In many states, employees owe a duty of loyalty to their employer as long as they remain on the employer’s payroll. In other words, employees must generally act in the best interests of their employer—and not solely for their own self-interest—throughout the course of their employment. This is particularly the case for employees serving in management- or supervisory-level roles or where the employee has access to the employer’s confidential information, trade secrets, or “secret sauce.” But what can an employer do when an employee does not meet this obligation? What remedy does an employer have when an employee is disloyal? In some state and federal courts, employers can rely on the rarely-invoked remedy of disgorgement to claw back the compensation an employee received while they were disloyal to the employer or the financial gains the employee received as a result of their breach of that duty of loyalty.
Consider this example: A company employs a highly-compensated business development or sales manager or another senior-level employee. That employee has intimate knowledge of the company’s catalog of products and services, an understanding of the company’s customers’ needs, and access to the company’s pricing and discount strategies. During his or her employment, the employee recognizes that if they start their own business, they can leverage their relationships with the company’s customers and knowledge of the company’s confidential information to build up the employee’s proposed new business venture. But the employee does not have the financial nest egg to leave his or her employment before beginning the business. To keep their income, the employee starts their own business on the side while still employed by the company. The employee creates the infrastructure of the new business over time and builds the company from the ground up, but customers are hard to come by, and the new business is not making any money. One day, a customer reaches out to the employee to place an order for products or services from the employer. The employee recognizes that he or she can leverage their relationships with vendors to undercut the employer and offer the products and services to the customer for less. So, instead of processing the order through his or her employer, the employee processes the order through their new company, unbeknownst to the employer. Over time, the employee does this many times for different customers, building a client base for their new business. Eventually, the employee resigns to work full time for their own business and some of the employer’s customers direct their business to the new company, recognizing that the smaller business with lower overhead can offer the same products and services at a lower price. By engaging in this conduct, the employee placed their self-interests in direct conflict with their employer’s interests, and they have diverted business away from the employer for the employee’s personal gain. This breaches the employee’s duty of loyalty.
The employer may have a number of litigation claims it could bring against the former employee. For instance, depending on the circumstances, the employer may be able to recover damages, such as lost profits, for the work diverted to the former employee’s new company on a claim that the former employee breached an employment contract, breached a fiduciary duty, misappropriated the employer’s trade secrets, or engaged in unfair or deceptive trade practices. But when recovering the lost profits does not make the employer completely whole, the remedy of disgorgement can fill the gap.
Disgorgement can be described in common-sense terms as “a person who renders service to another in a relationship of trust may be denied compensation for his service if he breaches that trust. . . . The remedy essentially returns to the [employer] the value of what it paid for because it did not receive the trust or loyalty.”[1] As noted above, the employer compensated the former employee on the expectation that the former employee would perform in the best interests of the employer at all times. In states that recognize the disgorgement remedy, a claim for breach of the employee’s duty of loyalty can result in clawing back the entire compensation paid to the employee during the period of disloyalty. This remedy applies even where the employee performed some, or even most, of their job duties well and for the employer’s benefit.
Disgorgement is not limited to recovering past compensation paid to a disloyal employee. The remedy also can be used to claw back other financial benefits the disloyal employee received as a result of their disloyalty, including the profits or equity received from usurped business opportunities. Indeed, a disloyal employee “must disgorge all wrongful benefits obtained by their disloyalty.”[2] This includes “any ill-gotten gain[,] even where the [employer] has sustained no direct economic loss” or is unable to prove a direct economic loss.[3]
The above example is a textbook situation where disgorgement may be an appropriate remedy. But disgorgement is an available remedy in many different types of cases. For instance, disgorgement has been ordered by courts or juries:
- where an employee violated a non-disparagement clause in their employment contract, resulting in a state contractor being terminated from a lucrative contract;
- where an employee funneled subcontracts to a family member’s company at higher-than-market prices;
- where an employee worked for two competing companies simultaneously; and
- where an employee misappropriated an employer’s confidential information and provided it to a competitor, among other examples.
The common theme running through these disputes is that an employee or other fiduciary owing a duty of loyalty to an employer acted outside that employer’s best interests while on the employer’s payroll.
Of course, there are limits to the disgorgement remedy. Some state and federal courts do not recognize disgorgement as a viable form of damages, and the remedy is not applicable to all breaches of fiduciary duty or breaches of the duty of loyalty. However, disgorgement can be another arrow in an employer’s quiver when litigating claims against a disloyal employee or former employee and can help make the employer whole when business is lost as a result of a disloyal employee’s conduct.
Matt Feinberg, Practice Group Chair of PilieroMazza’s Litigation & Dispute Resolution Group, recently earned a $3.5 Million verdict, including $497,000 in disgorgement, for a Firm client in a jury trial alleging misappropriation of company profits. Visit this link to learn more about the case. If you have concerns related to an employee’s duty of loyalty and whether your state offers employers this relief, please contact Matt at mfeinberg@pilieromazza.com.
[1] McCullough v. Scarbrough, Medlin & Assocs., Inc., 435 S.W.3d 871, 905 (Tex. App.—Dallas 2014) (citing Burrow v. Arce, 997 S.W.2d 229, 237 (Tex. 1999)).
[2] Mosionzhnik v. Chowaiki, 972 N.Y.S.2d 841, 847 (N.Y. Sup. Ct. 2013) (citations omitted).
[3] Excelsior 57th Corp. v. Lerner, 553 N.Y.S.2d 763, 764-65 (N.Y. App. Div. 1990) (citations omitted).
