April 28th, 2004

Suing Disloyal Employees & Agents: Court gives employers a powerful new weapon

There's good news for companies and individuals seeking to win compensation from unfaithful employees: New York's highest federal court has ruled that disloyal employees must forfeit all compensation received after their first disloyal act. Because forfeiture under this new rule includes compensation the employee earned while performing tasks loyally, the case, Phansalkar v. Andersen Weinroth & Co. L.P.,1 adds a powerful weapon to an aggrieved employer's legal arsenal. Indeed, we recently relied upon it to negotiate a favorable settlement with a musician's manager who had commingled funds and misappropriated record company advances, as well as to confront a law firm that represented a client while having a conflict of interest.

The "Faithless Servant" Doctrine
For more than 100 years, employees and other agents have been held by courts to the highest duty of loyalty to their employers, beneficiaries, and principals. Lawyers and courts refer to the breach of this duty as the "faithless servant" doctrine. Under this doctrine, an agent who commits any misconduct while working for her principal surrenders the compensation she earned for her services. The courts have made clear that it does not make any difference whether the services were beneficial to the principal, or whether the principal suffered no provable damage as a result of the disloyalty.

The "faithless servant" doctrine has been applied to all types of agents, including salaried employees, brokers, attorneys, artist and celebrity representatives, and executors of estates. And courts have applied it to a wide variety of misconduct, including conflicts of interest, secretly persuading other employees to start a competing business, stealing money or goods, and, in the case of a lawyer, violating the New York Code of Professional Responsibility while representing a client.

Scope of Forfeiture Remedy Had Been Unclear
Until recently, however, the scope of forfeiture under New York law remained unclear. Most courts held that a faithless servant forfeited the right to all compensation earned during the scope of the agency relationship. But the Second Circuit had been more circumspect, limiting forfeiture either to the "'specified items of work' as to which the agent acted faithlessly" or to the time period after the agent's misconduct began. This disagreement left lawyers, employers and employees uncertain as to whether limits on the scope of salary forfeiture existed and, if so, what those limits were.

That uncertainty ended with the Phansalkar decision. There, Anderson Weinroth & Co. ("AW"), a small merchant banking firm, sued one of its former partners, Rohit Phansalkar, for failing to disclose certain directors’ fees and compensation he had earned while working for AW. Under AW's written guidelines, partners who earned fees while serving as directors for AW clients had to pay those fees to the firm. AW contended that Phansalkar had failed to do so in several instances. For example, while serving on the Board of Zip Global Network, Ltd. (a company to which Phansalkar had introduced AW), Phansalkar received 40,000 Zip options and 600 Zip shares without disclosing that fact to AW. Phansalkar did the same thing on three of the four other AW deals he worked on.

The federal appeals Court ordered Phansalkar to forfeit to AW the options and shares he had earned on the deals on which he had been disloyal, noting that Phansalkar's disloyalty lasted for several months, and involved four out of five of his main areas of responsibility.2 That aspect of the ruling broke no new ground, as employees have generally been required to disgorge their ill-gotten gains. But the Court also focused on other compensation Phansalkar received from AW - namely, shares in a company called Millenium Cell that AW had offered Phansalkar (and Phansalkar had purchased) at a favorable price. Phansalkar argued, and the lower court agreed, that he should not forfeit these shares since he had engaged in no disloyalty to AW with respect to Millenium Cell.3

On this point the appeals Court reversed and ruled that Phansalkar had to forfeit the Millenium Cell shares as well. In ruling this way, the Court made clear for the first time that an investment opportunity made "available to an employee to reward him for his work" and "any benefit realized" from that opportunity "should be subject to forfeiture."4 The only exception: where there was an agreement that the agent would be paid only a defined amount for completion of a specific task or tasks.5 In such a case, forfeiture by faithless servants could be limited on a transaction-by-transaction basis. But in any other situation - where, for instance, the employee or partner is paid a salary, a partnership share, a manager's cut of a performer's overall income, a legal fee, or any other form of general compensation - forfeiture for disloyal conduct must be total.

Conclusion
Given the breadth of situations where forfeiture can apply (as one court put it: any situation where a defendant falls "below the standard required by the law of one acting as an agent or an employee of another"),6 the Phansalkar ruling creates a powerful new weapon for employers to wield against employees or agents who have acted against their interests. Proof that an employee, agent, talent manager, trustee, attorney, or other fiduciary committed an act of disloyalty or an ethical breach means that he or she must give back not only the illegal profits obtained, but any other compensation earned during the relationship, at least since the misconduct began. A supportable faithless servant claim therefore generates the risk of a devastating trial verdict, and provides an enormous incentive to resolve cases out of court.

If you have any questions about this, or any other litigation matters, please contact Ronald Minkoff at (212) 705 4837 or rminkoff@fkks.com Frankfurt Kurnit Litigation Group.

  1. 344 F.2d 184 (2d Cir. 2003).
  2. Id. at 202. 
  3. Id. at 207. 
  4. Id. at 209. 
  5. Id. at 207.
  6. Lamdin v. Broadway Surface Advertising Corp., 272 N.Y. 133, 138 (1936).