When Are Liquidated Damages Clauses Valid in Professional Contracts?
Insurance agents. Physicians. Salespeople. Mortgage brokers. Accountants. These are just some of the many professionals who may be asked to sign restrictive covenants not to compete or use confidential information after termination of employment. Indeed, nearly 20 percent of employees are now subject to restrictive covenants.
But restrictive covenants are not always easy to enforce. Some employment contracts may include so-called “liquidated damages” provisions that specify the amount of money departing employees must pay if they violate a non-compete covenant. For example, an insurance agent may be required to pay one times his book of business if he solicits past customers, or a doctor may be required to pay $50,000 if she opens up a practice in a 10-mile radius of her former clinic.
Whether a liquidated damages provision is enforceable depends on whether it is a fair and reasonable estimate of actual damages or an unfair penalty.
Damages v. Penalty. A party must prove three essential elements to assert a successful claim for liquidated damages: (1) the parties to the contract intended to liquidate damages; (2) the amount of liquidated damages in the contract was a reasonable estimate of the presumed actual damages that the breach would cause; and (3) it is difficult to determine the amount of actual damages that would result from the breach. St. Jude Medical, Inc. v. Medtronic, Inc., 536 N.W.2d 24, 28 (Minn. Ct. App. 1995).
The Minnesota Supreme Court has instructed district courts to analyze liquidated damages clauses associated with restrictive covenants to determine if they are “one for a penalty or one for damages.” Gorco Const. Co. v. Stein, 99 N.W.2d 69, 75 (Minn. 1959). The Court has stated that “when the measure of damages resulting from a breach of contract is susceptible of definite measurement, we have uniformly held an amount greatly disproportionate to be a penalty.” Id. (liquidated damage clause unenforceable where damages were susceptible of measurement and proof by ordinary rules). This is because punishment of a promisor for a breach, without regard to the extent of harm he has caused, is an unjust remedy, and such a liquidated damages clause in unenforceable. Id.
Forfeiture of Income Clauses. Minnesota courts disfavor liquidated damages penalties in noncompete agreements that amount to a forfeiture of prior income. For instance, in Bellboy Seafood Corp. v. Nathanson, 410 N.W.2d 349 (Minn. Ct. App. 1987), a seafood company paid an employee a percentage of the company’s profits. The employee agreed: (1) not to enter the meat-trading business if he left his employment and (2) to re-pay his share of the profits in the last year if he left and went into competition with the former employer. Bellboy, 410 N.W.2d at 349. The Minnesota Court of Appeals found that the liquidated damage provision was an unenforceable penalty, upholding the trial court’s conclusion that “the provision was unenforceable because it required a forfeiture of earned income.”) Id. at 352.
Similarly, in Harris v. Bolin, 247 N.W.2d 600 (Minn. 1976), an advertising agency provided that if an employee left the agency to work for a competing advertising agency, he would forfeit the proceeds of his profit-sharing plan. The Minnesota Supreme Court struck down the liquidated damages provision, noting that “forfeitures under covenants against competition are not favored and those claiming them must show that the equities are on their side.” Harris, 247 N.W.2d at 602.
Payments Disproportionate to Actual Damages. The courts also disfavor liquidated damages clause that require a former employee to pay a percentage of past fees or earnings that are disproportionate to actual damages. In Coffman v. Olson, 906 N.E.2d 201 (Ind. Ct. App. 2009), an accounting firm imposed a restrictive covenant that prevented an accountant from competing for the clients of the firm after his employment ended. A liquidated damages clause required the former employee to pay his previous employer two times the firm’s prior year’s billings for any customer who went with the accountant. Coffman, 906 N.E.2d at 205. A number of former clients made independent decisions to contact the former employee after learning he left the firm, and he performed accounting services for them. Id. The court found that, “The liquidated damage clause is clearly intended to act as a penalty and is therefore unenforceable.” Id. at 206.
