Business Arrangements

Confidentiality Agreement Traps & Trade Secret Destruction

A nondisclosure or confidentiality agreement (CA) is frequently viewed as an unnecessary formality to be satisfied with an off-the-shelf “form” so the parties can move on to a business purchase and sale, joint venture, supply relationship, employment arrangement, service arrangement or other business. If properly drafted, a CA offers legal protection of confidential information. If not, catastrophic outcomes include forfeiture of trade secret protection, possible destruction of business value, and incentivizing competitors to pirate employees.

As a four part series, we will highlight unintended consequences of improperly prepared CAs and discuss possible solutions in the last part.

Trade Secrets Require Secrecy

Although every business develops trade secrets, few recognize that their information, processes and methods are protectible. Under the Texas Uniform Trade Secret Act (TUTSA), customer lists, supplier lists and even “negative information” (unproductive methods and techniques that a business wants its competitors to waste resources exploring) may be trade secrets if their secrecy is properly maintained. TUTSA defines a “trade secret” as “information, including a formula, pattern, compilation, program, device, method, technique, process, financial data, or list of actual or potential customers or suppliers, that:

(A) derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use; and

(B) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.”

Trade secret owners may use TUTSA to obtain injunctions, royalties and damages (including double those amounts for willful and malicious misappropriation), and recover attorneys’ fees.

The Duration Trap ⇒ Trade Secret Destruction

Business brokers, private equity groups and venture capitalists commonly insist on a “duration clause” which terminates their confidentiality obligations after a stated time period (frequently two to four years). Proponents of pro-duration clauses argue the need to avoid: (1) claims of wrongful use/disclosure of confidential information when similar information is rightfully sourced elsewhere; and (2) being required to track the source of each item of confidential information across the multitude of deals reviewed.

While these arguments are frequently persuasive, the more compelling argument is the irreparable “collateral damage” to the disclosing business. Trade secret protection exists only if reasonable efforts are exercised to maintain secrecy. An agreement allowing disclosure of trade secret information at a future time establishes abandonment by the business of reasonable efforts to maintain secrecy. Courts considering this issue agree that a duration clause terminates trade secret status and protection. A few cases on this point include:

Because of a two-year duration clause in a third party CA, a trade secret owner lost an injunction proceeding against its primary competitor for trade secret misappropriation. Silicon Image, Inc. v. Analogk Semiconductor, Inc., 642 F. Supp. 2d 957 (N.D. Cal. 2008).
A 10-year time duration clause in a business relationship CA blocked the trade secret owner’s effort to obtain a preliminary injunction. DB Riley, Inc. v. AB Engineering Corp., 977 F. Supp. 84 (D. Mass. 1997).
A former employer lost trade secret protection and could not prevent a former employee from taking the information after a 12-month CA expired. ECT International Inc. v. Zwerlein, 597 N.W.2d 479 (WI 1999).

A business owner whose trade secret protection may find that the business is no longer an attractive purchase or business partner. Acquirers might conclude that “green fielding” the business is less expensive than paying a premium for a business with compromised trade secrets/intellectual property. Potential joint venturers may bypass the business by absorbing the critical information directly into their services and products. Employees might learn that their personal marketability has dramatically increased by bringing proprietary knowledge to a competitor.

Part II of this series is located here.

Different approaches to resolving this issue will be explored in the last part of this series.

This blog does not establish an attorney-client relationship and does not constitute legal advice. Legal outcomes are based on the particular facts of a situation and the application of the law to those facts. Anyone with issues described in this blog should hire an attorney for legal advice based on the relevant facts. The firm has no obligation to maintain the confidentiality of any information received by email or comments.

Confidentiality Agreement Traps & Trade Secret Destruction – Part 2

In the first part of this series on confidentiality agreement traps, we discussed how a “time duration” trap in a confidentiality agreement (CA) strips statutory protections from trade secrets. Failing to obtain signed confidentiality agreements from the recipient’s personnel sets up the second trap.

Personnel as Parties to the CA

Requiring the entity receiving confidential information (Receiving Entity) to sign a confidentiality agreement is beyond dispute. However, a Receiving Entity can act only through its officers, employees and other personnel. Accordingly, confidential information must be disclosed to these individuals for use on behalf of the Receiving Entity. Requesting signed confidentiality agreement from officers, employees and other personnel of the Receiving Entity can lead to contentious negotiations. Receiving Entities frequently claim that:

(1) obtaining and tracking CAs with personnel is too burdensome; and

(2) CAs with personnel are unnecessary since (if the CA is properly drafted) the Receiving Entity will be responsible for violations by its personnel.

