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Employment contracts that have a choice of law of California often times require a review of California Business and Professions Code Section 16600. It is a very employee-friendly statute. It reads that, “Except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.”
Thus, contracts drafted with a California choice of law must be careful so as not to over-extend rights for the employer after termination/expiration of the contract. Additionally, employees confronted with the potential for litigation based on a contract-related cause of action should be aware of certain protections that they have as well as the extent of those protections.
A point of contention that is sometimes litigated is the enforceability fee-sharing arrangements, also at times referred to as fee tails.
What Is A Fee Sharing/Fee Tail Arrangement?
A fee tail boils down to an obligation by an individual to make payments to a former employer based on revenues received after termination/expiration of the employment agreement. An example in the world of Sports Law, which I will use throughout this article, comes from the case of Hendrickson v. Octagon, which was brought in the U.S. District Court for the California Northern District (San Francisco).
The relevant portion of Hendrickson’s employment contract, for the purpose of this conversation, stated as follows:
Following the expiration of this Agreement and provided Employee is no longer employed by the Company, Employee agrees to pay Company the following percentages of all fees, commissions, or other compensation received directly or indirectly by Employee or any person or entity associated with Employee, or to which/whom payments were made at any suggestion or with any influence of Employee or which will inure in any way to the ultimate benefit of Employee, within (15) days of such receipt as follows:
Fees from new contracts, or from extensions, modifications, and/or renewals of contracts existing during the Employment Period, that are executed by “clients” where such new contract, extension, modification or renewal occurs within twelve (12) months following the end of the Employment Period:
- First year following the Employment Period: 50%
- Second year following the Employment Period: 40%
- Third year following the Employment Period: 30%
- Fourth year following the Employment Period: 20%
- Fifth year following the Employment Period: 10%
Clearly, this fee tail/fee sharing type of provision is intended to provide a windfall to the employer that is losing what it believes to be a valuable employee. It is built in to be a protection, but is it enforceable? California courts have weighed in, and the Hendrickson case can be quite enlightening on the subject.
Fee Tails Cannot Be Penalties And Must Not Restrain Trade.
Hendrickson and co-defendant C.J. LaBoy (who had an even more restrictive contract with Octagon) took the position that the fee sharing agreements that included the fee tail provisions violated the aforementioned California Business and Professions Code Section 16600.
Citing other cases, the court noted that Section 16600 “evinces a settled legislative policy” that favors “open competition and employee mobility.” Some of the strongest language of the opinion came in the form of the statement that “California courts take no prisoners when it comes to Section 16600″ (emphasis added).
Yet, the court also highlighted that Section 16600 does not bar all post-employment obligations. A prerequisite to Section 16600 applying in favor of the employee is that the provision(s) must “restrain” trade in the first place. An employer will have an issue enforcing a fee tail provision if it is viewed as a penalty, but such a provision is permissible to the extent that it is deemed to be a recoupment for the cost of training an employee if that employee leaves the employment within a specified period of time.
The Complicated Analysis Of A Fee Tail Provision In Litigation.
The court in Hendrickson highlighted that the reality of fee sharing/fee tail provisions is more complicated than simply coming to a broad conclusion about whether they are always enforceable or always voided. It used Seattle Seahawks quarterback Russell Wilson as an example to explain. It said that players like Wilson are why employers sometimes need fee sharing/fee tail arrangements to cover contracts that may be signed after employees have departed the employer.
Wilson was deemed to be a high-risk, third round draft pick who ended up being in line for a big pay day after the Seahawks beat the Denver Broncos in Super Bowl XLVIII by a score of 43-8. The court believed that, without a fee tail in place, an agent for Wilson could leave his employer and hit the jackpot simply by quitting at the right time.
If a fee tail is a hedge against rent-seeking, then it is fine. If it is a restraint on trade, then it is voidable. Figuring out what category the fee tail provision falls within can be a tricky task. The court in Hendrickson determined that Octagon did not “plainly design” the fee tail provision to prevent Hendrickson and LaBoy from leaving Octagon, but that does not mean that all fee tails are designed in a similar fashion that will rise to the level of being immune from challenge.
When A Fee Tail Is At Additional Risk Of Being Voided.
A fee tail has hope for survival when it is strictly about protecting an employer against the potential for an employee to suddely quit and take all of his clients with him. It is more susceptible to attack when it is joined with a penalty.
For instance, if the fee tail provision is joined with a liquidated damages provision (i.e. the employee is also required to pay back a sum of money that is not connected to the receipt of future commissions), then the employer invites exposure for the fee tail, and all restrictive covenants within the agreement, to potentially be invalidated.
As stated by the court in Hendrickson, “as long as the fee-sharing arrangements do not extend beyond protecting returns from bona fide firm investments, they pass muster under Section 16600.” Certainly, there is a question as to what constitutes a bona fide firm investment and whether anything beyond a percentage on future earnings is appropriate under this type of circumstance.
There Are Additional Limitations On Fee Tail Language.
While there are instances in which an employer will prevail in arguing the legitimacy of a fee tail provision, these provisions tend to have enforceability issues when employers seek to claw monies for business relationships between employees and third parties that were not even in place during the term of employment.
In Hendrickson, the court said that fee tail provisions where an employer sought to earn commissions on clients that Hendrickson did not personally represent while employed did not pass muster under Section 16600. The court stated that, “Agents cannot cut and run with clients they do not have.” Hendrickson’s fee tail only survived scrutiny to the extent that it applied to fees from players that he, himself, represented while at Octagon.
Thus, fee tail language needs to be narrowly drafted to avoid scrutiny, particularly when the choice of law of the contract is California and the California Business and Professions Code Section 16600 applies.