What Is The Faithless Servant Doctrine And Why Is It A Potent Weapon For Employers?

• Posted on: Nov 29 2016

Consider the following story.  John Smith has worked for Jane Doe for 15 years. Doe runs a small, but profitable, media consulting business.  Smith has been one of Doe’s most productive account executives, generating significant business over the 15 years of his employment. Though compensated well, Smith decides that he wants to open his own media consulting firm. Smith secretly advises Doe’s clients that he intends to strike out on his own and requests that they follow him.  Shortly thereafter, Smith opens his business a few miles from Doe’s firm with a substantial number of Doe’s clients.  Not surprisingly, Doe sues Smith.

Unfortunately, this story is not uncommon. Employees misappropriate confidential, proprietary information and trade secrets all too often. Some use the information for profit; others do nothing with the information. When an employee uses misappropriated information, an employer has an arsenal of claims that he/she can assert against the employee, including, among other others, the misappropriation of proprietary information and trade secrets, breach of contract, and breach of fiduciary duty.  But, perhaps, the most potent weapon, at least in New York, is the faithless servant doctrine.

The Faithless Servant Doctrine In New York:

The doctrine first appeared in New York in the late nineteenth century as part of a one-two-punch adopted by the Court of Appeals to address employee misconduct. Grounded in contract and fiduciary duty, respectively, each claim could result in the forfeiture of compensation. Under the former, an employee guilty of violating his/her employment agreement could be ordered to forfeit his/her compensation if the violation was found to be substantial. See Turner v. Kouwenhoven, 100 N.Y. 115, 120 (1885).  Under the latter (i.e., the faithless servant doctrine), an employee who acted adversely to the employer or failed to disclose any interest that conflicted with that of the employer (i.e., breaches a duty of loyalty or good faith) could be ordered to forfeit his/her compensation. See Murray v. Beard, 102 N.Y. 505, 508 (1886) (“[a]n agent is held to uberrima/fides [utmost fidelity] in his dealings with his principal, and if he acts adversely to his employer in any part of the transaction, or omits to disclose any interest which would naturally influence his conduct in dealing with the subject of the employment, it amounts to such a fraud upon the principal as to forfeit any right to compensation for services.”).

The faithless servant doctrine, also known as equitable forfeiture, is based on agency principles, and has been applied to brokers, salaried employees, attorneys, arts and entertainment representatives, and executors of estates.  The courts have applied the doctrine to a wide variety of misconduct, including, but not limited to, conflicts of interest, stealing money or goods, and secretly starting a competing business. Any act that can give rise to a claim for breach of fiduciary duty will trigger the doctrine.

Violating the Doctrine Can Result in A Harsh Result:

The penalty for violating the doctrine is harsh: the employee must forfeit all compensation earned since the first date of employment, even though the employee’s services may have otherwise benefitted the employer or the employer suffered no damages. Indeed, any value provided by the employee through loyal service is irrelevant. Thus, if an employee, even an otherwise valuable employee, is found to have been disloyal, then the employee will be required to disgorge all compensation even if the harm caused by the misconduct was minimal and the employee otherwise provided valuable service during the period of employment.

Some recent decisions by the lower courts in New York, however, have relaxed the severity of the penalty by endorsing the principle that a faithless servant forfeits all compensation from the date of the first disloyal act. See e.g., Herman v. Branch Motor Express Co., 67 Misc.2d 444, 446 (N.Y. Civ. Ct. 1971) (finding that a faithless employee is deprived of his right to compensation “only for the period of his faithlessness”); Maritime Fish Products, Inc. v. World Wide Fish Products, Inc., 100 A.D.2d 81, 91 (1st Dep’t 1984) (employer is entitled to return of compensation paid to employee “during the period of disloyalty”); St. James Plaza v. Notey, 95 A.D.2d 804, 806 (2d Dep’t 1983) (“an employee may forfeit his right to compensation for services rendered by him during such periods of disloyalty”).

