Six bills have been introduced in the Massachusetts Legislature that would limit or eliminate the enforcement of non competition agreements. These proposals were a favorite of the Patrick Administration. The thinking was that Massachusetts could be made more competitive by eliminating non competition agreements; after all, that thinking supposed that California was eating the commonwealth’s lunch when it came to attracting tech because California had long prohibited those agreements.

On January 14, 2015 Senator Jason M. Lewis introduced a new bill that is far more restrictive than the bill commented on in the prior post. Senate No. 169 would make “void and unenforceable” any non competition agreement of an employee or independent contractor to work after the employee or independent contractor relationship has ended, except in certain limited instances.[1]   The Bill also includes a version of the Uniform Trade Secrets Act with respect to the protection of trade secrets.

The Joint Committee on Labor and Workforce Development held a hearing on June 23, 2015 regarding the proposed legislation.

I attended the hearing and was frankly surprised and disappointed by the testimony, which was mostly for the proposed legislation. Much of it was related to the “brain drain” in high tech from Massachusetts to California. The proponents of the bills then attributed the drain to Massachusetts’s enforcement of non competition agreements. Yet those proponents offered no empirical evidence, at the hearing, that non competition agreements caused this “brain drain.” Could climate, business climate or favorable financing opportunities have made California more attractive?   The “pro” testimony also gave anecdotal—not empirical—evidence of the abuses of non competition agreements.

Both pros and cons missed the point.  Two somewhat competing considerations are involved with respect to enforcement of non competition agreements; (1) the protection of trade secrets and other intellectual property and (2) an employee’s free access to employment opportunity.

A non competition agreement is the best and least expensive way to protect trade secrets and intellectual property.   In litigating those agreements, I have found that if an employee, subject to a non competition agreement, is employed by a competitor, the former employer could seek a temporary restraining order against the individual prohibiting him or her from working for the competitor.  Thereafter, we would seek that prohibition for the remainder of the case’s pendency; a preliminary injunction. Although the case could proceed to trial, cases are generally settled at this point. There is little reason to proceed to trial because, while the case winds through the court system for a couple of years, the employee is either permitted to keep his job with the competitor or in enjoined from doing so. In short, within 10 or so days or less, any intellectual property or trade secrets are protected or the employee is free to compete. Because of the abbreviated time frame, the cost to both litigants is low and the decision swift.

Senate No. 169 contemplates enforcement of intellectual property and trade secrets.   Trade secret litigation, however, generally requires enormous amounts of discovery and, in my estimation, frequently a trial several years later to determine whether to prohibit the disclosure of the trade secret and, if disclosed, what the damages are.[2] I have found that, without extensive (and expensive discovery) it is difficult to determine what, if any, trade secrets or intellectual property has been appropriated and whether, if appropriated, what has been communicated to the competitor. This is a very expensive proposition for the party seeking to enforce the trade secret and the employee who may or may not have misappropriated the trade secret.

On the pro side, the lack of a non competition agreement promotes the free flow of information and innovation. Employees are free to start competing businesses. Businesses are forced to innovate or change. As mentioned above, enforcing a trade secret is difficult and expensive and many a trade secret or proprietary intellectual property, in the absence of a non competition agreement, finds its way to a competitor. I do not think this is necessarily bad; copying and improvement of technology advances business. Mozart and Beethoven copied other composers’ work in pre copyright days. In a local example, the textile mills of Lowell and Lawrence owed their being to (clandestine) copying the English textile mills. They did nicely until their technology was copied in a cheaper labor market. The upshot is that better goods were produced for a cheaper price and the public gained. It is no surprise that venture capitalists are in favor of the proposed legislation—it fosters more and better ventures to fund.

Neither side mentioned that if one of the bills were to become law, companies might devise devious methods that have the effect of non competition agreements. In the absence of non competition agreements in California, several tech companies in that state allegedly colluded to prevent employees from being hired by the other participants.

