Plus• Tax Consequences of Currency Trading• Hybrid Business Entities• Non-Compete Agreements

AdvisoryServices Rise Again at Large Audit Firms

It has been said that it is wise to keepyour friends close and your enemiescloser. In these challenging economictimes, accounting firms are increasing-

ly following this maxim when it comes topostemployment restrictions for departingprofessionals. In fact, growing numbersof accounting firms are making certain thatthey have the right form of non-competeand protective covenant agreements inplace with their employees, managers, andpartners in order to ensure that accountantscannot leave the firm and take their booksof business and client relations to a com-petitor. More and more well-known NewYork accounting firms are going to courtto enforce their rights under such agree-ments when once-loyal accountants leavethe firm and then seek to service formerclients or hire employees from their for-mer firm.

Many accounting firms recognize theimportance of including the correct andupdated form of a protective covenant intheir employment agreements. Others,however, rely on covenants drafted manyyears ago, neglecting to revise agree-ments to reflect changes in an employee’sseniority, market conditions, or the law.Even accounting firms that periodicallyupdate their protective covenants oftenimplement them on a forward-looking basisonly. Thus, these firms fail to require exist-ing employees to agree to the updated pro-visions and are left without complete pro-tection.

The discussion below explores some ofthe best practices for designing andupdating protective covenants, as well aspractical tips for implementing revised

agreements with existing staff and for hir-ing accountants with preexisting contrac-tual obligations. It will also focus on lead-ing and recent court cases involving NewYork accounting firms.

Leading New York Court CaseThe leading New York court case con-

cerning the enforcement of postemploy-ment protective covenants concerned anational accounting firm. The case—BDO Seidman v. Hirschberg, 93 N.Y.2d382 (1999)—demonstrates why account-ing firms should include carefully draftedprotective covenants in their employment,partnership, and shareholder agreements.

In BDO Seidman , the defendantHirschberg was an accountant whose localBuffalo firm had been acquired by BDO.

When Hirschberg was promoted to man-ager at BDO, he signed an agreement thatprohibited him from servicing BDO’sclients for 18 months after the terminationof his employment. In addition, itrequired that if Hirschberg violated theagreement, he would have to pay BDO150% of a particular client’s fees fromthe fiscal year prior to his departure fromBDO. When Hirschberg resigned fouryears after his promotion, he then provid-ed accounting services to several BDOclients—the equivalent of $138,000 in rev-enues to BDO in the year prior to hisdeparture.

The New York Court of Appeals exam-ined BDO’s agreement with Hirschberg todetermine whether it was enforceable. Thelaw is clear that, regardless of the actual lan-

The Increased Importance of Non-CompeteAgreements for Accounting Firms

M A N A G E M E N T

p r a c t i c e m a n a g e m e n t

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By Michael C. Lasky and David S. Greenberg

guage in the covenant, only reasonablerestrictions will be enforced. A “restraint isreasonable only if it: (1) is no greater thanis required for the protection of the legiti-mate interest of the employer, (2) does notimpose undue hardship on the employee, and(3) is not injurious to the public” (BDOSeidman, pp. 388–389).

The court emphasized that restrictionsof this type are more likely to be enforce-able against learned professionals who pro-vide specialized services, such as accoun-tants. It also scrutinized Hirschberg’scovenant to determine whether BDO wasindeed protecting a legitimate interest,and whether the covenant was tailored onlyas restrictively as necessary to protect thatinterest. The court ultimately held that thecovenant was overly broad because itprohibited Hirschberg from servicing allBDO clients—even those Hirschberg him-self recruited prior to joining BDO andthose with whom Hirschberg had notdeveloped any relationship as the result ofhis employment (BDO Seidman, p. 393).

