Although a few states have banned non-competes for years, new and expanding efforts to ban or restrict noncompete agreements by the Federal Trade Commission (FTC) and the federal government are raising concerns about an employer’s ability to protect against the loss or theft of trade secrets.
These agreements are best known for protecting employers from loss of clients or market share when former employees become competitors. However, they have become the subject of much controversy as some argue that they are by their nature anti-competitive.
A lesser-known outcome of banning noncompetes is that it would eliminate a key mechanism for businesses to protect against the potentially devastating loss of their intellectual property and trade secrets, because these “restrictive covenants” almost always include non-disclosure provisions.
Consider the impact of California’s already-existing ban on noncompetes and how that is now playing out for Twitter, which recently sent a cease-and-desist letter to Meta accusing them of trade secret misappropriation. Elon Musk’s acquisition of Twitter included his decision to terminate several members of the firm’s California-based engineering staff.
Subsequently, many of the furloughed Twitter engineering team members were hired by Meta and tasked with developing Meta’s new “Threads” social media messaging platform. Given the state’s noncompete law, none of Twitter’s California-based engineers could have had noncompete agreements in place (although surely there were other contractual obligations) even though they may have migrated to Meta with some of Twitter’s institutional knowledge.
A comprehensive trade secret asset risk management program encompasses proactively identifying specific know-how as trade secrets to prove their existence and ownership; ensuring the use of reasonable measure to keep information secret; giving notice to privileged employees that they are handling company trade secrets; and conducting exit interviews with departing employees, among other measures. Without such a program in place at Twitter departing employees may lack a clear understanding of what is their rightfully earned on-the-job growth versus protected trade secrets.
If Twitter is unable to demonstrate that its former employees willfully violated their trade secret protection policies and procedures, it will have little to no recourse against Meta and ultimately could lose hundreds of millions of dollars in value. Indeed, the inability to enforce a noncompete agreement can fuel the temptation to leverage competitive know-how as employees move to a new organization.
Banning of Noncompetes Gains Momentum
As the Twitter situation continues to unfold, the FTC’s proposed new rule will ban noncompetes full stop, which will have a major impact on employee retention and mobility in many industries. With respect to the protection of critical know-how such as trade secrets, the rule would put further emphasis on the need for contractual protections (non-disclosure agreements separate and apart from noncompetes), physical protections, technology protections, and business processes in general. It prohibits the use of noncompetes in employment agreements at all levels, for all workers and explicitly defines “noncompete” as including de facto noncompete clauses.
Furthermore, it requires employers to notify their workers of the prohibition and to rescind any existing noncompete provisions in effect. Finally, it will supersede state laws on noncompetes.
However, the proposal would allow a company to show it used “reasonable measures” to protect specifically identified know-how as “trade secrets” versus confidential information, such as customer lists and delivery routes.
Meanwhile, a bipartisan bill, the Workforce Mobility Act of 2023, has been reintroduced into the U.S. Senate this session. While its ban on noncompetes resembles that under the FTC proposal, it provides some exemptions in connection with the sale of a business or the dissolution of a partnership. It also provides for an acceptance of Non-Disclosure Agreements (NDAs) or other restrictive covenants specifically with respect to trade secrets.
Identifying and Protecting Trade Secrets
Trade secrets are the unique know-how that provides a company with its competitive advantage. They are among the intangible assets that collectively make up a significant and growing proportion of the overall value of most modern businesses—rising from 60% of total value of the S&P 500 companies 20 years ago to 90% today.
From a risk management perspective, the most significant challenge is that only about 15% of that value is protected by patents, trademarks or copyrights. Furthermore, while some new standalone insurance coverages for trade secrets are emerging in the insurance market, standard commercial property, cyber and crime policies typically do not provide protection for the value of intangible assets. As a result, essentially trillions of dollars of value are currently unprotected.
Along with the erosion of noncompete agreements, heightened cyber and occupational crime activity has made trade secrets more vulnerable and elevated the need for individual businesses to initiate or ramp up measures to protect them. In this environment, risk managers can play a key role in helping their organizations protect the value of their trade secrets.
An effective trade secret risk identification and protection plan typically involves several best practices:
1. Identify Your Organization’s Trade Secrets
For starters, risk managers need to distinguish trade secrets from other intangible assets, such as those typically protected by patents, trademarks and copyrights. Trade secrets also need to be culled from other types of intangible assets, such as personally identifiable data, HR or health information, billing and accounting data, and other “confidential” information that does not in itself provide value to the company.
What are the things that, if stolen, would immediately allow your competition to skip over a lot of “wrong turns” during the R&D process or eat into your market share? What assets could be stolen that you may have to discuss with your investors or board members?
If not already in place for other enterprise risks, this may require forming a multidisciplinary team involving legal, finance/accounting, human resources, information technology, marketing, research and development/engineering, compliance, government relations, and operations.
