"FAITHLESS SERVANT" DOCTRINE STILL FOLLOWED BY SOME STATES, BUT REJECTED AS OVERLY PUNITIVE BY OTHERS

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1 "FAITHLESS SERVANT" DOCTRINE STILL FOLLOWED BY SOME STATES, BUT REJECTED AS OVERLY PUNITIVE BY OTHERS Pearl Zuchlewski Geoffrey A. Mort Kraus & Zuchlewski LLI' The common law legal principle known as the "faithless servant" doctrine first appeared in an Alabama court decision in the late nineteenth century; New York quickly adopted this novel, draconian legal principle. Also known as equitable forfeiture and the faithless agent doctrine, the faithless servant doctrine requires employees who are "disloyal" to their employers to forfeit some or all of their compensation, a concept referred to in other contexts as "clawbacks." Disloyalty to an employer may take many forms, including fraudulent misconduct, gross negligence, behavior detrimental to a company, embezzlement or misstating a company's financial position. New York's faithless servant doctrine, one of the first to be established in the country, is similar to those of a number of other states. Its evolution represents a useful baseline to this article's discussion of this controversial principle which appears to be gradually eroding in the common law of some states. The Faithless Servant Doctrine in New York The faithless servant rule, which is grounded in the law of agency, was first enunciated by New York's highest court in Murray v. Beard, 102 N.Y. 505 (1886). In Murray, the New York Court of Appeals declared that "[a]n agent is held to uberrima/ides [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 su1:>iect of the employment, it amounts to such a fraud upon the principal as to forfeit any right to compensation for services." Jd. at 508 (emphasis in original).

2 For more than a century, New York's faithless servant doctrine has undergone little change. For example, in Feinger v. Irai Jewelry, Ltd., 41 N. Y.2d 928 (1977), the Court of Appeals held 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." Id. at The plaintiff in Feinger, during his last two years of employment with the company, had planned and taken preliminary steps to open his own, competing business in conjunction with one of its partners. Interestingly, despite its uncompromising language about the cost offaithlessness, the court found in favor of the plaintiff. The court concluded that his actions "involved no breach of fidelity," id. at 929, because he misappropriated no trade secrets and peri()rmed consistently at the same level before his departure. More recently, the court in William Floyd Union Free School District v. Wright, 61 A.DJd 856, 859 (2d Dept. 2009), reversed a lower court decision that limited the forfeiture of two disloyal employees' retirement benefits to ten years, holding that "complete and permanent forfeiture of two compensation" was appropriate under the doctrine. The employees had repeatedly embezzled funds from their school district employer before their retirement, and the appellate court concluded that relieving the school district of its obligation to pay the employees' retirement benefits for ten years was too lenient. Among the very few exceptions to the faithless servant doctrine is where the alleged disloyalty consists of a single act or where the employer knows of: but tolerates, the behavior. Nevertheless, some of New York's intermediate appellate courts and some federal courts in the Second Circuit applying state law have become increasingly uneasy about the draconian nature of the faithless servant doctrine. As a result, both state and federal court decisions have 2

3 begun to impose limitations on the rule, though leaving its core essentially intact. Most commonly, courts have restricted the periods during which compensation must be forfeited. One of the cases leading the way in this area is Maritime Fish Products, Inc. v. World-Wide Fish Products, Inc., 100 A.D.2d 81 (151 Dept. 1984), where the court rejected absolute forfeiture and instead ruled that an employee who worked for a company for approximately seven years need forfeit only compensation received during a fourteen month period of disloyalty. Additionally, a number of courts have expressed similar concerns about the doctrine's "sometimes harsh consequences," Astra USA, Inc. v. Bildman, 914 N.E.2d 36, 48 (Mass. Sup. Jud. Ct. 2009), and have adopted the principle that only compensation for the period of disloyalty or the task disloyally performed is subject to forfeiture. However, at least in the Second Circuit, this principle has been applied only in situations where the parties agreed to a task-by-task compensation scheme. Although somewhat pared down, the faithless servant doctrine continues to be accepted law in New York and the Second Circuit. See, e.g., Nebraskaland, Inc. v. Sunoco, Inc., 2010 U.S. Dist. LEXIS (E.D.N.Y. 2010) (court refused to consider constitutional challenge to faithless servant doctrine because issue deemed not ripe for judicial review). As the court in Carco Group, Inc. v. Maconachy, 2010 U.S. App. LEXIS 13574, **8 (2d Cir.), recently stated, "[al person who is found to be faithless in his performance of services is generally liable for all compensation from the date of the breach." States that Embrace the Faithless Servant Doctrine A number of other states have adopted variations of New York's faithless servant doctrine, some in the early years of the twentieth century and others more recently. Although 3