Rather than simply discarding the overlybroad covenant, however, the court next con-sidered whether the covenant should havebeen enforced to the extent that it was rea-sonable. It found no evidence of BDO’sdeliberate overreaching, bad faith, or coer-cive abuse of superior bargaining power.Because of this, the court rewrote—that is,“blue-penciled”— the covenant to effectivelynarrow it by precluding Hirschberg onlyfrom servicing those clients with whom hehad developed a relationship as a result ofhis employment with BDO (BDO Seidman,pp. 394–395). The court then sent the caseback to the trial judge to determine whetherBDO was entitled to receive damages basedon the formula of 150% of the client’sprior year’s revenue, as specified in thecovenant (BDO Seidman, p. 397). This casedemonstrates how valuable protectivecovenants can be in guarding an account-ing firm’s business interests. But BDOSeidman also highlights the importance ofchoosing appropriate covenants for givenemployees and carefully drafting suchcovenants so that they contain reasonableand clearly defined terms.

Types of Protective CovenantsProtective covenants come in a variety

of forms, and selecting the right covenantis the first step in protecting a business.

The following sections examine five dif-ferent types of covenants.

Noncompetition provision. The mostrestrictive covenant is the blanket noncom-petition provision, which prevents employ-ees from working in competition with theirformer firm for a specified period of timefollowing the termination of employment.Because this type of covenant imposes thegreatest restraints on an employee’s abilityto earn a living, courts are most reluctant toenforce it. A blanket noncompetition provi-sion is appropriate for only the most seniormembers of an organization—if at all—and it is often utilized in the context of alarger firm’s buyout of a smaller firm andthe hiring of that smaller firm’s principals aspartners or senior executives. Blanket non-competition provisions might also beappropriate for senior-level employees withwide-ranging access to sensitive confidentialinformation, which would necessarily be dis-closed if the employee were to go to workfor a competitor.

Nonsolicit/nonservice provision. Thisprovision is less restrictive than the blan-ket noncompetition provision; it prohibitsformer employees from soliciting or pro-viding services to firm clients for a speci-fied period of time. Because non-solicitprovisions are narrower in scope than non-competes, they are relatively easier toenforce when properly drafted. Non-solic-it/nonservice provisions are appropriate fora broader range of employees than blanketnoncompetition provisions, and firms com-monly use them for both senior- and mid-level employees. These covenants can beappropriate even for junior employees whowill have ongoing contact with firm clients.Moreover, such covenants can sometimesbe expanded in scope for more senioremployees who join the firm in the con-text of a buyout or merger, such that thecovenants protect even those employees’preexisting clients brought to the firm—acategory that is generally not protectable.(See Weiser LLP v. Coopersmith, 74A.D.3d 465, 467 [1st Dep’t 2010].)

Nonraid/nonhire provision. A non-raid/nonhire provision bars an employeefrom soliciting other firm employees for aperiod of time after departure. A nonraidprovision can be useful when a givenemployee has few direct or exclusiverelationships with firm clients, but worksclosely with other employees who do. Like

nonsolicit/nonservice provisions, non-raid/nonhire provisions are commonly usedfor a wide range of employees at variouslevels of seniority.

Extended notice provision. This type ofprovision simply requires employees togive advanced notice of their resignation.The long lead time gives the firm a betterchance to retain a client by introducingother personnel into the relationship, andit can assist the firm in retaining clients thatthe departing employee brought to thefirm—a category of client that a nonsolic-it/nonservice provision might not reach.Extended notice provisions can be appro-priate for employees at all levels, regard-less of whether those employees have con-tact with clients. The amount of noticerequired before resignation should be tai-lored to the employee’s level of seniority,with longer periods appropriate for moresenior employees.

Employment agreement. Last, employ-ment agreements can contain an agreementthat employees will not use the firm’s con-fidential or proprietary information afterdeparture. While the law itself prohibitsdeparting employees from improperlyusing confidential information, a contrac-tual provision can broaden the definitionof confidential information and can elim-inate disputes about whether specific typesof information are protected from anemployee’s use. Such covenants are appro-priate for employees at all levels.

