and trial court, finding that the clauses were unenforceable penalties. While the damages were difficult to ascertain, and the high court has indicated an unwillingness to interfere in parties’ “freely negotiated contracts,” the liquidated damages provisions were facially problematic for several reasons.

First, it was unclear how the prior year’s salary of a recruited employee correlated to ASI’s loss since it was not the only variable that determined revenue, and ASI could hire others. It was also unclear why the VP, who held a higher rank and made more money than the other two, was responsible for 50 percent of a recruited employee’s salary while the other two were responsible for 100 percent. And, ASI was effectively seeking 250 percent of the recruited employees’ respective salaries, which was “highly unlikely” to be ASI’s cost to replace them.

Served as punishment. Courts have enforced liquidated damages in an employment context where the sum is “certain and reasonably tied to the actual losses,” but have struck liquidated damages provisions that applied the same punishment for a broad range of conduct and served to punish the breaching employee. This case was more akin to the latter scenario since the VP was required to pay liquidated damages for recruiting ASI employees regardless of whether he hired or merely attempted to hire them. Moreover, the other two hourly employees were required to pay damages that exceed their own salaries.

Not correlated to actual losses. Because the liquidated damages were facially unreasonable, the burden shifted to ASI to show they were somehow correlated with its actual damages, which it failed to do. Though it argued that the damages provisions were reasonable forecasts of the loss it suffered since it lost seven valuable employees who generated revenue over a million dollars, it introduced no evidence that it could not replace these employees or their billing, in whole or in part. And as discussed, it was unclear how a portion of the recruited employee’s salary was correlated with damages.

Thus, the liquidated damages provisions as written were not correlated to the actual loss, even accepting ASI’s position that it was damaged by defendants’ actions, that those damages are hard to calculate, that the employees who were recruited were valuable and that ASI incurred costs to replace them. ASI failed to show a nexus between the two, which it may have done so by presenting evidence regarding how much it spent on the employee recruitment process or other evidence demonstrating some correlation between the liquidated damages and actual damages.

ASI also failed to show a correlation between its actual damages resulting from the VP’s alleged solicitation of ASI clients and the millions of dollars in liquidated damages he would purportedly be liable for under the agreement. He would be liable for the same amount regardless of how much revenue for the competitor he was able to solicit, which could be a “windfall” to ASI and a “penalty” to him. Thus, the liquidated damages provision, as written, was “too broad and captures too much conduct to be construed as a reasonable measure of damages resulting from a breach.”

Triable issue on tortious interference claim. Affirming denial of summary judgment on the tortious interference claim, the Indiana Supreme Court found that despite the parties’ dispute as to how the “absence of justification” element must be proven, a triable issue remained. There was evidence that the competitor had a legitimate business purpose in recruiting ASI employees and also evidence that it targeted ASI for an improper purpose.

Partial dissent. Dissenting in part, Justice Slaughter disagreed with the majority’s conclusion that ASI could not collect the liquidated damages that the parties agreed would be warranted in case of breach. Since the employees challenged the legality of the bargains they struck, they were required to establish that the liquidated damages provisions were unenforceable penalties and that ASI could not prove even a correlation to its actual damages. After an exhaustive analysis, Justice Slaughter opined that they failed to do either.

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