United States: The Faithless Servant Doctrine - Developments In The Law

Upon discovery of dishonest or disloyal behavior by a corporate employee, a number of recurrent legal issues arise. One such issue is whether and to what extent an employee terminated for cause is due fees, commissions, salary, or severance payments claimed to have been "earned" before discovery of the misfeasance. The "faithless servant doctrine" is well established and generally provides that a disloyal employee forfeits his right to compensation for services rendered by him. However, the law in New York continues to develop on the important corollary issue of whether and how to apportion the amount to be forfeited.

The faithless servant doctrine can be traced back at least to the nineteenth century in New York case law. In 1886 the Court of Appeals in the Murray case ruled that "[a]n agent is held to uberrima fides in his dealings with his principal, and if he acts adversely to his employer in any part of the transaction * * * it amounts to such a fraud upon the principal as to forfeit any rights to compensation for services."Murray v. Beard, 102 N.Y. 505, 508, 7 N.E. 553 (1886). This strict rule that a disloyal act results in complete forfeiture was reaffirmed by the Court of Appeals in the 1936 Lamdin case. Lamdin v. Broadway Surface Advertising Corp., 272 N.Y. 133, 5 N.E.2d 66 (1936). See also Wechsler v. Bownor, 285 N.Y. 284, 34 N.E.2d 322 (1941). The Court of Appeals has further ruled in the McConnell case that forfeiture may occur even where the employer was not the victim of the fraud. McConnell v. Commonwealth Pictures Corp., 7 N.Y.2d 465, 199 N.Y.S.2d 483 (1960).

In Murray, a timber broker, upon learning that a large pier was to be constructed in New York, entered into agency agreements with the several timber merchants in New York and Brooklyn such that, if the broker secured a sale for any of the merchants, the broker would receive a commission for each timber pile sold. The pier builder called for bids for the supply of timber piles for the pier and the timber broker submitted bids and took the position that he had effectively "cornered the market," and was due a fee from those of timber merchants who were awarded contracts. "Thus, if plaintiff’s services could have been of advantage to any one [timber merchant] he was under the necessity of being treacherous to one employer or another." Murray, 102 N.Y. at 508, 7 N.E. at 554. The timber broker’s suit for commissions against the timber merchants that were awarded pier contracts was thus dismissed.

In Lamdin, a former director of sales of street car advertising sued his former employer, an advertising agency, for unpaid salary. The employer defended on the ground that the employee had earned "secret profits." During the great depression, advertising agencies began accepting "due bills" or scrip rather than cash from advertisers who lacked funds. The due bills were in turn sold at a discount through "due bill brokers" to the public who could use them as credits at the advertiser’s place of business. The employee had personally profitted from "kickbacks" or "side commissions" paid by the due bill brokers. The Court of Appeals rejected the employee’s claim that such payments were a custom in the advertising business and affirmed the trial court’s dismissal of the lawsuit. Nothing in the decision indicates why the advertising agency did not seek by counterclaim the amount of the kickbacks. However the Court ruled that "not only must the employee or agent account to his principal for secret profits, but he also forfeits his right to compensation for services rendered by him if he proves disloyal." Lamdin, 272 N.Y. at 138, 5.N.E. 2d at 68.

In the McConnell case, a motion picture distributor agreed to pay plaintiff, acting as an agent, a fee of $10,000 upon the agent securing distribution rights for certain films from a third-party film producer. McConnell, 7 N.Y.2d at 468, 199 N.Y.S.2d at 486. The distributor had also agreed to pay the agent a percentage of gross receipts from distribution of the films. The agent obtained the distribution rights and received the $10,000 fee. However, the distributor then discovered that the agent had obtained the distribution rights by bribing a representative of the producer. Id. Treating the case as an extension of the rule prohibiting illegal contracts rather than under the faithless servant doctrine, the Court upheld the distributor’s affirmative defense based upon the bribe as follows: "Consistent with public morality and settled public policy, we hold that a party will be denied recovery even on a contract that is valid on its face, if it appears that he has resorted to grossly immoral and illegal conduct in accompanying its performance." 7 N.Y.2d at 471, 199 N.Y.S.2d at 489. Apparently the distributor did not counterclaim for the $10,000 fee.