In contrast, the disclosing party will claim that it needs the right to obtain injunctive relief and damages from personnel violating the confidentiality requirements. As a practical matter, most of the Receiving Entity’s personnel will have no knowledge of their company’s obligations under the CA without co-signing it.

The Second Trap

The “Second Trap” is highlighted in a recent judicial decision holding that the information’s confidentiality was lost and and the CA was unenforceable. In nClosures Inc. v. Block and Company, Inc., 770 F.3d 598 (7th Cir. 2014), after signing a confidentiality agreement the device designer provided confidential designs to a contract manufacturer. Six months after the first device was produced, the contract manufacturer developed its own competing device.

The federal district court ruled for the contract manufacturer when the designer sued for breach of the confidentiality agreement. On appeal, the Seventh Circuit Court of Appeals held that obtaining a confidentiality agreement only at the outset of the relationship was insufficient. Failing to obtain signed confidentiality agreements from each individual accessing confidential information was cited as a factor in the court’s ruling that:

(1) the designer failed to keep its proprietary information confidential, and

(2) the confidentiality agreement was unenforceable.

In reaching this decision, the Seventh Circuit referenced its previous holding that:

a federal court applying Illinois law “will enforce [confidentiality] agreements only when the information sought to be protected is actually confidential and reasonable efforts were made to keep it confidential.” Id. at 602.

Loss of Trade Secrets

As noted in the first part of this series, the Texas Uniform Trade Secrets Act (TUTSA) requires “efforts that are reasonable under the circumstances to maintain its secrecy.” Reasonable efforts to maintain secrecy generally include enforceable confidentiality agreements. Since an unenforceable confidentiality agreement is legally equivalent to no confidentiality agreement, nClosures would mean the “trade secret” owner failed to take reasonable efforts to maintain secrecy with a corresponding loss of the trade secret protections under TUTSA.

Effect on Business Value

Trade secrets add value to virtually all businesses. If trade secret protection is lost, the sale of the business may become impossible or possibly only at a drastically reduced valuation.

Sample Business Arrangements

Legal arrangements for business address:

entity formation
owner buy-sell agreements
ownership changes
purchase and sale of businesses, assets or franchises
creating collateral for payment or performance obligations, and
settling obligations with payments and/or releases.

A. Entity Formation

Legal arrangements for business address entity formation first. For liability protection, Texas offers corporations, limited liability companies (LLCs), limited partnerships, professional entities and combinations of the foregoing. Regardless of entity type, the formation process consists generally of the following:

confirming name availability by calling or emailing the Texas Secretary of State at 512.463.5555 or corpinfo@sos.state.tx.us. Name approval only determines name availability in the Secretary of State’s records; without a separate trademark search to confirm availability, the name may infringe another’s trademark.
engaging a registered agent
filing a certificate of formation with the Texas Secretary of State
preparing governing documents – bylaws (corporation or association), company agreement (LLC) or partnership agreement (limited partnership)
organizing the entity by issuing ownership interests, adopting governing documents, and electing governing persons (directors, managers and officers)
obtaining an employer identification number from the IRS – https://www.irs.gov/businesses/small-businesses-self-employed/apply-for-an-employer-identification-number-ein-online
providing a bank with the entity’s EIN and copies of the organizational documents to open a business account.

Series Limited Liability Companies

Series LLCs, popularized by real estate investors and owners of multiple assets desiring lower profiles, require additional formation. A series of an LLC is not a separate entity from the Master LLC and may be best conceptualized as a “cell” of the Master LLC. The certificate of formation and governing documents of Series LLCs establish one or more series of members, managers, membership interests, or assets that have separate rights, obligations and liabilities and business purposes from the Master LLC. Each individual series may sue and be sued, enter into contracts, hold title to assets, and grant liens or security interests in its assets.

Joint Ventures and Business Alliances

Joint ventures and strategic alliances combine or share joint operating and ownership activities for a specific business objective through contractual arrangements or through partnerships, LLCs or corporate entities.

DIY Issues

Entity formation services abound on the internet. Unfortunately, these services require the individual to determine the best type of entity for the particular business and ownership structure. These services also fail to advise the owners of best practices for avoiding personal liability for the entity’s debts and obligations.

