A tax consultant should not have been found liable for misappropriating trade secrets after he used his ex-employer’s allegedly proprietary “tax arbitrage” strategy in providing services to its former clients, the 1st U.S. Circuit Court of Appeals has ruled.

The Puerto Rico-based plaintiff, TLS Management and Marketing Services, helped mainland U.S. clients profit by availing themselves of Puerto Rico’s lower tax rates through a series of complex transactions between TLS and the client.

“This is a warning to make sure you craft your employment agreements that restrain post-employment activity carefully and with an eye to enforceability.”

— lawyer Samantha C. Halem

After defendant Ricky Rodriguez, a TLS executive, left the company, TLS accused him of misappropriating trade secrets by utilizing the company’s strategy (which TLS referred to as its “U.S. Possession Strategy” or “the Strategy”) to provide tax services to former TLS clients using TLS documents with which the clients provided him. The company also accused him of misappropriating trade secrets by downloading the company’s Capital Preservation Report — or CPR — documents to analyze client tax situations.

A U.S. District Court judge granted summary judgment to TLS, but the 1st Circuit reversed, finding that while client information may not have been available to the public, the plaintiff did not prove it had trade secrets.

“[A]ny trade secrets in the CPR were not identifiable because TLS did not ‘separate the [purported] trade secrets from the other information … known to the trade,’” Judge Timothy B. Dyk wrote for the panel, adding that the U.S. Possession Strategy consisted of public knowledge as well.

The court also reversed the lower court’s bench verdict in TLS’s favor on its claim that Rodriguez violated his nondisclosure agreement, finding that the agreement, which covered essentially any information he obtained through his work with TLS, was overly broad.

The 33-page decision is TLS Management and Marketing Services, LLC v. Rodríguez-Toledo, et al.

‘Correct and consistent’

Defense counsel Lydia M. Ramos Cruz of San Juan, Puerto Rico, called the ruling “correct and consistent” with other state and federal cases protecting the right to earn a livelihood.

“This case represents a major warning to employers that they will not be able to restrict a former employee’s ability to compete just because the employment contract states that everything in the business is unique or secret or confidential or proprietary,” she said.

“This case represents a major warning to employers that they will not be able to restrict a former employee’s ability to compete just because the employment contract states that everything in the business is unique or secret or confidential or proprietary.”

— Lydia M. Ramos Cruz, defense counsel

Ramos added that employers seeking to enforce trade secrets must make sure every element of the cause of action can be proven.

“The starting point is what is the employer’s trade secret?” she said. “If the employer cannot identify or define it, more likely than not that it is because it does not exist.”

San Juan attorney Manuel A. Pietrantoni, who represented the plaintiff, declined to comment.

But Boston attorney Russell Beck said the decision is a big deal for lawyers like himself who handle trade secret and nondisclosure cases.

“Appellate decisions involving trade secrets or nondisclosure agreements are not a frequent occurrence,” Beck said. “And when the 1st Circuit speaks, we all take note.”

More specifically, Beck said the case shows that courts will not reflexively find misappropriation of trade secrets when employees walk out the door with company materials; that plaintiffs must identify trade secrets with specificity before moving forward with discovery; and that the 1st Circuit will take a skeptical view of broad nondisclosure agreements.

Providence employment attorney Matthew H. Parker said the decision should remind employers and their counsel that, when suing to protect trade secrets, they must show they have not only taken steps to keep the information confidential, but that a member of the public or a competitor cannot figure it out simply by doing their homework and reading other publicly available information.

“In this trade secret claim, the plaintiffs lost on appeal despite the fact that while their strategy wasn’t publicly known, it was ascertainable from public information,” Parker said.

Christine K. Bush of Providence added that a plaintiff must be prepared to identify the trade secret, even if it means a “disclosure” during discovery or at trial of the information it is trying to protect.

For defendants, she continued, the decision justifies demanding early, specific disclosure of the exact trade secrets at issue.

