Closely-held business owner breakups often defy easy categorization. What seem at first blush to be traditional business divorce cases sometimes end up treading far into other legal practice areas. Other disputes blur meaningful distinctions entirely.
As we have written several times (read here, here, and here), business divorce cases often involve related matrimonial disputes, with the business breakup occasionally venued in the matrimonial court. Trust and estate and business divorce litigation frequently intertwine, a phenomenon about which we have written repeatedly (read here, here, and here).
We also often encounter an employment-law component to our cases. I wrote recently about the faithless servant doctrine in business divorce cases. The faithless servant doctrine now applies to a wide range of disloyal fiduciaries, including close business owners. But the faithless servant doctrine derived exclusively from the law of master-servant relationships and employment.
Restrictive covenants are a particularly frequent source of litigation in business divorce cases. Every day in New York, individuals acquire equity interests in closely-held businesses in exchange for agreeing to be bound by contractual non-compete and non-solicitation provisions in the event of a future dissociation from the business. When relations among co-owners break down, the individual’s alleged compliance, or lack of thereof, with the non-compete and non-solicitation provisions can take front and center in the business divorce case.
One need look no further than a bitter partnership breakup involving international investment banking firm Parella Weinberg Partners (“PWP”). The dispute focused on the defection of a group of PWP’s equity partners and their formation of a competing investment banking firm, Ducera Partners (“Ducera”). The litigation yielded a recent Decision and Order from Manhattan Commercial Division Justice Robert R. Reed, a fine launchpad to consider the law of restrictive covenants in New York business divorce cases.
The BDO Seidman Test
No treatment of New York’s law of restrictive covenants would be complete without mention of the Court of Appeals’ seminal decision in BDO Seidman v Hirshberg (93 NY2d 382 ). In BDO Seidman, the Court wrote:
The modern, prevailing common-law standard of reasonableness for employee agreements not to compete applies a three-pronged test. A restraint is reasonable only if it: (1) is no greater than is required for the protection of the legitimate interest of the employer, (2) does not impose undue hardship on the employee, and (3) is not injurious to the public.
New York’s three-part test for enforceability of restrictive covenants derives from the principle that “noncompete clauses in employment contracts are not favored” and “will only be enforced to the extent reasonable and necessary to protect valid business interests” (Morris v Schroder Capital Mgt. Intl., 7 NY3d 620 ). As the BDO Seidman Court explained, the “violation of any prong renders the covenant invalid.”
A universe of case law has evolved applying the BDO Seidman test. Much of the case law focuses on a few issues:
- Whether the covenant is too broad in geographic scope or temporal duration;
- Whether the covenant seeks to protect trade secrets or confidential customer lists, or to prohibit competition by an employee whose services are sufficiently “unique or extraordinary” to protect an employer’s “legitimate interest”;
- Whether the covenant improperly seeks to prohibit an employee from benefitting from employment relationships or goodwill; and
- Whether the employee’s departure was voluntary or involuntary / with or without “cause.” This distinction matters because most courts hold that New York law “mandates the invalidation of all restrictive covenants in an employment agreement upon the termination of the employee without cause” (Greystone Funding Corp. v Kutner, 137 AD3d 427 [1st Dept 2016]).
Legal challenges to restrictive covenants are often protracted. Courts generally hold that “attacks on the reasonableness, breadth, legality, and enforceability” of restrictive covenants “are all premature” on a motion to dismiss “as they are each fact-based determinations” (Grassi & Co. v Honka, 180 AD3d 564 [1st Dept 2020]). This principle is a good segue to Parella Weinberg Partners, a lawsuit involving three trial-level Justices, eight years of litigation, and no end in sight.
Kramer and His Team Join PWP
Shortly after PWP’s founding, PWP extended Michael Kramer an offer of employment and an equity interest in its investment banking business, absorbing Kramer’s financial services business, Kramer Capital Partners, pursuant to a Framework Agreement. Several of Kramer’s team members, including Derron Slonecker, Joshua Scherer, and Adam Verost, followed Kramer to PWP.
Kramer executed a Limited Partnership Agreement of PWP MC LP, a contract all members of the firm’s management committee signed. Scherer and Verost executed a Limited Partnership Agreement of PWP Equity I LP, a contract all partners who were not members of the management committee signed. Verost executed a Confidentiality and Related Covenants Agreement.
The contracts contained roughly identical provisions prohibiting solicitation of employees or partners of PWP:
Each Limited Partner agrees that, during the period in which such Limited Partner is an Active Limited Partner . . . and for a period of one year thereafter, such Limited Partner will not, directly or indirectly in any capacity . . . hire or solicit, recruit, induce, entice, influence, or encourage any Firm employee (or any Limited Partner) to leave the Firm or become hired or engaged by another firm.
The contracts also prohibited solicitation of clients or customers of PWP:
Each Limited Partner agrees that, during the period in which such Limited Partner is an Active Limited Partner . . . and for a period of 180 days thereafter, such Limited Partner will not, directly or indirectly in any capacity . . . solicit or entice away or in any manner attempt to persuade any client or customer or prospective client or customer, of the Firm (i) to discontinue his, her or its relationship or prospective relationship with the Firm or (ii) to otherwise provide his, her or its business to any person, corporation, partnership or other business Entity which engages in any line of business in which the Firm is engaged . . . .
The Falling Out and Departure of Kramer’s Restructuring Group
Problems arose in October 2014, when PWP’s management removed Kramer under disputed circumstances as head of its Telecom, Media, and Technology Practice Group. Kramer reacted by suggesting he might consider leaving the firm, though he ultimately declined to do so publicly. But privately, according to the complaint, Kramer began actively recruiting other members of PWP’s Restructuring Group, including his pre-PWP colleagues, Slonecker, Scherer, Verost, and others, to depart en masse to form what ultimately became Ducera.