Choosing and Drafting a CovenantIt often makes sense to use several of

the provisions described above in combi-nation in order to protect a company’sinterests. Firms should take a close lookat the types of services being rendered bya given category of employees, the close-ness of the employees’ relationships withclients and other employees, and the natureof information to which the employeeshave regular access. Next, firms shouldselect the appropriate blend of covenantsto fit a situation; different types of employ-ees might require different covenants, andfirms might impose greater restrictions onpartners or owners because of their con-tractual and fiduciary relationships with thefirm and its other partners or owners.

Once a firm has chosen the appropriatecovenants, it must refine them to makethem more effective by not only defining

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the firm’s protective covenants carefullyand completely, but also by reasonably lim-iting their scope. The sections belowdescribe the key strategies that accountingfirms should use in working with legalcounsel to draft protective covenants andavoid common pitfalls.

Leave nothing to guesswork. A protec-tive covenant that fails to adequately definewhat it seeks to protect and prevent couldfall short when put to the test—in otherwords: when in doubt, spell it out. By assum-ing that everyone knows what a given termmeans, firms run the risk that a court willend up defining that term for them—and theresults might not work in favor of the firmseeking to enforce the covenant.

For example, the New York Court ofAppeals recently decided a case definingwhat “solicitation” of a client means. InBessemer Trust Company v. Branin, 16N.Y.3d 549 (2011), an executive sold hiswealth management company, began work-ing for the buyer of his company, and thenlater resigned and joined a competitor.While the executive had not agreed toany specific protective covenants pur-suant to the deal, New York law imposescertain nonsolicit obligations on the sellerof a business because the purchaser is con-sidered to be buying the seller’s goodwilland ongoing client relationships.

Despite these obligations, the court heldthat the executive was still permitted 1) toanswer a former client’s questions aboutthe competitor’s business, 2) to assist thecompetitor in creating a pitch strategy for theformer client, and 3) to even attend a meet-ing between the competitor and the formerclient (Bessemer, pp. 559–560). In the court’sview, none of these constituted impropersolicitation under the implied covenant inher-ent in the sale of a business.

Bessemer illustrates several importantlessons. First, firms should not leave defin-ing the terms in protective covenants or fill-ing in missing provisions to the courts.An employment agreement should specif-ically define critical terms, such as whatconstitutes solicitation and who qualifies asa client subject to protection. Second, firmsshould examine their existing covenants toensure they prohibit departing employeesfrom not only soliciting clients, but alsofrom servicing them. Otherwise, depart-ing employees might find it easy to cir-cumvent their protective covenants.

Defining the scope of protections: keepit reasonable. In addition to being clearlydefined, a firm’s protective covenants mustbe reasonable in scope. As BDO Seidmanillustrated, courts will not enforce overlybroad covenants. Thus, firms must be rea-sonable in defining their protected interestsand their employees’ prohibited conduct.Firms should not overreach; if a courtsees overreaching, coercion, or bad faithby a firm, it will decline to partially enforcethe agreement and will simply throw outthe protective covenant in entirety. It is truethat the New York Court of Appealsblue-penciled the protective covenant inBDO Seidman and that, more recently,another appellate court blue-penciled anoverly broad covenant entered into betweenaccounting firm Weiser LLP and its part-ners (Weiser LLP, p. 469).

Other New York courts, however, haverefused to blue-pencil agreements betweenaccounting firms and their employees;instead, they struck down the covenant inentirety. For example, in Scott, Stackrow& Co., CPAs, P.C. v. Skavina, 9 A.D.3d805 (3d Dep’t 2004), a New York appel-late court refused to partially enforce anoverly broad protective covenant that theaccounting firm sought to impose on a staffaccountant who joined the firm when itacquired her previous firm. The court notedthat that the accounting firm had deliber-ately imposed the overly broad covenanton the accountant, prohibiting the defen-dant from servicing the firm’s entireclient base (regardless of whether she hadany dealings with these clients), and hadinsisted that she sign the covenant eachyear despite offering her no promotion orincrease in responsibilities (Scott, Stackrow,pp. 807–808).

