Liquidated damages provisions in restrictive covenants were enforceable
Wednesday, May 30, 2018

Liquidated damages provisions in restrictive covenants were enforceable

By Nicole D. Prysby, J.D.

An Indiana court of appeals has upheld liquidated damages provisions in restrictive employment covenants in a company’s suit against former employees who left to work for a competitor. Reversing a trial court on the damages issue, the appeals court rejected the notion that the liquidated damages were impermissible penalties and thus unenforceable. The appeals court also found the liquidated damages were roughly proportional to actual damages, and that actual damages resulting from the employees’ breach of their noncompete and non-recruitment agreements would be difficult to ascertain. The appeals court also found that the company’s tortious interference and breach of contract claims against the competitor should go forward because there was evidence the defendant had targeted the company’s employees and that it knew the likely damage its poaching would cause the company (American Consulting, Inc. v. Hannum Wagle & Cline Engineering, Inc., May 23, 2018, Robb, M.).

Background. In 1994, Marlin Knowles began working for American Structurepoint, Inc. (ASI), a civil engineering firm. In 2008, he acquired an ownership interest in the company and signed noncompete and non-recruitment agreements. The agreements provided that in the event of a breach of the noncompete provision, he would pay ASI liquidated damages of 45 percent of the amounts billed to that client by ASI during the 12 months prior to the breach; if he breached the non-recruitment provision, the liquidated damages would be 50 percent of the poached employee’s total compensation from ASI for the 12 months preceding his or her departure.

In 2013, Knowles moved to HWC Engineering, Inc. (HWC), a competitor. HWC was aware of the noncompete agreement and it intended to put him in an operations (as opposed to sales) role to honor that agreement. HWC subsequently did business with a number of ASI’s clients. Although Knowles was not directly involved with those clients, he did communicate with them to negotiate contracts and finalize details, and also interacted with representatives of those clients in social settings, having developed a friendly rapport with them over the course of his professional work.

Seven other employees left ASI to work for HWC. Although Knowles did not reach out to them directly, he did provide recommendations for them to HWC hiring managers. Some of the new hires had also signed restrictive covenants with ASI, although the terms of their agreements were different than Knowles’ agreement.

ASI sued HWC and its former employees alleging breach of contract, tortious interference with contractual relationships, and other claims. HWC moved for summary judgment. The trial court held the damages clauses in the restrictive covenants were unenforceable as a matter of law; it also denied HWC’s motion for summary judgment on the tort and contract claims.

Liquidated damages. A divided appeals court held the trial court erred in finding that the liquidated damages provisions were unenforceable, for several reasons. First, the agreements were individually and freely negotiated, and they expressly stated that the liquidated damages were not intended to constitute a penalty. Second, the agreements were not boilerplate; they were tailored to each employee and that employee’s position in the company and were based on the amount billed to the client in the prior year or the amount paid to the departing employee in the prior year. For example, not all agreements prohibited contact with clients, and the liquidated damages sums varied.

Third, the actual damages caused by the breach of the non-recruitment provision (and the poaching of any particular employee) would be difficult to ascertain, given the importance to ASI of maintaining client relationships and its need to hire multiple replacements. And because the industry tends to use multiple civil engineering firms even on the same project, it would be difficult for ASI to know how contracts would have been awarded, had HWC not had numerous contacts with ASI clients.

Finally, the court also must consider factors other than the dollar value of the damages provisions at trial, the appeals court said. ASI would need to demonstrate causation for each alleged breach. The usual rule is that the party seeking to enforce a liquidated damages provision must demonstrate some proportionality between the actual damages and the liquidated damages amount. Once causation is known, the question of whether the liquidated damages are roughly proportional to actual damages would be clearer.

Tortious interference. HWC argued that it was entitled to summary judgment on the tortious interference claim because it was justified in recruiting ASI employees and was motivated solely by legitimate business interests in doing so. However, the appeals court agreed with the court below that there were issues of fact precluding summary judgment. There was some evidence that HWC specifically targeted ASI employees for recruitment—including the fact that HWC maintained a list of ASI employees as potential recruits—and that HWC understood the impact its actions would have on ASI.

Breach of contract. Likewise, HWC argued it should have been awarded summary judgment in its favor on ASI’s breach of contract claim because there was no evidence of actual harm to ASI, since it had hired replacement employees. Again, the appeals court upheld the trial court, noting that ASI presented evidence of lost revenue and had at least created a fact dispute on the issue of damages.

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