Under New York law, the faithless servant doctrine permits an employer to recover compensation already paid to an employee where:
- the employee's material and substantial misconduct violates the contract of service; or
- the employee has engaged in misconduct that constitutes a breach of the duty of loyalty or good faith.
Two recent decisions – one from the US District Court for the Southern District of New York and one from New York's trial court – highlight the application of the faithless servant doctrine, which can be a powerful weapon in the arsenal of an employer that discovers wrongdoing by a current or former employee.
In Morgan Stanley v Skowron(1) US District Judge Shira A Scheindlin addressed Morgan Stanley's claims for disgorgement of more than $31 million in compensation that it had paid to the defendant, a former senior portfolio manager and managing director. The defendant had previously pled guilty to conspiracy to commit insider trading from April 2007 to November 2010 and to lying to the Securities and Exchange Commission regarding his receipt of material non-public information, and Morgan Stanley sought to recover all compensation paid to him during this period.
The defendant was hired when Morgan Stanley acquired FrontPoint Partners LLC in December 2006. His offer letter and standard sign-on agreement both required compliance with the firm's code of conduct. The code specifically prohibited insider trading and required employees to:
- cooperate fully with investigations (both governmental and internal); and
- inform the firm immediately of any violations of law or Morgan Stanley's policies.
While acknowledging violations of the code, the defendant argued that his misconduct "did not permeate his service in substantial part". Scheindlin soundly rejected that proposition:
"Insider trading is the ultimate abuse of a portfolio manager's position and privileges because it goes to the heart of his 'primary areas of responsibility.' Indeed, '[t]he duty of an employee not to use or divulge confidential knowledge acquired during his employment is implicit in the employer-employee relation, is an absolute, and not a relative duty.' That duty is all the more crucial for a portfolio manager who is 'entrusted to lawfully invest hundreds of millions of dollars and to safeguard the Firm's reputation.' In addition to exposing Morgan Stanley to government investigations and direct financial losses, Skowron's behavior damaged the firm's reputation, a valuable corporate asset."
The defendant also sought to limit the amount of compensation to be disgorged, relying on principles espoused by the Second Circuit in Phansalkar v Andersen Winroth & Co,(2) under which a disloyal employee may be permitted to retain certain compensation derived from transactions that were separate from and untainted by his disloyalty. However, the court ruled that the salary, management fees and incentive fees that the employee had received from Morgan Stanley were not linked to separate transactions and thus were not susceptible to apportionment.
The plaintiff in Trimarco v Data Treasury Corp(3) sought to enforce a series of agreements granting him equity in the defendant, which he had served first as a consultant and later as an employee and its chief operating officer. The plaintiff sought a declaratory judgment enforcing an option to purchase 1.5 million shares of the stock of the defendant, an interest that his expert valued at $60 million. The defendant asserted affirmative defences based on the plaintiff's alleged breach of the covenant of good faith and fair dealing and breach of his fiduciary duties.
The option was fully vested and the plaintiff was not required to remain employed by the defendant to retain that interest – indeed, the termination of his employment would have had no impact on the option. Given that the option was, by its terms, not subject to forfeiture, the plaintiff argued that any breach by him of the covenant of good faith and fair dealing or his fiduciary duties should not adversely affect his rights. The court rejected this argument, finding that "[i]nfidelity is a bar to a claim for enforcement of a contract".
The faithless servant doctrine is a powerful tool that may be used by employers that are the victims of wrongdoing by employees to recover compensation already paid and avoid payment of additional compensation that may otherwise be due. In addition to claims for damages arising out of misconduct by current or former employees, employers are advised to consider claims that they may have under the faithless servant doctrine.
For further information on this topic please contact Kevin B Leblang or Robert N Holtzman at Kramer Levin Naftalis & Frankel LLP by telephone (+1 212 715 9100), fax (+1 212 715 8000) or email (email@example.com or firstname.lastname@example.org). The Kramer Levin Naftalis & Frankel LLP website can be accessed at www.kramerlevin.com.