Similarly, in Cherry, Bekaert & Holland v. LaSalle, 413 So.2d 436, 437 (Fla. Ct. App. 1982), an accounting firm imposed a restrictive covenant prohibiting a former employee from performing accounting services for former clients for three years after his termination. If he served any client of his former employer in violation of the restrictive covenant, he was required to pay two times the fees his former employer charged those clients during the year prior to his termination. Id. The court affirmed the district court’s ruling that the liquidated damages provision was an unenforceable “oppressive penalty.” Id.
Flat Amounts in Excess of Actual Damages. Courts have similarly rejected flat-amount liquidated damage provisions where the amount was disproportionate to the damages. In Goldblatt, 77 So.3rd at 799, a medical device company imposed a restrictive covenant that prevented a business partner from competing after a sale. The covenant required the former partner to pay $250,000 for each breach. The court declared it unenforceable, finding that it bore no correlation to actual damages and that “there is little doubt that sophisticated business people with a long history in the industry could arrive at a standard or more formulaic approach for calculating damages.” Id. The court found that the liquidated damages provision “resembles a penalty or deterrent to the breaching party. Use of liquidated damages clauses to this end is never allowed.” Id. at 801. In noting that this liquidated damage amount “has the potential of conferring a windfall to the non-breaching party,” the court noted that, “Where there is doubt as to whether a provision is a penalty or a proper liquidated damages clause, ‘the tendency of the courts is to construe a provision for payment of an arbitrary sum a penalty rather than one for liquidated damages.’” Id.
Other courts have regularly reached similar results. See also Press-A-Dent, Inc. v. Weigel, 849 N.E.2d 661 (Ind. Ct. App. 2006) (declaring $50,000 liquidated damage provision for violation of noncompete agreement an unenforceable penalty, noting it is “grossly disproportionate to the loss”); Beneke, 550 S.W.2d at 322 ($25,000 flat liquidated damage clause for insurance adjuster who violated noncompete clause was an unenforceable penalty even though the contract states the parties agreed to the difficulty of ascertaining actual damages); Aztek Film Prod., Inc. v. Quinn, 569 P.2d 1366 (Ariz. Ct. App. 1977) ($40,000 liquidated damage clause in sale agreement requiring partner in movie business not to compete was an unenforceable penalty when profit from competing was $1,650; plaintiff only entitled to recover actual damages for breach of covenant).
Not a Substitute When Actual Damages Can Be Measured. Courts have routinely deemed liquidated damages provisions to be unenforceable penalties when actual damages can be measured. In Equity Enterprises, Inc. v. Milosch, 633 N.W.2d 662, 666 (Wisc. Ct. App. 2001), an insurance agency prohibited a former insurance agent from doing business with former customers for 18 months. If the former agent violated this provision, he was required to forfeit his right to further commissions otherwise owed to him. The actual damages caused by the alleged breach were about $74,000, but the liquidated damages clause would have required the agent to pay closer to $250,000, or three and one-half times actual damages. The Wisconsin Court of Appeals found this was “a penalty provision which cannot stand.” Equity Enterprises, 633 N.W.2d at 671.
The court applied a “reasonableness test” that “respects the parties’ bargain, but prevents abuse” and analyzed whether the injury caused by the breach is incapable of accurate estimation and whether the stipulated damages were a reasonable forecast of the harm caused by the breach. Id. The court held that the liquidated damage clause was unenforceable because the amount of damages caused by an insurance agent who breaches a noncompete clause by doing business with former policyholders was ascertainable. Id. at 672. The court also noted that “if the damages provided for in the contract are grossly disproportionate to the actual harm sustained, the courts usually conclude that the parties’ original expectations were unreasonable.” Id.
General Non-Competes vs. Non-Solicitation of Specific Customers. There are different types of noncompete clauses. For example, under a general noncompete clause, a person may be prohibited simply from entering into any type of competition with a former employer. This can make it harder for the employer to measure the lost business, because the employer doesn’t know who doesn’t become a customer due to the competition of the ex-employee. The same is true when a former business owner is prohibited from competing with his prior company after the sale of a business. The courts may be more likely to uphold reasonable liquidated damages provisions in these circumstances.