Samantha C. Halem of Wellesley, Massachusetts, emphasized the 1st Circuit finding that the nondisclosure agreement in the case was overbroad enough to constitute an unreasonable restraint on trade.

“This is a warning to make sure you craft your employment agreements that restrain post-employment activity carefully and with an eye to enforceability,” Halem said. “Otherwise, you risk being left with worthless documents and legal fees.”

Secret strategy?

In providing tax planning and consulting to clients, TLS claimed it generated two trade secrets.

The first alleged secret was the CPR, a report prepared by the TLS consulting division that provided tax recommendations specific to each client based on statutory and regulatory analysis. The alleged trade secret was the portion of the CPR not specific to the individual client.

The second alleged secret was the U.S. Possession Strategy, which broadly involved a series of sophisticated transactions between TLS and mainland U.S. clients through which the client effectively became subject to Puerto Rico’s 4-percent tax rate on mainland U.S. activities instead of a higher U.S. corporate tax rate.

In 2012, Rodriguez began working for TLS as its managing director, at which time he signed a nondisclosure agreement that barred disclosure of “confidential information,” defined broadly to include, among other things, any information provided him by TLS or its affiliates in connection with delivering TLS services and “any other information that [he] may obtain” while working there.

Rodriguez departed in 2015 and started providing tax services to former TLS clients.

In August 2015, TLS sued him in U.S. District Court, alleging that he misappropriated trade secrets by utilizing the U.S. Possession Strategy with former TLS clients, using TLS documents the clients had provided him.

TLS also accused him of misappropriating the CPR trade secret by downloading copies of particular reports before leaving the company. Meanwhile, the plaintiff alleged that the defendant violated his nondisclosure agreement by using confidential information to help those clients.

U.S. Magistrate Judge Bruce J. McGiveren granted summary judgment to TLS on the misappropriation claims, while ruling in TLS’s favor on the contract claim following a bench trial.

Rodriguez appealed.

No secrets

The 1st Circuit reversed both rulings.

Looking to Puerto Rico’s trade secret law, which defines “trade secret” similarly to the Uniform Trade Secrets Act, the court noted that TLS had to prove its alleged trade secrets were distinct from general knowledge, were not readily ascertainable, had independent value, and were subject to reasonable security measures.

With respect to the alleged CPR trade secret, the court found that TLS had not established that the two CPRs Rodriguez downloaded met that definition.

“The district court held that TLS’s ‘CPR itself qualifie[d] as a trade secret … because the compilation of [TLS employees’] knowledge and skill, applied to client information, provide[d] TLS with a competitive advantage,’” Dyk observed. “However, the district court did not apply the appropriate trade secret definition, and we conclude that, using the correct standard, as a matter of law TLS did not establish that the two CPRs constituted trade secrets.”

Here, Dyk said, “TLS made no showing as to what aspects of the CPRs were public knowledge and which were not” and thus did not establish that the CPRs contained a trade secret.

The U.S. Possession Strategy, like the CPRs, also consisted largely of public knowledge, Dyk noted.

“The general concept of ‘tax arbitrage’ based on Puerto Rico tax exemption laws was hardly secret,” he wrote. “TLS’s own CPR stated that it ‘[wa]s well established in the Internal Revenue Code and case law’ that the combination of the federal and Puerto Rico tax laws allowed ‘a business [to] reduce or eliminate potential double taxation.’”

Accordingly, Dyk said, “TLS failed to show that the Strategy was not readily ascertainable.”

Finally, the 1st Circuit concluded that the nondisclosure agreement was unenforceable.

“The Rodríguez Agreement’s astounding breadth and lack of any meaningful limitation restricted Rodríguez’s freedom to compete,” Dyk said. “The nondisclosure agreement ‘exceed[ed] the real need to protect [TLS] from … competition,’ essentially tied TLS’s clients to its services, and ‘excessively and unjustifiably restrict[ed] … the general public’s freedom of choice.’ … Similar broad agreements have been uniformly held invalid.”