B. Owner Buy-Sell Agreements; Admission and Withdrawal of Owners

Legal arrangements for business should address the inevitable ownership changes and their effect on business. A buy-sell agreement among owners anticipates these changes at a fraction of the cost of ensuing litigation from disputes regarding these foreseeable changes. Buy-sell agreements should address:

business “divorce” & impasse resolution
transfer restrictions and rights of first refusal
initial capital contributions & ownership vesting
withdrawing owner’s equity & purchase rights
additional capital contributions – obligations and penalties
treatment of deceased owner’s equity
representation on the board of directors
drag-along rights to prevent minority owners from blocking a sale
co-sale right whereby minority owners can elect to join in sale
permitted transfers for estate planning
confidentiality and noncompetition obligations

C. Purchasing or Selling Business Assets

Modify Default Terms of the Uniform Commercial Code

Buying and selling assets occur in discrete transactions and as part of ongoing supply or distribution arrangements. Sales involving significant seller-financed amounts should contain protective provisions restricting purchaser’s activities, addressing defaults and acceleration rights for certain events, and requiring collateral (see Security Interests discussed below). In lieu of specified quantities, purchase and sale arrangements may consist of purchaser’s agreement to purchase all of its goods from seller (a “requirements contract”) or of seller’s agreement to sell its entire production to purchaser (an “output contract”).

The Uniform Commercial Code (UCC) provides a “default” set of commercial laws which may be modified, for the most part, by written agreement. Unfortunately the UCC default rules regarding these types of contracts are generalized, vague and difficult to apply to particular situations. Contractual terms addressing obligations (while disclaiming others) and contingencies such as unanticipated production problems and demand or price spikes provide greater certainty and minimize disputes with valued trading partners.

Replace Implied Warranties with Custom Warranties

Warranties of merchantability, noninfringement and, if applicable, fitness for a particular purpose apply as a matter of law under the UCC to all goods sold. To avoid the ambiguity and scope of these implied warranties, knowledgeable suppliers adopt express written warranties detailing the scope and limits of their obligations to replace these UCC warranties. If the strict UCC requirements are not satisfied, attempts to limit the damages and remedies for violations of the UCC warranties are unenforceable.

Avoid “Term Changing” Purchase Orders

Purchase orders and invoices frequently contain conflicting terms. Deciding which terms are effective involves the dreaded “battle of the forms” triggering the various UCC “knockout” rules. While a favorite of law school professors for law school exams, few businesses want to become the subject of these exam questions. Rather than “after the fact” litigation of this battle, addressing this issue at the outset enhances certainty while saving money.

D. Purchasing a Franchise

Many of the issues outlined in Business Acquisitions – Part 1 and subsequent articles on this website apply to franchise purchases. Importantly, franchise purchases raise additional issues relating to the nature of a franchise. A franchise is essentially a license to operate a branded and systemized business for a limited time period (typically 10 years). Because the franchisor must protect its brand (trademarks and service marks), franchise agreements impose many financial, operating and quality obligations on the purchaser/franchisee. Just as commercial leases are landlord-biased, franchise agreements are franchisor-biased. When negotiating these agreements, prioritizing issues is critical as it counterproductive to request numerous changes of lesser importance.

The Inadvertent Franchise

Businesses licensing others to use their trademarks in connection with distribution or supply arrangements may be selling an “inadvertent franchise” or “accidental franchise.” Under trademark law, licensing a trademark without retaining adequate quality control results in abandonment or loss of the trademark. However, retaining these quality control rights resemble the operating and quality controls of a franchise. Unlike trademark licenses which are private contractual matters, franchises are heavily regulated by the Federal Trade Commission (FTC) and by many states. Although state definitions vary, the FTC defines a “franchise” as any continuing commercial relationship or arrangement in which:

“(1) The franchisee will obtain the right to operate a business that is identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark;

(2) The franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and

(3) As a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.

After analyzing the licensing arrangement under FTC regulations and applicable state franchising laws, modifying the proposed operations may be necessary to avoid elements of the “franchise” definition or to qualify for an exemption or exception from the definition.

E. Security Interests to Collateralize Payment or Performance Obligations

Legal arrangements for business should address performance assurances. A promise to pay or perform obligations may become an empty promise without collateral and/or personal guaranties. The UCC sets forth the requirements for security interests on most tangible and intangible assets. Requirements include a written agreement granting the security interest and identifying the collateral followed by “perfecting” the security interest to maintain collection priority over subsequent creditors. Security interests may also be granted on ownership interests in corporations, LLCs and limited partnerships as “general intangibles” under Article 9 of the UCC. However, these types of security interests are inadequately protected unless the issuer corporation, LLC or limited partnership “opts in” to UCC Article 8 (Investment Securities) as part of the collateralization process. The opt-in procedure is simple and prevents unscrupulous debtors from circumventing the perfection (priority protection) of the security interest.

F. Settlements and Releases

Not all business arrangements are successful. At times, breached obligations and liabilities must be settled with payments and releases. Releases should extend to affiliates of the parties and waive and release all business obligations (outside of the release agreement) and all known and unknown claims existing as of the release date. Texas courts require releases to have conspicuous language expressly stating any release of negligence claims. Other states have statutes require special language for releases. To be effective, releases of claims arising out of employment relationships must strictly comply with requirements under federal and state anti-discrimination laws.