Neither side mentioned that, at the present time, enforcing a non competition in a Massachusetts court requires the proponent to show necessity. To obtain a temporary restraining order and a preliminary injunction, the proponent must first show, among other things, that it will suffer irreparable harm without the order and that the balance of equities favors the proponent—this is no easy task. Next, a proponent must then show need and reasonableness. The highest court in Massachusetts stated:

“A covenant not to compete is enforceable only if it is necessary to protect a legitimate business interest, reasonably limited in time and space, and consonant with the public interest . . . Covenants not to compete are valid if they are reasonable in light of the facts of each case.”[3]

A federal court in Massachusetts stated that in, addition to the foregoing, “[c]ourts will not enforce non-compete provisions if their sole purpose is to limit ordinary competition.”[4] I believe the fact that courts view non competition agreements in the foregoing manner is an important consideration. It is thus misleading not to disclose that non-competition agreements are given judicial scrutiny to determine fairness.

There are valid reasons for limiting or eliminating non competition agreements and there are valid reasons for continuing their use in Massachusetts. I’ve found both sides a bit disingenuous and a little short on facts. As the discussion continues, I hope both sides do better. Both positions should be explored thoroughly. Few states have eliminated non competition agreements and if Massachusetts becomes one of those states, I hope it does so carefully and intelligently.

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[1]           Those instances are:

• Covenants not to solicit or hire employees or independent contractors of the employer,
• Covenants not to solicit or transact business with customers of the employer,
• Non disclosure agreements,
• Covenants in connection with the sale of a business if “the party restricted is an owner of at least a 10 percent interest of the business who received significant consideration for the sale,”
• Covenants outside of an employment relationship,
• Forfeiture agreements, and
• Agreements by which an employee agrees to not reapply for employment to the same employer after termination of the employee.

[2]           An additional drawback of a trade secret case is that damages in this kind of case are extremely difficult to prove.

[3]           Boulanger v. Dunkin’ Donuts, Inc., 442 Mass. 635, 639 (2004).

[4]           RE/MAX of New England, Inc. v. Prestige Real Estate, Inc., 2014 WL 3058295 (D. Mass. 2014).

Regulation A+ will become effective June 19, 2015. It updates and expands Regulation A and was mandated by the Jumpstart Our Business Startups (JOBS) Act. Will it facilitate capital formation. I think wit probably will not because it requires greater expense than a Regulation D offering but does not offer the offering company the equity distribution to form a viable market in the way an IPO does.

The regulation provides for two tiers of offerings. Tier one provides for up to $20 Million in offerings in a 12 month period with not more than $6 Million by Selling Shareholders that are affiliates of the issuer. Tier two provides for offerings for up to $50 Million in a 12 month period with not more than $15 Million by selling shareholder affiliates. The regulation limits sales by all selling shareholders to no more than 30% of the issuers initial Reg A offering and for subsequent Reg A offerings in the 12 months following the initial offering.

Both Tier one and Tier two offerings permit issuers to submit draft offering statements for non public review bye SEC staff, permit the use of offering materials after filing the offering statement and require electronic filings.

In addition issuers utilizing Tier 2 must:

1. Provide audited financials,
2. File annual semiannual and current event reports,
3. Have limitation upon non-accredited investors.

Both tiers have disclosure requirements and certain Tier 2 offerings preempt certain state security laws. The latter is being challenged in court by Secretary Galvin.

An earlier blog post commented upon a bill limiting non-competition agreements presented by Senator Brownsberger and Representative Ehrlich and submitted during the 2011-12 session of the legislature.  This year, a more simplified bill, S846, was presented by Senator Brownsberger.

The bill provides that a non-competition agreement having a duration of longer than six months is presumed unreasonable, and shall be unenforceable unless:

• The employee has breached his or her fiduciary duty to the employer,

• The employee has unlawfully appropriated the employer’s property, or

• The employee has at any time received an annualized taxable compensation of $250,000 or more.

In the event any of the foregoing exceptions exist, a court may enforce the restrictive covenant for a period “determined by the court to be appropriate.”