Notably, the Scott, Stackrow decision illus-trates the importance of routine “checkups”for a firm’s protective covenants. The courtspecifically mentioned that the firm hadcontinued to impose the overly broadcovenant, even though the BDO Seidmandecision had explained the reasonable limitsof such covenants only a few years prior.

Good protective covenants impose clearbut reasonable limits and conditions on whata departing employee can do. In the caseof a blanket noncompetition covenant—which might be appropriate only for seniorpartners or key executives involved in firm-wide strategy who have access to specific

types of highly confidential information—the agreement should define “competi-tion.” Where possible, the covenant shouldalso specify those competitors for whom theemployee may not work, and it shouldappropriately limit the period of time andthe geographic area, if applicable, in whichthe employee may not compete. This typeof covenant will more likely be enforced ifthe departing employee receives some con-tinued compensation during the term of thenoncompetition period.

A nonsolicit/nonservice provision shouldset forth a reasonable, definite time periodof effect and should specifically defineclients to include only actual or prospec-tive firm customers that the firm last ser-viced within a specific, limited period priorto the employee’s departure. The covenantshould define clients to include only cus-tomers that the employee personally ser-viced or pitched.

As with the term competition, the terms“solicitation” and “service” should be clear-ly defined. Service should list the variety ofservices performed by the employee oroffered by the firm (e.g., accounting, audit-ing, tax, management, consulting services).Similarly, solicitation should include director indirect efforts, such as assisting anotherperson, to cause a firm client not only toengage the employee’s new firm, but also toreduce, in any way, the amount of businessthe client does with the original firm. A non-raiding provision concerning the recruitmentof other employees should likewise explic-itly prohibit indirect efforts to recruit, suchas assisting a new employer in doing so.

Put a price tag on a violation. Finally,when drafting clear and well-defined pro-tective covenants, it can be advantageous forfirms to set forth specific remedies in theevent that departing employees violate theircovenants. Because the damages arising fromclient loss can be difficult to quantify,accounting firms now commonly include liq-uidated damages provisions in their protec-tive covenants. Such provisions require theexiting employee to pay a set sum (or a sumderived from a set formula) in the event ofa violation of the agreement.

Courts will enforce a liquidated-damagesclause if it does not result in the employ-ee paying a sum that is considered gross-ly disproportionate to the harm anticipat-ed at the time the parties signed theagreement. For example, in BDO Seidman,

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the court approved, in theory, a liquidated-damages formula based on 1.5 times theprior year’s billings of the lost client, wherethe protective covenant lasted 18 months(BDO Seidman, p. 396). More recently, aNew York court required a currency trad-er who competed with his former employ-er in violation of his covenant to pay anamount equal to the trader’s averagemonthly commissions, multiplied by thenumber of months remaining in hiscovenant (GFI Brokers LLC v. Santana,2008 WL 3166972 [S.D.N.Y 2008]).Likewise, a New York court approved aliquidated damages payment amounting toa consultant’s contractual share of oneyear’s estimated annual billings to a clientlost to the consultant’s subcontractor(Crown It Services Inc. v. Koval-Olsen, 11A.D.3d 263 [1st Dep’t 2004]). In all ofthese situations, the accounting firmsdesigned the covenants to provide therevenue stream of the lost client, rather thantrying to stop a once-trusted employee fromservicing an unhappy client.

Another common and powerful reme-dy for breach of a protective covenant isan injunction—that is, a court order com-manding the departed employee to stopworking in violation of the covenant. Thekey to obtaining an injunction is a firm’sdemonstration that it will suffer irrepara-ble harm if the employee continues vio-lating the covenant. Courts generally rec-ognize that the loss of client relationshipsand goodwill constitutes irreparable harm(e.g., Ticor Title Ins. Co. v. Cohen, 173F.3d 63, 69 [2d Cir. 1999]). While thelaw itself provides for injunctive reliefwhen the proper conditions have been met,protective covenants nonetheless ofteninclude an employee’s explicit acknowl-edgement that a violation of the covenantwould result in irreparable harm and thatthe firm, therefore, has the right to seekan injunction in the event of a breach; how-ever, this acknowledgment would not nec-essarily prevent a court from finding thatmonetary damages would be sufficient tocompensate the former employer for itsloss, which could serve as an obstacle tosecuring the injunction.