In February 2015, Kramer announced his resignation from PWP. Around the same time, PWP learned of Kramer and his cohort’s alleged scheme to “lift out” PWP’s Restructuring Group. A few days later, PWP sent written notice terminating Kramer, Slonecker, Scherer, and Verost’s employment for “cause,” also announcing the forfeiture of their vested equity in the business allegedly worth, according to defendants’ answer, roughly $60 million. In all, according to the complaint, PWP lost eight of the twelve members of its Restructuring Group to Kramer and his team at Ducera.
The Causes of Action
PWP alleged a host of traditional common-law business divorce claims, including breach of fiduciary duty, aiding and abetting breach of fiduciary duty, tortious interference, and unfair competition, several contract claims for breach of the restrictive covenants, and a single claim for declaratory judgment that the restrictive covenants are binding and enforceable.
Kramer and his group counterclaimed for breach of the “deferred compensation” provisions of the contracts, breach of the for “cause” termination provisions of the contracts, breach of the implied covenant of good faith, declaratory judgment that the covenants are void and unenforceable, tortious interference, and defamation.
Summary Judgment Denied on the Tort and Contract Claims
Both sides moved for summary judgment. You can a read a set of the briefs here, here, and here. Following a lengthy oral argument, Justice Reed issued his decision finding across-the-board triable issues of fact on all of the common-law and contractual claims, including whether the termination was for “cause,” writing:
[N]one of the parties adduce sufficient evidence to demonstrate the absence of material issues of fact requiring trial. Specifically, issues of fact remain as to exactly what conduct Individual Defendants undertook while still employed at PWP and during the time they were bound by restrictive covenants. The evidence as to such conduct is in large part dependent on witness testimony, and such testimony must be properly weighed by the finder of fact. Because factual issues remain, summary judgment is denied.
Summary Judgment Granted on the Declaratory Judgment Claims
For the declaratory judgment claims, Justice Reed framed his analysis around BDO Seidman’s three-part test.
“The first prong in determining whether a restrictive covenant is reasonable,” wrote the Court, “requires that the restrictive covenant be no greater than required for the protection of the legitimate interest of the employer.”
Observing that “New York case law on provisions prohibiting the solicitation of employees is scant,” Justice Reed held that “in cases concerning non-solicitation of employees, the same standards governing enforceability of noncompete provisions apply.” (quotations omitted).
“In other words,” held Justice Reed, “the standards that apply to the non-solicitation of employees provision in the PWP Agreements is the same standard as set forth in BDO Seidman . . ., but the provision for the non-solicitation of employees inherently is more likely to be found reasonable and less likely to infringe on the interests of the employee.”
Applying the law of noncompete agreements to the employee solicitation provisions, Justice Reed rejected defendants’ argument that “the services they provided were not unique,” relying upon case law holding that an employer has a “legitimate interest in preventing former employees from exploiting or appropriating the goodwill of a client or customer, which had been created and maintained at the employer’s expense, to the employer’s competitive detriment” (Crown IT Servs., Inc. v Koval-Olsen, 11 AD3d 263 [1st Dept 2004] [quotations omitted]). The Court found that PWP sufficiently demonstrated Kramer and his team were “key personnel in PWP’s Restructuring Group with specialized knowledge and skills” and that they “developed valuable relationships with PWP’s clients at PWP’s expense.”
“The second prong to determine whether a restrictive covenant is reasonable,” wrote the Court, “requires that the provision not impose undue hardship on the employee.” Justice Reed quickly rejected defendants’ “undue hardship” challenge to the covenants, writing:
The court does not find that the non-solicitation provisions create undue hardship on employees of PWP, including the Individual Defendants. Defendants make no argument against the length of the non-solicitation period, nor do they argue that such provisions might impact their ability to make a living.
“The final prong in the test for reasonableness of restrictive covenants,” wrote the Court, “is that such covenants must not be injurious to the public.” The Court found no credible basis to believe the covenant was injurious to the public, holding:
The three prongs all support a finding that the non-solicitation clauses are enforceable, and Plaintiffs are therefore entitled to summary judgment on their first cause of action for a declaratory judgment and dismissing Defendants’ fourth and fifth counterclaims solely to the extent of declaring the restrictive covenants are valid.
Commentary on Parella Weinberg Partners
I have read some wildly overbroad restrictive covenants purporting to prohibit an employee from practicing his or her occupation anywhere for years following cessation of employment. Such a provision is almost certainly unenforceable under BDO Seidman as “greater than required for the protection of the legitimate interest of the employer,” as an “undue hardship” upon the employee, and also possibly as “injurious to the public” depending on the kind of profession.
In contrast, the covenants in Parella Weinberg Partners were far more modest, prohibiting solicitation of employees for one year, and solicitation of customers for less than half a year. Those restrictions in my view are not particularly onerous, and ones just like them are very common in the financial services industry. If the Court were to have invalidated the covenants in Parella Weinberg Partners, it could have potentially called into question the validity of scores of similar covenants in the finance industry.
Though Justice Reed’s decision was a decisive win for PWP, the win may be short lived. At trial, Kramer and his team remain free to challenge the circumstances of their departure from PWP, including the key fact question of whether PWP terminated them with or without “cause,” and whether they are entitled to tens of millions of dollars in deferred compensation and payments for their forfeited equity. In other words, a great deal of risk remains for both sides. If forced to predict the future, I would envision a quiet settlement shortly before trial, the material terms of which are shielded from disclosure by a confidentiality agreement.