In other cases, though, an employee may be prohibited from targeting his former customers, clients, or patients. In these cases, it is easier for the courts to measure what customers were lost due to breach of the covenant. In those cases, the courts may be less likely to uphold a liquidated damages clause that is disproportionate to the actual harm caused by the breach. See Technical Aid Corp. v. Allen, 591 A.2d 262, 274 (N.H. 1991) (liquidated damages clause held unenforceable; differentiating liquidated damage clauses where the loss pertains to unknown customers from cases “where the damaged complained of is the loss of a part or the whole of a specific client’s business.”)
Conclusion.In Minnesota, restrictive covenants are closely scrutinized. The above caselaw makes clear that courts often reject liquidated damages clauses (1) where actual damages are reasonably susceptible to measurement and (2) where the liquidated damages are significantly disproportionate to the actual damages.
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Swanson Hatch, P.A. regularly represents employers and individuals in drafting and negotiating employment contracts and in disputes and lawsuits involving restrictive covenants.
Lori Swanson served as Attorney General from 2007 to 2019. Prior to that, she served as Solicitor General of the State of Minnesota and Deputy Attorney General. Mike Hatch served as Attorney General from 1999 to 2007. Prior to that, he served as Commissioner of the Minnesota Department of Commerce and regulated the insurance, real estate, banking, securities, and financial markets in Minnesota. Hatch and Swanson practice law at Swanson Hatch, P.A. They may be reached at 612-315-3037. Visit their website at www.swansonhatch.com.
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www.swansonhatch.com
431 South Seventh Street, Suite 2545
Minneapolis, MN 55415 612-315-3037
The materials in this article are for informational purposes and do not constitute legal advice, nor does your unsolicited transmission of information to us create a lawyer-client relationship. Sending us an email will not make you a client of our firm. Until we have agreed to represent you, nothing you send us will be confidential or privileged. Readers should not act on information contained in this article without seeking professional counsel. The best way for you to inquire about possible representation is to contact an attorney of the firm. Actual results depend on the specific factual and legal circumstances of each client’s case. Past results do not guarantee future results in any matter.
UNFAIR PENALTY OR FAIR COMPENSATION
When Are Liquidated Damages Clauses Valid in Professional Contracts?Insurance agents. Physicians. Salespeople. Mortgage brokers. Accountants. These are just some of the many professionals who may be asked to sign restrictive covenants not to compete or use confidential information after termination of employment. Indeed, nearly 20 percent of employees are now subject to restrictive covenants.
But restrictive covenants are not always easy to enforce. Some employment contracts may include so-called “liquidated damages” provisions that specify the amount of money departing employees must pay if they violate a non-compete covenant. For example, an insurance agent may be required to pay one times his book of business if he solicits past customers, or a doctor may be required to pay $50,000 if she opens up a practice in a 10-mile radius of her former clinic.
Whether a liquidated damages provision is enforceable depends on whether it is a fair and reasonable estimate of actual damages or an unfair penalty.
Damages v. Penalty. A party must prove three essential elements to assert a successful claim for liquidated damages: (1) the parties to the contract intended to liquidate damages; (2) the amount of liquidated damages in the contract was a reasonable estimate of the presumed actual damages that the breach would cause; and (3) it is difficult to determine the amount of actual damages that would result from the breach. St. Jude Medical, Inc. v. Medtronic, Inc., 536 N.W.2d 24, 28 (Minn. Ct. App. 1995).
The Minnesota Supreme Court has instructed district courts to analyze liquidated damages clauses associated with restrictive covenants to determine if they are “one for a penalty or one for damages.” Gorco Const. Co. v. Stein, 99 N.W.2d 69, 75 (Minn. 1959). The Court has stated that “when the measure of damages resulting from a breach of contract is susceptible of definite measurement, we have uniformly held an amount greatly disproportionate to be a penalty.” Id. (liquidated damage clause unenforceable where damages were susceptible of measurement and proof by ordinary rules). This is because punishment of a promisor for a breach, without regard to the extent of harm he has caused, is an unjust remedy, and such a liquidated damages clause in unenforceable. Id.