4 this is not intended to be a national survey of which states have and have not accepted this principle, the nature of the doctrine in some other states will be discussed. The Court of Appeals of South Carolina, a state which employs the rule, set forth the principle as it is utilized in many jurisdictions - "[tjhe general rule is that an agent guilty of disloyalty to his principal forfeits all compensation." Futch v. McAllister Towing 0/ Georgetown, Inc., 328 S.C. 312,316 (1997). Like courts in New York and elsewhere, the South Carolina courts base their doctrine on agency law principles and, specifically, the Restatement of the Law of Agency. Similarly, in Michigan - where the "faithless agent" doctrine took root in the late 1930s and early 1940s following a string of decisions regarding improper conduct by attorneys, brokers, estate executors and others - "an agent who engages in misconduct will forfeit the compensation related to the service that was improperly performed." Tooling Manufacturing & Technologies Association v. Tyler, 2010 Mich. App. LEXIS 2521 (Mich. Ct. of Appeals); see also Greater Bloomfield Real Estate Co. v. Braun, 64 Mich. App. 128, (1975) (applying rule to real estate agent and upholding deprivation of his compensation due to misconduct). Kansas is among those jurisdictions that have adopted the rule more recently, specifically in Bessman v. Bessman, 214 Kan. 510 (Kan. 1974). As elsewhere, the Kansas rule holds that "if an employee's actions are so disloyal or dishonest that they permeate his service to his employer, the employee forfeits the compensation to which he would otherwise be entitled." Hein v. TechAl71erica Group, Inc., 17 F.3d 1278 (1oth Cir. 1994). Kansas's faithless servant doctrine has served as a model to at least one other state. In 1989, one of Ohio's intermediate appellate eourts "adopt[ed] the 'faithless servant doctrine' enunciated by the Kansas Supreme Court." Roberto v. Brown County General Ho,\pital, 59 Ohio App. 3d 84, 86, 571 N.E.2d 467, 470 (Ohio Ct. App. 4

5 1989). Under Roberto, an employer can recoup an employee's compensation ifhis or her disloyalty "permeates" their service. Id. at 469. Other states that employ the faithless servant doctrine include Florida, e.g., Eskra v. Provident Life and Accident Ins. Co., 125 F.3d 1406 (11th Cir. 1997); Massachusetts, e.g.. Chelsea Indus., Inc. v. Gaf/iey, 449 N.E.2d 320 (Mass. 1983); Oregon, e.g., American Timber & Trading Co. v. Niedermeyer, 558 P.2d 1211 (Ore. 1976); and Alabama, e.g., ShafTer v. Regions Financial Corp., 29 So.3d 872 (Ala. 2009), where the doctrine, like New York, originated in the 1880s. The faitbless servant rules in thesejurisdictions, ifnot identical, differ little from each other. All appear to have agency law as their foundation, state that the faithless servant doctrine is a variation of tile duty of loyalty, and mandate a forfeiture of compensation for employees who are deemed to have behaved disloyally. Hybrid Jurisdictions Several states have rejected the bright-line faithless servant principle discussed above and, instead, use a balancing test approach to the issue of compensation forfeiture by disloyal cmployees. The balancing test used by at least two states looks at the nature of the employment relationship, the specific kind of disloyal action engaged in and the benefits received by the employer from the individual during the period of disloyalty. One of these jurisdictions is Colorado, which adheres to a principle of requiring forfeiture of all, some or none of an employee's compensation based on the severity of the disloyal conduct. In Jet Courier Serv., Inc. v. Mulei, 771 P.2d 486, 494 (Colo. 1989), the court ruled that there should be a total bar on compensation where an employee's conduct is as serious as soliciting the employer's customers. In the Wisconsin case Hartford Elevator, Inc. v. Lauer, 289 N. W.2d 280, 287 (Wis. 1980), the court also employed a balancing test, but perceived the employee's misconduct to be 5