Notwithstanding the absolutist language of the Court of Appeals in the Murray and Lamdin cases, a number of courts in recent years have applied New York’s faithless servant doctrine to require forfeiture of only the portion of compensation corresponding to the time period of faithlessness. The First Department has held that an employer is entitled to return of compensation paid to the employee "during the period of disloyalty." Maritime Fish Products, Inc. v. World Wide Fish Products, Inc., 100 A.D.2d 81, 91, 474 N.Y.S.2d 281, 287 (1st Dep’t 1984). Similarly, the Second Department has restated the doctrine as providing that "an employee may forfeit his right to compensation for service rendered by him during such periods of disloyalty." St. James Plaza v. Notey, 95 A.D.2d 804, 806, 463 N.Y.S.2d 523, 526 (1983). The federal courts in the Southern District have followed this reformulation of the strict rule. Trounstine v. Bauer, Pogue & Co., 144 F.2d 379, 383 (2d Cir.), cert. denied, 323 U.S. 777 (1944).

In the 1944 Trounstine case, the Second Circuit went further and allowed apportionment for forfeitures not only on the basis of time periods, but also to the completion of specific tasks. Trounstine v. Bauer, Pogue & Co., 144 F.2d 379, 383 (2d Cir.), cert. denied, 323 U.S. 777 (1944). There, the Court affirmed a district court decision which apportioned a forfeiture of fees so that the dishonest agents lost compensation only for tasks carried out dishonesty. The Court reasoned that "to deprive the defendants of [honesty earned] commissions would be mere punishment because they had violated their duty as to other transactions." Id. The Court distinguished Murray on the ground that there the breaches of duty had tainted all the dealings between the parties. While it is true that the dishonesty at issue in Murray involved all of the transactions between the parties, the general rule stated there does not suggest any such exception.

The Second Circuit revisited the issue in the Musico case. Musico v. Champion Credit Corp., 764 F.2d 102 (2d Cir. 1985). There, defendant, a New York financing company, had been operating plaintiff’s taxicab company pursuant to four agency agreements–one to operate the taxicab business, one to collect the proceeds from the sale of certain stock, one a power of attorney limited to five specific matters, and the last a general power of attorney. The district court found no misconduct with respect to the limited power of attorney or the collection of the stock sale proceeds, but nevertheless held that all compensation under all four contracts was forfeited because defendant had converted lease payments and sales proceeds related to certain taxicab medallions. The Second Circuit held this ruling in error, noting that "no modern New York case specifically and unambiguously rules out apportionment corresponding to completion of specific tasks." Thus, the Second Circuit reversed the bench trial judgment for forfeiture of compensation under all four agency agreements, and remanded for an agreement-by-agreement apportionment.

More recently, however, in Sequa Corp. v. GBJ Corp., the Second Circuit expressed reservations about the Musico ruling’s "somewhat tenuous posture" and refused to go further and adopt a "rule of proportionality" in the context of faithless servant forfeitures. Sequa Corp. v. GBJ Corp., 156 F.3d 136 (2d Cir.1998). In Sequa, a corporate consultant had received certain fees in connection with a series of tax-driven leasing deals. The district court, following a bench trial, found a breach of fiduciary duty through the use of a falsely worded document in only one of the transactions and held that the consultant had forfeited his fees in connection with the tainted deal. The consultant argued on appeal, citing Musico, that the forfeiture (estimated to be $900,000) was "disproportionate" to the harm born by the corporation (approximately $26,000 in misdescribed consultant’s fees). 156 F. 3d at 147. The Second Circuit affirmed the forfeiture, finding no support in New York law for a proportionality analysis.

The Musico ruling was further called into question by Judge Kaplan in the Interpool case involving diversion of corporate assets and opportunity. Interpool v. Patterson, 874 F. Supp. 616 (S.D.N.Y. 1995). The Interpool Court noted that the First Department’s decisions subsequent to Musico do not support the apportionment doctrine. In Interpool, a corporation’s former sales agent argued that he was entitled to retain his commissions on all sales except those that were, in substance, bogus sales to himself, on the theory that a commission arrangement inherently apportions compensation on a transaction by transaction basis. The Court rejected that argument, noting that there was a single employment contract and the Court limited Musico to the rule that, at most, "the agent is entitled to retain compensation only for properly performed tasks for which compensation is specifically apportioned by contract." 874 F. Supp. at 621. Thus, the jury was properly charged that "Interpool is entitled to recover all compensation that you find was paid to a disloyal agent during the period of disloyalty whether that compensation was attributable to improper transactions or to proper transactions." 874 F. Supp. at 620. Similarly, at least one other federal court has refused to apportion compensation for beneficial services performed within a period of disloyalty. Battle Fowler v. Brignoli, 765 F. Supp. 1202 (S.D.N.Y.), aff’d 952 F.2d 393 (2d Cir. 1991).

