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Prosperity for those not born to wealth often requires the taking of risk. Some risks, unfortunately, don’t pan out, leading to financial ruin. Federal bankruptcy law provides failed risk-takers relief, discharging debts and creditor claims to allow the bankruptcy filer a fresh start. But what if the risk involves breaching a non-competition agreement? Do the legal claims of a former employer get wiped out by a bang of the bankruptcy judge’s gavel? As in so many other areas of the law, the answer is “it depends.”

By way of background, most but not all liabilities are wiped out, or “discharged” in a Chapter 7 or Chapter 11 bankruptcy proceeding. Section 523 of the bankruptcy code contains a list of exceptions. Two (or three) have potential application to breaches of a non-compete or non-solicitation agreement. The first is 523(a)(2), which applies to money obtained by “false pretenses, a false representation, or actual fraud.” In the typical non-compete scenario, an employee goes to a competitor and sometimes brings along customers or clients with whom he/she had a business relationship. If the non-compete meets the legal test for enforceability, the former employer may sue not only for injunctive relief (to get a court order prohibiting the employee from working), but also for lost profit damages. If the claim goes to trial and the employer obtains a large judgment, however, that judgment will be wiped out under ordinary circumstances. Merely breaching a contract is not an act of fraud. That was the holding of a Louisiana Bankruptcy Court in the 2010 case of O’Connor v. Trost. Prior to filing for bankruptcy, the former employee had been sued by his former employer in state court for breaching a non-compete.  In defiance of a order from that state court barring him from further competing, the former employee set up several shell companies through which to compete, one of which he transferred to his brother. The bankruptcy court concluded that even though this conduct was a clear violation of the non-compete, it did not constitute “fraud” under the bankruptcy code.  As explained by the court, the employer did not rely on any misrepresentations made by the employee, an element of any fraud claim.

The second potentially applicable provision, also at issue in O’Connor, is 523(a)(6), which exempts from discharge debts arising from the “willful and malicious injury by the debtor to another entity.” That language, on its face, presents a high legal standard. Mere violation of a non-compete normally will not suffice, barring unusual circumstances. Misappropriation of trade secrets presents a closer question, naturally, but even then the employer would bear the burden of demonstrating that the employee actually knew his/her conduct was wrongful. The former employer in O’Connor was able meet its burden under 523(a)(6), because the disloyal former employee repeatedly violated a court order that he refrain from competing, as noted above.  Importantly, it held the provision inapplicable to the employee’s wife, who assisted him in violating the non-compete with full knowledge of his scheme, reasoning that she was not a party to the non-compete and was not subject to the court order that barred her husband from competing (and that he openly defied).  On this basis, it concluded that her actions were not “willful and malicious.” The ruling leaves unanswered the issue of breach in the absence of a violated court injunction; not all employers seek an injunction out of the gate, some opting to instead sue for damages, and some requests for injunctive relief are denied.  The court’s ruling concerning Mrs. O’Connor suggests that a garden variety violation of a non-compete, in the absence of a violation of a court order, will not suffice.

A similar result obtained under markedly different facts in Koch v. SKF USA, Inc., a 2012 case decided by the District Court for the District of Minnesota. The employee there filed for bankruptcy after his former employer obtained a $1.1 million dollar judgment against him in Illinois state court based on his theft of trade secrets (“thousands of files”), which he gave to his new employer and which were actually used by the new employer in its business operations. Among other arguments, the employee claimed his actions were not “malicious,” because that issue had not been before the Illinois court which had awarded the judgment against him. The bankruptcy court disagreed, as did the District Court on appeal, ruling that malicious intent could be “inferred” from the Illinois’ court’s award of punitive damages.

Finally, some aggrieved employers have argued for application of 523(a)(3), which concerns “fraud or defalcation while acting in a fiduciary capacity.” (Defalcation being a fancy word for misappropriation of funds). Under this argument, non-competes in the workplace establish a fiduciary relationship. Most courts have rejected this argument, because the employee-employer relationship is not inherently fiduciary in nature.  As compared to stock broker/client, trustee/beneficiary, corporate office/shareholder, attorney/client, and other such relationships. The too-cute argument for a “constructive trust” over ill-gotten gains resulting from a breach of non-compete did not impress the Delaware bankruptcy court in the 2012 case Hickman v. Wimbrow.  Other courts have concluded similarly.

As a cautionary note, a lower threshold for non-dischargeability may apply where the subject non-compete owes its existence to a sale of business. There, the non-compete is consideration for the purchase, and the test under 523(a)(6) may be easier to apply.  In the 2012 case Puy v. PLM Lake and Land Management Corp., a Minnesota Bankruptcy Court judge exempted from discharge a substantial state court judgment arising from a breach of a non-compete associated with the sale of a business.  The defendant in that case had sold the assets of his aquatic weed control company to plaintiff in exchange for $400,000 and a promise not to compete or solicit former customers for a period of time.  A year after signing the agreement, Defendant set up a competing venture and proceeded to poaching his former customers.  Plaintiff thereafter sued and obtained a judgment of $868,240.07 following a jury trial.  Although there was no specific finding of “malice” per se by the jury, the bankruptcy court concluded malice must have been found, based on a careful examination of the instructions read to the jury and the nature of their finding.  As stated by the court, “The verdict and judgment could only have been based on a recognition in fact that [Defendant] intended to take back, and to exploit, something that [Defendant’s company] had sold to [Plaintiff].”

The takeaway for employees subject to a non-compete who are considering switching jobs is to first contact an experienced employment law attorney. Good faith reliance on that opinion, even it proves to be wrong, will go a long way in protecting you from a finding of “malicious” conduct.  Should you be sued by your former employer and find your way to bankruptcy court.