There are at least two other difficultieswith relying on injunctive relief. First, theaccounting firm seeking to enforce thecovenant has a very high burden of proofand needs to prove its case (typically on

an emergency basis) before pretrial dis-covery. Meeting this high burden at suchan early stage can be daunting. For exam-ple, in April 2011, a New York courtrefused to issue a preliminary injunctionagainst J.H. Cohn LLP in a case involv-ing several managing directors and part-ners who had departed RSM McGladrey,and who had allegedly violated covenantsprohibiting their solicitation or servicing ofMcGladrey clients and their hiring of otherMcGladrey personnel (RSM McGladreyInc. v. J.H. Cohn LLP, No. 650523-2011,slip op. at 14 [Sup. Ct. N.Y. County, April 8, 2011]). Despite the fact thatMcGladrey was able to secure injunctiverelief against the managing directors andpartners themselves in other state courts,the New York court found that McGladreycould not demonstrate a likelihood ofsuccess on the ultimate merits of its claimsagainst J.H. Cohn and did not find thatMcGladrey would actually suffer irrepara-ble harm in the absence of an injunction(RSM McGladrey, pp. 11–12).

Second, former employees are likely toargue that it was their former firm’s fail-ure to service a client’s business properlythat caused the client to terminate his busi-ness relationship with the firm—rather thanthe employee’s violation of the covenant.In other words, a departing employee willtypically decide that the best defense is togo on offense and put the conduct of hisformer accounting firm on trial. This isanother reason why preset contractualremedies, such as liquidated damages, havebecome increasingly common in account-ing firms’ restrictive covenants.

Updating Covenants and Due Diligencein Hiring

Unlike some other jurisdictions, NewYork law recognizes that continuedemployment in an “at will” relationshipis sufficient consideration to supportnew protective covenants. Thus, from apurely legal standpoint, an accountingfirm does not need to offer employees anyadditional compensation in exchange fortheir agreement to sign new (and morestringent) protective covenants. As a prac-tical matter, however, many accountingfirms find that the best time to implementnew covenants is in the third quarter,when many firms begin to consider salaryincreases for the following year and

bonuses for the current year. The firm canpresent its new covenants to the employ-ees and ask that the employees sign andreturn the new covenants by a date priorto the announcement of salary increasesand bonuses.

In addition, accounting firms must con-sider any preexisting obligations that candi-dates have to their previous firms. Firmsshould always ask potential new hires if theyare subject to protective covenants, confi-dentiality agreements, or any other agree-ments with their former firm; they shouldalso insist on receiving and reviewing copiesof such covenants during the interview pro-cess, ideally along with the firm’s employ-ment counsel. When possible, accountingfirms should also make new accountants’employment contingent on their representa-tion that they have provided the firm withall prior protective covenants, and that noprior agreements prevent them from work-ing in the new position. This process ensuresthat an accounting firm’s investment in anew accountant is protected not only againstfuture loss of its client relationships, but alsoagainst claims by another firm seeking toprotect its own such relationships.

The Bottom LineProtective covenants offer accounting

firms a powerful means of protectingtheir most valuable assets: their client rela-tionships and their employees. It is criti-cal for a firm to make sure its profession-als agree to protective covenants thatreduce the likelihood of losing clients oremployees. With the right combination ofprotections—and provisions that clearlydefine those protections—savvy managingpartners and executive committees ofaccounting firms can ensure that theirfirm’s covenants will preserve the value oftheir business and include the latestindustry trends and legal developments.These proactive measures can be the dif-ference between the minimal disruptionof losing one accountant and waving good-bye to a substantial book of business, rev-enues, and employees. ❑

Michael C. Lasky is a senior partner andcochair of the litigation department at Davis& Gilbert LLP, New York, N.Y. David S.Greenberg is an associate in the litigationdepartment at Davis & Gilbert LLP.