While this may seem unduly restrictive another section of the bill provides that the following agreements are not so restricted:

• Covenants not to solicit or hire employees of the employer,

• Covenants not to solicit or transact business with customers of the employer,

• Covenants in connection with the sale of a business if the party restricted “is an owner of at least a ten percent interest of the business who received significant consideration for the sale,”

• Covenants outside of an employment relationship,

• Forfeiture agreements, or

• Agreements by which an employee agrees to not reapply for employment to the same employer after termination of the employee.

The bill applies to agreements signed on or after January 1, 2014.

Two other bills are also pending in the Massachusetts legislature; both of which would adopt the California approach to non-competition agreements.  California, by constitutional edict, renders void any non-competition agreements.  Representative Bradley presented a bill, H 1225, which would adopt the Uniform Trade Secrets Act.  Part of that bill renders void a covenant not to compete that is part of an agreement of employment (without rendering void the remainder of the agreement).  Representative Harrington presented another bill, H. 1729, which would effectively render “unlawful” any contract that serves to restrict an employee from engaging in any lawful employment, excepting restrictions in the sale of a business or of departing partners or LLC members.

The Joint Committee on labor and Workforce Development is conducting hearings on these bills in September of 2013.

The absence of non-competition agreements would have the effect of making protection of intellectual property and trade secrets extremely difficult, time consuming and expensive.  A non-competition agreement may be enforced by simply seeking and obtaining a temporary restraining order and/or a preliminary injunction preventing the employee from competing.  If this relief is granted the employer’s trade secrets and/or confidential information are secure—or at least protected by a court order.  Such relief can be obtained in days with little or no discovery.   If the “California” approach is adopted, however, an employer would have to show that the employee has revealed or appropriated trade secrets and confidential information in order to get relief from a court.  I have found this a very difficult task which involves protracted discovery and more than a little luck.  Rather than a court proceeding under a non-competition agreement that lasts days, one faces weeks, if not years of protracted litigation—all the while the competitor and the ex-employee may be utilizing the former employer’s confidential information or trade secrets.

Massachusetts adherents of the California approach, point to the drain of entrepreneurial businesses leaving or not starting up in the Commonwealth and attributing it to the lack of mobility of the workforce.  I would suggest California’s climate, availability of financing and a larger population plus the attitude of Californians have a lot more to do with its business generation than its absence of non-competition agreements.

I have been away from my blog for more than a year. I am hopeful that I can post more often. My goal is to provide timely and useful information to shareholders and management in close corporations. I have not been timely but my hope is that the information has been useful.

Much of what I do involves shareholder litigation in close corporations, preventing the same and the related area of succession planning. The preventative measures and succession planning techniques utilize creative estate planning, gifts, buy-sell agreements, voting trusts and agreements–the usual suspects. I came across a piece in The New York Times which added a new dimension to the discussion. A link is http://nyti.ms/12phzMV

Non competition agreements have long been central to protecting intellectual property and confidential information (together “IP”) of a business against unfair competition.  That may change because of a bill being considered by a committee of the Massachusetts legislature.  The text of the bill may be found here

In brief, the bill provides that a covenant not to compete must among other things:

1.   be in writing, signed by the employee and employer, be supported by fair and reasonable consideration and comply with certain procedural requirements,

2.    be necessary to protect trade secrets, confidential information or goodwill of an employer,

3.    be of a reasonable duration, and with one exception, not exceeding one year after the employee’s termination (6 months is presumptively reasonable),

4.    be reasonable in geographic scope,

5.    be reasonable in scope of prescribed activities in relation to the protected interests, and

6.    be “consonant with public policy.”

In the event that the agreement does not meet 2-6 above, it must be capable of being reformed by a court to meet those requirements.

If certain conditions are not met, the court must award the employee attorneys’ fees if it declines to enforce a material restriction or substantially reforms it. On the other hand, a court  may, if certain conditions are met, award the employer attorneys’ fees in connection with enforcement of the restriction.

The bill, however, does not include in the above, among other things, covenants not to solicit employees, or transact business with customers, of the employer.  These are important exceptions.