Forfeiture of Income Clauses. Minnesota courts disfavor liquidated damages penalties in noncompete agreements that amount to a forfeiture of prior income. For instance, in Bellboy Seafood Corp. v. Nathanson, 410 N.W.2d 349 (Minn. Ct. App. 1987), a seafood company paid an employee a percentage of the company’s profits. The employee agreed: (1) not to enter the meat-trading business if he left his employment and (2) to re-pay his share of the profits in the last year if he left and went into competition with the former employer. Bellboy, 410 N.W.2d at 349. The Minnesota Court of Appeals found that the liquidated damage provision was an unenforceable penalty, upholding the trial court’s conclusion that “the provision was unenforceable because it required a forfeiture of earned income.”) Id. at 352.
Similarly, in Harris v. Bolin, 247 N.W.2d 600 (Minn. 1976), an advertising agency provided that if an employee left the agency to work for a competing advertising agency, he would forfeit the proceeds of his profit-sharing plan. The Minnesota Supreme Court struck down the liquidated damages provision, noting that “forfeitures under covenants against competition are not favored and those claiming them must show that the equities are on their side.” Harris, 247 N.W.2d at 602.
Payments Disproportionate to Actual Damages. The courts also disfavor liquidated damages clause that require a former employee to pay a percentage of past fees or earnings that are disproportionate to actual damages. In Coffman v. Olson, 906 N.E.2d 201 (Ind. Ct. App. 2009), an accounting firm imposed a restrictive covenant that prevented an accountant from competing for the clients of the firm after his employment ended. A liquidated damages clause required the former employee to pay his previous employer two times the firm’s prior year’s billings for any customer who went with the accountant. Coffman, 906 N.E.2d at 205. A number of former clients made independent decisions to contact the former employee after learning he left the firm, and he performed accounting services for them. Id. The court found that, “The liquidated damage clause is clearly intended to act as a penalty and is therefore unenforceable.” Id. at 206.
Similarly, in Cherry, Bekaert & Holland v. LaSalle, 413 So.2d 436, 437 (Fla. Ct. App. 1982), an accounting firm imposed a restrictive covenant prohibiting a former employee from performing accounting services for former clients for three years after his termination. If he served any client of his former employer in violation of the restrictive covenant, he was required to pay two times the fees his former employer charged those clients during the year prior to his termination. Id. The court affirmed the district court’s ruling that the liquidated damages provision was an unenforceable “oppressive penalty.” Id.
Flat Amounts in Excess of Actual Damages. Courts have similarly rejected flat-amount liquidated damage provisions where the amount was disproportionate to the damages. In Goldblatt, 77 So.3rd at 799, a medical device company imposed a restrictive covenant that prevented a business partner from competing after a sale. The covenant required the former partner to pay $250,000 for each breach. The court declared it unenforceable, finding that it bore no correlation to actual damages and that “there is little doubt that sophisticated business people with a long history in the industry could arrive at a standard or more formulaic approach for calculating damages.” Id. The court found that the liquidated damages provision “resembles a penalty or deterrent to the breaching party. Use of liquidated damages clauses to this end is never allowed.” Id. at 801. In noting that this liquidated damage amount “has the potential of conferring a windfall to the non-breaching party,” the court noted that, “Where there is doubt as to whether a provision is a penalty or a proper liquidated damages clause, ‘the tendency of the courts is to construe a provision for payment of an arbitrary sum a penalty rather than one for liquidated damages.’” Id.
Other courts have regularly reached similar results. See also Press-A-Dent, Inc. v. Weigel, 849 N.E.2d 661 (Ind. Ct. App. 2006) (declaring $50,000 liquidated damage provision for violation of noncompete agreement an unenforceable penalty, noting it is “grossly disproportionate to the loss”); Beneke, 550 S.W.2d at 322 ($25,000 flat liquidated damage clause for insurance adjuster who violated noncompete clause was an unenforceable penalty even though the contract states the parties agreed to the difficulty of ascertaining actual damages); Aztek Film Prod., Inc. v. Quinn, 569 P.2d 1366 (Ariz. Ct. App. 1977) ($40,000 liquidated damage clause in sale agreement requiring partner in movie business not to compete was an unenforceable penalty when profit from competing was $1,650; plaintiff only entitled to recover actual damages for breach of covenant).
