Employers in New York State, among them many financial sponsors and their portfolio companies, have an extraordinarily powerful legal weapon at their disposal to wield against employees found to have engaged in disloyal conduct. Under the venerable, but not widely appreciated, “faithless servant” doctrine, a disloyal employee in New York may be required to disgorge compensation during the period of disloyalty.
In its strictest form, the doctrine can lead to the harsh penalty that the employee must disgorge all compensation earned since the date of the first act of disloyalty. Courts applying this strict form of the doctrine have held expressly that any value provided by the employee through loyal service is irrelevant and that the employer need not prove damages, causation or any proportionality between the harm caused by the disloyal conduct and the compensation to be disgorged. Rather, the doctrine works mechanically. The date of the first disloyal act is determined and every cent of compensation earned since that date must be disgorged. So, if an otherwise valuable executive is found to have engaged in an improper self-dealing transaction three years ago, the executive may be required to pay back all compensation earned during the past three years even if the harm caused by the self-dealing transaction was minimal and regardless of whether the executive otherwise provided valuable service during the period.
Some courts have recognized possible limitations on the strictest form of the doctrine. Under one such line of authority, disgorgement is required only if the disloyalty “permeated the employee’s service in its most material and substantial part.” Under this more nuanced approach, there is room for the employee to craft an argument that any disloyalty should be balanced against the value of legitimate services provided by the employee. Another line of authority may support an argument that disgorgement should be apportioned either by pay period or by task. Under this approach, a disloyal employee would be required to disgorge compensation only from pay periods in which misconduct occurred, or, if the employee is paid on a per-task basis, disgorgement would be required only as to those tasks that were performed disloyally.
Notwithstanding the fact that courts have recognized these possible limitations, the strictest form of the doctrine remains viable. As recently as 2013, courts have observed that conflicting standards persist under the case law and have not yet been reconciled. Thus, employers may continue to advocate for, and employees will continue to have exposure to, application of the doctrine in its strictest form.
The doctrine has been asserted across a broad array of job categories, ranging from CEOs, to investment professionals, to low-level employees. The predicate act of “disloyalty” that can trigger application of the doctrine is any conduct that could give rise to a claim for breach of fiduciary duty, including, for example, any improper self-dealing transaction, any taking of unauthorized compensation or perquisites, or any usurpation of corporate opportunities. Employers may assert the doctrine in any of the myriad factual scenarios in which employer-employee conflict arises. For example, an employer may invoke the doctrine when negotiating a separation package; as a counterclaim when an employee has sued or threatened to sue for wrongful termination, breach of contract or some other claim; or when pursuing an employee for having set up a competing business at a time when the employee was still employed and still owed undivided loyalty to the employer.
There may, of course, be circumstances in which an employer would be reluctant to file a public litigation detailing the ways in which an employee has misbehaved. Such a public airing of dirty laundry can have reputational and business consequences for the employer. Concerns about these types of adverse consequences may be less compelling, though, if the employee’s misconduct is already in the public record because the employee is being charged criminally or is the subject of other litigations or investigations. Any such concerns also may be minimized if the employer and the employee have an agreement to resolve any disputes through confidential arbitration rather than in court.
In any event, even if the employer is ultimately unwilling to file a claim against the employee under the “faithless servant” doctrine, the mere threat of doing so – given the draconian nature of the remedy – may provide the employer with substantial leverage to achieve a favorable negotiated outcome.
Situations of this kind are fortunately uncommon, but when they do arise they can be corrosive to an organization, costly and painful to work through. Private equity firms take note. If a “faithless servant” appears in your midst, you may have more recourse than you think.