In addition, whether or not the bill becomes law, non competition agreements should not be the sole means of protection of a company’s IP.  Non-disclosure and trade secret agreements are also protective.  This is best illustrated by a recent case.  An ex-employer was trying to stop an ex-employee from duplicating its products in a company the ex-employee had just started. The ex-employer brought suit.  The court found that the ex-employee’s non competition agreement had lapsed.  The court, however, let the case progress on the basis of confidentiality agreements the then employer had required the then employee to sign and on the basis of the ex-employee’s possible appropriation of trade secrets.

When a business seeks to enforce the foregoing agreements, courts look carefully and critically at the agreements and systems the business has taken to protect a company’s IP.  Needless to say, these agreements and systems must be carefully crafted.  Thus the court in the above case, on oral argument, focused upon the systems the employer had put in place to protect its trade secrets.

Boston attorney, Theodore A. Lund, Esq., brought to my attention, an excellent discussion regarding non competition agreements.  This may be found here.

When it comes to incorporating a business, there is a mystique that may cause the business owner to want the “benefits” of a Delaware corporation. After all, most public companies are incorporated in Delaware, aren’t they? Most of the time, however, incorporation is best in the state where the principal office of the business is located.
What then, if any, are the benefits of incorporation in Delaware. The main benefit is that the Delaware corporation law is clear, well thought out, predictable and undergoes change gradually. In addition to the law, the Delaware courts are excellent and are experienced in corporate matters. This advantage is somewhat lessened by so-called business litigation courts which have developed in several states. The Business Litigation Session in Massachusetts, for example, is excellent.
Another advantage of a Delaware corporation over a Massachusetts corporation is that, in a plain vanilla corporation, Delaware does not recognize the enhanced fiduciary duty that shareholders owe one another in a close corporation. (See my earlier post of July 25, 2011 discussing fiduciary duty in a Massachusetts corporation). The duty owed fellow shareholders in a Delaware corporation is lower than the duty owed in a Massachusetts corporation.
Some have argued that the Delaware courts are “management friendly” though I have not observed any evidence of that.
Unless a complicated capital structure is planned for the business, I recommend incorporation in Massachusetts, if that is the corporation’s place of business. This is because, in addition to Massachusetts fees and taxes, a Delaware corporation will also incur Delaware taxes, will be required to appoint a representative in Delaware and will be required to qualify as a foreign corporation in Massachusetts. All of this is unnecessarily expensive for a new venture.
Down the road, when it comes to venture capital financing, most VCs will require that the corporation be incorporated in Delaware. Changing the state of incorporation of a corporation at that point, however, is relatively easy.
A business’s choice of state of incorporation as well as choice of entity (LLC or corporation) depends on many factors. One should carefully consider these decisions with the business’s lawyer and accountant.

Rule 506 of SEC’s Regulation D provides a “safe harbor” for the private placement of securities. Under Rule 506, a company is able to raise an unlimited amount of money. One of the requirements of the rule is that the company cannot use general solicitation or advertising to market the securities offering. Rep. Kevin McCarthy (R-Cal.) recently introduced H. R. 2940 which, if enacted, would require the SEC to provide in Rule 506, that the prohibition against general solicitation or advertising would not apply to offers and sales, provided that all purchasers of the securities are accredited investors. Although the definition of “accredited investor” can be complex, with respect to natural persons (humans) other than company insiders, an accredited investor is one (a) with income exceeding $200,000 in each of the last two years, or joint income with a spouse exceeding $300,000 during that period, and a reasonable expectation of the same level in the current year or (b) one who has individual net worth, or joint net worth with a spouse (in each case exclusive of the value of the principal residence) that exceeds $1 Million at the time of purchase.
On the surface, eliminating the requirement of general solicitation or advertising is laudable. In these gritty times, any enhancement to capital formation is helpful. The bill, if enacted, would also provide more precision to Rule 506 compliance. I have always been concerned about what was meant by the term “general solicitation or advertising.” If the SEC were to adopt guidelines, in the rule for the term “general solicitation or advertising,” it might be helpful in constructing the “safe harbor.”
On the other hand, state securities regulators, such as Heath Absure, Arkansas Securities Commissioner, have expressed concern about the bill’s possible effect of increasing fraud under Rule 506. I think this is possible. As noted above, the test for non insider accredited investors who are natural persons is based either on income or net worth. The tests, with one recent modification, were set some time ago and are pretty low bars today. Furthermore, the tests deal with relative wealth and not with the sophistication of the investor. It is quite possible for one to be relatively rich and unsophisticated. Also, Mr. Absure observes, that many purchasers will lie about their income or net worth qualifications and purchase the securities anyway.
The prior paragraph, however, repeats criticisms of the existing regulatory scheme, which have been voiced apart from Rep. McCarthy’s bill. It is difficult to see how general solicitation or advertising (which complied with guidelines provided by the SEC) which would require each purchaser (who must be an accredited investor) to be given, prior to sale, a comprehensive private placement memorandum would significantly increase securities fraud.
The SEC had, in 2007, proposed, but did not enact, a rule that would have permitted limited solicitation or advertising in certain private placements to “large accredited investors.”