Trade secrets are the only “unregistered” intellectual property asset, so the details around them are not available to the public. They encompass all forms and types of financial, business, scientific, technical, economic or engineering information. Trade secrets include patterns, plans, compilations, program devices, formulas, designs, prototypes, methods, techniques, processes, procedures, programs or codes that:
- The owner has taken “reasonable measures” to keep secret, and
- The information derives independent economic value, actual or potential, from not being generally known, and not being readily ascertainable through “proper means.”
Specifically, financial algorithms, AI, blockchain, business processes, designs, software code, formulas, unique workflows and industrial processes are examples of intangible assets most likely not patentable (or that should not be patented) and consequently could be categorized as trade secrets.
Risk managers might want to consider the following widely used six-factor “litmus test” to ascertain what is (or is not) a trade secret:
- The company is using “reasonable measures” to guard the secrecy of the information.
- The extent to which the information is known outside the company.
- The extent to which the information is known by employees and others involved in the company.
- The value of the information to the company and competitors.
- The amount of time, effort and money expended by the company in developing the information.
- The ease or difficulty with which the information could be properly acquired or duplicated by others.
2. Assess Your Countermeasures
While the “reasonable measures” mentioned in the first factor may vary depending on the nature of the trade secret, company size and industry, they typically include:
- Use of non-disclosure agreements (NDAs) with any individuals or parties with access
- Noncompete agreements (where permissible by law)
- New hire guidelines and employee termination practices
- Exit interviews and related documentation
- Training
- Making those with access aware of the existence of a trade secret
- Physical access controls and protection/seclusion
- Technology access controls, DLP policies and cybersecurity control
At present, the market is relatively nascent in its use of automation to identify and document trade secret assets with at least one tool now incorporating the six-factor litmus test to streamline this process.
3. Obtain Accurate Trade Secret Valuations
Once you have a thorough understanding of what your company’s trade secrets are, you can proceed to ascertain their value. In addition to helping set priorities for risk management and evaluating potential insurance coverages, valuation can help your firm document its financial position with greater accuracy and precision. This exercise may also be helpful in securing investment or funding opportunities in a difficult economy.
Accordingly, be sure to engage a qualified third party, such as an accounting firm or credentialed specialist provider with knowledge of your industry sector. Because trade secrets are changing constantly as more time and effort is spent on developing them—or they are abandoned altogether—the valuation should ideally be done at least annually. Once an automated system is in place, the valuation can be updated more often.
4. Assess Risk Mitigation Protocols
This involves a thorough understanding of the nature of your trade secrets, how they are maintained, who has access and when. Are they potentially vulnerable to cyberthreats? If so, are appropriate security measures in place and updated on a regular basis?
In addition, the impact of bans on noncompetes is going to require you to examine what measures are sustainable, what needs to be changed, and how.
Even without noncompetes, NDAs are still acceptable provided they are not “de facto” noncompetes. While it remains to be tested, it may imply that NDAs cannot be applied universally but rather with respect to pre-identified trade secret assets and employees with access to that know-how.
Although in California noncompetes have not been legal for years, there has been a great deal of successful enforcement/litigation of non-disclosure rules/requirements pertaining to trade secrets at the state level. However, according to report by global investment bank and advisory firm Stout, plaintiffs (asset owners) in California succeed only 44% of the time when a claim is taken to trial, whereas the average success rate in other states with highly active trade secret litigation is 68%.
5. Insure
Depending on the nature of the trade secret, there may be limited coverage available under a company’s crime, property or cyber insurance policies—although it is not the intent of any of those policies to cover the value of IP assets (the “valuation” clause and the exclusions need to be reviewed carefully). It may be worth exploring the new standalone coverages now available in the marketplace.
These programs can protect your trade secrets by helping to fund investigation and injunctive relief against the misappropriating party, assist in the recovery of the asset, indemnify you for the agreed value of the trade secret, and fund subrogation which becomes litigation for damages.
In addition, as was the case with cyber insurance, simply completing the application process can help your firm confirm the value of its trade secrets and benefit from a more robust assessment its potential vulnerabilities.
6. Litigate for Damages (or Subrogate if Insurance is Involved)
Without insurance, the remedy available for theft or disclosure of a trade secret is limited strictly to a company’s ability to prevail in litigious enforcement of their rights.
There is a significant cost and burden of proof upon the asset owner/litigant, and many do not have proper policies or proof necessary to win. As a result, billions of dollars in IP value leaves U.S. companies each year with little to no recourse for the creator/owner. This also leaves investors and other stakeholders vulnerable to uninsured losses.
Trade secrets may be a company’s most valuable asset. In the past three years alone, several cases involving trade secrets had settlements or jury verdicts exceeding $2 billion. The average cost to litigate a claim all the way to trial is $4.2 million and the average time of that litigation is 2.7 years.