6 less serious than the Jet Courier Serv., Inc. court. The Wisconsin Supreme Court ruled in favor of forfeiture, but only to the extent of the difference between the harm suffered by the employer and the benefits the employer received during the period of disloyalty. Approaches such as those used by the courts in Colorado and Wisconsin are noteworthy for their flexibility and recognition of the fact that the traditional faithless servant doctrine is one-sided, penalizing employees who are guilty of wrongdoing without taking into account their achievements or contributions to the company. Repudiation of the Faithless Servant Doctrine Many states have not adopted the faithless servant rule, in part because they view it as excessively harsh, unbalanced and punitive. Among these jurisdictions is New Mexico, whose Court of Appeals in Woods v. Collins, 533 P.2d 759 (N.M. 1975), addressed an employer's argument that a lower court erroneously failed to apply the rule against an employee accused of conversion of funds. Observing that recoupment pursuant to the terms of an agreement between the parties was entirely permissible, the court went on to declare that the employer "asks this court to go beyond the intention of the parties to apply the 'faithless servant' rule. We conclude that to apply this doctrine would be... inequitable and unjustified." Id. at 761. The court also pointed out that the doctrine "has never been adopted as the law in New Mexico" and stated, not entirely accurately, that it "has been substantially restricted by the New York courts." Id. at 760. The approach of the New Hampshire courts is similar. In General Insulation Co. v. Eckman Construction, 992 A.2d 613 (N.H. 2010), the court made the unremarkable observation that "[a 1 plaintiff is entitled to restitution for unjust enrichment if the defendant received a benefit and it would be unconscionable for the defendant to retain that benefit." The employer in Glynn v. Impact Science & Technology, Inc., 2011 U.S. Dist. LEXIS (D. Md. 2001), 6

7 relying on this language, argued in a counter-claim that it was entitled to restitution for unjust enrichment from the plaintiff commensurate with his compensation. The court applied New Hampshire law and noted that "presumably" the employer "believes that the monies it paid to [the plaintiff] as salary... constitute a benefit that would be unconscionable for [the plaintiff] to retain in light of his breach of contract." Id. at * I 01. Finding no merit in this argument, the court pointed out that "New Hampshire has not adopted the faithless servant doctrine or any equivalent." Id. at * 103. Statutory Clawback Provisions During the last decade, the faithless servant doctrine has acquired a counterpart in several federal statutes that require forfeiture of compensation for certain individuals under some circumstanccs. The Sarbanes-Oxley Act of 2002 ("SOX") provides in Section 304 for the rccoupmcnt of scveraltypes of compensation, i.e., incentive or equity-based compensation or bonuses in limited situations. It applies only to chief executive officers and chief financial officers of public companies, and then only when the company is required to prepare an accounting restatement because of a failure to comply with financial reporting requirements because of misconduct. Thus, the company can recoup the compensation noted abovc from such executives during the one year period before the earlier of the filing with the SEC or first public issuance of the restated financial statement. In sum, Section 304 of SOX is both very limited as well as vague, and it has affected few individuals. The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in 2010, is considerably broader, though it also has very little reach compared to state common law faithless servant doctrines. Dodd-Frank provides for mandatory clawback ii'om all "executive officers." If a company must restate its financial statements because of significant non-compliance with 7

8 financial reporting requirements under the securities laws, it must recover compensation that was awarded during the three-year period before the datc the restatement is required that exceeds what the restatement warrants. Dodd-Frank also requires that publically-listed companies "develop and implement a policy regarding clawbacks of erroneously awarded incentive-based compensation." Although Dodd-Frank almost certainly will result in a greater number of recoupments than SOX, its clawback provisions will have little if any impact beyond the highest levels of publically-traded corporations. Conclusion The perception of many that the faithless servant doctrine is a pernicious vehicle for enabling companies to recapture the hard-earned compensation of employees, notwithstanding episodes of dishonesty or misconduct by such employees, is not without validity. Although disloyalty by employees, particularly in its more extreme forms, is hardly to be applauded, recouping a large portion of what such individuals have earned over a period of years that may have included many significant contributions to their employers is an unjustified overreaction. One of the many cases that illustrate this point is Sequa Corp. v. GB.! COIl)., 156 F.3d 136 (2d Cir. 1998). The court in Sequa Corp., following an earlier Second Circuit decision, affirmed the decision by a district court requiring, under the New York faithless servant doctrine, the forfeiture of $900,000 by a consultant whose conduct had caused the company to lose only $26,000. Seemingly unconcerned about the huge disparity between the harm to the company and the amount of the forfeiture, the court declared that "the district court's forfeiture holdingunder which [the individual] forfeited only his fees in connection with [aj single transaction, rather than all his fees from the entire consulting relationship with [the company] - in fact 8

9 represented a rather generous interpretation of New York law," Id. at 147, If that is the case, New York law in this area is unfair and unduly harsh, A saner and more balanced approach is represented by Colorado and Wisconsin, which utilize the balancing test discussed above, Only by taking into account the benefits the employer has enjoyed due to the employment relationship, the gravity and nature of the misconduct and the details of the employment relationship can an equitable result be obtained, The strict approach represented by the faithless servant doctrine - where the employee forfeits either all of the compensation earned during the period of disloyalty or even all of the compensation earned during his or her period of employment - does little (0 advance this end, 9