Generally, it is unlawful to sell securities unless they are the subject of an effective registration statement and, in most states unless, qualified under their securities laws, unless in either case the transaction or the security is exempt.  An earlier post discussed sales of securities to friends and family and the dangers of running afoul of federal and states’ securities laws.

The start up venture will infrequently have sufficient funds to adequately compensate, officers, directors, consultants and employees.  Issuance of stock or options to purchase stock are an easy and inexpensive way to increase such compensation.  How difficult is it to issue officers,  directors, consultants and employees options or stock within the confines of federal and state securities laws?

SEC Rule 701 offers a safe, direct and simple way to do this.  That rule permits nonpublic companies to issue their securities to, among others, employees, officers, directors and some consultants, under a written benefit plan or compensation contract, without registration, and without filings, if the requirements of the rule are met.  The rule is non exclusive and the Company may claim any other exemption from the registration requirements of the Securities Act of 1933.

First, the total sales price of securities sold under Rule 701 during any consecutive 12 month period can’t exceed the greatest of the following:

a    $1 Million,

b    15% of the total assets of the company, measured at the company’s most recent balance sheet date (if no older than its last fiscal year end), or

c    15% of the outstanding amount of the class of securities being offered and sold in reliance of Rule 701, again measured at the company’s most recent balance sheet date (if no older than its last fiscal year end).

Sales of securities underlying options must be counted as sales on the date of option grant.

Second, the Company must deliver to the investor a copy of the benefit plan or compensation contract.  The preliminary notes to the rule, however, state that the Company and those acting on its behalf  “have an obligation to provide investors with disclosure adequate to satisfy the antifraud provisions of the federal securities laws.”  This is a little tricky and any such disclosure beyond the mere delivery of the plan or contract depends upon the Company and the composition of the proposed sales under Rule 701.

If the aggregate price of securities sold exceed $5 Million during any consecutive 12 month period, the Company must make further disclosures.  For example risk factors, and plan and financial information must be provided.

There are restrictions on transfer of the shares sold under Rule 701.

Not all consultants or advisers may be granted shares or options under the rule. There are restrictions as to which persons may be granted shares or options.

State securities laws should be checked.  By regulation, Massachusetts has a self-executing exemption for shares issued pursuant to Rule 701.

Many start-up ventures raise money from friends and family without regard to compliance with federal or state securities laws.  Many believe that compliance is unnecessary (the company is too small), is too expensive (why should I pay money to a lawyer, when I can put it to work in the company—money is a valuable and scarce resource, after all) or that the offering will fly under regulators’ radar.

This is a mistake.

There are registration (or similar qualification, under state law) requirements and antifraud provisions in securities laws that affect friends and family offerings.  An excellent article by Alexander Davie discusses, in plain English, the foregoing requirements and civil and criminal penalties for non compliance.  I would only add the following.