In recent years, the First Department has returned to a rule closer to the absolutist doctrine of Murray and Lamdin. For example, in the Soam case the First Department rejected a claim of unconscionable penalty in light of "New York’s strict application of the forfeiture doctrine which mandates the forfeiture of all compensation" where an employee has been disloyal. Soam Corp. v. Trane Co., 202 A.D. 2d 162, 163-64, 608 N.Y.S. 2d 177, 178 (1^st Dept. 1994) (emphasis added). In Soam, plaintiff was a sales agent who contracted to sell exclusively Trane HVAC equipment and sued Trane for commissions on certain sales. Trane defended on the ground that, in one instance, the sales agent had promoted a competitor’s product. Thus, as in Murray the case involved a sales agent with an undisclosed and competing principal. The First Department affirmed the dismissal of the sales agent’s complaint and held that "plaintiff’s contention that forfeiture is an ‘unconscionable penalty’ is negated by New York’s strict application of the forfeiture doctrine which mandates the forfeiture of all compensation, whether commissions or salary, where as here, one who owes a duty of fidelity to a principal is faithless in the performance of his services." Similarly, The First Department recently expressed reservations about apportioning forfeiture in the GRG Group, Inc. v. Ravenal case. There, the Court upheld a complete forfeiture of two years’ fees and commissions where there existed "no basis in the record for apportionment." GRG Group, Inc. v. Ravenal, 247 A.D.2d 201, 202, 668 N.Y.S.2d 352, 352 (1st Dep’t 1998)

The First Department’s two decisions reversing different trial courts in the Bon Temps case illustrates the still developing nature of the law in this area. See Bon Temps v. Greenfield, 184 A.D. 2d 280, 584 N.Y.S. 2d 824 (1st Dep’t 1992) ("Bon Temps I"); Bon Temps Agency, Ltd. v. Greenfield, 212 A.D. 2d 427, 622 N.Y.S. 2d 709 (1^st Dep’t 1995) ("Bon Temps II"). See also Schwartz v. Leonard, 138 A.D. 2d 692, 526 N.Y.S. 2d 506 (2d Dep’t 1988). There an employment agency sued an employee who had placed two of the agency’s personnel with a client of the agency, but had the related commissions paid to herself. The plaintiff agency sued to recover the commissions, and the employee counterclaimed to recover unpaid compensation allegedly earned by her for placement of other employees. There was no contention that the services for which the employee counterclaimed to recover commissions were affected by disloyalty. The Appellate Division nevertheless held that the plaintiff agency was entitled to partial summary judgment dismissing the counterclaim (as well as to recover on its claim for the diverted commissions) on the ground that a faithless employee is not entitled to any compensation whatever. Thus, the faithless employee was not entitled to be paid commissions on transactions in which there was no claim of disloyalty.

Upon remand the employer then made a second motion for partial summary judgment on its affirmative claim for reimbursement of all of the previously paid commissions paid to the former employee for work performed during the period from the date she first received a diverted fee and the date she was fired. Bon Temps II, 212 A.D. 2d at 427, 622 N.Y.S. 2d at 710. On appeal a second time, the First Department reversed the trial court’s grant of summary judgment to the employer, finding that questions of fact remained concerning whether the disloyal employee’s placement of the agency’s employees in other positions during her tenure as a placement representative were isolated incidents or part of such "a persistent pattern of disloyalty,"so as to warrant forfeiture of all commissions earned by defendant while working in plaintiff’s name subsequent to the first act of disloyalty. Id.

The Court of Appeals has not applied the faithless servant doctrine since Lamdin which stated a strict rule of forfeiture. The Second Circuit’s Musico decision stands as the "high water mark" of forfeiture apportionment - - allowing an employee to retain certain compensation received during the period of disloyalty. The recent First Department decisions in Soam, BonTemps I, and BonTemps II indicate a trend away from Musico as well as the continuing and unresolved tension in the law of faithless servant forfeitures. Further, the case law differentiates between (i) salaried or fee-based employees who forfeit their entire compensation (St. James Plaza), (ii) employees working on commission who forfeit illegal profits from undisclosed competitors, tainted commissions, and even innocently earned commissions at least where there is a persistent pattern of disloyalty (Interpool, Soam, Bon Temps I and II), and (iii) agents performing services under distinct contracts who forfeit compensation at least under the tainted contracts (Musico). Further, the Bon Temps ruling suggests that the courts may be tougher with a disloyal employee seeking unpaid compensation than with the same employee facing a claim for reimbursement of paid compensation.