The Law in New York Since 1886:

Notwithstanding the few decisions that apportion forfeiture relative to the period of disloyalty, the faithful servant doctrine has remained relatively unchanged in New York since its origin. In 1977, for example, the Court Appeals reconfirmed the doctrine, noting that an employee “faithless in the performance of his services … is not entitled to recover his compensation” even if “his services were beneficial to the principal” or the employer “suffered no provable damage as a result of the breach of fidelity by the agent.” Feinger v. Iral Jewelry, Ltd., 41 N. Y.2d 928, 929 (1977).

On September 26, 2006, the First Department rejected attempts by the defendant to escape the harshness of the doctrine by trying to reverse the motion court’s ruling requiring complete forfeiture of his compensation, including that which was untainted by the disloyal acts. In Matter of Blumenthal [Kingsford], 32 A.D.3d 767, 768 (1st Dep’t 2006), the Court affirmed the motion court’s ruling, holding that “[i]n light of respondent’s repeated disloyalty throughout his tenure [as the former executor of an estate], there is no merit to his assertion that there should have been an apportionment of his salary or of Wise Acre commissions as to which disloyalty was not found.”

In William Floyd Union Free School District v. Wright, 61 A.D.3d 856, 859 (2d Dept. 2009), the Second Department reversed the decision of the motion court, finding that the lower court erred “in limiting the defendants’ forfeiture of insurance benefits to a period of 10 years.” In doing so, the Second Department made clear that “complete and permanent forfeiture of compensation, deferred or otherwise, [was] warranted under the faithless servant doctrine.”

Beach v. Touradji Capital Management, LP – The Doctrine is Alive and Well:

On November 22, 2016, the First Department had another opportunity to consider the doctrine. In Beach v. Touradji Capital Management, LP, 2016 NY Slip Op. 07852, the Court held that the faithless servant doctrine could be used to recover the compensation paid to the disloyal employees (former employees who formed a competing company), regardless of whether damages could otherwise be proven:

Although plaintiffs were at-will employees, they could be found to have breached a fiduciary duty to their employer if they acted directly against the employer’s interests. Plaintiffs do not dispute that they were employed by TCM ….

Plaintiffs contend that the breach of fiduciary duty counterclaim should have been dismissed in its entirety because TCM failed to show that their actions caused it damage. They submitted evidence that investors withdrew from TCM for reasons other than their actions. However, counterclaim defendants’ damages are not limited to the loss of investors. For example, under the faithless servant doctrine, TCM could seek to recover the compensation it paid to plaintiffs.

Takeaway:

Beach shows that the faithless servant doctrine is alive and well in New York and remains a potent weapon for employers faced with an employee who acts disloyal during his or her employment.  The question, however, is whether the doctrine is fair? To be sure, a faithless servant should not benefit from his/her acts of disloyalty. But, should the employer benefit too by strict application of the doctrine?  That is, should the employer recoup compensation paid to the employee for activities and contributions untainted by acts of disloyalty? That too seems to be unfair.

Perhaps there is a middle ground, where the court could look at the nature of the employment relationship, the severity of the disloyal action engaged in and the benefits received by the employer from the employee during the period of disloyalty to determine the amount of forfeiture.  Such an approach would still penalize an employee who is guilty of disloyal conduct, but it would also recognize his/her achievements or contributions to the employer.

Notably, the Second Circuit has advanced this middle ground approach in applying New York law, at least under certain circumstances; namely: a) the employer and employee agree that the latter would be compensated on a “task-by-task basis”; the employee was disloyal as to only certain tasks; and the employee was otherwise loyal with regard to other tasks. See Design Strategy, Inc. v. Davis, 469 F.3d 284, 300-02 (2d Cir. 2006). Some lower courts in New York have applied the Second Circuit’s approach, finding that it comports with the Restatement (Second) of Agency, which calls for apportioning forfeitures when an agent’s compensation is allocated to periods of time or to the completion of specified items of work. E.g., G.K. Alan Assoc., Inc. v. Lazzari, 44 A.D.2d 95, 103-04 (2d Dep’t 2007).

The Court of Appeals has not weighed in on the Second Circuit’s less draconian approach. Thus, until the Court reviews that approach, employers and employees are reminded that the faithless servant doctrine is alive and well.