To comply with the anti fraud provisions of federal and state securities laws, the company must carefully determine what it discloses to potential investors.  It must appraise potential investors of the risks of investing in the company.  These risks are not always obvious.  I recommend that a private placement memorandum (“PPM”) be used.  The PPM describes, among other things, the company, its officers and directors, the use of proceeds of the offering and its risk factors.  The PPM is then given to each of the potential investors.  I, and many corporate lawyers have done a number of these and, except for information peculiar to an offering and to the company, the prior deal can be marked up.  The expense is not  significant, especially considering the risks.  This is especially so as many friends and family offerings often proceed to friends of friends of friends offerings.  In addition to reducing risk the PPM should be a selling document.

As to registration (qualification) requirements, a non-compliant offering could impair further rounds of financing.  At the closing of institutional financings the company’s lawyer will be required to give an opinion that all prior sales of the company’s securities were in compliance with federal and state securities laws.  If the past financings were not compliant, the financing might not take place or a rescission offer (an offer to buy back the securities) to the friends and family might be required.  In any event, the financing, if it took place at all would be messy and expensive.  Where future financings are planned, I recommend that the offering comply with the requirements of Regulation D under the federal Securities Act.  All that is required is a simple filing with the SEC and state securities laws (New York’s filing is a little more difficult) and compliance with certain other requirements.  Properly done, that assures compliance with the registration or qualification requirements.

Posted August 8, 2011 by Edmund Polubinski, Jr.

Many people assume that a corporation or an LLC insulates its principals from liability.  That is not necessarily true.   The principal is protected from contract liability.  He is also shielded from tort liability unless the principal him/herself commits the tort.  For example, if X, the president, director and an owner of stock in a corporation is negligent in an accident, in the course of the corporation’s business, the corporation and X are liable.  If, however, the corporation has an employee who is negligent in such an accident, only the corporation is liable (as long as X was not at fault).

As mentioned above, the law protects the principal from contract liability.  Principals may, however, voluntarily undertake contractual liability.  Banks may require personal guarantees of the principal in connection with loans to the corporation and landlords may require personal guarantees in connection with leases to the corporation.  There are many other instances.  For example, I recommend to my clients that are food wholesalers, when extending terms, to include a personal guaranty of the principal on the corporate credit application.

Courts will also impose liability in certain cases by “piercing the corporate veil.”  This is an equitable doctrine and thus very flexible; courts will use it to make liable principals of corporations in order to prevent fraud or to do justice in particular situations.  The cases in Massachusetts are a little confusing but Massachusetts courts have recently adopted a 12 part test, asking:

1. In the case of multiple corporations, whether there was common ownership,
2. Whether there is “pervasive control,”
3. Whether there is a confused intermingling of assets,
4. Whether there is thin capitalization (Have the owners enough equity in the business?),
5. Whether there is a non-observance of corporate formalities (Do directors approve important matters?),
6. Whether there is an absence of corporate records (Is there a minute book?  Bylaws?  Minutes?),
7. Whether there is a record of non-payment of dividends,
8. Whether the corporation was solvent at the time of the transaction that is the subject of the lawsuit,
9. Whether there was “siphoning” away of corporate funds by the dominant shareholder,
10. Whether there was non-functioning of corporate officers and directors,
11. Whether the dominant shareholder used the corporation for personal matters (Are personal bills paid out of the company’s checkbook or are company assets used for personal use?  I was once involved in a lawsuit that involved a corporation paying utility bills for service at the homes of the controlling shareholders),
12. Whether the corporation was used in promoting fraud.

At least one Massachusetts case has embellished the 12 tests above and adopted further tests. A glance at the twelve factors shows that a lot of the factors are subjective, but the corporation can and should take steps to make sure that the objective factors are met.

The above is applicable to an LLC.  Is it worth it to incorporate or to form an LLC?  The answer is that it depends on the particular circumstances.  Incorporation or formation of an LLC itself is not expensive but it does result in annual fees, taxes and other expenses.  This must be weighed against the benefits of a somewhat limited liability.  This is one more thing that should not be done at home, but at your attorney’s office.

Posted August 4, 2011 by Edmund Polubinski, Jr.