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What Is an Employee’s ‘Duty of Loyalty’?

Samuel Goldwin, the legendary movie producer, was famous for lines like, “A verbal contract isn’t worth the paper it’s written on.” When he was dealing with employees, one of his favorite sayings was, “I’ll take 50 percent efficiency to get 100 percent loyalty.” What does that have to do with employment law? Loyalty.

In the day-to-day rush of getting the work done, it’s easy to forget that there’s a whole bundle of obligations that go along with the employer-employee relationship. A recent decision from the Tenth U.S. Circuit Court of Appeals illustrates those often-forgotten obligations.

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Employees’ duty to employer
Employees’ duties to their employer include the duty of loyalty. The laws in every state require that an employee refrain from behaving in a manner that would be contrary to his employer’s interests, an obligation often given the shorthand name “duty of loyalty.”

The degree of that duty of loyalty is related to the degree of responsibility and trust that an employer gives to an employee. In some cases, when an employee has extensive independent responsibility or access to confidential information, the duty can rise to a higher — or fiduciary — level.

Once employees move into the area of fiduciary responsibility, they must handle their employer’s matters with the highest degree of integrity and fidelity and always deal fairly, openly, and totally for the employer’s benefit.

A fiduciary can’t use the relationship to help with his own personal interests unless the employer has full knowledge and consents. On the other hand, employees with only minimal independent responsibilities may not have obligations that rise to that level, but they do have an obligation not to work against their employer’s interests.

Competing agent: your own employee
J.V. Industrial Companies (JVIC), a Texas firm, decided to expand its operations into Oklahoma. It hired the aptly named Clayton Rash to start and manage the Oklahoma division. He was provided with a salary, a net-profit bonus, and a termination bonus. His employment contract required him to devote his full work time and efforts to the company.

After a few years of operation, Rash apparently decided that business was so good, he needed to branch out. He started at least four other businesses, none of which was ever disclosed to his employer. One was a scaffolding business that bid on projects for JVIC’s Oklahoma division. Not surprisingly, since he was picking the subcontractors, his scaffolding business often was selected.

At one point, the company started its own scaffolding business. Again, it’s no surprise that JVIC’s Oklahoma division never used its own scaffolding services, preferring to hire the Rash-owned company instead.

In 2004, Rash and JVIC parted ways. They met again in court when Rash sued the company for breach of contract, claiming that it had improperly calculated his net-profit and equity bonuses. The company counterclaimed, accusing him of breaching his duty of loyalty and fiduciary duty by operating the scaffolding business in competition with JVIC’s own scaffolding operation without disclosing the connection.

The Tenth Circuit ruled that Rash owed a fiduciary obligation to the company and that he had breached that duty.

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Rash: no loyalist
The Tenth Circuit examined the relationship between Rash and JVIC to see whether his obligations to the company brought him up to the level of a fiduciary relationship:

  • Rash was hired specifically to build JVIC’s Oklahoma division from scratch and had sole management responsibilities for its operations.
  • He handled all operations (and everything else out of the Oklahoma division).
  • He located the facilities to operate the business, hired and trained employees, procured tools and equipment, and promoted JVIC’s Oklahoma business.
  • He solicited and received bids from subcontractors and received invoices for bids.
  • He set the rates charged to JVIC’s customers.
    In short, Rash was totally in charge of the Oklahoma operation.

While agreeing that he ran the show, Rash argued that the scope of his obligations to JVIC didn’t include scaffolding-related ventures, so his side business with JVIC was legitimate.

After looking at Rash’s level of responsibilities, the Tenth Circuit had no trouble deciding that he owed JVIC a fiduciary duty. Specifically, he had a duty to account for any profits arising out of his employment and the duty not to act as an adverse party or compete without the employer’s knowledge and consent.

He also had a duty to deal openly with JVIC and fully disclose all matters affecting the company’s business. The court said there was no question that he had an ownership stake in the scaffolding company, which bid for subcontracts with his employer.

Also, he had the role to select subcontractors and chose his own company as a subcontractor without ever disclosing the situation to JVIC. In fact, the company’s president testified that he didn’t learn about Rash’s ownership of the scaffolding company until the litigation.

How should Rash be penalized for violating his fiduciary duty? The court considered fee forfeiture, which is based on two ideas: (1) the employer didn’t receive what it bargained for if its employee breached his obligation of loyalty and (2) the threat of forfeiture discourages employees from being disloyal. If the penalty was applied, JVIC could use it as a defense to all of Rash’s compensation claims, and he wouldn’t be entitled to any compensation for his services.

While the Tenth Circuit ultimately didn’t apply fee forfeiture, it sent the case back to the trial court to reconsider the penalties and make a decision on whether Rash was entitled to collect his compensation or lose it because he violated his fiduciary duty. Rash v. J.V. Industrial Companies, Case No. 06-5128 (10th Cir., 8/22/07).

Employee loyalty: alive and well
So what lessons can you take from Rash’s case? As your agents, employees have duties in addition to their day-to-day work responsibilities. They have a legal obligation to avoid acting in a manner that’s contrary to your interests. They have an obligation to be loyal to your company, maintain your confidential and proprietary information, and not compete with you so long as they’re employees (noncompete agreements are a separate issue altogether since they control competition after the employment relationship is over).

For the most part, the days of starting to work for a company and retiring 20 years later are gone. Employees have become mobile, and many employers have faced the hard economic reality of having to cut workforces in response to increasing economic pressures. The result is that we operate in an environment in which the duty of loyalty to the employer is often forgotten. Rash’s case, however, is a reminder that it still exists and can be enforced under the proper circumstances.

Does that mean it’s all right to root out disloyal employees who don’t eat, sleep, and breathe your company? Well, probably not, but it does mean that you should be careful about letting employees — especially those with significant decisionmaking responsibilities — operate too freely. A system of checks and balances and some critical questioning might have brought Rash’s activities to light earlier.

In summary, you aren’t required to tolerate employee behavior that’s contrary to your interests. Workers need to be reminded that they have a responsibility to your company that doesn’t end when they clock out.

Clearly, the more responsibility they have and the more they’re identified with the company, the more you will want to ensure that they aren’t acting contrary to your interests. They should know that there’s more to being a good employee than simply punching the clock on time.