Not a Substitute When Actual Damages Can Be Measured. Courts have routinely deemed liquidated damages provisions to be unenforceable penalties when actual damages can be measured. In Equity Enterprises, Inc. v. Milosch, 633 N.W.2d 662, 666 (Wisc. Ct. App. 2001), an insurance agency prohibited a former insurance agent from doing business with former customers for 18 months. If the former agent violated this provision, he was required to forfeit his right to further commissions otherwise owed to him. The actual damages caused by the alleged breach were about $74,000, but the liquidated damages clause would have required the agent to pay closer to $250,000, or three and one-half times actual damages. The Wisconsin Court of Appeals found this was “a penalty provision which cannot stand.” Equity Enterprises, 633 N.W.2d at 671.
The court applied a “reasonableness test” that “respects the parties’ bargain, but prevents abuse” and analyzed whether the injury caused by the breach is incapable of accurate estimation and whether the stipulated damages were a reasonable forecast of the harm caused by the breach. Id. The court held that the liquidated damage clause was unenforceable because the amount of damages caused by an insurance agent who breaches a noncompete clause by doing business with former policyholders was ascertainable. Id. at 672. The court also noted that “if the damages provided for in the contract are grossly disproportionate to the actual harm sustained, the courts usually conclude that the parties’ original expectations were unreasonable.” Id.
General Non-Competes vs. Non-Solicitation of Specific Customers. There are different types of noncompete clauses. For example, under a general noncompete clause, a person may be prohibited simply from entering into any type of competition with a former employer. This can make it harder for the employer to measure the lost business, because the employer doesn’t know who doesn’t become a customer due to the competition of the ex-employee. The same is true when a former business owner is prohibited from competing with his prior company after the sale of a business. The courts may be more likely to uphold reasonable liquidated damages provisions in these circumstances.
In other cases, though, an employee may be prohibited from targeting his former customers, clients, or patients. In these cases, it is easier for the courts to measure what customers were lost due to breach of the covenant. In those cases, the courts may be less likely to uphold a liquidated damages clause that is disproportionate to the actual harm caused by the breach. See Technical Aid Corp. v. Allen, 591 A.2d 262, 274 (N.H. 1991) (liquidated damages clause held unenforceable; differentiating liquidated damage clauses where the loss pertains to unknown customers from cases “where the damaged complained of is the loss of a part or the whole of a specific client’s business.”)
Conclusion.In Minnesota, restrictive covenants are closely scrutinized. The above caselaw makes clear that courts often reject liquidated damages clauses (1) where actual damages are reasonably susceptible to measurement and (2) where the liquidated damages are significantly disproportionate to the actual damages.
Swanson Hatch, P.A. regularly represents employers and individuals in drafting and negotiating employment contracts and in disputes and lawsuits involving restrictive covenants.
Lori Swanson served as Attorney General from 2007 to 2019. Prior to that, she served as Solicitor General of the State of Minnesota and Deputy Attorney General. Mike Hatch served as Attorney General from 1999 to 2007. Prior to that, he served as Commissioner of the Minnesota Department of Commerce and regulated the insurance, real estate, banking, securities, and financial markets in Minnesota. Hatch and Swanson practice law at Swanson Hatch, P.A. They may be reached at 612-315-3037. Visit their website at www.swansonhatch.com.
www.swansonhatch.com
431 South Seventh Street, Suite 2545
Minneapolis, MN 55415
612-315-3037
The materials in this article are for informational purposes and do not constitute legal advice, nor does your unsolicited transmission of information to us create a lawyer-client relationship. Sending us an email will not make you a client of our firm. Until we have agreed to represent you, nothing you send us will be confidential or privileged. Readers should not act on information contained in this article without seeking professional counsel. The best way for you to inquire about possible representation is to contact an attorney of the firm. Actual results depend on the specific factual and legal circumstances of each client’s case. Past results do not guarantee future results in any matter.
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Swanson | Hatch, P.A.
431 S. 7th Street, Suite #2545
Minneapolis, MN 55415
612-315-3037
www.swansonhatch.com